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confidence, then investor confidence in Delaware stocks must have been continuously less than in stocks of other states for more than a generation. This lack of confidence would have been long reflected in the price of shares.
However fashionable it may be to picture the consumer as the witless tool of sellers who is constantly in need of protection from his own ignorance, no such claim can be made about the consumer of securities. Better than half the equity of American corporations is held by institutional investors-insurance companies, mutual funds, pension funds, etc.—who are sophisticated and whose only interest is in the size of the return on their investment. Even a relatively unsophisticated investor responds to the risk, if Professor Cary is correct, for the investor need know none of the intricacies of corporate law. He needs know only the word "Delaware,” which, after all, is only two letters longer than the word "Poison.”
Common observation of the success of Delaware corporations in attracting investors of all sorts many of the largest corporations are chartered there strongly suggests that the conventional wisdom among academic lawyers is exactly backwards: the unrestrictiveness of the Delaware Code generally benefits both investors and management, and confidence in Delaware corporations is, if anything, higher than in corporations of other states. That this has been difficult to perceive, or at least to accept, is the result, first of a dilemma of regulation and, second, of an obsession with legal constraints which has obscured other less visible but more effective constraints on managerial discretion.
B. The cost of restricting management discretion by law The regulatory dilemma is found in numerous contexts. Rules which prohibit undesirable conduct will often deter conduct which is blameless. Rigorous drug regulation impedes the introduction of beneficial as well as harmful drugs and thus harms those who would benefit from an earlier introduction. The foreclosure of advocacy in advertising will increase accuracy but also reduce the incentive to advertise and thus deprive the public of the benefits it would otherwise receive in the form of greater information and increased competition.
Much of the literature which attacks the performance of the private sector fails to recognize these trade-offs and the high price an imperfect world exacts for the elimination of all pollution, all defective products and all fraud. The literature of consumerism, for example, almost without exception ignores the higher costs which fall upon consumers as a result of requiring additional safety devices upon cars or compelling businesses to comply with a myriad of administrative requests for information.
So too, the legal literature dealing with the governance of corporations simply assumes that no costs will fall upon shareholders if "controls" are imposed on managerial discretion. To be sure, some self-dealing and fraud exist in corporate affairs and its elimination is desirable. But at some point the exercise of control by law must also impose costs on investors which damage them in both quantity and quality quite as much as self-dealing or fraud. And so the dilemma: maximizing the yield to investors generally may, indeed almost surely will, result in a number of cases of fraud or self-dealing, and the converse: eliminating some instances of fraud of self-dealing may decrease the yield to shareholders generally.
For example, numerous proposals have been made to increase the power of shareholders by enabling them to initiate proposals to be submitted to shareholders, by requiring cumulative voting, by compelling management to make extensive information available to any requesting shareholder, by requiring shareholder votes on certain matters, etc. But, to indulge in an understatement, there is no necessary connection between increasing shareholder power and increasing the yield to investors. Corporate efficiency may well call for decisional and operational processes wholly inconsistent with periodic much less constant intrusion by shareholders. Such intrusion not only may reduce efficiency but carries with it other costs, such as legal fees and increased personnel needs.
That this is so is nowhere better demonstrated than in the open and notorious fact that the vast majority of shareholders in large corporations do not want the power to interfere in corporate affairs and do not regard themselves as corporate overseers. Instead, they quite sensibly view themselves solely as investors. In fact, the calls for more power for shareholders are invariably more on behalf of a tiny group who happen not to view themselves solely as investors and who (like many of their academic supporters) are not particularly interested in maximizing the monetary yield to shareholders.
To be sure, this may (or may not) be an overstatement and the steadily diminishing shareholder "control" has probably allowed some managements to profit from self-dealing. But the basic point remains: the elimination of selfdealing by increasing shareholder control involves a trade-off with corporate efficiency and may well reduce the monetary return to shareholders generally. Whether the amount saved in eliminating certain instances of self-dealing through increased shareholder control is greater than the general loss in corporate efficiency is the issue, and it is neither a priori nor empirically selfevident that the Delaware Code is not a satisfactory resolution.
Similarly, Professor Cary has criticized the Delaware courts for too easily ratifying management conduct and for not applying a rigorous standard of "fairness"to its actions. Even assuming his description of Delaware law is accurate—and that is not without some considerable doubt-his analysis addresses the wrong issue.
For example, Professor Cary's resort to idiosyncratic notions of "fairness" provide little in the way of guidance as to the fashioning of a fiduciary duty which would serve shareholders' interests well. He attacks the Delaware Getty Oil decision, which permitted a parent company to continue to take advantage of its full quota of imported crude oil after a government agency had ruled that a subsidiary of Getty was not entitled to a quota of its own, since it was controlled by the parent. Not to have allocated the quota between the two, Professor Cary says, is unfair and an "abdication of responsibility by the court."
Of course, putting the loss on the subsidiary is unfair, but putting part of the loss on the parent is also unfair, because the administrative decision has created a no-win situation. One solution is just as arbitrary as another, after all, and Professor Cary's solution, which seems based entirely on a penchant for whoever seems in the minority at the time, has no monopoly on justice and little if any relation to shareholder protection. If one were to discover that the minority interests in the subsidiary were Saudi sheikhs of untold wealth while the parent was owned largely by a pension fund which was the sole support of miners disabled by black lung, the feeling in the pit of our stomach might lead the other way.
In truth, defining the scope of fiduciary duty in the corporate context is exceedingly difficult once one moves beyond blatant and egregious cases of selfdealing. Groups of shareholders frequently have conflicting interests and expectations which, when accommodated within the corporation, inevitably leave some feeling they have been treated unfairly. Those who would substitute the judgment of a court are surely obligated to offer more than idiosyncratic notions of "fairness" and to establish discernible criteria by which a court decides which group is to bear which loss under which circumstances.
In an analogous field, the field courts have generally declined to elaborate a pervasive fiduciary duty on the part of labor unions as bargaining representatives. This is particularly significant since constitutional overtones are present in that workers are by law barred from individual bargaining once a majority votes to be represented by a union. So long as discrimination on the basis of race, sex or anti-union activities is not proven, the federal courts have been most reluctant to second guess the union decision. For example, in a case very similar to Getty Oil, Britt v. Trailmobile, a union in a merged company was allowed to put the employees of the acquired firm at the bottom of the enlarged seniority list, thus giving junior employees of the acquiring company a significant advantage. Again, any result would be unfair to some but the lack of preexisting and discernible criteria induced the court to refrain from imposing its idiosyncratic preferences.
An outbreak of extensive judicial second guessing would inevitably plunge the courts not only into the question of what is "fair" but also into what is the right business decision. If the assumption that business decisions are best left to entrepreneurs is correct, then Professor Cary's remedy may be more damaging than the disease. One Delaware case which he attacks, for instance, involved a parent corporation which held 97% of the stock of a subsidiary and which decided to contract the subsidiary's activities by paying out dividends far in excess of earnings. Although other firms held by the parent were at the time expanding, no corporate opportunities were lost to the subsidiary in question and the dividends were on a pro rata basis.
Professor Cary would have had the Delaware Court invoke a rule, based on "traditional concepts of fairness," prohibiting a parent from contracting the operations of a subsidiary during a period of expansion when there are minority stockholders. Consider how deeply such a rule intrudes on the corporation's power to make business decisions. Among the matters which are irrelevant under such a rule are estimates of the subsidiary's likely success in expansion and the value of competing investment opportunities. Nor is weight given to the much greater risk taken by a 97% holder than a 3% holder. And what if the 3% holder blackmails the 97% with the threat of preventing the latter from pursuing the higher valued opportunities? In effect, Professor Cary would give the 3% holder a veto on these matters, a rule which, I submit, cannot be in the interests of shareholders generally.
As was true in the case of increased shareholder power, increased judicial intervention on behalf of complaining shareholders will not necessarily increase the yield to shareholders generally. Some self-dealing may be eliminated but again only at a price in economic efficiency. Such intervention will necessarily, as Professor Cary's analysis demonstrates, affect business judgments are well as attempts at self-dealing. This will increase the costs of the corporate enterprise by limiting management's ability to run the business and by saddling the corporate enterprise with the distractions and expense of litigation.
A final example involves the standard of care required of directors. Here the Delaware decision attacked held that directors might rely on summaries, reports and corporate records as evidence that no antitrust violations were being committed by the company, even though 19 years earlier the Federal Trade Commission had issued a cease and desist order against price fixing. It is probably the case that an internal control system to prevent repeated antitrust violations would have prevented the fines and treble damages paid by the company.
The issue, however, again is not whether damages might be avoided but whether, even employing a simple negligence calculus, the probability of having to pay a likely amount of damages is greater than the cost of avoiding them. Requiring perfect fail-safe systems in every corporation can be far more costly than any potential loss to shareholders. Professor Cary is on more solid ground in suggesting that the need for preventative measures was greater in the par. ticular case in light of past violations since that is relevant to the likelihood of
Again, the point is not that Professor Cary's position is or is not the "right" rule. Rather, the point is that interventionist rules may reduce the yield to shareholders generally and this cost must be weighed against the benefits to be gained by the reduction of self-dealing or mismanagement.
What rules of law optimally protect shareholders is unlikely to be selfevident except at ends of the spectrum. For example, the proposals to increase shareholder "power" in the case of widely held corporations seems as much designed to aid tiny groups of shareholders of forces outside the corporation to infuence corporate behavior through obstruction as to protect shareholders generally. And proposals for extensive judicial intervention on behalf of 3 percent shareholders in the name of "fairness" will likely entail rigid rules restricting management's ability to make business judgments. Between these extremes, however, are a vast number of cases in which the cost benefit judgment seems inconclusive and the proper role of law unclear. What that role ought to be can be determined only after an excursion into the question of the extent to which economic market considerations discipline corporate management behavior.
C. Market constraints on managerial discretion With a few exceptions, the legal literature is single-mindedly concerned with the unregulated discretion corporate management has achieved as a result of the "separation of ownership and control.” This latter phrase, which accurately describes the lack of close supervision of corporate activities by shareholders but inaccurately suggests a lack of accountability on management's part, refers almost entirely to the fact that the legal controls on management behavior, e.g. shareholder approval, derivative suits, election of directors, etc., seem unsatisfactory methods of exerting direct control over corporate affairs.
And so they are, but the structure of a legal system does not necessarily reflect the reality of the institutions it governs. A literal student of the Constitution might well be appalled at the fact that voters in presidential elections are not even told the names of the people they are voting for (the electors) and that, once elected, these people rarely exercise any judgment in performing their functions. He might also conclude that there was, therefore, a "separation of voting and control" of presidential elections and call for a strengthening of the Electoral College.
We all know, of course, that a party system unsanctioned by the Constitution transformed the electoral college into an institution which has no functional resemblance to the legal system which continues to surround it. So too, an obsession with the formal legal system surrounding corporations obscures the actual functional relationships involved.
For example, the "separation of ownership and control" is a problem only if one views corporation law as a comprehensive functional description of the corporate system. Viewed in other terms, however, the "separation" is no more than a perfectly sensible division of labor. As Richard Posner has written,
. . The management) group consists of people who are experienced in the business and involved in it on a full-time, day-to-day basis. In contrast, the typical shareholder is not knowledgeable about the business of the firm, does not derive an important part of his livelihood from it, and neither expects nor has an incentive to participate in the management of the firm. He is a passive investor and, because of the liquidity of his interest, has only a casual, and frequently quite brief, relationship with the firm. His interest, Mke that of a creditor, is a financial rather than managerial interest.
"It is no more anomalous that shareholders do not manage or control “their” corporations than that bondholders do not manage or control the corporations whose bonds they hold, or trust beneficiaries the trustee. All three groups have an investment interest."
Similarly, many have criticized the role played by institutional investors in controlling corporate behavior. For the most part, such investors have not at. tempted to influence management behavior by invoking their rights on shareholders. Such criticism demonstrates the depths of economic misunderstanding corporate critics are prone to. If a pension fund, for example, were to undertake to exert control over the firms in which it owned stock, it would have to add a sufficient number of managerial personnel to keep informed about the activities of each firm. This would impose enormous additional salary costs upon the fund and would compel it to diminish diversification, since the marginal cost of buying stocks in firms not then in the portfolio would be increased by the need for additional personnel to keep informed about their activities. And for all this, what would be gained? The fund's managerial personnel are unlikely to be better than those in corporations and their additional “control" is unlikely to add much in the way of returns.
The obsession with "control" through the exercise of right has been the cause of neglect of a small but important part of the legal literature. For a decade and a half, Professor Henry Manne has written a series of articles demonstrating that share price and the capital market disciplines the behavior of corporate management and the body of his work has yet to be seriously confronted, much less weakened. And while Manne stands out in the legal literature, economists of varying stripe accept the same propositions as true or at least plausible theories of corporate behavior.
As Professor William Baumol has written:
"Reports of the deliberations of the top levels of management in major American corporations seems to indicate a widespread concern with the performance of the companies' securities. Even in companies which have long refrained from the issue of new stocks and which apparently have no plans for such an issue in the foreseeable future there seems to be a heavy preoccupation with the market's evaluation of the corporation's shares. Whatever the reasons, and I shall discuss these briefly in a moment, this concern is by itself sufficient to empower the market to oversee the behavior of management. If the businessman is motivated to avoid reductions in the price of his firm's securities and if, in fact, he hopes that those prices will rise rather steadily and dependably with the passage of time, he will be driven to adapt his decisions to this purpose. Behavior which depresses security prices will then conflict with company objectives."
A most recent example of this phenomenon involves the Washington Post, which, soon after going public, brought on a confrontation with a major union of its employees and won a brutal labor dispute. Some attributed the Post's change in attitude to the fact that it had become a "hostage to the stock market."
Corporate management's attention to the price of the firm's stock is perfectly understandable. The lower the price, the easier it will be for others to take over the corporation and hire new management. Thus, if a firm is mismanaged, robbed or overly attentive to non-profit goals, the price of its shares will drop and others will perceive an opportunity to take-over the corporation and install new and more efficient management to raise the share price. The take-over may be by way of a proxy fight, purchase of control or merger. Those who take over the corporation will thus profit either by the compensation received as successful managers and/or by capital gains incurred as a result of the increase in share price.
Trading in corporate share therefore, is not only a market in investments but also a market in management control. It is this latter market which, because it is closely related to the behavior of the former, constitutes a constraint on management conduct. The implications of this for the debate over corporate power are profound. Product market competition alone is a pressure on corporate management to profit maximize on behalf of the corporation, for any other goal would quickly be reflected in the company's earnings and in the price of its stock. Management thus has substantial incentive to maximize the profits of the corporation, and this incentive is directly related to investor behavior.
Two serious challenges are made to this analysis: (1) the constraints on management may not be very severe if product market competition does not exist; (2) the cost of a take-over is so great that management has unwarranted discretion.
Where product market competition does not exist because the industry is regulated, it is probably the case that the cost of a takeover does allow manage. ment considerable discretion not to profit maximize on behalf of the corporation. Additions to the costs of doing business such as lavish community affairs programs, expensive office furnishings, etc., will not incur the penalties imposed by rigorous competition and management may thus exercise some discretion at a cost in the price of the stock.
Where competition is lacking because of an oligopolistic industrial structureand here I assume arguendo that such structures in fact reduce competitionthe incentive to profit maximize on behalf of the corporation is not, it seems to me, reduced. Oligopolies, or price fixing cartels for that matter, rely heavily on a mutual forebearance among firms induced by the belief that price cutting will go for naught since it will immediately be matched by one's competitors. Thus, it is said that within an oligopolistic structure of four firms holding 35 percent, 25 percent, 25 percent, and 15 percent respectively, a price cut by any will immediately be met and all will retain the same market share but at a lower price. There is no incentive on anyone's part to bring about such a result. Similarly, a cartel of price fixers must reach a compromise price which for each member offers a higher return than a situation where all compete.
In either case, however, the price level reached is based on a relative cost structure which cannot be changed without creating incentives to cut price among some of the firms. And this in turn creates pressure on corporate management, whether in an oligopoly or in a cartel, to profit maximize on behalf of the corporation. For example, if the management of one firm in an oligopoly increases that firm's costs by lavish contributions to Yale, extravagant office suites or just plain robbery, its competitors will no longer view a price cut as a fruitless endeavor since the ability of the first firm to meet it has been impaired and market share can be increased by a price cut. This is so not only because the first firm's costs are higher but also because the resultant decline in share price will have impaired its ability to raise capital either by equity or debt, since a decline in share price will mean an increase in interest rate.
Unlike management in a firm protected by law from competition, therefore, management of oligopolistic firms or firms engaged in private (non-legal) cartels are under considerable pressure to maintain stock prices at the highest level and thus to profit maximize on behalf of the corporation.
The cost of corporate takeovers governs the effectiveness of the market constraints described above. If these costs are invariably large, as some have argued, then even larger rewards must be anticipated by those seeking to oust management, and the constraints imposed on the exercise of management discretion may be relatively weak.
Not every item in the costs of takeovers, however, is relevant to the federal chartering issue. Thus, one cause of high takeover costs is federal regulatory law. The antitrust laws, for example, forbid mergers of all but the tiniest of firms, and the securities laws discourage takeover bids and aid management in proxy fights. If we want to reduce the cost of takeovers, the remedy is less, not more, federal law.
A high takeover cost may also reflect an efficient management. The cost of a takeover will, no matter whether by merger, tender offer or proxy fight, be