Originally published on the Harvard Law School Forum on Corporate Governance and Financial Regulation - https://corpgov.law.harvard.edu/2018/11/04/shareholder-driven-corporate-governance/
In the decade since the global financial crisis, shareholders have asserted more and more control in public corporations, no longer content to play the part of the passive owner. In response to this pressure, law makers continually confront the question of what additional rights shareholders should be afforded. This issue similarly invites us all to revisit the nature of the relationship between shareholder and corporation, and to ask what role law should play in affirming shareholders’ ability to influence corporate governance. Indeed, as shareholder activism grows, so does the need to develop a theory about the public corporation, including an acknowledgement of a new concept that I call “shareholder-driven corporate governance.”
The contractarian model maintains that shareholders’ relationships with corporations are defined by the bargain that the two parties have reached. Corporate law is a layer added onto this relationship, consisting of a set of default terms that apply in the absence of explicit contractual terms between the parties. But it is impossible to understand the public corporation through the contractarian lens alone; the enabling features of corporate law comprise only a subset of obligations to which these corporations adhere.
The contractarian model has three fundamental weaknesses as a basis for thinking about corporate governance in public corporations. First, when shares are purchased, there is little or no negotiation between contracting parties, unlike other contractual settings. Second, the corporation and shareholder as the contracting parties are usually brought together by a third-party intermediary, namely, an investment advisor: how does this third party affect the bilateral contractual relationship especially given that the advisor typically receives a commission upon executing a trade on behalf of investors? This commission may be known to the investor, or it may be embedded in the purchase price and it affects the bargain that the investor is prepared to make. Third, the contractarian model does not consider the central role of securities regulation with its explicit investor protection mandate.
In short, despite the many contributions of the contractarian school, notably from Easterbrook and Fischel (1996), shareholders’ rights in the corporation should not be viewed as entirely a matter of private agreement. They are often not sufficiently protected by the bargains they make, especially in the context of public corporations and complex change of control transactions. Securities law is at least partially premised on this very point, given its goal of protecting investors even after they become shareholders in a corporation. This is the legislated goal of securities regulation regardless of the type of shareholder at issue.
“Shareholder-Driven Corporate Governance” (SCG) is an alternative to the contractarian model of governance. I devised this term to identify an approach to governing the corporation that seeks to protect shareholders’ interests while also affirming their involvement in governance. It captures both actual and potential governance strategies. SCG is a normative concept in the sense that it presents a goal to which lawmakers (not to mention investors) may aspire especially in light of concerns relating to management and board entrenchment. It is also a descriptive term with practical import, explaining the ongoing phenomenon of shareholder activism and the corresponding shift in the balance of power within public corporations.
In jurisdictions throughout the world, reform agendas and board decision-making evidence a movement toward SCG and away from Berle and Means’ (1967) understanding of shareholders as mere passive agents in the corporation. The Dodd Frank “Say on Pay” reforms are a prime example as is proxy voting and the increasingly popular move to separate the roles of board chair and CEO. In firms with multiple voting shares, the goal of SCG would be to ensure that the subordinate voting shareholders, who do not hold sufficient equity to affect voting in the corporation are protected by mandatory sunset provisions, disclosure relating to shareholder votes, and buyout protections.
In the analysis of SCG, it is important to remember that shareholders come in different sizes and forms. They are often described as being “retail” or “institutional”, a classification that depends in part on the level of sophistication of the shareholder itself. To the extent that shareholders are naive bystanders who do not read disclosure, it is not ideal to shift the balance of power to them. They are largely passive investors who wholly rely on securities regulators’ comprehensive exercise of their investor protection mandate. If shareholders are sophisticated, as in the case of pension funds and hedge funds, the rationale underlying SCG makes good sense to counter the undeniable possibility of board and management entrenchment.
In reconceptualizing our thinking about the corporation, SCG stands as a trend to be observed and an ideal to be achieved by ensuring greater shareholder participation in corporate governance. This weighty objective highlights the need for SCG as a theory that accounts for the fact that securities legislation, more than setting default contractual terms, plays a conspicuously central role in defining the formidable relationship between the corporation and its shareholders.
The complete paper is available here.