Shareholder Collaboration

Jill E. Fisch is Perry Golkin Professor of Law at the University of Pennsylvania Law School and Simone M. Sepe is Professor of Law and Finance at the College of Law at the University of Arizona. This post is based on a recent paper by Professor Fisch and Professor Sepe.

Legal and economics scholars have developed and debated theories of the firm since the groundbreaking work of Ronald Coase in 1937. Two models have come to dominate that discourse. Under the management-power model, the firm is a hierarchical organization, and decision-making power authority belongs to corporate insiders (officers and directors). The competing shareholder-power model de-emphasizes authority in favor of accountability and contemplates increasing shareholder decision-making power to hold insiders accountable. Both models share two key assumptions. First, they view managerial moral hazard as the central problem of corporate law. Second, they assume that insiders and shareholders are engaged in a competitive struggle for corporate power.

Corporate practice has moved on, however. Increasingly, the insider-shareholder dynamic is collaborative, not competitive. Although shareholders are no longer dispersed and passive but empowered, in many cases they are using their greater power not to wrest control from corporate insiders but to work together with insiders and bring new information and insights to operational decision-making.

Our paper, Shareholder Collaboration, traces the development of insider-shareholder collaboration and constructs a taxonomy of the novel collaborative model. We first explain how collaboration originated in the venture capital context. In the VC firm, founders and investors routinely bargain for collaborative structures that promote shared power and joint decision-making, rather than competing for unilateral decision-making power. Collaboration enables participants in the VC firm to address partial information costs and to develop and aggregate information that would be lost under unilateral decision-making.

We then explore how the increasing problem of partial information costs together with the growing sophistication of institutional investors provide a similar rationale for collaboration in public companies. We document the spectrum of collaboration in the public company context, showing how different types of institutional investors collaborate in different ways. Activist hedge funds invest in industry and firm-specific information that enables them to provide operational input. Mutual funds offer expertise on governance issues and broader policy developments. Examples of shareholder collaboration include direct shareholder engagement about matters of concern, the flourishing of private initiatives aimed at introducing shared governance principles, activist interventions oriented to the longer term, the appointment of activist directors and several other forms of “constructivist” activism.

Using insights from game theory, we demonstrate how, in appropriate circumstances, collaboration promotes the production and aggregation of the partial information of insiders and shareholders, adding value that is lost under unilateral decision-making by either the board or the shareholders. We identify the necessary conditions to make collaboration effective and demonstrate how collaboration can be more efficient than market mechanisms for aggregating information to increase firm value. We also document how specific features of corporate law, such as the equity contract, make collaboration incentive-compatible.

We do not claim that collaboration is universal, and we note that the range of collaborative engagements continues to evolve, but we argue that a shift toward committed shareholders participating in a joint decision-making role with insiders has occurred, and we argue that shareholder collaboration will continue to increase and, to an extent, supplant the traditional competitive model of corporate law.

We conclude by noting that the growth of shareholder collaboration has important implications that may require modifications to existing corporate law principles that focus primary on policing insider-shareholder confrontations. In particular, collaboration increases the potential that insiders and shareholders may act opportunistically. Opportunistic behavior may jeopardize the viability of value-increasing collaboration. We identify three main risks. First, there is the risk that the collaborative process will afford shareholders access to firm-specific information and that shareholders will mis-use that information to benefit themselves or harm the corporation. Second, there is the broader risk that both shareholders and insiders may engage in deviating behaviors by acting to further their private interests, jeopardizing the viability of collaboration. Third, there is the risk of shareholder-insider collusion that may sacrifice the interests of other shareholders or non-shareholder constituencies. As the Article shows, the existing tools to address these concerns—confidentiality agreements and fiduciary duties—are ill-suited for a collaborative context and should be rethought.

The complete paper is available for download here.

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