COMMON AGENCY THEORY AND ITS APPLICATION TO
In the classic theory of the firm, agency costs rise when ownership is separated from control, as managers with reduced share ownership bear less of the costs associated with their personal benefits To mitigate this issue, shareholders aim to align the interests of managers with their own, leading to the concept of agency costs, which encompass monitoring costs, bonding costs, and divergence costs Monitoring costs involve expenses related to limiting managerial opportunities to exploit benefits at shareholders' expense, including budget restrictions and auditing Bonding costs arise when managers provide guarantees to shareholders, such as contractual limitations on their decision-making authority Lastly, divergence costs stem from any misalignment between the interests of the principal (shareholders) and the agent (managers).
17 Michael C Jensen & William H Meckling, Theory of the Firm: Managerial Behavior,
Agency Costs, and Ownership Structure, 3 J FIN ECON 305 (manuscript at 1), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid043## (1976)
23 Id at 29 despite the monitoring and bonding efforts to align their interests, are referred to as residual losses 24
Agency costs in the corporate realm often center on executive compensation and management perks, with federal regulators increasingly scrutinizing these aspects to enhance accountability and reduce costs The prevailing assumption is that shareholders aim for wealth maximization, viewing themselves as a unified principal in a straightforward principal-agent relationship This model effectively addresses various economic phenomena within corporations However, as noted by Bernheim and Whinston, the actions of an agent can impact multiple principals with conflicting preferences, leading to a common agency scenario This distinction highlights the complexity of agency relationships beyond the traditional single-principal framework, emphasizing the need for a broader understanding of collective principal dynamics in agency theory.
25 See, e.g., Lucian Arye Bebchuk & Jesse M Fried, Executive Compensation as an Agency Problem, 17 J ECON PERSP 71 (2003); Geoffrey S Rehnert, The Executive Compensation
Contract: Creating Incentives to Reduce Agency Costs, 37 STAN L REV 1147 (1985)
26 B Douglas Bernheim & Michael D Whinston, Common Agency, 54 ECONOMETRICA 923, 923-942, (1986)
28 The typology set out here and in the accompanying figure is derived from Daniel L
Nielsen & Michael J Tierney, Principals and Interests: Common Agency and Multilateral Development Bank Lending, 2008 Midwest Pol Sci Assoc Meeting (April 2008)
Figure 1: Types of Agency Relationships
Common Agent of Multiple Principals
Common agency theory is a valuable framework for understanding various principal-agent relationships, particularly in political economics It is utilized by game theorists to model these interactions, especially in the context of government agencies that report to multiple entities, including the executive branch, legislative branch, and the courts.
29 See, e.g., Avinash Dixit, Power of Incentives in Private Versus Public Organizations, 87
AM ECON AsS'N PAPERS AND PROc 378, 378-379 (1997)
Avinash Dixit highlights that government bureaucracies uniquely respond to various principals, including the executive, Congress, courts, media, and organized lobbies He explores the implications of common agency theory within corporations, but assumes a homogeneity of shareholder interests, which leads to discussions on its relevance to stakeholder theory.
In recent developments in the United States and the United Kingdom, the concept of a "stakeholder economy" has emerged, emphasizing that companies should be accountable not only to their shareholders but also to a broader range of stakeholders.
Common agency theory in corporate law suggests that managers act as agents not only for shareholders but also for various stakeholders, including employees, suppliers, and creditors While these stakeholders share some interests, they also have competing goals; for instance, shareholders aim for stock price maximization, whereas workers focus on their own utility This conflict becomes evident when decisions, like closing an underperforming factory, arise Although stock options may align some worker interests with shareholders, they do not fully bridge the gap between the two groups Consequently, when boards of directors favor one constituency over another, they act as common agents However, the prevailing U.S corporate governance framework, which is increasingly influenced by federal regulations favoring shareholder primacy, limits the applicability of common agency theory as a descriptive model for management's relationships with corporate stakeholders.
Common agency theory can be applied to public corporations, where managers are accountable to multiple shareholders with diverse interests This perspective includes not only shareholders but also workers, creditors, and the local community as influential stakeholders If this approach is integrated into the legal and organizational framework of corporations, these groups will act as principals, with the firms serving as common agents This "politicization" of firms may further diminish the effectiveness of incentives, which are already weakened by various factors.
The concept of the "constituency director" highlights the conflict between representing specific stakeholder interests and the legal obligation of directors to prioritize the corporation and all shareholders According to Joseph Hinsey in the Harvard Law School Forum, while constituency directors may advocate for their specific groups, they must ensure full disclosure and ultimately vote in the best interest of all shareholders, maintaining a balance between their advocacy role and their fiduciary duties.
Common agency theory has yet to be explicitly applied to the management-shareholder relationship in legal scholarship, despite Jeffrey Gordon's recognition of shareholders as "multi-principals" nearly twenty years ago His game-theoretic insights into shareholder voting remain relevant as they highlight the dynamics of management acting as agents while shareholders unite as principals Federal regulations governing public corporations are typically based on a collective principal agency theory; however, this framework fails to account for the complexities introduced by competing shareholder groups and their activism By adopting a common agency theory perspective, we can achieve a more nuanced understanding of management-shareholder interactions, which is essential for developing effective regulatory strategies to address agency costs.
Evidence of Common Agency in Public
Shareholder Influence in Public
Shareholder influence manifests in various ways, as highlighted by Stephen Choi and Jill Fisch's survey on public pension fund activism, which identified twenty-six distinct types of activism Notably, over half of the surveyed funds frequently engaged in activities such as writing comment letters to the SEC, building coalitions for support, withholding votes from management director candidates, and participating in corporate governance programs and organizations Additionally, more than one-third of the funds directly influenced managers through letters or negotiations.
A small but active group of shareholders participates in proxy activism by submitting shareholder proposals, which can be categorized into two main types: corporate governance proposals and power increases This article takes a unique approach by applying the theory of common agency to the relationship between shareholders and management, expanding the focus to encompass overall shareholder influence beyond just voting.
34 Stephen J Choi & Jill E Fisch, On Beyond CalPERS: Survey Evidence on the Developing Role of Public Pension Funds in Corporate Governance, 61 VAND L REV 315 (2008)
36 Id Choi and Fisch report that 17.5 percent of public pension funds engage in proxy activism. and social proposals With respect to corporate governance, investors have focused on a number of key issues in the past several proxy seasons.
In recent years, shareholder activists have successfully pressured corporations to remove antitakeover measures that are often viewed as tools for management entrenchment This has led to a significant reduction in companies with classified or staggered board structures, which previously hindered the election of directors As a result of sustained efforts, annually elected boards have become the norm Activists have also championed majority voting proposals and the elimination of certain poison pills, while executive compensation proposals have gained traction among proxy advisors and institutional investors Notably, activists have advocated for "say-on-pay" provisions and clawback policies to recover compensation linked to executive misconduct Additionally, the influence of shareholder activists is evident in their ability to secure board seats, with reports indicating that from 2006 to 2008, activists gained seats at 218 companies, often without formal proxy fights, highlighting their growing impact on corporate governance.
37 GEORGESON, 2007 ANNUAL CORPORATE GOVERNANCE REVIEW 18 (2007)
39 Id at 4-5 Majority vote provisions require a director candidate to have received a majority of affirmative votes in order to be seated For a discussion of the various types of majority vote proposals and their merits, see William K Sjostrom Jr & Young Sang Kim, Majority Voting for the Election of Directors, 40 CONN L REV 459 (2007)
40 GEORGESON, 2009 ANNUAL CORPORATE GOVERNANCE REVIEW 4 (2009)
41 Dennis K Berman, The Game: In Era of Activists, Look to Changes, WALL ST J., July 8,
2008, at C1 already won or wrested concessions in nearly 60% of 78 completed or threatened proxy contests of 2008, the highest percentage ever." 4 2
Shareholder proponents have faced challenges in advancing social causes via the proxy process, yet they have achieved gradual progress Notably, successful proposals often focus on environmental concerns, exemplified by calls for the board to conduct studies assessing the environmental impact of the company's operations.
While the proxy process is the most researched method of shareholder activism, shareholders have also engaged directly with other shareholders and the public This activism often has political undertones, exemplified by the campaign to pressure South Africa to end apartheid through divestment from companies operating there Additionally, corporate governance proposals can be communicated to shareholders via public channels, including press releases and SEC filings A notable instance occurred in 2008 when activist investor Bill Ackman presented a public strategy for improving Target Corporation's performance, targeting both the company's board and management with actionable recommendations.
44 Under the Bush administration, the SEC considered pushing back against non-binding shareholder proposals In 2007, the SEC sought public comment on a number of proposals, three of which would have affected social proposal proponents particularly According to ISS, "The SEC has asked whether boards should be allowed to opt out of non-binding proposals without obtaining investor approval if the company is incorporated in a state that would permit such a change Second, the SEC asks whether companies should be allowed to institute electronic shareholder forums in lieu of non-binding proposals Finally, the agency is seeking comment on whether to raise resubmission thresholds to ten, fifteen, and twenty percent Such a change would primarily impact social resolutions, which historically have received less support than many governance proposals." Id at 34.
45 As a study conducted by Teoh, Welch, and Wazzan suggests, such activism often has more bark than bite:
Contrary to popular belief and strong claims in financial media, there is no evidence that anti-apartheid shareholder and legislative boycotts negatively impacted the financial sector In fact, the introduction of legislative or shareholder pressure did not significantly influence the valuations of banks and corporations operating in South Africa, nor did it affect the South African financial markets.
In their study, Teoh, Welch, and Wazzan (1999) analyze the impact of socially activist investment policies on financial markets, specifically examining the South African boycott They conclude that the minimal significant effect observed is largely due to a reallocation of investments rather than a direct influence on market performance.
The authors emphasize that while the boycott may not have succeeded as a punitive measure, it likely played a role in elevating public awareness and moral standards regarding South African repression Furthermore, the public disclosure of Ackman's presentation not only informed shareholders about his vision for the company but also set the stage for anticipated responses from the board and management regarding his value-creation proposals.
These forms of activism share a common characteristic: they are all public-obviously intended to be visible to other shareholders.
Activist shareholders are increasingly engaging directly with company directors through private communications, as fund managers act as fiduciaries for the beneficial owners According to Institutional Shareholder Services (ISS), this trend of activism has grown significantly, with boards more open to dialogue with investors One indicator of this increased engagement is the rise in withdrawn proposals during proxy seasons; while numerous proposals are submitted for inclusion in annual proxy statements, only a small percentage make it to the final statement Many proposals are excluded due to company objections, but others are voluntarily withdrawn after discussions with management, often resulting in agreements to adopt or modify policies in line with shareholder interests For instance, the 2007 proxy season saw unprecedented collaboration between investors and U.S corporate issuers, as noted by RiskMetrics, highlighting a significant shift towards aligning corporate best practices Richard Ferlauto from AFSCME emphasized that this level of engagement between companies and shareholders is unprecedented.
46 See Why Activist Shareholders Are Gaining Support, THEDEAL.COM (on file with author)
47 GEORGESON, supra note 37; GEORGESON, 2008 ANNUAL CORPORATE GOVERNANCE REVIEW (2008); see also RISKMETRIcS GROUP, supra note 43 While this is explained partially by the increase in activism generally, especially as practiced by many hedge funds, the increase in this type of activism may also be attributable in part to an increase in the number of independent directors
48 RISKMETRICS GROUP, supra note 43, at 43 now part of the landscape." 49 Amy Goodman, a prominent practitioner, reported that the settlements achieved between management and shareholders on political contributions were a "perfect example of engagement Companies and investors agreed this year to a scalable solution on political contribution disclosures whereby smaller companies would have less onerous disclosure demands." 50
The increase in shareholder engagement is attributed not only to a rise in votes supporting various proposals but also to the SEC's new compensation rules, according to Ferlauto He posits that boards are motivated to engage with shareholders to address pay-related concerns and avoid negative publicity This indicates that while managers and directors may prioritize personal interests, they are still open to negotiating on governance issues that, while less personally significant, remain crucial to the corporation's overall governance.
Heterogeneity of Interests Among
The traditional agency model views shareholders as a cohesive group focused solely on maximizing shareholder wealth However, this perspective is increasingly questioned, as shareholders often have diverse motivations influencing their support for specific corporate transactions or policies.
55 Willard Carleton et al., The Influence of Institutions on Corporate Governance Through Private Negotiations: Evidence from TIAA-CREF, 53 J FIN 1335 (1998)
56 See GLOBAL INVESTOR, TOP 100 LARGEST ASSET MANAGERS, available at http://www.riskcenter.com.tr/risknews/risknewsfiles/assetmanagementdunyasiralamasi.pdf.
57 Carleton et al., supra note 55, at 1336
In a system with limited shareholder power, individual shareholders' differing opinions have minimal impact, making it difficult for them to compel managers to implement changes Consequently, only shareholder initiatives that garner widespread support can drive company actions However, as shareholder power grows, the chances of influential shareholders effectively voicing their preferences also rise.
Shareholder proposals indicate that a small but active group of shareholders prioritize non-wealth-maximizing preferences, often driven by moral or ethical concerns rather than financial motivations These proposals frequently lack support from the broader shareholder base, limiting their influence on corporate management due to low ownership levels Even when assuming a common goal of long-term wealth maximization among shareholders, proposals related to corporate governance highlight divergent beliefs about achieving this objective Overall, shareholder voting demonstrates minimal interest in most proposals, with many shareholders voting in alignment with management rather than supporting initiatives from their peers.
61 George Dent makes this argument, among others, in a recent paper George Dent, The Essential Unity of Shareholders and the Myth of Short-Termism, 35 DEL J CORP L 97, 107
While it's acknowledged that most shareholders typically oppose proposals that diminish value or alter corporate governance, this article presents evidence indicating that shareholders can still impact corporate management without needing substantial backing from their peers through proxy votes, except in cases involving social welfare proposals.
62 See, e.g., RISKMETRICS GROUP, 2009 POSTSEASON REPORT 15-16
63 Some shareholders hold shares simply to provide themselves with another forum in which to air their grievances against the company It is possible that even shareholders who own few shares are able to promote change in corporate behavior by waging a public relations campaign against the corporation, with shareholders' proposals as a minor front in a larger campaign The focus of this Article is not on this type of public relations activity, however, but on the use of shareholder power Many social activists are influential because of their public status, but not because of their shareholder status.
64 See, e.g., RISKMETRICS GROUP, supra note 62, at 5
65 Id recommendation 66 However, some shareholders likely vote against shareholder proposals simply because shareholders differ in how they believe the corporation should be managed Such corporate policy preferences may not have mattered under a norm of shareholder passivity in which shareholders would express their displeasure by selling stock; however, in an era in which shareholders are increasingly successful in lobbying for corporate change, these differences create costs that undermine the utility of shareholder activism.
This section explores the diverse dimensions of shareholder differences, particularly focusing on their varying interests in corporate goals, governance initiatives, and expectations Shareholders often exhibit heterogeneity in their social preferences, which may diverge from the traditional norm of maximizing shareholder wealth Understanding these differences is crucial as they are likely to drive shareholder activism and influence corporate decision-making.
Some investors acquire shares primarily to leverage the proxy process for promoting their policy preferences, aiming to influence corporations despite these preferences potentially conflicting with shareholder wealth maximization For instance, the People for the Ethical Treatment of Animals (PETA) has bought shares in companies where animal mistreatment was evident and has actively filed shareholder proposals PETA also urges its supporters to submit resolutions focusing on the humane treatment of animals in various industries, including pharmaceuticals and food However, such investors often struggle to effect meaningful changes in corporate practices, and when changes do occur, their share ownership is usually a minor factor in the corporation's decision-making process, serving mainly as an additional platform for advocacy.
67 PETA's Shareholder Resolution Campaign, PEOPLE FOR THE ETHICAL TREATMENT OF ANIMALS, http://www.stopanimaltests.com/f-shareRes.asp (last visited Aug 31, 2010)
68 Id likely effect of such activism is to draw attention and increased financial support to the social cause, rather than bring about a change in corporate practices.
Social investors typically hold minor stakes, which diminishes their threat to management, leading managers to respond more to them as public activists than as shareholders Generally, larger shareholders wield greater influence over management decisions, but even those with a small ownership percentage, around two to five percent, can significantly affect corporate policies While it is uncommon for investors with solely nonfinancial motives to invest at such levels, some shareholders may have mixed motives, prioritizing financial returns while also supporting specific social causes.
Public pension funds often exhibit mixed motives in their investment strategies, influenced by political pressures to align with local interests, such as boosting in-state employment, as highlighted by commentators like Roberta Romano Similarly, sovereign wealth funds may also have conflicting investment objectives, particularly when their controllers are political and economic rivals of the United States This raises concerns that such funds could be leveraged to acquire control over enterprises critical to national security or to gain access to sensitive technologies However, these risks are somewhat alleviated by regulations, including those enforced by the Committee on Foreign Investment in the United States (CFIUS), which aim to safeguard national interests.
69 Roberta Romano, The Politics of Public Pension Funds, 119 PUB INT 42, 43 (1995)
70 For a discussion of the investment motives of sovereign wealth funds, see Paul Rose, Sovereigns as Shareholders, 87 N.C L REV 83, 99-102 (2008)
71 While the CFIUS regulations take effect only if the sovereign wealth fund exercises control over the firm, control is broadly defined and includes some types of direct influence over corporate affairs Besides the potential application of CFIUS, there are a number of economic justifications for passivity that make sovereign wealth funds unlikely to attempt to exert significant influence over public corporations See id governmental owner over U.S public corporations has come from the U.S government itself A conspicuous example was the successful effort of Representative Barney Frank, chairman of the House Financial Services Committee that helps oversee the Troubled Asset Relief Program ("TARP"), to convince General Motors to keep in operation a plant in his district that the automaker had determined to close 72
Assessing the impact of social and mixed-motive investments is challenging due to the difficulty in distinguishing between social and corporate governance objectives For instance, high executive pay raises questions about whether it indicates managerial empire building or highlights social stratification The American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) appears to advocate for addressing executive compensation based on both of these concerns.
Americans are outraged as CEOs and executives linked to the financial crisis have received millions in bonuses and golden parachutes, highlighting concerns over agency costs In 2008, the average CEO perks reached $364,041, fueling public discontent over corporate accountability.
10 times the median salary of a full-time worker [social stratification] 7 3
The influence of social investors on public corporations is generally minimal, yet David Yermack's recent survey highlights their growing numbers, which may enable them to challenge corporate governance and compensation practices While social investors may not anticipate significant success with initiatives that reduce shareholder wealth, they could orchestrate a voting campaign powerful enough to impact corporate leadership For example, an environmentally-focused hedge fund might gather sufficient support to replace directors at a high-polluting utility, potentially backed by university endowments and conservation groups This scenario underscores the complexities of common agency within corporations, as managers must navigate the competing interests of socially motivated voters and traditional shareholders seeking financial returns.
72 Michael O'Brien, Barney Frank Convinces GM CEO to Keep His District's Plant Open, HIL (June 4, 2009), http://thehill.comlblogs/blog-briefing-roominews/lawmaker-news/35028- barney-frank-convinces-gm-ceo-to-keep-his-districts-plant-open.
73 2009 Executive Pay Watch, AFL-CIO, quoted in Why Unions Are Important, GRASS ROOTS PRESS, http://www.grassrootspress.net/code/labor.html (last visited Sept 17, 2010).
74 David Yermack, Shareholder Voting and Corporate Governance 30 (Mar 17, 2009) (working paper), available at http://ssrn.com/abstract23562.
GOVERNANCE IMPLICATIONS OF COMMON AGENCY
Under agency theory, the influence of shareholders is primarily seen as a way to mitigate high agency costs associated with managers who may shirk responsibilities or engage in rent-seeking behavior Extensive literature supports this perspective and has influenced regulatory changes, particularly from the SEC, aimed at enhancing shareholder empowerment However, current regulations may overestimate the advantages of this empowerment while underestimating the associated costs, especially in situations involving common agency This common agency can lead to significant costs for both the corporation and its shareholders.
1 More influential principals will attempt to persuade management to adopt policies and business decisions that are preferred by the influential shareholders but may not benefit all shareholders Some of these policies and business decisions will provide private benefits to influential shareholders, and some decisions will result in the adoption of inefficient governance mechanisms.
2 Lobbying efforts by shareholders create costs for both the company and for the lobbying shareholders.
3 Because of the potential costs of shareholder influence, cross- shareholder monitoring and monitoring by any beneficiaries of influential investors become commensurately important.
Understanding the management-shareholder relationship as a common agency framework enables shareholders to better assess the advantages and drawbacks of shareholder empowerment This includes the potential decrease in management agency costs while also considering the new agency costs that may arise, such as intrashareholder monitoring and bonding expenses This section explores the increasing body of research on how shareholder influence can mitigate agency costs stemming from managerial expropriation, followed by an examination of the costs generated by a common agency relationship.
Shareholder Activism and Corporate Performance: A Review of the Literature
Recent scholarly research has focused on the impact of increased shareholder activism on corporate benefits, particularly examining hedge fund activism as a key case study Hedge funds possess unique advantages over traditional institutional investors, such as pension and mutual funds, due to their lack of diversification requirements, allowing them to concentrate on fewer target companies Additionally, their investors' capital is often locked in, providing hedge funds with the flexibility to invest in a wider array of options, including less liquid securities Moreover, hedge funds can operate with greater discretion, facing fewer disclosure obligations, which enables them to employ trading strategies not available to other institutional investors Consequently, these factors suggest that hedge funds may incur lower activism costs and present more opportunities for effective shareholder engagement.
The relationship between effective corporate governance structures and firm performance is a contentious topic in academic circles, often used to support shareholder activism A trading strategy utilizing the G-index, which comprises twenty-four governance provisions identified by Gompers, Ishii, and Metrick, yielded above-average returns in the 1990s This finding highlights the potential financial benefits of strong corporate governance as discussed in their study, "Corporate Governance and Equity Prices."
Cohen and Wang observed that the correlation between governance and returns diminished over the subsequent decade In their discussion paper, they attributed this change to the market's growing recognition of the value of strong corporate governance, influenced by increased media attention throughout the 2000s, which led to governance differences being reflected in share prices Other researchers, such as Fodor and Diavatopoulos, have offered additional insights, suggesting that the strong governance firms of the 1990s were primarily tech companies impacted by the technology bubble, a phenomenon not seen in the 2000s This evolving understanding of corporate governance's impact on equity returns has been further explored in various studies and discussions, including a notable article in The Economist.
John Armour and Brian Cheffins analyzed the market conditions that have empowered hedge funds as shareholder activists They noted that recent deregulation of investor eligibility and reduced financing limitations, combined with historically low borrowing costs, have enabled hedge funds to economically acquire stocks Additionally, advancements in technology have facilitated the targeting of underperforming companies and minimized the costs associated with activism Tools like email and websites are now utilized for public campaigns against incumbent managers Armour and Cheffins assert that these factors contributed to the peak of hedge fund activism in the early 2000s, and they anticipate that the market will remain favorable for activism in the future.
The literature on hedge fund activism presents a mixed perspective, yet it generally indicates a positive influence on portfolio companies Research by Bange and De Bondt, along with Klein and Zur, suggests that effective hedge fund activism does not diminish research and development investments, implying that hedge funds may not jeopardize long-term company health for short-term profits Furthermore, studies by Bray, Jiang, Portnoy, and Thomas reveal that hedge fund investments lead to sustained stock price increases and improvements in return on assets and sales for up to two years post-investment Additionally, findings by Boyson and Mooradian indicate that the benefits of hedge fund activism often stem from "aggressive" strategies, such as acquiring substantial shares and gaining board control.
118 John Armour & Brian Cheffins, The Rise and Fall (?) of Shareholder Activism by Hedge
Funds 1 (Eur Corporate Governance Inst., Law Working Paper No 136, 2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid89336.
Mary M Bange and Werner F.M De Bondt explore the relationship between R&D budgets and corporate earnings targets in their 1998 study published in the Journal of Corporate Finance Additionally, April Klein and Emanuel Zur examine hedge fund activism in their 2006 working paper for the European Corporate Governance Institute, highlighting its implications for corporate governance and financial performance.
Hedge fund activism can yield significant returns, particularly when activists acquire a diverse range of securities from the targeted company However, less aggressive forms of activism tend to lack positive financial outcomes.
A study by Robin Greenwood and Michael Schor reveals mixed outcomes for activist funds, indicating they thrive primarily when pushing for a company sale When a target company remains unsold, the effectiveness of activist investors diminishes significantly, with little change observed in the company's stock price or financial performance over the following 18 months, even if the company implements suggested actions like executive firings, stock buybacks, or board additions.
Public pension funds play a role as influential activists, though their impact appears to be less significant compared to hedge fund activism Research by Yermack and others, including studies by Wahal, Carleton, Nelson, Weisbach, Ertimur, Ferri, and Stubben, suggests some effectiveness of public pension fund activism in prompting corporate policy changes However, Jonathan Karpoff's extensive literature review indicates that activism generally has negligible effects on share values and earnings Additionally, Stuart Gillan and Laura Starks found minimal long-term positive effects from shareholder proposals on firm value, highlighting the mixed evidence regarding the impact of shareholder activism.
126 Nicole M Boyson & Robert M Mooradian, Hedge Funds as Shareholder Activists from 1994-2005, at 2-4 (July 31, 2007) (unpublished manuscript), available at http://ssrn.com/abstract2739.
128 Scott Thurm, When Investor Activism Doesn't Pay, WALL ST J., Sept 12, 2007, at A2
(discussing the study by Robin Greenwood and Michael Schor).
131 Sunil Wahal, Pension Fund Activism and Firm Performance, 31 J FIN & QUANTITATIVE ANALYSIS 1, 4 (1996)
132 Carleton et al., supra note 55, at 1335-37
133 Yonca Ertimur, Fabrizio Ferri & Stephen R Stubben, Board of Directors' Responsiveness to Shareholders: Evidence from Shareholder Proposals, 16 J CORP FIN 53, 69 (2010).
134 Jonathan M Karpoff, The Impact of Shareholder Activism on Target Companies: A Survey of Empirical Findings 28 (Aug 18, 2001) (working paper), available at http://ssrn.com/abstract5365.
135 Id certain kinds of activism, there is little evidence of improvement in the long-term operating or stock-market performance of the targeted companies 136
Many activist shareholders often pursue their objectives discreetly, complicating the assessment of agency costs linked to their influence Initially, these shareholders may engage in discussions with management, hoping to have their proposals adopted as management initiatives This covert approach can be advantageous for both parties; the activist increases the chances of success by possibly withdrawing their proposal and negotiating its presentation as a management initiative, which tends to receive broader support from passive shareholders like mutual funds Simultaneously, the company can sidestep contentious governance disputes, enhance its image, and showcase its commitment to shareholder engagement.
Empirical evidence indicates limited support for the effectiveness of behind-the-scenes shareholder influence, with data suggesting that companies often adopt governance policies that have little or no correlation with firm performance A significant study by N.K Chidambaran and Tracie Woidtke analyzed shareholder proposals withdrawn between 1989 and 1995 to assess their valuation effects They compared the three years before and after the SEC's 1992 proxy rule changes, which aimed to enhance information flow and coordination among investors, thereby increasing shareholder negotiating power The study revealed that prior to the 1992 reforms, proposal withdrawals were linked to positive valuation effects, whereas post-reform withdrawals showed a negative valuation impact, indicating that the enhanced negotiating power of activist shareholders may not have yielded the anticipated benefits.
136 Stuart Gillan & Laura Starks, The Evolution of Shareholder Activism in the United
States, J APPLIED CORP FIN., Winter 2007, at 69
137 N.K Chidambaran & Tracie Woidtke, The Role of Negotiations in Corporate
Governance: Evidence From Withdrawn Shareholder-Initiated Proposals 17 (N.Y Univ Ctr for
Law & Business, Research Paper No 99-12, 1999), available at http://ssrn.com/abstract 9808
Shareholders have increasingly succeeded in advocating for corporate governance proposals; however, these changes have not led to improved corporate performance The authors suggest that this outcome aligns with the idea that some shareholders may pursue special interests when proposing policy changes that do not necessarily enhance value.
Numerous studies indicate that shareholder influence has limited effectiveness in enhancing corporate performance, yet targeted activism can be a valuable strategy for reducing high agency costs However, the motivations behind shareholder activism extend beyond merely lowering agency costs and maximizing returns, suggesting that some activists may engage in efforts that do not significantly impact their investment value This raises the possibility that certain activist shareholders may misinterpret the effectiveness of corporate governance policies The following section will explore alternative reasons for shareholder attempts to shape corporate policy and decision-making.
Private Benefits from Shareholder Activism
Shareholders strive to influence the board and management primarily to reduce agency costs By exercising their influence, shareholders act as a check on the board's and management's power, aiming to minimize management shirking and curtail the private benefits that managers might extract at the shareholders' expense.
Shareholders may attempt to influence a corporation to secure private benefits that do not benefit other shareholders This influence often aims not just for direct financial gain, but also to promote specific interests, achieve political objectives, or drive social change.
Joseph Grundfest has labeled "megaphone externalities"1 4 2 ).
Common agency theory posits that shareholders' ability to influence managerial decisions for private gain impacts overall agency costs Research by Craig Depken, Giao Nguyen, and Salil Sarkar indicates that increased blockholder ownership, seen as a proxy for influential investor ownership, correlates positively with agency costs, supporting the private benefit hypothesis.
Some commentators argue that hedge funds may prioritize their interests over those of other investors by influencing managers and engaging in practices like "empty voting," which separates their economic interests from voting rights Critics highlight that hedge funds typically have short investment horizons, conflicting with the goals of long-term investors Iman Anabtawi notes that to attract capital, some hedge funds pursue short-term gains, potentially sacrificing higher long-term returns, in contrast to pension funds and life insurance companies that focus on long-term value to meet future obligations.
142 Joseph Grundfest, The SEC's Proposed Proxy Access Rules: Politics, Economics, and the Law, 65 Bus LAw 361, 365 (2010)
In their 2009 study, "Agency Costs, Executive Compensation, Bonding and Monitoring: A Stochastic Frontier Approach," Craig A Depken, Giao X Nguyen, and Salil K Sarkar highlight the inherent tension in shareholder influence They explore the complex dynamics between agency costs and executive compensation, emphasizing the importance of effective monitoring and bonding mechanisms to align the interests of shareholders and executives Their findings underscore the critical role of governance structures in mitigating agency problems within organizations.
Blockholders play a dual role in corporate governance; they can enhance management oversight and drive improvements that benefit all shareholders However, there is also a risk that blockholders may pursue personal interests, potentially misusing corporate resources or supporting harmful managerial decisions that negatively impact firm performance.
Activist shareholders can exert pressure on corporate officers to pursue business opportunities that align with their interests, as discussed by Anabtawi and Stout in their 2008 article in the Stanford Law Review The ongoing debate regarding the distribution of corporate decision-making power is explored in Anabtawi's 2006 UCLA Law Review article, which raises skepticism about enhancing shareholder authority.
145 Henry T.C Hu & Bernard S Black, The New Vote Buying: Empty Voting and Hidden
146 Anabtawi, Some Skepticism About Increasing Shareholder Power, supra note 144, at
Investors can pursue private benefits by promoting corporate governance changes that reflect their social values, such as good corporate citizenship For instance, labor unions may oppose director nominees of a portfolio company facing labor disputes These private benefits are more likely to be prioritized when investors have less incentive to focus on maximizing share prices, particularly if fund managers' compensation is not linked to fund performance or if the investment mandate imposes social or ethical investment criteria.
Shareholder activism, viewed through a common agency lens, indicates that even non-profit-seeking shareholders often advocate for shifts in corporate power to enable future personal benefits This dynamic sheds light on the actions of professional corporate governance advisors and influential institutional investors, who strive to maintain a shareholder engagement model that enhances their governance influence, despite uncertainties about whether the changes they endorse will positively impact corporate performance.
This analysis does not imply that influential shareholder activity will always harm a corporation; in fact, it can benefit poorly managed firms Increased shareholder involvement may improve firm performance, even if it also serves the shareholder's interests For instance, a significant shareholder might advocate for limits on executive compensation to promote social equity, which could simultaneously reduce managerial expropriation while providing private benefits to the shareholder.
149 See Ashwini K Agrawal, Corporate Governance Objectives of Labor Union Shareholders
A study by Agrawal in the Stern Working Paper Series (2008) examined the proxy voting behavior of AFL-CIO pension funds, revealing that the AFL-CIO showed increased support for directors in companies where employees switched their affiliation away from the AFL-CIO This trend was not observed among mutual funds and other labor union shareholders, suggesting that labor relations significantly influence the voting patterns of certain union shareholders Additionally, the research indicated that during labor disputes at AFL-CIO affiliated companies, the organization was more inclined to vote against directors; however, this tendency diminished when employees disaffiliated from the AFL-CIO.
When the reduction in managerial expropriation surpasses the private benefits received by influential shareholders, minority shareholders are likely to support such arrangements, essentially paying a corporate governance premium However, shareholder influence can negatively impact the majority if powerful shareholders and managers engage in vote trading during director elections to secure preferred governance changes This practice leads to two significant issues: it reinforces the positions of directors and management who cater to specific shareholders, and it fosters governance structures that are less than optimal.
Other Common Agency Costs
Lobbying Costs
In a typical corporate agency model, managers are expected to prioritize fiduciary duties to all shareholders, striving to meet their diverse preferences When shareholders have varying interests, they often lobby companies to sway governance decisions, incurring costs in the process For instance, if two shareholders advocate for different governance policies, they will invest resources to persuade managers, while potentially opposing each other's views This dynamic can lead to a situation where the corporation does not adopt either shareholder's preferred policy.
I appreciate Jill Fisch for her valuable insight Both the corporation and its investors incur expenses related to lobbying activities, which Anabtawi refers to as "squabbling costs." These costs are primarily shouldered by conflicting shareholders.
Squabbling among shareholders diverts valuable resources that could be utilized more effectively elsewhere in the economy, as it primarily focuses on redistributing wealth rather than enhancing firm value Consequently, even if such disputes do not directly impact the overall value of the firm, they diminish the welfare of the shareholders involved.
Efficiency Costs
Corporate responses to shareholder influence can negatively impact governance efficiency by redistributing power within the organization, potentially hindering effective decision-making As Stephen Bainbridge points out, increased shareholder authority can undermine the director-centric governance model, which relies on centralized, non-reviewable decision-making by the board of directors This centralization is crucial for public corporations, especially in environments characterized by dispersed information and the necessity for swift decisions, where authoritative control at the tactical level is vital for success.
Increasing shareholder power can lead to suboptimal changes in corporate governance, even without the exchange of private benefits When a shareholder influences a corporation to adopt a specific policy, the resulting reduction in agency costs must be balanced against the long-term implications of that policy change The newly proposed say-on-pay rules, largely driven by institutional investor lobbying, illustrate how empowering investors to lower agency costs can introduce governance challenges, such as uniform governance structures Jeffrey Gordon's analysis of the UK's say-on-pay rules highlights these complexities.
152 Anabtawi, Some Skepticism About Increasing Shareholder Power, supra note 144, at
154 Stephen Bainbridge, Director Primacy and Shareholder Disempowerment, 119 HARV L. REV 1735 (2006)
155 Id at 1749 (quoting KENNETH ARROw, THE LIMITS OF ORGANIZATION 69 (1974)).
To create a more effective compensation system that aligns pay with performance, the proposed mandatory "say on pay" may not be the best solution Drawing from the UK's experience, a similar framework in the U.S could result in a limited set of strategies for addressing the complex issue of executive compensation, which would then be uniformly applied across approximately 10,000 U.S companies.
The concept of "one size fits all" in annual voting is primarily driven by the tendency of investors, especially institutional ones, to delegate the assessment of various pay plans to a limited number of proxy advisory firms These firms often aim to minimize costs associated with proxy reviews, leading to a standardized approach Custom evaluations can be expensive, and the focus on cost-efficiency may hinder thorough monitoring of compliance with pay practices.
In light of our recent experiences with stock options, which were heavily advocated by institutional investors in the 1990s as a means to align shareholder interests, it is crucial to exercise caution against a hasty, widespread adoption of a specific approach to executive compensation.
Steen Thomsen argues that influential codes of best practices for corporations, which many powerful shareholders depend on, drive governance changes at public companies The costs associated with monitoring compliance may explain why institutional investors and proxy advisors favor standardized governance policies, even if they are not suitable for every firm Additionally, Thomsen highlights that while companies vary widely, institutional investors tend to share similar characteristics, offering standardized services to their clients through comparable financial strategies, particularly portfolio diversification This competition for investment may pressure companies into adopting governance structures that are not well-suited to their unique circumstances.
In his article "Say on Pay," Jeffrey Gordon discusses the U.K experience regarding executive compensation and advocates for a shareholder opt-in approach His insights are bolstered by research conducted by Cai and Walkling, highlighting the importance of shareholder involvement in compensation decisions.
Recent proposals by Congress and activists aim to give shareholders a vote on executive pay, known as the Say-on-Pay Bill Our analysis reveals that the market reacted positively for firms with high abnormal CEO compensation and low pay-for-performance sensitivity when the House passed this bill Interestingly, activist-sponsored say-on-pay proposals primarily target large firms rather than those with excessive CEO pay or poor governance Additionally, the market tends to react negatively to labor-sponsored proposal announcements while responding positively when these proposals are defeated Overall, our findings indicate that while say-on-pay can enhance value for companies with inefficient compensation structures, it may negatively impact others.
Jay Cai & Ralph A Walkling, Shareholders' Say on Pay: Does It Create Value?, J FIN & QUANTITATIVE ANALYsIS (forthcoming) (manuscript at 1), available at http://ssrn.com/abstract=
157 Steen Thomsen, The Hidden Meaning of Codes: Corporate Governance and Investor Rent Seeking, 7 EUR Bus ORG L REv 845 (2006)
Inefficient governance structures can lead to significant value loss for companies, driven by shareholder pressures similar to those seen in direct transactions When firms alter their structures to placate shareholders and avoid proxy battles, they incur costs akin to making direct payments to those shareholders The effectiveness of corporate governance initiatives championed by proxy advisors and activist shareholders in enhancing corporate value remains uncertain Moreover, calls for "best practices" in corporate governance often result in the application of a one-size-fits-all model, disregarding unique factors specific to each company's governance rating.
159 Sanjai Bhagat, Brian Bolton, & Roberta Romano, The Promise and Peril of Corporate Governance Indices, 108 COLUM L REV 1803, 1803-04 (2008)
160 In their recent study Bhagat, Bolton and Romano conclude:
There is no consistent relationship between governance indices and corporate performance, as no single measure of corporate governance is universally applicable The effectiveness of governance systems varies based on specific contexts and circumstances of firms, making it challenging for any index to capture the essential nuances needed for informed decision-making Consequently, governance indices are inadequate tools for guiding corporate proxy votes or investment decisions Investors and policymakers should be cautious when interpreting a firm's quality or future stock market performance based on its ranking in any corporate governance measure.
Research by Daines, Gow, and Larcker indicates that governance ratings from RiskMetrics, The Corporate Library, and GMI have shown limited effectiveness in predicting firm performance and other shareholder-relevant outcomes.
L and Econ Olin, Working Paper No 360; Stan Univ Rock Ctr for Corp Governance, Working Paper No 1, 2009), available at http://ssrn.com/abstract52093 They note, however, that despite their deficiencies, governance ratings still significantly affect the decisionmaking of shareholders, directors and managers:
Corporate governance ratings significantly influence firm practices, as evidenced by Aetna and GE's engagement with ISS to enhance their ratings, resulting in improvements from ten percent to over ninety percent This raises the question of whether such ratings-driven changes yield better outcomes A broader perspective reveals that many firms seek guidance on governance changes, with a recent survey indicating that corporate governance advisors rank as the third most influential factor for public firm directors, following institutional investors and analysts Additionally, directors view low governance ratings as critical warning signs, prompting increased monitoring, just behind the importance of missing analysts' earnings estimates.
Bratton and Wachter highlight that corporate policies influenced by diverse investor expectations can lead to significant costs for the corporation Their analysis of heterogeneous expectations models reveals three key implications for corporate governance: the market price may not accurately reflect the collective views of shareholders, it may fail to represent the corporation's true value, and mispricing could negatively impact investment behavior within the company Additionally, in a common agency framework, managers often strive to satisfy both influential institutional investors and passive retail investors, which can lead to a tendency to manage for the market This approach may encourage managers to pursue riskier strategies that align with the more optimistic expectations of certain shareholders.
Heterogeneous investor expectations can negatively impact business strategies, leading to instability within firms Falaschetti highlighted that varying motivations among shareholder groups can result in internal conflicts He argued that corporations thrive when decision-making authority is concentrated, and provided evidence showing that increased shareholder power compels managers and bondholders to negotiate more effectively.
161 Bratton & Wacher, supra note 101, at 706
Cross -Shareholder Monitoring
This article identifies two primary types of agency costs linked to common agency Firstly, agency costs emerge when shareholders influence decision-making, leading to residual losses through the payment of private benefits Secondly, inefficient governance structures can incur agency costs, even without providing private benefits to any specific shareholder Additionally, minor costs arise from cross-shareholder monitoring, where shareholders keep an eye on one another to mitigate opposing influences This monitoring is effectively supported by mandatory public disclosures, which primarily impose costs on the corporation However, as will be addressed in the next section, current regulations fail to ensure sufficient disclosure of common agency costs.
To mitigate potential costs associated with shareholder influence, some investors, particularly foreign investors and sovereign wealth funds, incur bonding costs by agreeing to limit their activities when purchasing large blocks of shares in U.S corporations These investors often provide a bond to other shareholders through mitigation agreements with U.S regulators or securities purchase agreements, which may restrict their voting rights Additionally, other investors may face internal institutional constraints that further limit their ability to engage in activism.
167 See Paul Rose, Sovereigns as Shareholders, 87 N.C L REV 83, 128 (2008) (citing the examples of Germany, France, and Russia).
Fund managers often have specific proxy voting policies that outline their stance on issues like executive compensation and social responsibility These policies may indicate that matters concerning a company's daily operations are mainly the responsibility of its management Consequently, funds typically vote against shareholder proposals aimed at disclosing or altering business practices unless they believe the proposal would significantly benefit the company's economic performance.
This article examines the costs associated with common agency in public corporations and explores strategies for reducing these expenses through both private and governmental regulatory measures.
III REGULATORY IMPLICATIONS OF COMMON AGENCY: PRELIMINARY
Analyzing shareholder activism through a common agency model reveals substantial regulatory gaps when relying solely on a standard agency framework, where shareholders function as collective principals This article highlights the inadequacies of current and proposed regulations in addressing the unique challenges posed by common agency It suggests that regulators could mitigate these issues by imposing fiduciary duties and enhancing disclosure requirements, which may help reduce overall agency costs.
The SEC's commitment to shareholder primacy is challenged by the implications of common agency, as regulations designed to limit shareholder influence—such as restrictions on communication, voting matters, and proposal sponsorship—often curtail institutional investors' capacity for social activism However, the SEC's growing focus on empowering investors undermines the effectiveness of these regulatory limitations.
169 See, e.g., OAKMARK FUNDS, DESCRIPTION OF PROXY VOTING POLICIES, GUIDELINES, AND
PROCEDURES, available at http://www.oakmark.com/forms/pdf/proxypolicy.pdf
170 Id on the exercise of shareholder power, enhancing shareholder power is more likely to exacerbate agency costs than resolve them.
The SEC's recent and proposed proxy regulations aim to shift power dynamics between shareholders and managers, making managers more accountable to shareholders While this increased accountability enhances shareholder influence, it raises concerns about whether all shareholders will benefit, especially given the potential for higher costs linked to common agency Attempts to roll back shareholder power may face significant resistance, as illustrated by an unusual proposal from ExxonMobil shareholder Steven Milloy during the 2008 proxy season Milloy suggested amending the company’s bylaws to restrict the submission of non-binding shareholder proposals unless approved by the board Although ExxonMobil acknowledged the proposal, the board recommended against it, believing it was not the best approach to reforming the shareholder proposal process Ultimately, Milloy's proposal garnered less than three percent support in shareholder voting.
Milloy has been a vocal opponent of what he describes as "junk science," which refers to flawed scientific data and analyses that are utilized to promote specific, often concealed agendas.
In a 2008 Definitive Proxy Statement, Milloy contended that stock ownership has been politicized, with many shareholders utilizing the proxy process to promote their social or political agendas He emphasized that activist shareholders could leverage proposals to enhance their influence over various aspects of corporate governance, including executive compensation, political contributions, employment policies, and environmental practices.
Reducing shareholder power is generally met with resistance from active shareholders and management, as seen in cases like ExxonMobil Efforts to limit shareholder influence within corporate structures face regulatory challenges and are unlikely to gain traction A comprehensive reform that diminishes shareholder power seems improbable A more sensible approach would be to assess how shareholders have utilized their existing power before considering any enhancements to their authority.
The implementation of fiduciary duties and disclosure requirements are two key regulatory mechanisms that can help reduce agency costs for shareholders, even amid the complexities of regulating shareholder behavior However, addressing common agency costs through enhanced regulations presents a more intricate challenge compared to regulating managerial expropriation.
Regulating Agency Costs Through
Fiduciary Duties Owed by
Fiduciary duties play a crucial role in situations where market forces lack the ability to regulate, particularly in pension funds where investors' capital is immobilized Federal laws that govern these funds often restrict their capacity to prioritize their own benefits at the cost of other shareholders In light of the growing activism among many funds, the Department of Labor under the Bush Administration emphasized the necessity of making investment and voting decisions based on economic considerations Regarding proxy voting, the Department clarified that fiduciaries are required to act in the best interests of the beneficiaries.
When evaluating investment plans, it is crucial to focus solely on factors that impact the economic value of the investment, prioritizing the retirement income of participants and beneficiaries over unrelated goals Additionally, funds must avoid voting on proxies if the associated costs, including research expenses, are expected to outweigh the potential economic benefits of such voting.
The Department of Labor emphasizes reducing management agency costs by addressing key issues such as director independence, nominee expertise, executive compensation, and antitakeover protections Additionally, it focuses on the implications of debt financing, capitalization, long-term business strategies, and workplace practices linked to economic value Notably, the Department asserts that fiduciaries must not leverage investment policies to advance various public policy preferences.
The Department of Labor's "Avon Letter," dated February 23, 1988, outlines a significant position regarding retirement benefits, as detailed in a correspondence to Helmuth Fandl, Chairman of the Retirement Board at Avon Products, Inc This letter has since become a pivotal reference in discussions on pension and benefit regulations.
178 See Dep't of Labor Advisory Opinion No 2007-07A, Pens Plan Guide (CCH) P 19,991Z,
2007 WL 4616370 (Dec 21, 2007) With respect to the exercise of shareholder influence generally, the Department of Labor has also stated:
An investment policy that includes monitoring or influencing corporate management aligns with fiduciary duties under ERISA when the fiduciary believes that such actions, either independently or alongside other shareholders, will increase the investment's economic value, considering the associated costs.
The Department of Labor has cautioned plan fiduciaries about the enforcement risks associated with social activism, as highlighted in Advisory Opinion No 2008-5A and a letter to AFL-CIO General Counsel Jonathan P Hiatt.
The SEC, like the Department of Labor, has established regulations that impose fiduciary duties on investment advisers concerning proxy voting Registered investment advisers manage trillions of dollars in assets, granting them substantial voting power that can significantly influence shareholder votes and corporate governance Although the Investment Advisers Act of 1940 does not explicitly outline these fiduciary duties, the SEC asserts that the duty of care mandates advisers to act in the best interests of their clients.
Advisers have a duty of loyalty to their clients, which mandates that proxy votes be cast in a manner that aligns with the clients' best interests, avoiding any conflicts of interest The SEC identifies two primary conflicts that may arise: first, an adviser managing a pension plan may face pressure to vote in favor of a company's management to maintain business relationships; second, personal or business connections with individuals involved in proxy contests, such as board members related to the adviser's executives, may compromise impartiality To mitigate these conflicts, the SEC requires advisers to establish and implement clear policies for proxy voting that prioritize clients' interests and to communicate these procedures transparently to clients.
Plan fiduciaries may risk violating the exclusive purpose rule when using their authority to advance legislative or public policy issues through proxy voting The Department expects fiduciaries to demonstrate compliance with section 404(a)(1)(A) and (B) in enforcement actions Given the potential for abuse, fiduciaries must clearly justify that their proxy votes or activities aimed at influencing corporate management are likely to enhance the economic value of the plan's investments before using plan assets Utilizing pension plan assets for proxy resolutions unrelated to improving investment value could be viewed as a violation of the prudence and exclusive purpose requirements outlined in section 404(a)(1)(A) and (B).
181 In re Proxy Voting By Investment Advisors, Investment Advisors Act of 1940 Release
No IA-2106, 79 SEC Docket 1673, 2003 WL 215467, at *2 (Jan 31, 2003)
185 Id clients how they may obtain information about how the adviser has actually voted their proxies." 186
The SEC advises that financial advisers may need to refrain from voting proxies when the costs outweigh the benefits for the client However, they must not neglect their responsibility to vote client proxies diligently.
Despite the significant voting power of active institutional investors, the SEC has largely overlooked enforcing fiduciary duties outlined in its proxy voting rules A notable exception occurred in a 2009 case where the SEC settled with Intech, a registered investment adviser, for allegedly violating these duties Intech utilized the third-party proxy voting service ISS to align its votes with AFL-CIO recommendations while participating in the AFL-CIO Key Votes Survey, which ranked advisers based on their adherence to these guidelines The firm aimed to enhance its ranking to retain and attract union clients However, Intech failed to disclose a material conflict of interest regarding clients opposed to AFL-CIO positions, asserting that reliance on ISS would prevent any conflicts in the voting process Ultimately, the SEC determined that Intech's actions constituted a breach of fiduciary duty to its investors.
Agency theory suggests that shareholders often prioritize their own interests, potentially to the detriment of other shareholders In some cases, fund beneficiaries may not only tolerate but also promote these self-serving behaviors, raising concerns about the adherence to fiduciary duties.
189 In the Matter of Intech Investment Management LLC and David E Hurley Respondents, Investment Advisors Act of 1940 Release No IA-2872, 95 SEC Docket 2265, 2009
The Department of Labor and SEC rules dictate that advisers' obligations are to the beneficiaries of the investment fund rather than the company or its shareholders This raises concerns in scenarios where a fund adviser pressures a company to enter into agreements that may benefit another major investor, potentially leading to a situation where the company incurs a loss while the other investor gains significantly Notably, neither the SEC nor Department of Labor rules prevent advisers from pursuing such transactions, as they have no fiduciary duties to the company or its other shareholders Furthermore, state corporate law may not effectively restrict this self-serving use of shareholder influence, despite the potential imprudence of the directors in approving such actions.
Federal application of fiduciary duties faces several limitations, particularly in its relevance to investment vehicles like mutual funds Donald Langevoort suggests that fund fiduciaries' belief in consumer sovereignty may hinder their proactive protection of investors Additionally, even if fiduciaries aimed to fulfill their responsibilities more effectively, there is a significant lack of clarity in federal fiduciary law While some cases address fiduciary duties concerning management fees, guidance on other fiduciary relationship aspects remains sparse, with limited input from courts and regulators However, as U.S securities markets become more institutionalized, increased federal regulation and SEC guidance are anticipated, which may eventually reduce the significance of state law in favor of enhanced shareholder influence.
196 Donald C Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds:
Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 WASH U
The Supreme Court's decision in Jones v Harris Associates L.P., 130 S Ct 1418 (2010), has intensified pressure on states, especially Delaware, to address high common agency costs and maintain their relevance This article will examine a proposed significant response from state regulators to these challenges.
Shareholder Fiduciary Duties to the
Imposing a fiduciary duty on shareholders towards the corporation would directly address common agency costs by compelling shareholders to function as collective principals Some scholars suggest that, in certain instances, these fiduciary responsibilities should extend from activist shareholders to the portfolio company Unlike the obligations placed on fund managers, these duties would likely be governed by state regulations rather than federal ones.
Roberta Karmel emphasized the importance of holding institutions that gain the right to nominate board directors, as proposed by the SEC, to the same responsibilities as controlling shareholders She argued that these institutions must actively monitor the directors they appoint and maintain their shareholder status throughout the directors' terms Additionally, Karmel highlighted the need to prevent these institutions from nominating directors in situations where conflicts of interest may arise, particularly cautioning against labor funds nominees, who may prioritize labor concerns over shareholder interests.
Iman Anabtawi and Lynn Stout have proposed a comprehensive framework for applying fiduciary duties to activist shareholders They observe that, despite the growing influence of minority shareholders, the existing legal framework still treats them as rationally passive due to various barriers to activism Furthermore, the law presumes that minority shareholder activism is advantageous, as their efforts to engage with public corporations are primarily focused on enhancing the firm's overall economic performance.
198 Roberta S Karmel, Should a Duty to the Corporation Be Imposed on Institutional Shareholders?, 60 Bus LAW 1, 20 (2004).
200 Anabtawi & Stout, Fiduciary Duties for Activist Shareholders, supra note 144, at 1294.
As shareholders gain more power, their interests are becoming increasingly diverse and conflicting This shift means that activist shareholders are leveraging their influence not to enhance overall firm performance, as traditionally believed, but rather to benefit themselves at the expense of other shareholders.
Anabtawi and Stout highlight recent instances where minority shareholders leverage their shares for personal gains, often at the expense of other shareholders Notable examples include a labor union's pension fund threatening a proxy fight to secure concessions during contract negotiations and a hedge fund pressuring a portfolio company with a proxy fight unless it acquires a target in which the hedge fund holds substantial interest.
Anabtawi and Stout propose that minority shareholders should have fiduciary duties to the corporation in specific situations to guard against opportunism These duties arise not from a shareholder's general power to direct decisions but from their ability to sway the outcome of a corporate decision where they have a personal conflict of interest Their approach updates the concept of control, recognizing that modern shareholders can impact corporate policy through various means without holding a majority of voting shares According to their framework, a shareholder is deemed to "control" corporate actions when their involvement decisively influences a particular corporate decision.
Anabtawi and Stout highlight significant concerns regarding the imposition of fiduciary duties on minority shareholders, particularly the risk of increased litigation They argue that while the potential for lawsuits may rise, the advantages of holding self-dealing directors and controlling shareholders accountable ultimately surpass the costs associated with such legal actions, benefiting the corporation as a whole.
Anabtawi and Stout highlighted that the substantive and procedural protections designed to deter frivolous lawsuits related to duty of loyalty violations by officers, directors, and controlling shareholders are equally relevant for activist minority shareholders.
Management may exploit lawsuits to deter activism, even if litigation against conflict-free activists is unlikely to succeed The mere threat of legal action could effectively dissuade legitimate activism To address this issue, lawmakers could limit the right to initiate lawsuits to shareholders, allowing managers to sue only in their capacity as shareholders and removing corporate resources from funding such litigation However, this restriction could significantly decrease the number of lawsuits, undermining their potential to enforce fiduciary duties owed to minority shareholders.
Andrew Shapiro, a prominent activist investor, cautions that failing to address litigation concerns could lead to increased risks for shareholders if Anabtawi and Stout's proposal is implemented This heightened risk may result in shareholders lowering the price they are willing to pay for stocks to offset the potential for greater direct liability or the additional costs associated with purchasing insurance to mitigate such risks.
Shapiro also noted that a majority vote protects against many instances of shareholder activism, and even where it doesn't-for instance, where a shareholder vote is not required-"the buck stops
Directors face constraints that may not deter hedge funds, such as the reputational risks associated with self-dealing transactions While these activities can harm a director's reputation and impact their chances of re-election or board nominations, hedge funds may also experience reputational consequences, albeit for different reasons Specifically, hedge funds could face increased scrutiny from other companies in which they invest, potentially limiting their ability to engage in self-dealing transactions.
212 Andrew Shapiro, Comment to Lynn A Stout, Fiduciary Duties to Activist Shareholders, HARV L SCH CORP GOVERNANCE & FIN REGULATION BLOG (Mar 3, 2008, 17:26), http:/Iblogs.law.harvard.edulcorpgov/2008/03/03/fiduciary-duties-for-activist-shareholders/.
In cases where lawsuits are initiated on a contingency basis, the potential damages sought must be substantial enough to motivate an attorney to pursue the case, particularly when considering the private benefits gained by minority shareholders.
Activist minority shareholders are increasingly conducting undisclosed negotiations with management, which hinders other shareholders from assessing the agency costs associated with these interactions This situation can lead to a troubling dynamic where activists, motivated by profit, may choose to share their gains with management Such benefit-sharing can occur even when activists have fiduciary duties, driven by the costs of defending against activism and the potential rewards from maintaining proxy support Consequently, activists can extract value from the corporation despite inherent conflicts of interest, while directors and officers may feel incentivized to avoid taking legal action against these activists.
Imposing fiduciary obligations on minority shareholders may pose a significant risk for states competing for incorporations, despite the potential reduction of shareholder-generated common agency costs While federal proxy rules have increased shareholder influence across all companies, state law continues to govern corporate structures and fiduciary duties, which help shape director and manager behavior In response to the Delaware Supreme Court's decision in Smith v Van Gorkom, the Delaware legislature enacted a liability exculpation statute, Section 102(b)(7), to mitigate the risk of losing incorporations Given the rising activism among shareholders, including traditionally passive investors, there is likely resistance to reincorporation under regimes that suppress activism, especially as proxy advisory firms may recommend against such moves, further influencing shareholder decisions.
Duties Owed by Managers to
To enhance corporate law, states should consider the implications of common agency and reinforce traditional fiduciary duties owed by managers and directors to shareholders A pertinent example is the case of Portnoy v Cryo-Cell International, Inc., where Vice-Chancellor Leo Strine examined a proxy contest involving management and activist shareholder Andrew Filipowski Management's agreement to grant Filipowski a board seat in exchange for his vote was complicated by the failure to disclose plans to add another seat for a Filipowski designee, who had a troubling past involving an SEC insider trading settlement This lack of transparency meant shareholders were unknowingly voting on two positions linked to Filipowski, raising significant concerns about the suitability of the designee as a fiduciary.
Vice-Chancellor Strine determined that the voting agreement between management and Filipowski was a significant arrangement that required disclosure While he did not apply an entire fairness review to the initial agreement—where Filipowski was elected to the board in return for his support of the management slate—he emphasized that there was no indication Filipowski sought financial compensation from Cryo-Cell through contracts or consulting fees He noted that any settlement involving financial benefits to a shareholder in exchange for votes would necessitate adherence to the entire fairness standard.
Directors of Delaware corporations have a fiduciary duty to fully and fairly disclose all material information within their control when seeking shareholder action This obligation applies to proxy statements and any other disclosures related to stockholder decisions.
Under Schreiber, agreements between management and shareholders, even if beneficial for all stockholders, are only voidable rather than inherently void The taint on such transactions can be removed if a majority of independent stockholders ratify the agreement following full and honest disclosure of all relevant facts However, most agreements between shareholders and management, excluding those leading to board seats, remain undisclosed, raising questions about the necessity of disclosure that Delaware courts should clarify While management may not face actionable breaches of fiduciary duty for adopting a suboptimal governance structure after negotiations with a shareholder, the business judgment rule protects them, assuming no conflicts of interest exist Nonetheless, business judgment review of these agreements may depend on proper disclosure.
Portnoy emphasizes the importance of disclosure in enforcing fiduciary duties, particularly regarding minority shareholders By imposing fiduciary responsibilities on these shareholders, enhanced disclosure obligations can effectively support the enforcement of these duties, similar to how they aid in holding directors, managers, and controlling shareholders accountable.
Regulation by Disclosure
Shareholder activism disclosure, similar to management dealings disclosure, can lower common agency costs Effective disclosure requirements may deter private benefit pursuits, uncover some lobbying expenses, and encourage governance decisions focused on long-term performance The proposed limited disclosure requirements embody a precautionary principle, illuminating investor activities without drastically changing the existing corporate power dynamics.
Current research indicates that while shareholders possess increased power and influence, the full extent of its impact remains unclear Evidence suggests that some shareholders may leverage this power in ways that could negatively affect other shareholders and corporate stakeholders.
The proposed disclosures aim to mitigate harmful shareholder influence and enhance the effectiveness of fiduciary standards By promoting collective shareholder action, these disclosures seek to diminish the potential for common agencies to emerge.
Federal disclosure requirements, aligned with a shareholder primacy model, facilitate effective monitoring of management behavior by mandating public corporations to disclose executive compensation and related party transactions In addition to state corporate law disclosures, federal securities laws impose specific requirements on significant shareholders under Section 13(d) of the Exchange Act and Schedule 13D, originally designed to curb coercive tender offers Detailed disclosures are necessary when a minority shareholder owns over five percent of the company's stock, with the SEC focusing on nonpassive purposes such as initiating extraordinary corporate transactions, altering management or board composition, changing capitalization or dividend policies, modifying corporate charters, or actions that could obstruct control acquisitions.
An implicit justification for the disclosures of Schedule 13D is to provide information on other shareholders as an agency-cost reducing mechanism in the event of a contest for control Presumably,
When an activist shareholder acquires five percent of a company's stock, it can trigger a response from other investors who may choose to sell, as they become aware of the potential for changes in control under 13D disclosure requirements However, many significant shareholders may possess less than five percent of the stock or may conceal their economic interests through various means, such as derivative transactions and complex structures.
The SEC aims to minimize agency costs through Item 404 of Regulation S-K, which addresses management and activist minority shareholder interests Under 404(a), companies must disclose any transaction exceeding $120,000 in which they are involved, particularly if a "related person" has a direct or indirect material interest "Related persons" include officers, directors, and five percent blockholders.
Shareholders with less than five percent ownership can still significantly influence corporate governance, potentially leading to detrimental changes or transactions that favor the activist investor at the expense of other shareholders Due to the disclosure obligations of Schedule 13D, these shareholders often prefer to stay below the five percent threshold However, Schedule 13D does not address agency costs for shareholders owning less than five percent, even if they have greater economic interests through derivative instruments like total return swaps Additionally, many activist investors fail to comply with the filing requirements of Schedule 13D, which primarily targets transactions indicating control rather than mere influence.
Some shareholders are neglecting to file 13D statements, which is crucial for their activist intentions, as noted by Steven Davidoff in the N.Y Times DealBook blog This lack of disclosure impacts the transparency of corporate decisions influenced by shareholders.
Securities laws typically associate the regulation of shareholder influence with the size of a company's holdings, yet the agency costs generated by activist investors are not solely determined by their share ownership The SEC's current model restricts regulated shareholder influence to those holding over five percent, potentially overlooking significant impacts from blockholders with smaller stakes Many companies may lack activist shareholders with five percent ownership, yet still face considerable influence from those owning less Instead of extending the 13D filing requirements, the SEC could implement a disclosure rule not based on numerical thresholds, similar to the Treasury Department's approach to foreign acquisitions, where risk assessment considers shareholder actions rather than just ownership size This would entail requiring shareholders to disclose activities that lead corporations to incur higher agency costs, particularly when special benefits are granted to activist shareholders in exchange for concessions.
Anabtawi and Stout propose that fiduciary duties for activist investors should depend on whether their activism is a decisive "but for" cause of corporate decisions They also suggest that disclosure obligations could be implemented if the shareholder's activism significantly influences a corporate decision Additionally, it is essential to distinguish between two types of potential regulations, as each would impact the common agency relationship differently The first, narrower form of disclosure regulation would restrict the scope of disclosure requirements.
The Treasury Department regulates influential minority investors by distinguishing between mere influence and "control," focusing on transactions that indicate control to address national security concerns related to foreign control of U.S entities While the regulations are not aimed at managing agency costs directly, they seek to limit the activities of investors, especially sovereign wealth funds, whose interests may significantly diverge from those of the company and its other shareholders.
In their discussion on fiduciary duties for activist shareholders, Anabtawi and Stout emphasize the need for disclosure regulations when shareholder activism directly influences corporate decisions, particularly when such decisions yield specific benefits for the activist shareholder They propose a broader disclosure requirement that applies whenever a shareholder is the proximate cause of a decision, regardless of personal gain from the outcome This transparency aims to illuminate the interactions among shareholders, directors, and management, addressing potential agency costs for other shareholders Importantly, this disclosure would extend beyond transactional scenarios to include shareholder influence on governance matters, ensuring that those advocating for beneficial governance changes through private negotiations or the proxy process are not negatively impacted by the requirement, as it would not expose any private benefits.
The SEC has crafted its disclosures to tackle agency costs arising from management activities, with executive compensation disclosures serving as key examples Annually mandated disclosures of related-party transactions under Item 404 of Regulation S-K also highlight this focus Although Item 404(a) requires disclosure of certain shareholder transactions, it only applies when a shareholder owns more than five percent, which overlooks the fact that agency costs can occur regardless of ownership percentage Amending Item 404(a) to mandate disclosure whenever a shareholder gains a material benefit from a transaction, not shared equally with other shareholders, could effectively address agency costs linked to shareholder activism Additionally, the SEC could maintain exemptions for minor transactions under $120,000.
The expanded disclosure requirements may mandate the reporting of any significant events triggered by a shareholder's actions, posing challenges in aligning with current securities regulations This disclosure would primarily consist of a concise overview of the negotiations between the company and the shareholder, along with the outcomes of those discussions A common strategy for shareholders to influence companies involves engaging in such negotiations.
Shareholders may submit proposals to prompt management negotiations, which can lead to the withdrawal of the proposal if certain conditions, like changes in corporate governance, are met Management might also present a modified version of the shareholder proposal However, details of the negotiations between management and shareholders are typically not disclosed Since this influence is primarily linked to the annual proxy process, it is fitting for Schedule 14A to include such disclosure requirements.