The case against shareholder empowerment.

• Author: Bratton, William W.

Many look toward enactment of the law-reform agenda held out by proponents of shareholder empowerment as a part of the regulatory response to the current financial crisis. This Article argues that the financial crisis exposes major weaknesses in the shareholder empowerment case. Our claim is that shareholder empowerment delivers management a simple and emphatic marching order: manage to maximize the market price of the stock. This is exactly what the managers of a critical set of financial firms did in recent years. They managed to a market that focused on increasing observable earnings, and, as it turned out, they failed to factor in concomitant increases in risk that went largely unobserved. The fact that management bears primary responsibility for the disastrous results does not suffice to effect a policy connection between increased shareholder power and sound regulatory reform. A policy connection instead turns on a counter factual question: whether increased shareholder power would have imported more effective risk management in advance of the crisis. We conclude that no plausible grounds exist for making such a case. In the years preceding the financial crisis, shareholders validated the strategies of the very financial firms that pursued high-leverage, high-return, and high-risk strategies and penalized those that did not. It is hard to see how shareholders, having played a role in fomenting the crisis, have a positive role to play in its resolution.

The prevailing legal model of the corporation strikes a better balance between the powers of directors and shareholders than does the shareholder-centered alternative. Shareholder proponents see management agency costs as a constant in history and shareholder empowerment as the only tool available to reduce them. This Article counters this picture, making reference to agency theory and recent history to describe a dynamic process of agency-cost reduction. It goes on to show that shareholder empowerment would occasion significant agency costs of its own by forcing management to a market price set under asymmetric information in most cases and set in speculative markets in which heterogeneous expectations obscure the price's informational content in others.

INTRODUCTION I. FRAMING THE ISSUES: THE PREVAILING LEGAL MODEL, SHAREHOLDER EMPOWERMENT, AND AGENCY COSTS A. The Economic Stakes: Trade-Off Versus Win-Win 1. The Trade-Off 2. The Win-Win B. The Law-Reform Agenda C. Summary II. SYSTEMIC RESPONSIVENESS A. Corporate Governance and the Market for Corporate Control B. New Blockholders C. Cash Payouts D. Summary III. SHAREHOLDER EMPOWERMENT AND ECONOMIC THEORY A. Pricing Efficiency and the Case for Shareholder Empowerment 1. ECMH, CAPM, and the Value of a Share 2. Implications for the Case for Shareholder Empowerment B. The Information Asymmetry Problem 1. Persistence 2. Evidence and Effects 3. Idiosyncratic Volatility C. Heterogeneous Expectations 1. The Models 2. Implications for Business Policy and Corporate Governance a. Implications for Shareholder Voting b. Implications for Business and Investment Strategy c. Implications for the Legal Model of the Corporation d. Controlling Shareholders Compared e. Implications for Management Compensation D. Summary IV. SHAREHOLDERS, MANAGERS, MARKETS, AND THE FINANCIAL CRISIS OF 2008 A. Financial Risk and Shareholder Inputs B. The Changing Policy Context CONCLUSION INTRODUCTION

In 2006, shareholder empowerment figured prominently in a well-publicized law-reform agenda presented by the Committee on Capital Markets Regulation, a private group concerned about the competitiveness of U.S. capital markets. The Committee's report connected shareholder power to market control, reasoning that enhanced shareholder rights provide accountability and that accountability means lower agency costs, higher market prices, and, accordingly, a more competitive equity marketplace. (1) In addition, the Committee argued that strong shareholder rights invite more dependence on market discipline of managers and "go hand in hand with reduced regulation or litigation." (2) Restating, "accountability" means market control, which means lower agency costs. The Committee thereby weighed in on corporate law's leading structural question: who should decide how best to maximize long-term value for the shareholders' benefit--the managers or the shareholders themselves? (3) The question holds out a choice between a shareholder-driven, agency model of the corporation, guided by informational signals from the financial markets, and the prevailing legal model, which vests business decisionmaking in managers who possess an informational advantage regarding business conditions. The shareholder side contends that the prevailing model fails to provide a platform conducive to aggressive entrepreneurship and instead invites management self-dealing and conservative decisionmaking biased toward institutional stability. It looks to a shareholder community populated with actors in financial markets for corrective inputs. Unlike the managers, who are conflicted and risk averse, the shareholders come to the table with a pure financial incentive to maximize value. It is a high-stakes debate. For the Committee on Capital Markets Regulation, along with many other proponents of shareholder empowerment, the nation's global competitive fitness hangs in the balance.

Even so, shareholder proponents have shifted their emphasis in the wake of the financial crisis of 2008. (4) Although "accountability" remains the ultimate goal, we hear fewer references to market control as the means to that end, presumably because it resonates equivocally in light of recent market failures. Proponents instead hold out the need to restore "trust." (5) We illustrate this approach with the comments of former Securities and Exchange Commission (SEC) Chairman Arthur Levitt on the meltdown in the financial sector, (6) which was still in its early phase when he wrote in the summer of 2008. For Levitt, the subprime collapse, the Bear Stearns implosion, and revelations of poor risk management at large financial firms had "injected a dangerously large degree of mistrust into the markets." (7) He believes that managers and boards should have raised the alarm, and that enhanced shareholder voice, "[w]hile not a panacea, ... would go a long way in helping to restore trust." (8)

The trust characterization resonates because it focuses on management culpability, and the managers who now have (or recently have had) to rely on government largesse do bear primary responsibility for the decisions that precipitated the financial crisis. Executive pay has become a flashpoint political issue as a result of the culpability designation, and the resulting popular picture is not pretty. (9) Managers of financial companies appear as quick-buck artists who used their compensation schemes to siphon millions of dollars from companies on the brink of collapse. (10) Their shareholders, as the primary bearers of losses incurred, emerge as victims along with the taxpayers. (11)

Blame for managers means sudden political traction for a longstanding law-reform agenda put forward by proponents of shareholder empowerment. We have already seen "say on pay" mandates imposed on TARP recipients, along with substantive constraints on modes and amounts of compensation. (12) Broad "say on pay" mandates appear in prominent proposed legislation (13) and in the Administration's reform agenda. (14) There is also a high-profile SEC proposal to amend the proxy rules to require inclusion of shareholder board nominees in management proxy statements. (15)

While this reaction is perfectly understandable, it remains highly questionable as a policy matter. This Article states the contrary case, showing that the financial crisis, far from concluding the matter in the shareholders' favor, bolsters the case for the prevailing legal model. A shareholder-based agency model of the corporation sends management a simple instruction: in all circumstances, manage to maximize the market price of the stock. And that is exactly what managers of some critical financial firms did in recent years. They managed to a market that focused on their ability to increase observable earnings and, as it turned out, failed to factor in concomitant increases in risk that went largely unobserved.

Risk taking is at the heart of the capitalist system, but so is the incentive-compatible rule that the risk takers internalize not only the expected higher returns but also the expected higher systematic risk. For the financial institutions judged too big to fail, and apparently for others as well, risk internalization has not proven to be the case. The economic rescue's net costs amount to an externalization of the risks taken and an uninvited external shock to the political economy.

A negative implication follows for shareholder empowerment. If managers misunderstood the quantum of risks they were taking, then shareholders with more limited access to the relevant information certainly were no better informed and accordingly had no role to play in preventing externalization. Even as managers must shoulder the blame for the crisis, current complaints about management irresponsibility can legitimately be restated as complaints about management to the market. At the same time, management's risk aversion--its long-derided willingness to accept reduced risk in exchange for institutional stability--all of a sudden holds out advantages. Managers are risk averse because they fear losing their jobs in bankruptcy. Whereas bankruptcy is a natural element in the "winds of creative destruction," (16) those winds blow no good when the losses are externalized to the U.S. Treasury.

The prevailing legal structure of the corporation holds out a robust framework. Corporate law has always performed a balancing act with management discretion and shareholder power. The balance, however, has...