The shareholder as Ulysses: some empirical evidence on why investors in public corporations tolerate board governance.

• Author: Stout, Lynn A.
• Position: Delaware - Symposium: Corporate Control Transactions

This Article evaluates two possible explanations for why shareholders of public corporations tolerate board control of corporate assets and outputs: the widely accepted monitoring hypothesis, which posits that shareholders rely on boards primarily to control the "agency costs" associated with turning day-to-day control over the firm over to self-interested corporate executives, and the mediating hypothesis, which posits that shareholders also seek to "tie their own hands" by ceding control to directors as a means of attracting the extracontractual, firm-specific investments of such stakeholder groups as executives, creditors, and rank-and-file employees.

Part I reviews each hypothesis and concludes that each is theoretically plausible and internally consistent, and that the validity of each theory must be established or rejected on the basis of empirical evidence. Part II evaluates the available empirical evidence, including new evidence on charter provisions of initial public offerings, and concludes that, as both a positive and a normative matter, corporate takeover law is consistent with the view that directors are not just monitors, but also perform a mediating function. Finally, Part III discusses future directions for empirical research, identifies some pitfalls to be avoided, and concludes that the current empirical evidence favors the mediating model.

INTRODUCTION

Shareholders are often described as the "owners" of corporations. (1) Since at least the days of Adolph Berle and Gardiner Means, however, corporate scholars have understood that in public corporations, shareholder "ownership" does not mean shareholder control. (2) To the contrary, in the typical large public firm with dispersed stock ownership, control over the corporation's assets and outputs rests in theory and in practice not with stockholders, but with the company's board of directors.

This delegation of control poses a puzzle for corporate theorists. The investor who uses her hard-earned money to buy shares from a public firm relinquishes her power to determine how those funds will be used in the future. Her personal assets become corporate assets subject to the directors' control. It is now the directors, and not the investor, who will decide how the firm shall be run, whom it shall hire, and in what it shall invest. It is also now the directors, and not the investor, who will decide whether corporate earnings will be used to pay dividends--or used instead to build empires, raise salaries, and support charities. (3)

The end result is a system of public corporate governance that has been aptly described as "director primacy" instead of "shareholder primacy." (4) This raises the question: why do shareholders tolerate such an arrangement? On first inspection, one might conclude that shareholders accept director primacy in public firms simply because corporate law requires it. Section 141 (a) of the Delaware Corporate Code, for example, begins by stating that "It] he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors...." (5)

Yet this sentence of section 141 (a) ends with the caveat, "except as may be otherwise provided ... in [the] certificate of incorporation." (6) Delaware law accordingly treats board governance as a default rule that can be "bargained around" in the corporate charter. In practice, closely held companies sometimes do adopt alternatives to board governance; public corporations, however, do not. In fact, a board of directors is a near-universal feature of the publicly held firm. (7)

This pattern suggests that, for some reason, participants in public corporations--including investors--value director primacy. Just as the legendary Ulysses served his own interests by binding himself to the mast of his ship, investors may be serving their own interests by binding themselves to boards.

This Article explores the question of how shareholders might benefit from ceding control over their investments to boards of directors. Part I begins by surveying the widely accepted model of board function that will be referred to herein as the "monitoring" model. The monitoring model of the board posits that shareholders cede control to boards primarily because boards are in a better position than shareholders to police against the "agency costs" that corporate executives would otherwise impose on firms. The monitoring model accordingly views boards of directors as shareholder agents hired to watch over other, less-trustworthy shareholder agents.

The monitoring model is the dominant theory of board control today and offers many useful insights into the patterns of board structure and behavior that we observe. At the same time, however, Part I argues that the monitoring model is seriously incomplete because it fails to explain the fundamental attribute of public firms first highlighted by Berle and Means--extreme separation of share ownership and control. Put differently, the monitoring model explains why shareholders might hire boards of directors to advise them on how to run the firm, and especially to advise them on how and when to hire, compensate, and fire executive employees. It does not explain, however, why shareholders would take the additional (and radical) step of actually relinquishing their control over firm assets and outputs to a board that is free, as a matter of law, to ignore their wishes.

Part I argues that this separation of share ownership from control can be explained by an alternative, but less widely accepted, theory of board function described as the "mediating" model. The mediating model does not reject the idea that shareholders rely on directors to overcome the coordination problems shareholders themselves face in overseeing the firm's executives. At the same time, however, the mediating model posits that shareholders do not rely on corporate boards only to rein in executives. Shareholders also rely on boards to rein in themselves by weakening shareholder control over firm assets and outputs.

Obviously, weakening shareholder control sometimes works against shareholders' ex post interests. According to the mediating model, however, shareholders--like Ulysses--gain greater benefits from tying their own hands in this fashion. Diluting shareholder power--and with it, shareholders' ability to extract wealth from the firm--may ultimately benefit shareholders by enhancing the firm's ability to attract the firm-specific, sunk-cost investments of other important corporate "constituents," including creditors, executives, and rank-and-file employees. The mediating model accordingly does not view the separation of ownership from control accompanying board governance as a problem. Instead, the model views it as a solution.

Which of these two theories--the purely monitoring board model or the mediating board model--best captures the reality of modern public companies? Part II of the Article begins by observing that the answer cannot be determined at the theoretical level. Each model of board function is internally consistent and theoretically plausible. To evaluate their merits, we must look to the available empirical evidence.

Part II examines some of this evidence. It begins by inquiring which model better describes the way modern corporate governance actually functions. In many business contexts, the answer to this question is not obvious: in a number of situations where corporate law allows boards to pursue business strategies that seem to sacrifice shareholders' interests in favor of those of other constituencies, it is nevertheless possible to argue that these strategies actually serve shareholders' "long-run" interests. Such long-run arguments lose much of their traction, however, in the context that is the subject of this Symposium--change of control transactions. In this context, the extent to which corporate law follows the mediating model becomes clearly visible.

Commentators who subscribe to the monitoring model accordingly are often forced, in the change of control context, to concede that takeover law is inconsistent with a purely monitoring board. In response, they argue that this phenomenon reflects a deficiency of the law rather than a deficiency of the model. Put differently, adherents of the monitoring model argue that the legal rules governing change of control transactions are defective and in need of reform.

As Part II observes, however, this latter argument runs afoul of a second important source of empirical information about the normative value of a mediating board versus a purely monitoring board. Despite the enabling nature of corporate law, public firms generally avoid shareholder primacy-enhancing "reforms," even at the initial public offering (IPO) stage where corporate promoters have the greatest incentive and ability to select governance rules that appeal to outside investors. In fact, when firms do modify the default rules of corporate governance, they almost always move in the opposite direction, selecting charter provisions that strengthen director control over the firm. This pattern strongly suggests that investors, managers, and other corporate participants collectively perceive director primacy as advantageous ex ante.

Part III concludes by observing that, while the current empirical evidence supports the mediating model more strongly than the purely monitoring model, the question has hardly been resolved with certainty. As a result, there is much to be gained from further empirical inquiry. Part III points out, however, that many of the existing empirical studies that have been devised to test the monitoring model are intrinsically unable to distinguish between results consistent with the monitoring model and results consistent with the mediating model. As a result, new tests will have to be devised. In the meantime, however, it makes little sense to ignore the clear import of the data that...