I. SHAREHOLDER PRIMACY: The Dominant View
It is helpful to set the stage for Market Incentive Theory by briefly elaborating the current dominant view of the agency relationship between the shareholder and the director. The Dominant contractarian approach holds that the corporation is a wealth-generating machine that operates by efficiently bringing together a host of various resources to produce something of greater value.
Further, the contractarian view holds that all of these resources are derived from markets and suppliers that contract with representatives of the corporation. The nexus of all these contracts is the board of directors.[i] This nexus-of-contract, where directors rule by fiat, is held out as the genius of corporate law making sense of the cacophonous rent seeking interests of the stakeholders and distributing the spoils to all parties in a way to placate their demands.[ii]
Part and parcel of the canonical model is the idea that shareholders maintain a unique position relative to all other stakeholders. All other stakeholders have efficient markets that expressly set the fair market value for their various contracts. The commodities market will set the price for steel at a specific time, place, quantity and quality. Similarly, the labor market will set the price of labor for a technician with a bachelor’s degree and five years of experience in Silicon Valley.
Shareholders on the other hand do not have a market that sets their terms with certainty. The contracts between the shareholders and the board are unfixed by necessity and majoritarian default.[iii] Necessity requires that the terms of the contract remain unfixed because any contract governing every minute detail of the complex agency relationship between shareholder and director would become unmanageably large and inefficient.
Majoritarian default suggests an unfixed contract that is evidenced by the vast majority of State law that requires a fiduciary duty instead of an explicit contract. This shows that the majority of investors, if they were to choose, would choose to have a contract with unfixed terms governed by duties of loyalty and care.[iv] This conclusion is also supported by recognizing that most shareholders are passive investors and are rationally apathetic.[v] Shareholders, therefore, desire an unfixed agency relationship instead of taking time and effort to negotiate explicit contracts.
This dominant view imagines passive investors whose wealth is entrusted to directors and who remain passively and helplessly at the mercy of the directors’ business judgment. However, this canonical account overlooks the brutal force with which the free market operates. Our society has seen fit to distribute our scarce financial resources with the mechanism of the open market and thereby placing the investor over directors, rewarding and punishing them as they see fit.
The market fully accounts for every director action, all book value, and every corporate road map when allocating financial resources. The shareholders’ role in our market penalizes bad decisions and rewards good decisions by distributing society’s limited financial resources to corporations that make shareholders happy and away from corporations that make them sad.
II. MARKET INCENTIVE: Resource Allocation
Market incentive operates because shareholders set the market value of all publicly traded corporations. This value is loosely based on a corporation’s book value in light of the corporation’s potential to produce wealth in the current socio-economic environment. All aspects of the society and the economy are generally believed to factor into our efficient market valuation of a corporation. The market is believed to ingest every piece of news and reflect a corporation’s ability to produce wealth, relative to all other investment instruments, in a corporation’s stock price.
However, this does not actually allocate the dollars to the corporation. Investors set the “market value” of the corporation on a secondary market. The price on the secondary market then determines the cost of capital that a corporation must pay if it must raise more money on either the bond or equity market.
For example, a corporation has a balance sheet including 90 dollars of liabilities in bonds and 10 dollars of market capital. The market may decide that the corporation’s equity should be revalued at 7 dollars because the U.S. dollar has risen against the Euro, and a strong U.S. dollar will likely make the corporation less competitive in the export market.
This revaluation makes borrowing money from the debt market and the equities market more expensive. The debt market will be more expensive because the corporation’s debt to equity ratio will increase from 900% to 1276%. This will increases the cost of debt because the risk of default is greater as it is positively correlated to increased leverage.
This same scenario would create a higher cost of capital if the corporation chose to raise money through the equities market with a follow-on offering. The cost to the corporation would be dilution of asset value when the corporations issues new stock at a lower rate. Essentially the corporation would be agreeing to the asset devaluation by locking in the market capitalization when it issues and sells new stock at the current market value.
The opposite is true as well. When a corporation is revalued higher, both the risk of default and the amount of asset dilution is less relative to the pre-revaluation price. In this way the market determines the access and cost of society’s limited capital resources to every publically traded corporation. This is a powerful role.
In our financial market, shareholders are the ones holding all the cards. Shareholders penalize and reward corporations with access to capital resources by assigning market value. Shareholders value corporations by considering many factors. Some factors the corporation can control and some the corporation cannot; building a plant versus oil prices, respectively.
An easy example, as alluded to above, is a strong currency which hurts exporters. By having a factory in the United States a corporation’s ability to produce goods at a globally competitive price is strongly tied to the relative value of the U.S. dollar against other currencies.
If the U.S. dollar falls against the Euro, the domestic factory is able to pay its workers and overhead with relatively cheaper U.S. dollars. When the U.S. goods show up in the Euro-zone, the corporation can either choose to sell the goods for less Euros and gain market share or sell for the same amount of Euros and reap a larger profit margin. This is a win either way for the U.S. Corporation. Similarly, when the U.S. Corporation attempts to sell its goods on the domestic market, it also competes with European goods. The European corporations must decide either to take a profit margin hit or a competitive price hit when selling their goods in the U.S. market because the European corporations must pay their workers and overhead in a relatively more expensive currency.
The market will anticipate and internalize this winning situation and will express it in a revaluation of the corporation’s stock. This will allow cheaper access to capital should the corporation wish to expand or restructure. All the while the corporate directors do nothing but business as usual and enjoy their privileged position courtesy of a strong American trade deficit. On the other hand, while the manufacturing sector will benefit from a weak U.S. dollar, domestic corporations that import goods and services or have a large manufacturing base overseas will suffer.
Market value is therefore adjusted by the shareholders in large part because of what shareholders expect from the market external to the corporate book value or directors’ decisions. To require a director to maximize the wealth of the shareholder thus requires the director to control global variables well beyond their ability and control. Shareholders cannot reasonably expect this.
It may be argued that a director’s duty to the shareholder extends to maximizing wealth in the broader setting of the socio-economic climate; in other words, corporations should hedge their bets. For example, a corporation may do this by building production facilities on domestic and foreign soil. The canonical account of shareholder primacy would disagree. Shareholder primacy generally asserts that shareholders will themselves hedge their bets and they therefore prefer to invest in a corporation that is willing to take risks. The idea of a risk adverse board of directors does not sit well with the canonical view.[vi]
Although directors may not be able to control the market capitalization set by the shareholders, directors do have a strong incentive to increase the book value of the corporation and thereby influence the market value. Directors are incentivized because if a director does this well, the costs of capital will be significantly less. A well managed corporation should increase its market value reducing the cost of capital to the corporation. This market incentive stands in opposition to shareholder primacy because the market incentive to maximize book value of the corporation falls substantially short of placing a duty on directors to maximize shareholder wealth.
Market incentive provides directors with the incentive to increase the true or actual value of the corporation which will likely provide easier access to capital. On the other hand, the duty to maximize shareholder wealth amounts to a requirement that directors control the market price set by shareholders based on the shareholder’s view of the current socio-economic conditions.
As evidenced by recent inflationary bubbles, the market may make a valuation seemingly detached from the actual cost of an asset or growth potential of a corporation. In these periods of overvaluation, bubbles may form based purely on shareholder speculation. In arguing to replace the U.S. dollar as the global reserve currency, the United Nations recognized this problem and took a cynical view of market valuations by stating:
“Moreover, actors in financial markets are not concerned with properly assessing the performance of corporate firms or with the long-term valuation of real estate; otherwise large bubbles would not have occurred in stock and real estate markets.”[vii]
After the bursting of the real estate bubble, arguments are beginning to emerge that home owners and passive investors were the helpless victims of hedge funds and large corporate banks. After all, it was the home owners and the poor investors that lost their shirts in the crash. Absent clear cases of fraud, this argument overlooks the single fact that home owners could have chosen to rent. Home buyers from 2003 until mid-2006 purchased homes with mortgages upwards of two or three times what it would cost to rent a similar house.[viii]
The United States Department of Labor recognized that the cost of property was becoming detached from the actual consumption value of the property as early as 1983. In response, they changed how they measure the consumer price index (CPI, or price inflation) to reflect this detachment. The Department of Labor reasoned that calculating inflation based on the “market value” of the real estate: “can lead to inappropriate results for goods that are purchased largely for investment reasons”.[ix] To remove the speculative spread above actual consumption, the Department of labor began using “owners’ equivalent rent” to calculate the inflation metric of actual U.S. real estate consumption. In short home owners became speculators having the primary role in overvaluing real estate. In so doing home owners misallocated societies scarce resources.
The government’s uncommon prescience was validated when the market vastly overvalued the real estate market during the housing bubble. This overvaluation by investors and buyers engulfed this sector of our economy in a surfeit of financial resources using the mechanics discussed above regarding resource distribution through market valuation. The ravenous appetite of the market incentivized banks and hedge funds to produce ever riskier investment instruments to satisfy the unquenchable demand of the market.
Market incentive theory would submit that regulating the banks and the hedge funds will not prevent future bubbles or misallocation of financial resources because misguided regulations will either stymie creativity of innovative investment instruments, or the overwhelming force of the market will provide incentive to skirt regulatory laws. If investors choose to overguess the market value of a future asset, business entities will inexorably pander to market demands of resource allocation. Instead, market incentive theory would assert that the market is shortsighted and must be protected from itself. To ensure future economic sustainability the market itself should be regulated.
One solution may be to impose a progressive tax on trades that are increasingly detached from a base-line cost accounting value of the underlying asset. This may function to relieve some of the speculative pressure that builds asset bubbles while still preserving the freedom of the market to set the market value of an asset.
If the overwhelming force of the market is considered, the duty of shareholder primacy seems curiously misplaced. Shareholder primacy was given life based on a concept of shareholder ownership and has been reanimated by the idea of an unfixed contract.[x] This idea is inconsistent with itself because if fiduciary duties necessarily arise from unfixed contracts it is only proper to also place this duty on shareholders under the same contract. Possibly shareholders should have a duty to not undervalue a corporation and thereby cripple its access to the capital markets, but no duty is suggested by the canonical model.
Although not fixed, this contract is explicit, and it is in the shareholders hands. The contract between shareholders and the corporation explicitly states: well-managing directors may perhaps have access to affordable capital so long as shareholders view the corporation favorably, in light of and relative to the market; notwithstanding director actions, the shareholders have sole discretion to determine the corporate market capitalization. Parenthetically, when the shareholders decide what the market value of the corporation is, they are determining the value of their own wealth.
Happily, the courts have long freed directors from the confines of a fiduciary duty to shareholders with the application of the business judgment rule. The business judgment rule only requires that a director’s decision be informed and free of personal interest.[xi] If these two requirements are satisfied, then no substantive assessment of director performance regarding his duty toward the shareholders is made. This allows courts to pay lip service to shareholder primacy without disrupting the business world by actually enforcing it.[xii]
A reasonable canonical response might be that if there is no duty placed on directors, they will be inclined to shirk their responsibilities or self-deal. While it is true that a director who engages in self-dealing actions can be held accountable by shareholders, shirking would not be substantively critiqued under the canonical view so long as the director is informed.
Initially, the market incentive model would predict positive law to punish self-dealing directors because of society’s interest in the wealth production of corporations. The market incentive model would reward legal remedies for self-dealing directors by factoring in the lower risk this creates in corporate investment, thus allocating more resources to corporations relative to other investment instruments.
Further, a response based on market incentive would be twofold. First, there is the market incentive to diligently discharge the directors’ managerial duties and so win access to affordable capital. Second, the market incorporates the managerialism principal that managers’ actions should be substantively critiqued based on objective criteria. Directors and managers that do not meet objective criteria should be replaced or be financially penalized. It is worth noting again that these objective criteria should be independent of the prevailing financial market such as consumer market share and return on asset.
This argument may be evidenced by a study of over 11,000 corporations that comprise the S&P 500, S&P Mid Cap 400, and S&P Small Cap 600, between 1996 and 2004.[xiii] This study established a correlation between corporations with active founders and those without. This study explains that corporations having active founders or founder family members are 85% more likely to replace an underperforming CEO and have nearly double the pay-to-performance sensitivity than corporations without.[xiv] Also, the market places a premium on corporations where the founders or their family members are active in the corporation.[xv]
This premium has been termed the “founder premium” and quantified it at an average Tobin Q of .32 higher than firms without active founders.[xvi] Essentially this equates to the market pricing the replacement value of a corporation’s assets an average of 32% higher than a corporation without an active founder or family member. This study is strong support for the idea that shareholders reward corporations for a reasonable correlation between objective manager performance and between manager pay and turnover.
Another canonical response would be that in a hypothetical contract between shareholders and directors, shareholders would insist on the duties of shareholder primacy and the non-enforcement of this duty by the courts, courtesy of the business judgment rule.[xvii] This hypothetical transaction is evidenced by the majority of state law applying these concepts.[xviii]
While managerialism would likely not refute the idea that shareholders would insist on this duty and its non-enforcement, managerialists would argue only that it does not matter. This duty is not enforceable and therefore worthless in most real world applications. Directors further have no reasonable ability to discharge this duty because shareholders determine the market value in light of considerations that directors cannot control.
Although shareholders may insist on a duty of shareholder wealth maximization, this insistence does little to reify the duty. The managerialists might only add to the hypothetical bargain a requirement to manage utilizing objective criteria as evidenced by the founder premium.
Applying a Market Incentive model to current corporate governance offers an explanation of the intense and many times overpowering force of the financial markets under which corporations operate. This model calls into question the basic assertion of the dominant view that shareholders are at the mercy of corporate directors. Market incentive explains and integrates asset bubbles into the complex interactions between corporations and investors not accounted for in contemporary models. Market incentive further may be used to justify regulation of the forces controlling our society’s resource allocation by taxing risky speculation.
[i] Steven M. Bainbridge, The New Corporate Governance In Theory and Practice 33 (2008).
[ii] Class Lecture by David G. Yosifon, Assistant Professor, Santa Clara Law (February 9, 2010).
[iii] Steven M. Bainbridge, The New Corporate Governance In Theory and Practice 67 (2008).
[iv] Id. at 155.
[v] Id. at 202.
[vi] Id. at 115.
[vii] Conference On Trade And Development Geneva, Geneva, Switz., September 8, 2009, Trade And Development Report, 116.
[viii] Mike Shedlock, Case-Shiller CPI Now Tracking CPI-U; Real Interest Rates Are Once Again Negative, (2010), available at http://globaleconomicanalysis.blogspot.com/2010/03/case-shiller-cpi-now-tracking-cpi-u.html.
[x] Steven M. Bainbridge, The New Corporate Governance In Theory and Practice 68 (2008).
[xi] See Smith v. Vangorkum, 488 A.2d 858, 871 (Del.,1985)
[xii] See In re Walt Disney Co. Derivative Litigation, 907 A.2d 693, Del.Ch. (2005) (holding substantive director decisions protected by the business judgment rule after an 84 page diatribe chastising Disney directors for their actions and their fiduciary duty to the Disney shareholders).
[xiii] Feng Li and Suraj Srinivasan, Corporate Governance when Founders are Directors, 2 (2007), available at http://www.gsb.stanford.edu/facseminars/events/accounting/documents/FoundersasDirectors-LiSrinivasan2007.pdf.
[xiv] Id. at 3, 8.
[xv] Id. at 1.
[xvi] Id. at 2.
[xvii] Steven M. Bainbridge, The New Corporate Governance In Theory and Practice 123 (2008) (The argument asserts that shareholders will prefer the error of a director to that of a judge).
[xviii] Id. at 123.
© 2011 Santa Clara Law