Oliver Hart and Luigi Zingales are pushing a concept they call the "New Corporate Governance," none of which is exactly new and from which I must dissent.
They start with two anecdotes: The 2021 approval of a shareholder proposal at Dupont "requiring the company to disclose how much plastic it releases into the environment each year and to assess the effectiveness of DuPont’s pollution policies." Actually, their description of the proposal is inaccurate in an important way. The proposal does not require such a report, it merely requests such a report. This is important because part of their claim is that we are seeing (and should see even more of ) a shift towards a more shareholder-centric model of corporate governance.
The other anecdote is the 2021 approval of a shareholder proposal at ExxonMobil "requiring the company to describe 'if, and how, ExxonMobil’s lobbying activities … align with the goal of limiting average global warming to well below 2 degrees Celsius…'" Once again, they misdescribe the proposal. In fact, as with Dupont, the actual proposal was a request not a mandate.
Based on these anecdotes, they argue that:
It is hard to explain this behavior using the dominant corporate governance paradigm, according to which shareholders have a single objective: shareholder value maximization (SVM). In the above examples, shareholders seem to be pushing companies to do things that might reduce value. Many scholars have criticized the SVM paradigm, arguing that managers should act in the interest of other stakeholders – workers, consumers, the community – or that companies should have a social purpose over and above making money.
It turns out that lawyers are not the only ones who think data is the plural of anecdotes.
When we look at the data it remains the case that the majority shareholder proposals in the ESG space (i.e., environmental, social, and governance) still fail. According to Gibson Dunn's analysis of the 2021 proxy season, in 2021, environmental proposals averaged 42.% support, while social proposals averaged 30%.
Should Shareholders Vote on Corporate Strategy?
Hart and Zingales contend that these anecdotes tells us that the traditional norm of shareholder value maximization (SVM) is neither what shareholders prefer nor socially optimal.
In a classical world of perfect competition, complete markets, and no externalities, SVM will be unanimously favored by shareholders and will lead to a socially efficient outcome. These results still hold in the case of externalities as long as these externalities are perfectly regulated by the government. But what happens if the government has not regulated optimally, a particular concern when an externality is global, as with climate change, and coordination by many governments is required for optimal mitigation? There is then no reason to think that SVM will be unanimously favored by shareholders or be socially efficient. Consider the above DuPont example. Some shareholders may favor a less-polluting technology, even if it is more costly, because plastic waste affects them directly or they care about the effect of the waste on others. Other shareholders may not be personally affected or may care less about the welfare of others and so would like to stick to the current technology.
Hart and Zingales therefore want "to allow shareholders to vote on company strategy."
I could not disagree more.
No serious scholar of corporate law denies that shareholders have heterogenous preferences. In fact, however, it is precisely for that reason that SVM is the preferable decision-making norm and that corporate governance is board- rather than shareholder-centric.
In my book, The New Corporate Governance in Theory and Practice, I explain that claim at considerable length. But a short version of why shareholder heterogeneity leads to board-centric governance is available in an older post here.
As my colleague Iman Anabtawi observed: “On close analysis, shareholder interests look highly fragmented.” Iman Anabtawi, Some Skepticism About Increasing Shareholder Power 4 (unpublished manuscript on file with author). She documents divergences among investors along multiple fault lines: short-term versus long-term, diversified versus undiversified, inside versus outside, social versus economic, and hedged versus unhedged. Shareholder investment time horizons are likely to vary from short-term speculation to long-term buy-and-hold strategies, for example, which in turn is likely to result in disagreements about corporate strategy. Even more prosaically, 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.
Consequently, as I explain in The Case for Limited Shareholder Voting Rights, it is hardly surprising that the modern public corporation’s decision-making structure precisely fits Kenneth Arrow’s model of an authority-based decision-making system. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly, of course. Even if one could do so, moreover, shareholders lack both the information and the incentives necessary to make sound decisions on either operational or policy questions. Under these conditions, 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.” Accordingly, shareholders will prefer to irrevocably delegate decision-making authority to some smaller group.
What is that group? The Delaware code, like the corporate law of virtually every other state, gives us a clear answer: the corporation’s “business and affairs ... shall be managed by or under the direction of the board of directors.” Hence, as an early New York decision put it, the board’s powers are “original and undelegated.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).
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: “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. For the reasons identified above, 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 Government is the Problem, Corporations are not the Solution
Note, by the way, that Hart and Zingales' argument depends on a multinational failure of governments to regulate optimally. This is actually a very old argument.
Back in the 1930s E. Professor Merrick Dodd’s pro-corporate social responsibility argument rested in large part of the belief that society demanded that business assume social responsibilities. Forty years later, liberals were still arguing that society was plagued by a host of urgent social ills and that, there being no time to wait for the political process to solve them, business should take the lead. They believed that business could effect social change faster and more effectively than politics.
Setting aside the inconsistency of this argument with democratic principles, does it make sense to draft the corporation to tackle social ills the government can’t or won’t solve?
A core problem thus is that most directors and officers likely lack the skill set necessary to make decisions about ESG issues. If asked to resolve the more complex and difficult questions required by stakeholder capitalism, managers therefore would need to acquire much new information and expertise. As long as they lack such information and skills, asking managers to focus on such questions will inevitably distract them from ensuring that their company makes money for the shareholders.
Even if managers had the requisite knowledge and skills, they probably have a very weak idea of what shareholders would prefer with respect to social issues. Of course, some large shareholders can communicate their preferences to management. Larry Fink’s annual letters to the CEOs of BlackRock’s portfolio companies are but the best known example of this phenomenon. Yet, as we’ll see below, those shareholders often act in ways that are inconsistent with the messages they are sending. Should management pay attention to what these investors say or what they do? In addition, it is hardly clear that Larry Fink’s preferences are representative of that of investors as a class, especially that of small retail investors.
Finally, corporate executives lack incentives to solve social ills especially insofar as those ills fall outside their enterprise’s business. Put another way, while business may have incentives to deal with the negative externalities produced by the enterprise’s activities, they lack incentives to generate positive externalities that bestow benefits on society without generating a return for their shareholders. To the contrary, managers’ incentives are aligned more closely with the shareholders’ interest in value maximization than with ESG concerns.
