Maximizing the wealth of fictional shareholders: which fiction should directors embrace?

• Author: Crespi, Gregory Scott

ABSTRACT

Corporate directors are generally committed to the social norm of maximizing the wealth of their corporation's common shareholders. Their current practice is to simplify their investment decisions by positing a generic fictional shareholder who is undiversified in his investments as the person to whom they hold themselves accountable. In this Article I discuss this fictional undiversified shareholder concept and compare it with three alternative fictional characterizations that differ from it and among themselves only in the extent of assumed investor diversification, and which could each serve this same analytical function. These three alternatives are the fictional diversified shareholder, the fictional equity-only diversified shareholder, and the fictional corporation-specific diversified shareholder concepts. I also consider a hybrid characterization that would include both fictional undiversified shareholders and fictional diversified shareholders.

My conclusion is that despite its advantages of greatly simplifying directors' decision making we should discard the fictional undiversified shareholder concept for two reasons. First, it is highly unrealistic, more so than the other alternatives here considered. Second, it is indeterminate as to the degree of risk-aversion that should be ascribed to this fictional shareholder, and this degree of freedom completely undercuts ability of the shareholder wealth maximization norm to constrain director conduct.

I also conclude that if corporation investment decisions are best pursued through the use of a fictional shareholder concept, rather than through attempts by directors to ascertain and satisfy to the extent possible the conflicting preferences of their corporation's actual shareholders and perhaps other stakeholders as well--a question discussed but not resolved in this Article--then the fictional diversified shareholder concept, despite its significant implementation difficulties, is the preferred alternative among those here considered.

ABSTRACT I. INTRODUCTION II. THE SHAREHOLDER WEALTH MAXIMIZATION NORM A. The Widespread Embrace of the Shareholder Wealth Maximization Norm B. Different Fictional Shareholder Characterizations 1. The Fictional Undiversified Shareholder 2. The Fictional Diversified Shareholder 3. The Fictional Equity-Only Diversified Shareholder and the Fictional Corporation-Specific Diversified Shareholder III. MAXIMIZING THE WEALTH OF FICTIONAL SHAREHOLDERS A. Maximizing the Wealth of Fictional Undiversified Shareholders B. Maximizing the Wealth of Fictional Diversified Shareholders C. Maximizing the Wealth of Fictional Equity-Only Diversified Shareholders D. Maximizing the Wealth of Fictional Corporation-Specific Diversified Shareholders E. Choosing the Optimal Generic Fictional Shareholder Characterization 1. Comparison of the Four Alternative Fictional Shareholder Characterizations 2. Maximizing the Wealth of a Mixture of Fictional Undiversified and Fictional Diversified Shareholders 3. Contrast with the Conclusions Reached by Other Analysts F. Implementation of the Fictional Diversified Shareholder Characterization G. Summary IV. MAXIMIZING THE WEALTH OF ACTUAL SHAREHOLDERS V. MOVING BEYOND SHAREHOLDER WEALTH MAXIMIZATION VI. CONCLUSION I. INTRODUCTION

In recent years corporate governance practices have come under close scrutiny. (1) In particular, there is currently a vigorous debate among leading corporation law scholars regarding whether legal changes that would enhance the ability of common shareholders of public corporations to nominate directors and initiate changes in key charter provisions would result in corporate boards being more responsive to shareholder interests. (2)

I believe that this debate is useful but somewhat misdirected. Even if governance reforms such as those that have been proposed are adopted, the severe collective action problems involved in coordinating the large and diverse population of public corporation shareholders will likely prevent these shareholders from effectively exercising these enhanced rights. (3) Nor are the courts likely to respond to calls to depart significantly from their traditional deferential business judgment rule standard of review that effectively shields directors from judicial accountability for their actions except for duty of loyalty violations involving fraud, illegality or self-dealing. (4) As a practical matter, the norm of shareholder wealth maximization--the widely shared understanding among directors that their main objective should be to maximize the wealth of their corporation's common shareholders--will likely remain the most effective constraint on director conduct in favor of those shareholders.

What is often overlooked, however, is that the conduct of directors seeking to maximize shareholder wealth depends critically upon their conception of who exactly is the "shareholder" to whom they hold themselves accountable. As Daniel Greenwood insightfully argued, (5) the corporate statutes and case law do not encourage the directors of public corporations to take referenda of the preferences of their many direct and indirect human shareholders (6)--who in general will have conflicting interests and preferences based on their differing attitudes, life circumstances, other asset holdings, etc.--before making decisions, and those directors rarely, if ever, do so. (7) The law instead allows directors to greatly reduce the burden of discharging their fiduciary duties to this diverse group of shareholders by permitting them to consider only the impacts of their actions upon a generic "fictional shareholder" abstraction. (8) Moreover, the law does not impose any particular definition of this hypothetical shareholder, which leaves directors with the discretion to choose among a wide range of possible fictional shareholder characterizations to guide them in their investment decisions. The choice of characterization used may well have significant consequences for those decisions. (9)

It is certainly possible to offer an "external" critique of the use of any fictional shareholder characterization by directors to guide their investment decisions. Whether our society would be better off if directors were encouraged to assess the consequences of their actions for their actual shareholders, thereby importing into boardroom deliberations all of the complex and contentious political differences among shareholders that are now avoided through use of a unitary fictional shareholder concept, and requiring reassessment of decisions whenever a corporation's shareholder profile materially changes, is a difficult question whose full consideration goes well beyond the scope of this brief Article. (10) As I will later discuss, the conclusions that I reach in this Article suggest that this broad question should receive more attention, and I will offer some preliminary comments and suggestions in that regard. What I would like to primarily focus upon in this Article, however, are several related but somewhat narrower "internal" questions that arise if one accepts as a given the shareholder wealth maximization norm, and the need for the use of some fictional shareholder characterization to facilitate investment decisions in accordance with that norm. If directors are going to continue to embrace this norm and implement it through the use of a fictional shareholder concept that obviously cannot be an accurate representation of the circumstances of every actual shareholder, what are the optimal contours of that concept? (11) What is the most plausible and operationally feasible characterization of the nature of that fictional shareholder, and what difference would it make as to which of the possible characterizations was embraced by directors to guide their conduct?

In Part II of this Article, I will first briefly discuss the shareholder wealth maximization norm, and will identify several different plausible fictional conceptions of the nature of public corporation shareholders that are each grounded to some extent in actual shareholder circumstances, and that could each provide an alternative frame of reference for making corporate decisions in accordance with that norm. (12) In Part III, I will attempt to demonstrate the significance of the differences among these characterizations for public corporation investment decisions. (13) I then will compare their relative implementation difficulties, and will offer my recommendations as to which of these characterizations would be most likely to lead to the maximization of actual shareholders' wealth. (14) In Part IV, I will offer a few preliminary comments regarding why and how directors might attempt to assess and balance their actual shareholders' interests and preferences in making decisions rather than embrace any of the fictional shareholder characterizations. In Part V, I will offer a few preliminary concepts regarding whether the norm of shareholders' wealth maximization should be replaced by a broader norm of director loyalty to a more inclusive stakeholder constituency. Part VI of the Article will present a brief conclusion.

2. THE SHAREHOLDER WEALTH MAXIMIZATION NORM

   1. The Widespread Embrace of the Shareholder Wealth Maximization Norm

      Corporate directors generally regard themselves as subject to an overriding fiduciary duty to maximize the wealth of their common shareholders, (15) who they commonly regard in simple, straightforward terms as the "owners" of the corporation who therefore merit their fealty and prudence. This widely shared understanding, somewhat surprisingly, is not explicitly grounded in state corporation statutes. (16) Moreover, most of the state statutory frameworks include "constituency statutes" that explicitly permit (but do not require) directors to consider the impacts of their actions on various non-shareholder constituencies. (17) However, the judicial case law on balance clearly endorses this...