In a comment on an earlier post on shareholder activism, reader Pithlord asks:
If I understand your position, it is that executives should focus solely on shareholder interests, but shareholders should not have any power to make them do so. What, then, will be their incentive? The law won't work except in cases of outright fraud. Compensation will create its own conflicts between how executives get paid and long-term shareholder value. What's left? Conscience?
A fair question, deserving a fair answer.
In the first instance, corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents.
In the second, agency costs are the inescapable result of placing ultimate decision-making authority in the hands of someone other than the residual claimant. Neither the power to wield discretionary authority nor the necessity to ensure that power is used responsibly can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, however, they also are antithetical. Because the power to hold to account differs only in degree and not in kind from the power to decide, one cannot have more of one without also having less of the other.
As Nobel laureate economist Kenneth Arrow explained:
[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem.
Hence, directors cannot be held accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.
The central argument against shareholder activism thus becomes apparent. Active investor involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non- reviewable decision-making authority in the board of directors.
The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decision-making structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge. Again, I quote Arrow: ?Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.?
While some argue that shareholder activism ?differs, at least in form, from completely shifting authority from managers to? investors, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel.
As noted, giving investors this power of review differs little from giving them the power to make management decisions in the first place. Even though investors probably would not micromanage portfolio corporations, vesting them with the power to review board decisions inevitably shifts some portion of the board?s authority to them. This remains true even if only major decisions of A are reviewed by B. The board directors of General Motors, after all, no more micromanages GM than would a coalition of activist institutional investors, but it is still in charge.
If the foregoing analysis has explanatory power, it might fairly be asked, why do we observe any restrictions on the powers of the board of directors or any prospect for them to be ousted by shareholders via a takeover or proxy contest? Put another way, why do we observe any right for shareholders to vote?
In the purest form of an authority-based decision-making structure, all decisions would be made by a single, central body?here, the board of directors. If authority were corporate law?s sole value, shareholders thus in fact likely would have no voice in corporate decision making.
Authority is not corporate law?s only value, because we need some mechanism for ensuring director accountability with respect to those rights for which shareholders and other constituencies have contracted. My direct or primacy theory views the corporation as a vehicle by which directors bargain with factors of production. All corporate constituencies thus end up with certain bargained-for contractual rights, including the shareholders.
Chief among the shareholders? contractual rights is one requiring the directors to use shareholder wealth maximization as their principal decision-making norm. Like many intra-corporate contracts, however, the shareholder wealth maximization norm does not lend itself to judicial enforcement except in especially provocative situations. Instead, it is enforced indirectly through a complex and varied set of extrajudicial accountability mechanisms, of which shareholder voting is just one.
Importantly, however, like all accountability mechanisms, shareholder voting must be constrained in order to preserve the value of authority. As Arrow observes:
To maintain the value of authority, it would appear that [accountability] must be intermittent. This could be periodic; it could take the form of what is termed ?management by exception,? in which authority and its decisions are reviewed only when performance is sufficiently degraded from expectations. . . .
Accordingly, shareholder voting is properly understood not as an integral aspect of the corporate decision-making structure, but rather as an accountability device of last resort to be used sparingly, at best.
Indeed, as Robert Clark observes, the proper way in which shareholder voting rights are used to hold corporate directors and officers accountable is not through the exercise of individual voting decisions but rather collectively in the context of a takeover. Because shares are freely transferable, a bidder who believes the firm is being run poorly can profit by offering to buy a controlling block of stock at a premium over market and subsequently displacing the incumbent managers, which presumably will result in an increase in firm value exceeding the premium the bidder paid for control.
Hence, just as one might predict based on Arrow?s analysis, shareholder voting properly comes into play as an accountability only ?when [management] performance is sufficiently degraded from expectations? to make a takeover fight worth waging.
In sum, given the significant virtues of discretion, one ought not lightly interfere with management or the board?s decision-making authority in the name of accountability. Indeed, the claim should be put even more strongly: Preservation of managerial discretion should always be default presumption. Because the separation of ownership and control mandated by U.S. corporate law has precisely that effect, by constraining shareholders both from reviewing most board decisions and from substituting their judgment for that of the board, that separation has a strong efficiency justification.
