Confronting a New Agency Problem

Adi Libson is associate professor at Bar-Ilan University. This post is based on a recent article by Professor Libson, forthcoming in the U.C. Irvine Law Review. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

2016 Nobel Laureate Oliver Hart and Professor Luigi Zingales have recently published an article justifying companies’ pursuit of social objectives at the expense of profits from within the shareholder primacy framework. They argue that in cases in which shareholders have social preferences besides maximization of profits, the maximization of their welfare requires managers and the directors to take these preferences into account.

My article, Taking Shareholders’ Social Preferences Seriously: Confronting a New Agency Problem, highlights an important consequence of this approach: a new agency problem between managers and shareholders regarding social preferences. It argues that there exists a systemic gap between managers and shareholders in regards to prosocial preferences. Shareholders have a greater tendency to sacrifice profits in order to promote a social goal than managers, who are more sensitive to the bottom line profit. Data regarding shareholders’ proposals during the 2016 proxy season support this claim. Among the 916 proposals of shareholders, 299 were aimed at enhancing the corporations’ engagement to promote social objectives such as diversity, environmental protection, and minimum wage. No proposals were made for scaling down social objectives in order to increase profits. There are two reasons for such systemic gap: managers’ human capital investment in the firm is less diversified than that of shareholders; and the existence of bonding mechanisms such as options and bonuses which intensifies managers’ sensitivity to the firm’s profits.

While Hart and Zingales discuss the need to delegate decisions on social matters to shareholders due to the possibility of a gap in the preferences of managers and shareholders, this article which points to the systemic gap in preferences, emphasizes the urgency of this delegation. It discusses two possible solutions to this agency problem: a bottom-up solution focused on enhancing shareholder ability to submit proposals on such issues, and a top-down solution based on an independent board sub-committee intended to identify social objectives and forward them for shareholder approval.

The analysis has various implications on existing rules regarding shareholder proposals. On the one hand, it justifies limiting the ordinary business exclusion. Rule 14a-8(i)(3) allows corporations to exclude shareholder proposals regarding “ordinary business operations”. This exclusion may undermine the cases in which the justification for promoting social goals through the corporation is strongest: existence of a synergy between the corporations’ business activity and the promotion of social objectives. The more the promotion of social goal is weaved and integrated within the corporations’ business activity, the greater is the potential for synergies. Proposals regarding promotion of racial and gender equality provide a sharp example for demonstrating this argument. The SEC backed ABC (1991) and Cracker Barrel (1992) in its no-action letters pertaining ABC’s exclusion of a proposal regarding the composition of its workforce and employment practices on grounds that it involves ordinary business operations. Since then the SEC retracted a bit its position (1998) limiting the exclusion from applying to issues that transcend the day-to-day business matters and are of “widespread debate”, but there is still much uncertainty regarding such proposals (Anderson, 2017). The fact that the promotion of gender and racial equality is done through ordinary business operations is exactly what makes it an effective tool for promoting those goals. In order to enable the fruition of such synergies, the “ordinary business exclusion” should be limited.

On the other hand, the analysis supports extending the exclusion of proposals regarding risks. In the aftermath of the financial crisis in 2008, the SEC has limited the ability to exclude proposals regarding financial risks based on the ordinary business exclusion. Unlike social goals, the gap between managers and shareholders’ concerns regarding risks isn’t as wide as the gap regarding social goals: managers are typically conservative and are also sensitive to financial risks. As such, the grounds for enabling proposals on such issues is weaker and there are stronger grounds for the ordinary business exclusion to apply to such proposals.

The top-down solution proposed in this article is to form a sub-committee of the board that would be in charge of surfacing the preferences of shareholders regarding potential social issues. The function of such committee is fundamentally different than that of conventional social responsibility committees that currently exist in many corporations. The function of the conventional social responsibility committee is to enhance the engagement of the corporation with social goals as much as possible. Studies that measure their efficacy use the listing of the corporation on the Dow Jones Sustainability Index as a proxy assuming a higher ranking reflects greater efficacy of such committees (Eberhardt-Toth 2017). This is not the function of the committee suggested in this paper: its main function is surfacing the preferences of shareholders. If most of the shareholders of the company want to maximize profits, a low level of engagement in social activities is a success of such a committee.

There are two versions in which such committee can function: formal and informal. Under the formal model when the committee detects a potential issue for social engagement of the company it can question whether the company should engage in such activity on the proxy ballot accompanied by relevant proxy material for making the decision. Under the informal version, the committee polls a certain fraction of the shareholder base regarding a potential issue for social engagement, in order that the management would have some sense of the preferences of the shareholder regarding the desirability of engaging in the social issue at question. The former version may be more binding for the management, but more costly to implement. The article also discusses whether each of the versions may give rise to a duty of care or duty of loyalty for the management and the board to pursue social goals that have received support from a majority of the shareholders.

The complete article is available here.

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