Shareholder Primacy

Question 1

What was the Berle-Dodd debate?

Answer 1

• Berle argued corporations should ‘serve … all society’ through legally enforceable rules -> separation between ownership and control
  -> directors should serve the interests of shareholders above all others (Shareholder Primacy)
• Dodd argued corporate powers should be regarded as held on ‘trust’ by directors and managers
  -> ‘undesirable for corporations to exist for sole purpose of making profits for stakeholders’ -> firms are an economic institution which have a social service as well as a profit-making function
  -> Stakeholder Theory

Question 2

Explain why shareholders don’t truly ‘own’ the corporation

(Against Shareholder Primacy)

Answer 2

Shareholders don’t truly ‘own’ the corporation (Lynn Stout)
-> Despite Milton Friedman claiming they do (1970, NYT) and the only ‘social responsibility of business is to increase its profits’
-> Rather, shareholders own stock and lack rights (Derives from Salomon v Salomon 1897)
e.g. Shareholders cannot exercise control over corporations’ assets, directors do
e.g. Shareholders cannot help themselves to company’s earnings -> only dividends, at discretion of directors
-> Especially prevalent as ownership dispersed in large corporations (Berle + Means 1932)

Question 3

Explain why shareholders are NOT sole Residual Claimants

(Against Shareholder Primacy)

Answer 3

Shareholders are NOT sole Residual Claimants
-> Easterbrook + Fischel argue that non-shareholder groups (e.g. employees) enter into explicit contracts that entitle them to fixed payments (e.g. salary) whereas shareholders rely on implicit contract and as the sole ‘residual risk bearers’ are entitled to whatever remains after the firm has met its explicit obligations and fixed claims
-> BUT, corporate law only treats shareholders as residual claimants in bankruptcy -> however, even here it is debatable if shareholders are residual claimants -> secured creditors get paid first, usually meaning shareholders get nothing
-> Before bankruptcy, directors decide on dividend pay-outs, reinvestments, other use of profits
-> Also, other stakeholders are ‘residual risk bearers’, not just shareholders
e.g. Employees -> receive raises/bonuses when things go well and staff cut when things go bad

Question 4

Explain how Team Production Theory undermines Shareholder Primacy

(Against Shareholder Primacy)

Answer 4

Team Production Theory undermines Shareholder Primacy
-> Corporate production requires multiple groups -> shareholders alone cannot make a firm (e.g. employees, managers, creditors, even gov.)
-> Shareholder Primacy can discourage firm-specific investments from these stakeholders, harming overall efficiency
e.g. Strine’s James Trains hypothetical
—> To maximise shareholder profits, James Trains will be sold to highest bidder -> BUT, highest bidder has said it will fire employees, managers, etc. Whereas, 2nd highest bidder will ensure prosperity for stakeholders
—> If stakeholders believed the consequences of Shareholder Primacy, i.e. will be sold to highest bidder (ignoring desires of stakeholders), and their jobs are always at risk, they will not be so willing to commit their future + invest in the firm

∴ Directors should balance the interests of all stakeholders to encourage efficient investment and cooperation (more so Dodd argument)

Question 5

Explain the Agency Cost Argument

(For Shareholder Primacy)

Answer 5

Agency Cost Argument
-> It is hard to tell if a director is doing a good job and not acting in self-interest ∴ stock price (and therefore shareholder primacy) offers a clear, measurable metric for director accountability
–> Mark Roe ‘allowing directors to consider all stakeholders gives them too much discretion so they could easily pursue their own goals’

-> BUT, this is not necessarily an argument for shareholder primacy in concept, just that there might be a lack of means to achieve it in reality

-> Also, BUT, Lynn Stout speaks on reality where many companies prefer director-led model where various stakeholders are considered
e.g. State of Delaware’s case law follows the director-led ‘entity’ model

-> Also, BUT, reality of large corporations, institutional/foreign investors and short-termism where shareholders do not care about contributing to the company means it’s better for directors to consider the longer-term impacts to all in their business decisions.