The Case for Limited Shareholder

Rights

by Stephen M.
Bainbridge
UCLA School of Law

Presentation contributors:
Laura Montenovo
Elisabetta Favretto
Corina Greab
Gabriel Pressman
 Introduction
In this article, Stephen M. Baimbrage discusses
three main points:
 why shareholders are the only constituency in a
corporation to be granted voting rights
 why those rights are limited
 why, in the author's
opinion, the corporate
structure should remain
this way
 Introduction
 Three types of firms in regards to
shareholder power:
 Closely held corporation
 small number of shareholders
 ready access to information about the business
 homogeneous preferences
 voting = managerial power
 no specialized managers
 the firm lacks separation of ownership and control
 Introduction

 Publicly held corporations with controlling

shareholders
 partial separation of ownership and control
 shareholders have substantial access to firm
information and retain incentives to cast informed
votes
 although there are likely professional managers, they
could be voted out of office by the controlling
shareholder at any time
 voting has managerial and oversight functions
 Introduction

 Publicly held corporation

 numerous shareholders with diverse preferences
 shareholders don't have the knowledge or the
incentives necessary to exercise an informed vote
 complete separation of ownership and control

 This is the type of corporation that we will be

discussing
 Introduction
 Despite the separation of ownership and control in
these companies, shareholder voting is still an integral
component of corporate governance
 there are many recent efforts to extend the shareholder
franchise
 corporate compensation plans that must be approved by
shareholders
 permitting shareholders to nominate directors and have
their nominees listed in the company's proxy statement
 amending the Model Business Plurality Act to require a
majority vote instead of the current plurality to elect
directors
 Introduction
 the author believes these efforts are fundamentally
misguided
 record of success in U.S. corporate governance has occurred
not in spite of the separation of ownership and control, but
because of that separation.
 shareholder voting has very little to do with corporate
decision-making
 the separation of ownership and control is inherent in the
basic structure of the law of corporate governance
 according to Delaware General Corporation Law, a
corporation’s business and affairs are “managed by or under
the direction of a board of directors”
 Introduction
 shareholders have virtually no right to initiate corporate
action and are entitled to approve or disapprove only a few
board actions
 the board acts, and shareholders, at most, react

So...
 why do only shareholders get the vote?
 why are shareholder voting rights so limited?
 1. Why shareholders and only shareholders?

Why only shareholders get the vote? What about the other corporate
constituencies?

Traditional answer: shareholders own the corporation but this is

ERRONOUS

Indeed they own the residual claim on the corporation's assets and earnings but
this is different from the ownership of the corporation itself.
CORPORATION = it is a legal fiction where someone owns each input,
but no one owns the totality can't be owned.

Ownership is not a meaningful concept in contractarian theory.

This statement implies the elimination of the obvious answer to our starting
question.

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BETTER ASNWER by Kenneth Arrow’s analysis of the two basic ways in
which organizations make decisions: consensus and authority.

Consensus requires that each member of the organization have identical

information and interests, otherwise authority-based decisionmaking
structures arise.

ASSUME an employee-owned corporation with a lot of employee-

shareholders.
Could such a firm use some form of consensus-based decisionmaking?
NO
IN FACT our hypothetical employee-shareholders necessarily will have
different degrees of access to information because the number of
communication channels within the firm will be great.

The expected benefits of becoming informed are quite low, as an

individual decisionmaker’s vote will not have a significant effect on the
vote’s outcome.
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Under such conditions, Arrow’s model predicts that the corporation will
tend toward authority-based decisionmaking.

SUPPOSE we are talking about the same corporation as before.

Is it reasonable to expect that the similarity of interest required for
consensus-based decisionmaking will exist? SURELY NOT.

Divergent interests raise the cost of using consensus-based

decision making structures in employee-owned firms.

Both the existence of such divergent interests within the employee

group and the resulting costs are confirmed by the empirical
evidence.

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 Multiple constituencies in a
public firm: introduction
• Previous section: corporations with many
thousands of employees and shareholders
cannot rely on consensus based decision
making. Authority decision making is
needed,for example trought a Board
• This section: in a publicly held firm
shareholders are in the best position to
participate in Board decision-making
• - US vs German co-determination model
 Multiple constituencies in a
public firm: problems
• interests diverge between shareholders and employee
representatives, as well as managers

• - sensitive information witheld from the Board

• - real work takes place in to Committee level instead of
• the Board
• - when employee representatives on the Board belong
to strong trade unions the interests divergence between
shareholders and managers will not resolve.

• self-interest of management and employees may align against

interests of the shareholders, resulting in lax management

• proven by empirical evidence from German co-determination

model
 Why only shareholders on the
Board rather than employees?
Reasons:
• Board consensus is easier to achieve if
directors follow only the shareholders
• There are 2 reasons:
• - allocation of votes easier for financial
capital than human capital
• - employees care most about wages and
working conditions, instead shareholders care
about profits and will consequently elect
directors that are committed to maximising
profits
 Why only shareholders on the Board
rather than employees?
• better control of managerial performance:
• - shareholders can transfer their shares to an outsider who
can vote out the present management.

• better control of employees:

• - because employees are not represented on the Board they
have to be disciplined and reduce shirking

• better protection of employees without representation on

board:
• - mobility: workers can move to another company
• - legal protection: unemployment benefits, extra pay when
losing a job, collective barganing
•
• In conclusion this shows that in a publicly held firm decision
making should be left to shareholders rather than employees
 Limits on Shareholder Control
Why Not Shareholder Democracy?
 separation of ownership and control
characteristic of public corporations is enforced
both directly and indirectly
 Directly:
 Under the Delaware Code, shareholder voting rights are
limited to:
 the election of directors
 approval of charter or bylaw amendments

 mergers

 sales of substantially all of the corporation’s assets

 voluntary dissolution

 of these, only the election of directors and amending the

bylaws do not require board approval
The Limits on Shareholder Control
 Indirect
 rules that indirectly prevent shareholders from
exercising significant influence
 disclosure requirements pertaining to large holders
 shareholder voting and communication rules
 insider trading and “short swing profits” rules
 these rules discourage the formation of large stock
blocks and discourage communication and
coordination among shareholders
 The Limits on Shareholder Control
The “Wall Street” Rule
 Many investors, especially institutional investors,
rationally prefer liquidity to activism
 these investors are less likely to become involved in
corporate decision-making
 “Wall Street” Rule - it’s
easier to switch than fight
(a play on an old cigarette
advertisement)
B. The Survival Value of the Separation of
Ownership and Control
Berle & Means’s “The Modern Corp. and Private Property”:
Separation of Ownership and Control in Public Corp.:
• The firm’s nominal owners (shareholders) had no control
over daily operations or long-term policies;
• Control was in the hands of professional managers
(owning a small portion of the shares);
Cause of separation:
• Dispersion of stock ownership among many shareholders;
• Shareholders didn’t own enough shares to materially affect
the corporation’s management;
=> In Berle & Means’s opinion, the separation was a
departure from the historical norms and a serious economic
problem.
Berle & Means’s version of economic history:
• Dispersion of ownership as a consequence of the
development of large capital-intensive industrial corp.
(19th Cent);

Required investments far larger than a

single entrepreneur/family could provide.

=> Need for funds from many small/medium investors

But: Small investors needed diversification:

Fragmented share ownership;
Separation of ownership and control;
According to Berle & Means, «corporations once behaved as they
were supposed to» - that is, shareholders:

– Owned the corporation and controlled it;

– Elected the board of directors, that had delegated management power;
– Retained residual control, uniting control and ownership.

But, when the state curtailed regulation:

 Corporations expanded and became a huge concentrate of resources;
 It was run by managers accountable only to themselves, not to shareholders
and society;
 «Erosion doctrine».

Prof. Werner, instead, argues that the economic separation of ownership and
control was already a feature of the American corporation at the beginning of the
19th Century, since «banks and other public-issue corp. had a tripartite
government structure, a share market that dispersed shareholdings and divided
ownership and control, and tended to centralize management in full-time
administration and to diminish participation of outside directors on management.
Short:

• Berle & Means’s account rested only on technological changes in

the 19th Century;
• Prof. Werner’s account rests on the early development of the
secondary trading markets:
– secondary trading markets already existed;
– investments were attractive because of the resulting liquidity of corporate stock;
– selling stock to the public became also an attractive mechanism;

 stocks were purchased by a diversified and dispersed clientele (institutions and

individuals);
 a national taste for speculation was developing;
 early growth of the secondary trading markets & dispersion of
stock ownership;
So:
 separation of ownership and control is an essential economic
characteristic of corporations, that took place at the very
beginning.
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Alchian & Demsetz argue that:

“…the firm has no power of fiat (that is, authoritative command or order to
do something), no authority, no disciplinary action any different in the
slightest degree from the ordinary market contracting between individuals.”

Instead, power exists within firms and the firm is not a quasi-market area
within which a set of contracts between various factors of production are
constantly renegotiated.

 Fiat is the chief characteristic distinguishing firms from markets.

R. Coase argues that: “firms emerge when it is efficient to substitute

entrepreneurial fiat for the price mechanisms of the market.”

 Fiat is essential in public corporations.

Recall:

 all organizations must have a mechanism for aggregating the preferences of the
organization’s constituencies;
 the mechanism must convert these preferences into collective decisions;
 they are between consensus and authority.

 Authority-based decision making (based on a central office empowered to

make decisions binding on the firm as a whole) arise when the
constituencies have different interest and access to information.

 There is a need of literal nexus – center of power capable of exercising fiat

– where there is information and interest asymmetry between the
corporation’s constituencies.

Separating ownership and control by vesting decision making authority in a

centralized nexus distinct from the shareholders and all other constituents is
what makes the large public corporation feasible.
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In order for the corporation to function:

 Directors and managers specialize in effective coordination of other

specialists
 The other corporation constituents should specialize in functions
unrelated to decision making:
• Risk-bearing – that is, shareholders;
• Labor – that is, employees etc.;

A’
So, these other corporation constituents
B’
must delegate decision
making to the board and to senior management.

Even though shareholder interests are less fragmented than those of the
corporation’s multiple constituencies, they very much vary: short-term vs.
long-term; diversified vs. undiversified; inside vs. outside; social vs. economic,
and hedged vs. unhedged.
So:
• Shareholders lack incentives to gather the information necessary to
actively participate in decision making
• A rationale shareholder will expend the effort necessary to make
informed decisions only if the expected benefits of doing so outweigh
its costs.

 It’s so much easier to switch to a new investment than to fight

incumbent management when the capital market is an efficient and
reliable indicator of performance (recall Wall St. Rule).
 The modern public corporation’s decision making structure fits a
model of an authority-based decision making system, since:

 Involving shareholders would be difficult and costly;

 They lack both the information and the incentive to make sound decisions;
 Shareholders prefer to irrevocably delegate decision making authority to
some smaller group (in the long run, this will max.shareholders’ wealth).

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…a smaller group:

Delaware Code def.: “Corporation’s business and affairs shall be managed by

or under the direction of a board of directors; its powers are original and
undelegated.”

 Principal-Agent Problem: associated with the shareholder’s purchase

of the residual claim on the corporation’s assets and profits is an
obbligation on the part of the board of directors and managers to
maximize shareholders’ wealth.
 Role of Corporate Law: provide the mechanisms for constraining
agency costs, considering that:

i. Accountability mechanisms can, to some degree, substitute for

monitoring by residual claimants;
ii. Agency costs are the result of placing ultimate decision making
authority in the hands of someone other than the residual claimant.
The central governance issue is establishing the right mix of discretion
and accountability.
Chief economic virtue of the Public Corp.: it provides a hierarchical
decision making structure well-suited to the problem of operating a
large business enterprise with numerous “actors” and inputs.

Shareholder activism contemplates that institutions will:

 Review management decisions;

 Step in when management falters;
 Exercise voting control to effect a change in policy/personnel.

 Why do we observe any right for shareholder to vote?

We observe voting rights for shareholders because:
 There is a need for a mechanism to ensure director accountability
w.r.t. the rights for which shareholders have contracted (especially
the one requiring the director to use shareholder wealth
maximization as principal decision making norm).

This is because director primacy views the corporation as a means by which

directors bargain with factors of production.

Shareholders’ “main right” is enforced directly through a complex and varied set of
extrajudicial accountability mechanisms of which shareholder voting is just one.

Nevertheless, shareholder voting rights must be constrained in order to

preserve the value of authority:

 Shareholder voting comes into play properly as an accountability

mechanism only when management performance is sufficiently
degradated from expectations to make a takeover fight worth waging.
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C. The rise of institutional investors

1990s: some ACADEMICS argued that shareholder activism could

become an important constraint on agency costs within the firm

and they focused their attention on

Institutional investors because they may approach corporate governance

quite differently than dispersed individual investors.

INDEED: corporations with large blocks of stock held by institutional

investors might reunite ownership of the residual claim and ultimate
control of the enterprise.

IT FOLLOWS THAT: concentrated ownership in the hands of institutional

investors might lead to a reduction in shirking and, hence, a reduction in
agency costs.
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In the early 1990s, it seemed possible that this theory would be
realized.

But while there seemed little doubt that institutional investor activism
would have some effect, the question remained whether the impact
would be more than merely marginal.

By the end of the 1990s,empirical studies found “no strong

evidence of a correlation between firm performance and
percentage of shares owned by institutions.”

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TODAY, institutional investor activism remains rare because most
of the times costs (ex.monitoring, coordinating, communicating) exceed
benefit, and if gains occur they are likely to accrue the activist
institution.

Many institutional investors will prefer liquidity to activism, because

they tend to be more interested in short-term gains.

This is an example of FREE-RIDING :given that activism will only rarely

produce gains, cost-conscious money managers will remain passive in
hopes of free riding on someone else’s activism.

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 What type of shareholder or
investor is best?
• large institutional investor or a small private
one?
• the interests between the two are different
• Large ones are interested in power small ones
are intrested in profit maximum
• Managers may follow only large investors, and
harm small investors
• This is inefficient and raises costs.
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Conclusions
 Do you agree with the author’s opinions?
 Do you believe that any of the
stakeholders should have more power?

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