Lawsuit Against Meta Invokes Modern Portfolio Theory To Protect Diversified Shareholders

Frederick Alexander is the CEO of The Shareholder Commons. This post is based on the class action filed against the directors of Meta Platforms (formerly Facebook, Inc.), and is part of the Delaware law series; links to other posts in the series are available here.

New Lawsuit Argues that Directors Failed to Consider Portfolio Impacts of Corporate Decisions

On Monday, October 3, a class action was filed in the Delaware Court of Chancery against the directors of Meta Platforms (formerly Facebook, Inc.), alleging that they breached their fiduciary duties by ignoring the impact of the company’s operations on the diversified portfolios of its shareholders. Among other matters, the McRitchie v Zuckerberg complaint challenges (1) the conduct revealed by Frances Haugen, the “Facebook Whistleblower,” (2) the large distributions of cash made to shareholders through stock repurchases, and (3) the board’s rejection of shareholder proposals that would have helped discern the broader impact of the company’s business model.

The complaint is based on the traditional shareholder primacy model, which provides that directors have fiduciary duties to the holders of a company’s residual equity–generally its common shareholders. It does not seek to expand those duties to encompass other stakeholders. However, the complaint does drill down on an issue that courts have yet to fully address: the fiduciary implication of the fact that modern investors are generally diversified, so that their interests extend beyond (and may be in opposition to) the maximization of the value of future cash flows to be received from owning a company’s shares.

The complaint alleges that the Meta directors failed to consider that shareholders with diversified portfolios may be subject to net losses from Meta’s pursuit of a business model that maximizes advertising revenue without regard to the harms it inflicts on the rest of their portfolios. In particular, the complaint identifies press reports establishing that the company knew that its conduct was leading to mental health issues for millions of users and increasingly negative political rhetoric, while facilitating ethnic cleansing, drug cartels, modern slavery, and vaccine disinformation. These activities pose risks to political stability, public health, and rule of law, threatening the intrinsic value of the global economy and thus the value of diversified portfolios. (As diversified portfolios represent a slice of the economy, reducing the value of the global economy inevitably reduces portfolio value. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV.)

The complaint also notes that when shareholders used the shareholder proposal process under Rule 14a-8 to suggest that the company should consider these concerns, the board of directors declined to do so:

These press reports were followed by multiple stockholder proposals to investigate the types of risk articulated in the press reports. The Board rejected each proposal without giving any consideration to the benefits that limiting external costs would provide to the diversified stockholders to whom it owed duties of care, loyalty and good faith.

Distinguishing the Complaint From Models Based on Either Stakeholder or Enterprise Value

It is important to note two things that the complaint does not claim. First, it does not claim that stakeholders (e.g., users of its platforms or citizens of destabilized countries) are owed fiduciary duties, or that harm to these stakeholders in and of itself constitutes a fiduciary breach. Secondly, the complaint does not allege that this conduct was bad for Meta’s own finances. Instead, the complaint alleges that the conduct revealed by Haugen threatens the global economy, and consequently the portfolios of the Company’s diversified shareholders. The complaint explains:

Meta is the largest social media network company in the world, with 3.5 billion users—43% of humanity. Its business decisions inevitably create financial impact well beyond its own cash flows and enterprise value and have significant impacts on the global economy. While defendants have a duty to operate the Company as a business for the financial benefit of its stockholders, those stockholders are often diversified investors with portfolio interests beyond Meta’s own financial success. If the decisions that maximize the Company’s long-term cash flows also imperil the rule of law or public health, the portfolios of its diversified stockholders are likely to be financially harmed by those decisions.

Moreover, the plaintiff asserts, diversification is not merely incidental to some of the shareholdings. Portfolio diversification optimizes risk and return because it allows investors to obtain the increased returns available from first loss securities while eliminating idiosyncratic company risk. The opportunity presented by diversification is the critical insight of Modern Portfolio Theory, and it has been incorporated into many of the laws that govern institutional investors. In other words, for typical investors, the ownership of common stock is inextricably linked to diversification. (Before the advent of MPT, “legal lists” prohibited many fiduciaries from owning common stock.)

The complaint posits that in light of these realities—the company’s widespread economic impact and the diversification principle applicable to modern investing–the well-established doctrine of stockholder primacy cannot be rationally applied on behalf of investors without considering the impact of company decisions on diversified portfolios:

The economic benefits from— indeed the viability of– a system of corporate law rooted in maximizing financial value for stockholders would vanish if it forced directors to make decisions that increased corporate value but depressed portfolio values for most of its stockholders.

The Conflict of Interest between Insiders with Concentrated Investments in a Company and Diversified Shareholders

The complaint also notes that the company is under the absolute control of Mark Zuckerberg, its Chairman and CEO, who holds a type of common share that has ten times the voting power of the shares held by the public. Moreover, because Zuckerberg’s wealth is dependent almost entirely on the value of Meta shares, he is not diversified, so that his interests diverge from the interests of typical, diversified shareholders:

This circumstance is particularly troubling because it favors the small subset of stockholders who control the Company through the ownership of highly concentrated positions of high-voting common stock, including the Company’s CEO and Chairman. For this controlling subset, maximizing the value of the Company by undermining the global economy is financially beneficial. This conflict is exacerbated by Company policies that require all directors and high-ranking officers to own Company stock, as well as the granting of initial and annual awards of stock to all directors . . . .

This conflict is directly implicated when the board chooses to repurchase shares, which increases cash flows to Meta shareholders, because that cash could be invested to address the broader concerns that threaten diversified portfolio values:

Every year, the Board elects to spend tens of billions of dollars on stock repurchases, while ignoring the costs it visits on diversified portfolios. In 2021, it used this tool to pay more than $44 billion to stockholders. The media reports make it clear that there are opportunities for the Company to improve its economic impact (and thus the financial position of its diversified stockholders) by investing some of its cash flows in greater security or by changing certain practices in a manner that would reduce those cash flows.

Fitting Shareholder Primacy Into a Rational Financial System

A prior post cited multiple authorities showing why the fiduciary obligations of pension trustees and other investment fiduciaries, which require them to manage portfolios for the best interests of their beneficiaries, obligate these fiduciaries to consider the interdependence of the different companies within their portfolios. This means, where possible, preventing portfolio companies from maximizing their own enterprise values to the extent such maximization would externalize costs that create a net negative return for their beneficiaries’ portfolios.

The understanding of corporate fiduciary duties implicit in the McRitchie complaint is thus consonant with the obligations of the institutional investors that dominate today’s capital markets because an overemphasis on enterprise value is likely to harm most shareholders. It is also consonant with recent economic literature: a paper from Oliver Hart and Luigi Zingales observes that “the shareholders of one firm may be concerned about the impact of that firm’s externalities on the profitability of other firms the shareholder owns,” and finds that this is one of several reasons that shareholders might object to a company they own focusing solely on maximizing its own financial returns. Hart and Zingales, The New Corporate Governance.

There are two primary justifications for the doctrine of shareholder primacy. The first is that it is necessary to encourage investors to provide the risky first-loss capital that undergirds a creatively destructive economy. The second is that profit-seeking guides the invisible hand of the market, recruiting the motivation of private gain to serve the public good by allocating scarce resources. One might argue that these two social technologies are as responsible for the material bounty of today’s global economy as are the technologies brought to us by scientists and engineers. The McRitchie complaint demonstrates how each of these justifications are betrayed when a company prioritizes its own enterprise value over the intrinsic value of the economy upon which its shareholders rely.

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