Radical Shareholder Primacy

The following post comes to us from David Millon, the J.B. Stombock Professor of Law at Washington and Lee University.

My article, Radical Shareholder Primacy, written for a symposium on the history of corporate social responsibility, seeks to make sense of the surprising disagreement within the corporate law academy on the foundational legal question of corporate purpose: does the law require shareholder primacy or not? I argue that disagreement on this question is due to an unappreciated ambiguity in the shareholder primacy idea. I identify two models of shareholder primacy, the “radical” and the “traditional.” Radical shareholder primacy makes strong claims about both shareholder governance rights, conceiving of management as the shareholders’ agent, and also about corporate purpose, insisting that corporate law mandates shareholder wealth maximization. Because there is no legal basis for either of these claims, those who deny that shareholder primacy is the law are correct at least as to this model. However, the traditional version of shareholder primacy accords to shareholders a special place in the corporation’s governance structure vis-à-vis the corporation’s nonshareholder stakeholders, for example, with respect to voting rights and the right to bring derivative suits. Beyond this privileged position in the horizontal dimension, there is no maximization mandate and corporate law does very little to provide shareholders with the tools necessary to exercise governance powers; there is no primacy in the vertical dimension or on the question of corporate purpose. Nevertheless, this conception of shareholder primacy—modest as it is—is enshrined in corporate law. Those who deny that shareholder primacy is the law need to acknowledge this fact, but once it is understood that traditional shareholder primacy has little in common with the radical version there is no reason to be reluctant to do so.

The key feature of radical shareholder primacy is the assertion that corporate management is the agent of the shareholders, charged with maximizing their wealth. The agency characterization is descriptively inaccurate because of corporate law’s assignment of broad discretion to management and its weak commitment to managerial accountability to shareholders. This is evident in the general inefficacy of voting rights in public companies, the procedural hurdles that stand in the way of derivative suits, the business judgment rule’s broad protection of director discretion, and the statutory assignment of governance authority to the board of directors. The right of control that is the hallmark of an agency relationship is essentially nonexistent. Nor does the law impose a general duty to maximize shareholder wealth. The few cases like Dodge v. Ford that prioritize shareholder interests over those of nonshareholders do not speak of maximization and Revlon‘s mandate applies only in a narrowly defined range of situations that management can freely avoid.

Radical shareholder primacy originated at the University of Chicago in the later 1970s. It was part of the rapid emergence of law and economics at Chicago and its colonization of virtually every area of law. In corporate law, Daniel Fischel was the key player and deserves a large measure of credit (or blame, depending on one’s point of view) for reorienting corporate law scholarship around the agency idea. In his Texas Law Review article published in 1978, [1] Fischel conceived of corporate management as the agent of the shareholders charged with maximizing their wealth and criticized legal regulation of corporate takeovers from that perspective. He drew the agency and maximization ideas not from corporate law, where they were not to be found, but—like other Chicago scholars applying economics to their legal specialties—from cutting edge economic theory. Fischel was the first legal academic to rely significantly on Michael Jensen and William Meckling’s now well-known “Theory of the Firm” article published in 1976. [2] He did so even though Jensen and Meckling were using the agency idea in a non-legal sense, referring generally to situations in which one person acts on behalf of another. Once appropriated by legal academics, the agency idea took on a life of its own, providing a powerful normative boost to claims about shareholders’ rights of control over management and management’s fiduciary duty to maximize the value of their investments. For these scholars, agency costs became the central problem for corporate law.

In contrast to the radical version of shareholder primacy, traditional shareholder primacy is grounded in corporate law. It is based on the idea that shareholders hold a privileged position within the corporation’s governance structure, enjoying a monopoly over voting rights and the right to bring derivative lawsuits and singled out for special mention in the traditional specification of fiduciary duties as being owed to “the corporation and its shareholders.” In this sense, shareholders enjoy primacy over the corporation’s other stakeholders, although there is no maximization mandate and corporate law is largely ineffective in empowering shareholders to insist that management privilege their interests. In the governance dimension, traditional shareholder primacy resonates with Stephen Bainbridge’s “director primacy” account of corporate law, although I would disagree with his view that the law requires even a watered-down commitment to shareholder wealth maximization.

Traditional shareholder primacy has its roots in the nineteenth century. Early corporations were closely held and employed one or a few salaried managers. Because of these firms’ functional similarities to partnerships, it was plausible as a descriptive matter to analogize shareholders’ governance authority within the corporation to those of partners in a general partnership. The shareholders, or at least a majority of them, typically participated directly in control over the firm’s activities and enjoyed the legal right to do so. It made sense to describe managers, directors, and lower-level employees as the shareholders’ agents because the idea of the corporation as a distinct legal person (and therefore the agents’ principal) was not yet well established.

The agency characterization ceased to be accurate by the end of the nineteenth century as corporations grew in size and complexity, the number of shareholders increased, and the “separation between ownership and control” became increasingly typical. Corporate law and legal theory adjusted to the fact that most shareholders no longer had the expertise or the inclination to participate directly in control of the business or to exercise meaningful control over those who possessed managerial authority. Most notably, the relation between shareholders and management was reconceived such that the powers of the board of directors were now said to be “original and undelegated,” an express repudiation of the older idea that shareholders conferred authority on the board and others who worked for the business. The development of the business judgment rule further enhanced managerial autonomy. Voting and informational rights survived as vestiges of an older age when shareholders, like partners, controlled their firms, but state corporate law did little to transform these rights into meaningful control mechanisms. While it was assumed that a business corporation is organized in order to generate profit and, as a practical matter, a corporation that regularly loses money cannot survive long-term, there was no legal requirement that management maximize current share price or long-term profits to the exclusion of competing objectives. These could include regard for the interests of non-shareholder constituencies under circumstances management deems to be in the corporation’s best interest, as well as long-term investments that reduce current earnings for the sake of future gains. Certainly there was no sense that an agency relationship existed between management and shareholders. The traditional conception of shareholder primacy, widely accepted for much of the twentieth century and only derailed relatively recently by the radical version, thus offers scant support for a robust shareholder empowerment agenda.

The full article is available for download here.

Endnotes:

[1] Daniel R. Fischel, Efficient Capital Market Theory, the Market for Corporate Control, and the Regulation of Cash Tender Offers, 57 Tex. L. Rev. 1 (1978).
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[2] Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).
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