The shareholder value of empowered boards.

Author:Cremers, K.J. Martijn
Position:III. Empowered Boards: Microeconomic Foundations through Conclusion, with footnotes and appendices, p. 108-148
  1. Empowered Boards: Microeconomic Foundations

    This Part revisits the theoretical foundations of the board empowerment claim by drawing primarily from three different strands of economic literature: general equilibrium theory in the context of incomplete markets; asset pricing; and contract theory. Our analysis of these three theoretical strands makes clear that market imperfections are more complex and more important than typically acknowledged in the corporate law debate. (175) Once these imperfections are taken into account, they not only strip away the alleged desirability of shareholder empowerment, but also expose the existence of a larger tradeoff in corporate governance than shareholder advocates generally realize.

    Indeed, while shareholder advocates admit that shareholder empowerment may result in increased short-termism, they quickly dismiss this tradeoff as being of little relevance because they consider short-termism to be a marginal risk relative to the risk of moral hazard. (176) On the polar opposite side, board advocates seem largely unconcerned about directorial or managerial moral hazard, (177) instead emphasizing that short-termism poses a first-order problem in corporate governance. So far, however, these commentators have drawn more from real-world experience than from theory for support, (178) which helps explain the perception that their claims rest on a fragile theoretical basis within the larger academic debate. (179)

    The theoretical foundations we provide below serve to fill this void in the debate, pointing to the existence of a weightier tradeoff in governance structures. (180) Our analysis reveals that concerns about managerial moral hazard are subordinate to the competing concerns posed by what we refer to as the shareholder limited-commitment problem. This problem is a consequence of market imperfections that render shareholders unable to credibly commit to the long-term horizon and, in turn, distort the incentives of both managers and other firm stakeholders to make optimal firm-specific investments. As explained below, an empowered board--which includes both staggered boards and, more broadly, boards that retain their historical authority to resist short-term shareholder and market pressures--emerge as a desirable governance tool with which to address these distortions. It does so by serving as a value-increasing device through which shareholders can credibly commit themselves to long-term engagements vis-a-vis managers and other firm stakeholders, in their own interest and that of society as a whole.

    1. General Equilibrium Theory in a Shareholder Economy

      General equilibrium analysis attempts to explain how prices coordinate the activities of an entire economy--including production, exchange, and consumption activities--in a way that leads to an efficient allocation of resources. (181) In contrast, partial equilibrium analysis focuses on a single market or product, assuming that the prices of all other markets or products are fixed. (182) While this simplifying assumption renders economic discussion more tractable, a general shortcoming of partial equilibrium analysis is that it may fail to accurately model real-world phenomena.

      This shortcoming exposes the limits of Jensen and Meckling's agency theory in modeling shareholder behavior. (183) By casting the interactions among market actors as a principal-agent relationship within the limited economic domain of a single firm, Jensen and Meckling reduce market imperfections to managerial moral hazard. This simplified setting assumes away shareholders' future consumption preferences as well as feedback from other markets, and all market prices and value-relevant information are assumed to be general knowledge. Under these assumptions, no shareholder disagreement ever occurs over production choices, as all shareholders unanimously favor (expected) high-profit production plans over (expected) low-profit production plans. (184) Sidestepping the shareholders' collective action problems, the only residual issue is the question of how to best induce the board and managers not to deviate from the firm's objective maximization function; empowered shareholders--in the jargon of economists, a shareholder economy--emerge as the naturally desirable solution.

      Considerable complications arise, however, when we relax the assumption that shareholders' consumption preferences (185) are uniform. (186) The problem is not only the divergence of interests that arises between shareholders with short-term objectives (i.e., liquidity needs) and long-term goals; divergence in risk preferences matters greatly as well. For example, shareholders who prefer a steady flow of income could favor a lower-profit production plan as long as it reliably delivers a stable dividend stream. Under general equilibrium theory, an additional assumption is therefore necessary to ensure that the firm's profit maximization will continue to be objectively defined: the existence of complete markets. (187) Under this assumption, there is a complete set of contingent markets that allows the buying and selling of claims on any good at every future point of time and in all possible economic circumstances. (188) This set allows shareholders to insure their consumption preferences against unwanted uncertainty by trading securities that are contingent on future states of the world. (189) In this environment, the Fisher Separation Theorem illustrates that the production function (i.e., a firm's choice of investments) becomes independent of shareholder preferences. (190) Accordingly, a firm's profit maximization function is once again objectively defined as the maximization of that firm's net present value. (191) Consequently, as in Jensen and Meckling's partial equilibrium framework, empowered shareholders again emerge as a desirable solution.

      The market structure observed in the real world, however, is quite distant from the idealized structure of complete markets in which everything is tradable in advance. (192) Among other factors, transaction costs, nonverifiable symmetric information, and asymmetric information limit existing insurance opportunities. (193) Under the more realistic assumption of incomplete markets, the argument that production is independent of shareholder preferences breaks down, as shareholders can no longer rely on fully contingent contracts to insure their future consumption needs. How to practically manage the firm's assets and opportunities under a profit-maximization objective becomes a subjective decision, which varies with shareholder preferences. (194)

      Consequently, shareholder disagreement may occur--as evidenced by the fact that one does not generally observe unanimous shareholder deliberations--causing equilibrium security prices to no longer be uniquely defined. (195) Research on specific investment criteria in the context of incomplete markets has accordingly concluded that even the most promising forms of shareholder economy result in inefficient allocations, (196) unless it is possible to artificially replicate a mechanism of full insurance. (197)

      General equilibrium theory with incomplete markets thus challenges the claim that shareholders are optimally situated to make decisions that maximize firm value. Nonetheless, general equilibrium theory focuses on market dynamics, touching only upon institutional mechanisms (i.e., the internal operations of the firm). (198) In order to move to a positive account of board empowerment, a broader theoretical approach is necessary. This Article develops such an approach in Subparts B and C below.

    2. Asset Pricing Theory and Shareholder Commitment

      1. Price dynamics and shareholder value

        An additional assumption on which shareholder advocates rely to defend shareholder empowerment is that asset prices may serve as an efficient informational focal point, thus mitigating asymmetric-information issues between firm insiders and outsiders. Board advocates reject this claim by asserting that the informational focal point provided by market prices is at best imperfect. Accordingly, discussion of asset pricing theory in corporate law can be described as hinging on assumptions about the greater or lesser informational efficiency of market prices, as reflected in the strong or semi-strong versions of the ECMH. (199) The financial economics literature, however, evidences a tension between two more radically opposed views of financial market dynamics. (200) While the Hayekian view of markets substantially reproduces the semi-strong version of the ECMH, the Keynesian view holds that prices are cyclically influenced by herding and short-run speculation and are thus cyclically uninformative. (201)

        As explained by Keynes through his influential metaphor of financial markets as a beauty contest, (202) rational herding behavior may induce investors to react to aggregate market demand rather than to their own information, because "each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors." (203) Understanding market prices thus requires not just an understanding of all market actors' average expectations about future liquidation value, but also an understanding of all market actors' beliefs about other market actors' beliefs (that is, higher-order beliefs). (204) Because consideration of higher-order beliefs incentivizes an excessive reliance on public information, the mean path of prices may depart from the consensus estimate about the fundamental value of a firm, (205) negating the predictive power of even the semi-strong form of the ECMH. (206)

        Speculative factors unrelated to the true value of market assets may also push prices away from fundamentals. Indeed, when the possibility of differential investor information is taken into account, better-informed investors may rationally choose to exploit their partly private...

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