Economist is back boosting shareholder activism. The latest Bartleby column argues that:
Arthur Balfour was a British prime minister who did not think much of his party members. “I’d rather take advice from my valet than from the Conservative party conference,” he said. Corporate Corporate executives, particularly in America, seem to take a similar attitude towards their shareholders, believing that, like children, they should be seen but definitely not heard. ...
This disdain for shareholder views contradicts the ethos of American capitalism.
Wrong. In my article, The Case for Limited Shareholder Voting Rights. UCLA Law Review, Vol. 53, pp. 601-636, 2006;available at SSRN: https://ssrn.com/abstract=887789, I explain that the separation of ownership and control is not a bug but a core feature of American corporate law. Indeed, one might call it the genius of American corporate law.
All organizations must have some mechanism for aggregating the preferences of the organization’s constituencies and converting them into collective decisions. As Kenneth Arrow explained in work that provided the foundation on which the director primacy model was constructed, such mechanisms fall out on a spectrum between “consensus” and “authority.”[1]Consensus-based structures are designed to allow all of a firm’s stakeholders to participate in decision making. Authority-based decision-making structures are characterized by the existence of a central decision maker to whom all firm employees ultimately report and which is empowered to make decisions unilaterally without approval of other firm constituencies. Such structures are best suited for firms whose constituencies face information asymmetries and have differing interests. It is because the corporation demonstrably satisfies those conditions that vesting the power of fiat in a central decision maker—i.e., the board of directors—is the essential characteristic of its governance.
Shareholders have widely divergent interests and distinctly different access to information. To be sure, most shareholders invest in a corporation expecting financial gains, but once uncertainty is introduced shareholder opinions on which course will maximize share value are likely to vary widely. In addition, shareholder investment time horizons vary from short-term speculation to long-term buy-and-hold strategies, which in turn is likely to result in disagreements about corporate strategy. Likewise, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects.
As to Arrow’s information condition, shareholders lack incentives to gather the information necessary to actively participate in decision making. A rational shareholder will expend the effort necessary to make informed decisions only if the expected benefits outweigh the costs of doing so. Given the length and complexity of corporate disclosure documents, the opportunity cost entailed in making informed decisions is both high and apparent. In contrast, the expected benefits of becoming informed are quite low, as most shareholders’ holdings are too small to have significant effect on the vote’s outcome. Accordingly, corporate shareholders are rationally apathetic.
In sum, it would be surprising if the modern public corporation’s governance arrangements attempted to make use of consensus-based decision making anywhere except perhaps within the central decision-making body at the apex of a branching hierarchy. Given the collective action problems inherent with such a large number of potential decision makers, the differing interests of shareholders, and their varying levels of knowledge about the firm, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.”[2]Shareholders therefore will prefer to irrevocably delegate decision-making authority to some smaller group. As we have seen, that group is the board of directors.
Strong limits on shareholder control are essential if that optimal allocation of decision-making authority is to be protected. Any meaningful degree of shareholder control necessarily requires that shareholders review management decisions, step in when management performance falters, and effect a change in policy or personnel. Giving shareholders this power of review differs little from giving them the power to make management decisions in the first place. Even though shareholders 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. As Arrow explained:
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.[3]
This remains true even if only major decisions of A are reviewed by B. The separation of ownership and control mandated by U.S. corporate law effects thus has a strong efficiency justification.
Part of Bartleby's problem seems to be a fundamental misunderstanding of the nature of the corporation. The column posits that:
Imagine if you appointed a letting agent to look after your house and they decided to spend lots of your money on gold taps and chandeliers. When you complain, they respond that you are only entitled to sell the house or to fire them at the end of their contract.
But owning stock is nothing like owning a house. The analogy is thus spurious.
Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.
Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.
As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.
Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. For example, shareholders have no right to use or possess corporate property. Cf. W. Clay Jackson Enterprises, Inc. v. Greyhound Leasing and Financial Corp., 463 F. Supp. 666, 670 (D. P.R. 1979) (stating that ?even a sole shareholder has no independent right which is violated by trespass upon or conversion of the corporation?s property?). Management rights, of course, are assigned by statute solely to the board of directors and those officers to whom the board properly delegates such authority. Indeed, to the extent that possessory and control rights are the indicia of a property right, the board is a better candidate for identification as the corporation?s owner than are the shareholders. As an early New York opinion put it, ?the directors in the performance of their duty possess [the corporation?s property], and act in every way as if they owned it.? Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).
