The Case for Limited Shareholder Rights

8/6/2019 The Case for Limited Shareholder Rights

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The Case for Limited ShareholderRights

by Stephen M.Bainbridge

UCLA School of Law

Presentation contributors:

Laura Montenovo

Elisabetta Favretto

Corina Greab

Gabriel Pressman


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Introduction

why, in the author's

opinion, the corporatestructure should remainthis way

In this article, Stephen M. Baimbrage discussesthree main points:

why shareholders are the only constituency in acorporation to be granted voting rights

why those rights are limited


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Introduction

Three types of firms in regards toshareholder power:

Closely held corporation

small number of shareholders

ready access to information about the business

homogeneous preferences

voting = managerial power

no specialized managers

the firm lacks separation of ownership and control


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Introduction

Publicly held corporations with controllingshareholders

partial separation of ownership and control shareholders have substantial access to firm

information and retain incentives to cast informedvotes

although there are likely professional managers, theycould be voted out of office by the controllingshareholder at any time

voting has managerial and oversight functions


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Introduction

Publicly held corporation

numerous shareholders with diverse preferences

shareholders don't have the knowledge or theincentives necessary to exercise an informed vote

complete separation of ownership and control

This is the type of corporation that we will bediscussing


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Introduction

Despite the separation of ownership and control inthese companies, shareholder voting is still an integralcomponent of corporate governance

there are many recent efforts to extend the shareholder

franchise corporate compensation plans that must be approved by

shareholders

permitting shareholders to nominate directors and havetheir nominees listed in the company's proxy statement

amending the Model Business Plurality Act to require amajority vote instead of the current plurality to electdirectors


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Introduction

the author believes these efforts are fundamentallymisguided

record of success in U.S. corporate governance has occurrednot in spite of the separation of ownership and control, but

because of that separation.

shareholder voting has very little to do with corporatedecision-making

the separation of ownership and control is inherent in the

basic structure of the law of corporate governance

according to Delaware General Corporation Law, acorporations business and affairs are managed by or underthe direction of a board of directors


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Introduction

shareholders have virtually no right to initiate corporateaction and are entitled to approve or disapprove only a fewboard actions

the board acts, and shareholders, at most, react

So... why do only shareholders get the vote?

why are shareholder voting rights so limited?


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1. Why shareholders and only shareholders?

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Why only shareholders get the vote? What about the other corporate

constituencies?

Traditional answer: shareholders own the corporation but this isERRONOUS

Indeedthey own the residual claim on the corporation's assets and earnings butthis is different from the ownership of the corporation itself.

CORPORATION = it is a legal fiction where someone owns each input,but no one owns the totality can't be owned.

Ownership is not a meaningful concept in contractarian theory.

This statement implies the elimination of the obvious answer to our startingquestion.


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BETTER ASNWER by Kenneth Arrows analysis of the two basic ways inwhich organizations make decisions: consensus and authority.

Consensus requires that each member of the organization have identical

information and interests, otherwise authority-based decisionmakingstructures arise.

ASSUME an employee-owned corporation with a lot of employee-shareholders.

Could such a firm use some form of consensus-based decisionmaking?

NO

IN FACT our hypothetical employee-shareholders necessarily will have

different degrees of access to information because the number ofcommunication channels within the firm will be great.

The expected benefits of becoming informed are quite low, as anindividual decisionmakers vote will not have a significant effect on thevotes outcome.

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Under such conditions, Arrows model predicts that the corporation willtend towardauthority-based decisionmaking.

SUPPOSE we are talking about the same corporation as before.

Is it reasonable to expect that the similarity of interest required forconsensus-based decisionmaking will exist? SURELY NOT.

Divergent interests raise the cost of using consensus-baseddecision making structures in employee-owned firms.

Both the existence of such divergent interests within the employeegroup and the resulting costs are confirmed by the empirical

evidence.

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Multiple constituencies in apublic firm: introduction

Previous section: corporations with many

thousands of employees and shareholderscannot rely on consensus based decisionmaking. Authority decision making is

needed,for example trought a Board

This section: in a publicly held firm

shareholders are in the best position toparticipate in Board decision-making

- US vs German co-determination model


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Multiple constituencies in apublic firm: problems

interests diverge between shareholders and employeerepresentatives, as well as managers

- sensitive information witheld from the Board

- real work takes place in to Committee level instead of the Board - when employee representatives on the Board belong

to strong trade unions the interests divergence betweenshareholders and managers will not resolve.

self-interest of management and employees may align againstinterests of the shareholders, resulting in lax management

proven by empirical evidence from German co-determinationmodel


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Why only shareholders on theBoard rather than employees?

Reasons: Board consensus is easier to achieve ifdirectors follow only the shareholders

There are 2 reasons:

- allocation of votes easier for financialcapital than human capital

- employees care most about wages andworking conditions, instead shareholders careabout profits and will consequently electdirectors that are committed to maximising

profits


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Limits on Shareholder Control

Why Not Shareholder Democracy?

separation of ownership and controlcharacteristic of public corporations is enforced

both directly and indirectly

Directly: Under the Delaware Code, shareholder voting rights are

limited to:

the election of directors

approval of charter or bylaw amendments mergers

sales of substantially all of the corporations assets

voluntary dissolution

of these, only the election of directors and amending thebylaws do not require board approval


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The Limits on Shareholder Control

Indirect

rules that indirectly prevent shareholders fromexercising significant influence

disclosure requirements pertaining to large holders shareholder voting and communication rules

insider trading and short swing profits rules

these rules discourage the formation of large stock

blocks and discourage communication andcoordination among shareholders


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The Limits on Shareholder Control

Wall Street Rule - itseasier to switch than fight

(a play on an old cigaretteadvertisement)

The Wall Street Rule

Many investors, especially institutional investors,rationally prefer liquidity to activism

these investors are less likely to become involved incorporate decision-making


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B. The Survival Value of the Separation ofOwnership and Control

Berle & MeanssThe Modern Corp. and PrivateProperty:

Separation of Ownership and Control in Public Corp.:

The firms nominal owners (shareholders) had no controlover daily operations or long-term policies;

Control was in the hands of professional managers(owning a small portion of the shares);

Cause of separation:

Dispersion of stock ownership among many shareholders;

Shareholders didnt own enough shares to materially affectthe corporations management;

=> In Berle & Meanss opinion, the separation was adeparture from the historical norms and a serious economic

problem.


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Berle & Meanss version of economic history:

Dispersion of ownership as a consequence of thedevelopment of large capital-intensive industrial corp.

(19th Cent);

Required investments far larger than asingle entrepreneur/family could provide.

=> Need for funds from many small/medium investors

But: Small investors needed diversification:

Fragmented share ownership;

Separation of ownership and control;

A di t B l & M ti b h d th


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According to Berle & Means, corporations once behaved as theywere supposed to - that is, shareholders:

Owned the corporation and controlled it;

Elected the board of directors, that had delegated management power; Retained residual control, uniting control and ownership.

But, when the state curtailed regulation:

Corporations expanded and became a huge concentrate of resources; It was run by managers accountable only to themselves, not to shareholders

and society;

Erosion doctrine.

Prof. Werner, instead, argues that the economic separation of ownership andcontrol was already a feature of the American corporation at the beginning of the19th Century, since banks and other public-issue corp. had a tripartitegovernment structure, a share market that dispersed shareholdings and dividedownership and control, and tended to centralize management in full-timeadministration and to diminish participation of outside directors on management.


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Short:

Berle & Meanss account rested only on technological changes inthe 19th Century;

Prof. Werners account rests on the early development of thesecondary trading markets: secondary trading markets already existed;

investments were attractive because of the resulting liquidity of corporate stock;

selling stock to the public became also an attractive mechanism;

stocks were purchased by a diversified and dispersed clientele (institutions andindividuals);

a national taste for speculation was developing;

early growth of the secondary trading markets & dispersion of

stock ownership;So:

separation of ownership and control is an essential economiccharacteristic of corporations, that took place at the verybeginning.

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Alchian & Demsetz argue that:

the firm has no power of fiat (that is, authoritative command or order to

do something), no authority, no disciplinary action any different in theslightest degree from the ordinary market contracting between individuals.

Instead, power exists within firms and the firm is not a quasi-market areawithin which a set of contracts between various factors of production are

constantly renegotiated.

Fiat is the chief characteristic distinguishing firms from markets.

R. Coase argues that: firms emerge when it is efficient to substituteentrepreneurial fiat for the price mechanisms of the market.

Fiat is essential in public corporations.


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Recall:

all organizations must have a mechanism for aggregating the preferences of theorganizations constituencies;

the mechanism must convert these preferences into collective decisions;

they are between consensusand authority.

Authority-based decision making (based on a central office empowered to

make decisions binding on the firm as a whole) arise when theconstituencies have different interest and access to information.

There is a need of literal nexus center of power capable of exercising fiat where there is information and interest asymmetry between the

corporations constituencies.

Separating ownership and control by vesting decision making authority in acentralized nexus distinct from the shareholders and all other constituents iswhat makes the large public corporation feasible.


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A

B

In order for the corporation to function:

Directors and managers specialize in effective coordination of otherspecialists

The other corporation constituents should specialize in functionsunrelated to decision making:

Risk-bearing that is, shareholders;

Labor that is, employees etc.;

So, these other corporation constituents must delegate decisionmaking to the board and to senior management.

Even though shareholder interests are less fragmented than those of thecorporations multiple constituencies, they very much vary: short-term vs.long-term; diversified vs. undiversified; inside vs. outside; social vs. economic,and hedged vs. unhedged.


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So:

Shareholders lack incentives to gather the information necessary toactively participate in decision making

A rationale shareholder will expend the effort necessary to make

informed decisions only if the expected benefits of doing so outweighits costs.

Its so much easier to switch to a new investment than to fightincumbent management when the capital market is an efficient and

reliable indicator of performance (recall Wall St. Rule). The modern public corporations decision making structure fits a

model of an authority-based decision making system, since:

Involving shareholders would be difficult and costly;

They lack both the information and the incentive to make sound decisions; Shareholders prefer to irrevocably delegate decision making authority to

some smaller group(in the long run, this will max.shareholders wealth).

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a smaller group:

Delaware Code def.: Corporations business and affairs shall be managed by

or under the direction of a board of directors; its powers are original andundelegated.

Principal-Agent Problem: associated with the shareholders purchaseof the residual claim on the corporations assets and profits is an

obbligation on the part of the board of directors and managers tomaximize shareholders wealth.

Role of Corporate Law: provide the mechanisms for constrainingagency costs, considering that:

i. Accountability mechanisms can, to some degree, substitute formonitoring by residual claimants;

ii. Agency costs are the result of placing ultimate decision makingauthority in the hands of someone other than the residual claimant.

The central governance issue is establishing the right mix of discretion

and accountability.


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f


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We observe voting rights for shareholders because:

There is a need for a mechanism to ensure director accountabilityw.r.t. the rights for which shareholders have contracted (especiallythe one requiring the director to use shareholder wealth

maximization as principal decision making norm).

This is because director primacy views the corporation as a means by whichdirectors bargain with factors of production.

Shareholdersmainright is enforced directly through a complex and varied set ofextrajudicial accountability mechanisms of which shareholder voting is just one.

Nevertheless, shareholder voting rights must be constrained in order topreserve the value of authority:

Shareholder voting comes into play properly as an accountabilitymechanism only when management performance is sufficientlydegradated from expectations to make a takeover fight worth waging.


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1990s: some ACADEMICS argued that shareholder activism could

become an important constraint on agency costs within the firm

and they focused their attention on

Institutional investors because they may approach corporate governancequite differentlythan dispersed individual investors.

INDEED: corporations with large blocks of stock held by institutionalinvestors might reunite ownership of the residual claim and ultimate

control of the enterprise.

IT FOLLOWS THAT: concentrated ownership in the hands of institutionalinvestors might lead to a reduction in shirking and, hence, a reduction inagency costs.

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C. The rise of institutional investors


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In the early 1990s, it seemed possible that this theory would berealized.

But while there seemed little doubt that institutional investor activismwould have some effect, the question remained whether the impact

would be more than merely marginal.

By the end of the 1990s,empirical studies found no strongevidence of a correlation between firm performance andpercentage of shares owned by institutions.


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TODAY, institutional investor activism remains rare becausemostof the times costs (ex.monitoring, coordinating, communicating) exceed

benefit, and if gains occur they are likely to accrue the activistinstitution.

Many institutional investors willprefer liquidity to activism, becausethey tend to be more interested inshort-term gains.

This is an example of FREE-RIDING :given that activism will only rarelyproduce gains, cost-conscious money managers will remain passive inhopes of free riding on someone elses activism.

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The Case for Limited Shareholder Rights