The Case Against Shareholder Empowerment
William W. Bratton
Institute for Law and Economics, University of Pennsylvania Law School; European Corporate Governance Institute (ECGI)
Michael L. Wachter
University of Pennsylvania Law School - Institute for Law and Economics
University of Pennsylvania Law Review, Vol. 158, p. 653, 2010
U of Penn, Inst for Law & Econ Research Paper No. 09-35
Georgetown Law and Economics Research Paper No. 1480290
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 financial crisis. This Article argues that the financial crisis exposes major weaknesses in the shareholder case. Our claim is that shareholder empowerment delivers management a simple and emphatic marching order: manage to maximize the market price of the stock. And that 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, 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 counterfactual 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 on its own by forcing management to a market price set in most cases under asymmetric information and set in some cases in speculative markets in which heterogeneous expectations obscure the price’s informational content.
Number of Pages in PDF File: 76
Keywords: Corporations, corporate governance, financial crisis, law reform, regulatory reform, shareholder wealth maximization, shareholder primacy, risk management, leverage, high risk strategies, balance of power between directors and shareholders, agency costs
JEL Classification: G30, K22
Date posted: October 1, 2009 ; Last revised: April 4, 2010