Corporate Law and the Myth of Efficient Market Control

William W. Bratton is Nicholas F. Gallicchio Professor of Law and Co-Director, Institute for Law & Economics at University of Pennsylvania Law School; and Simone M. Sepe is Professor of Law and Finance at the University of Arizona James E. Rogers College of Law. This post is based on their recent article, forthcoming in the Cornell Law Review.

A central question in corporate legal theory is whether large corporations should be conceived as hierarchical enclaves that operate apart from markets or as entities that operate within markets and under market control. The majority favors market control, making two basic assumptions: first, shareholders have the right incentives to mitigate the managerial agency problem, and, second, competitive markets are intrinsically superior to institutions as coordinators of production. Recent developments in practice appear to vindicate this majority view, turning shareholder empowerment from a normative aspiration to a positive reality. The rise of hedge funds and other activist investors has brought an unprecedented shift in power from managers to shareholders, who are now empowered to determine business decisions at publicly-traded companies.

In our article Corporate Law and The Myth of Efficient Market Control, forthcoming in the Cornell Law Review, we take the occasion of these transformative changes to put corporate legal theory’s majority view to the test, through a comprehensive economic examination of the claim of efficient market control. This examination brings to the forefront a substantial theory of markets and prices that has never been explored before in corporate law, general equilibrium theory (GE).

Corporate legal theory’s equation of market control and economic efficiency has its roots in Jensen and Meckling’s (J-M’s) principal-agent model. We reconsider the model’s operation and implications, highlighting a neglected feature—its narrow partial equilibrium framework. Partial equilibrium models deal with one market at a time, taking the market in isolation in determining the equilibrium outcome. Thus does the J-M analysis assume that management moral hazard is the firm’s only unsolved problem and then apply market control to minimize the resulting agency costs. In the model’s framework of reference, agency cost reduction, and hence greater shareholder influence, always enhances efficiency because all other things are assumed to be not only equal but efficient.

Results produced in a partial equilibrium analysis tend to vary with the model’s “details”—its assumed variables of interest and mode of exploring the variables’ behavior in an environment in which all other variables are kept fixed. Different details can yield a contrasting picture of the same phenomenon. Thus does another line of partial equilibrium analysis, which models management “myopia,” send a contrary signal. Here the locus of imperfection shifts from management moral hazard to the asymmetric information problem bound up in the fact that market shareholders know less about the business than do its managers. On this different assumption, these models show formally that inefficiencies result under greater shareholder influence.

How does one decide which model is “right” when confronted with such opposing results? The answer is that we cannot. Both sets of models should be seen as useful examples which can highlight logical shortcomings in normative arguments. But neither can provide the basis for a more general theory with normative implications for corporate governance. This is the infirmity at the core of corporate legal theory: it takes J-M’s brilliant example and deploys it as a normative theory.

Our article’s introduction of general equilibrium theory to corporate governance seeks to remedy this infirmity. Unlike in partial equilibrium analysis, in a general equilibrium framework the equilibrium concept sweeps in all markets simultaneously and incorporates their interactions. Methodologically, GE looks at the economy as a closed and interrelated system, simultaneously determining the equilibrium values of all variables of interest in all markets. Further, because all relevant variables are considered as endogenous, a change in one variable always results in re-computation of all other variables. This explains why GE can aspire to normative implications where a partial equilibrium model cannot.

Reference to GE yields three crucial lessons. The first concerns the widely-held assumption that economic theory instructs us that consumer surplus is maximized when competitive markets guide production. GE shows that this assumption is unfounded unless one also assumes complete markets, as did Arrow and Debreu in the first and fundamental GE model of the economy. Complete markets imply a world where everything can be traded and parties can deal with uncertainty by insuring their preferences in advance, almost as if uncertainty did not exist. A reasonable observer quickly will conclude, however, that markets are, in fact, not complete. Once this reality is factored in, GE shows that market control yields inefficient results.

The second lesson follows when one brings GE models of business decision-making by shareholders to corporate legal theory. The models yield a picture of distorted incentives due to market incompleteness, with the shareholders making production decisions based on idiosyncratic consumption preferences rather than fundamental value. GE models also show uncertainty undermining market pricing accuracy, results that are replicated by contemporary asset pricing theory. Between the two results, corporate law’s prevailing market control paradigm is undercut. Microeconomics teaches that it is not safe to assume that agency cost reduction stemming from the shareholder power shift maximizes value. It instead situates us in a world with a two-sided incentive problem, one concerning managers and already well-traversed in corporate legal theory and the other concerning shareholders and only beginning to be acknowledged, much less studied.

The third lesson is negative, for GE does not tell us how optimally to address the two-sided problem of agency costs and market inefficiency. The shift of decision-making power to shareholders transforms the corporation into a hybrid form that straddles the firm and the markets. As yet no general economic theory tells us the best way to structure this hybrid corporate form. Indeed, economic theory does not even offer any useful presumptions. While the microeconomics of incentives shows (in partial equilibrium examples) that agency cost reduction enhances firm value, GE denudes the assertion of normative salience when it shows that shareholder business decision-making can produce suboptimal results. At the same time, while GE models could appear to support a policy presumption against shareholder empowerment, a closer look teaches a different lesson. Management moral hazard remains in the GE’s picture as a source of market incompleteness, thus blocking any anti-shareholder or pro-management presumptions.

We walk away from these lessons with two policy recommendations and a novel economic justification of Delaware’s system of judicial decision-making. The first recommendation suggests a moratorium on policy proposals favoring either market control or management insulation. While GE’s ultimate normative teaching is negative, it is by no means irrelevant for it implies a presumption that proposals for either market control or for management insulation lack support in economic theory and have distortionary effects in practice. This lesson by itself has radical implications for corporate legal theory.

A second recommendation follows from this cautionary policy outcome, one that restates and updates the old presumption favoring private ordering in corporate governance. Economic theory counsels that in an imperfect world off-market contracting that directs incentives in the proper direction offers a more promising route to productive efficiency than does market control. More promising but not necessarily efficient: in bargaining theory the party with bargaining power controls the result whether or not the outcome is optimal. It follows that the possibility of contracting does not preclude suboptimal outcomes, as it cannot rule out the opportunistic abuse of bargaining power by either managers or empowered shareholders. Today’s challenge for corporate law is thus to avoid distortionary dominance of the bargaining process by either contracting party.

We also make a prediction: corporate law, as interpreted and enforced in Delaware, is well-positioned to face the challenges posed by the hybrid corporation. Delaware courts have never imposed maximizing directives based on economic theory. They instead leave the basic alignment of the parties’ entitlements to the parties’ own bargaining process and address problems that arise in the course of events through a pragmatic process of equitable adjudication. As equity adjudicators, the Delaware chancellors have wide latitude to mold earlier decisions to fit new facts and thereby adapt the law to ever-changing economic circumstances and legal relationships. In light of the results of our analysis, we think this flexible approach can be characterized as economically astute.

The complete article is available here.

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