Corporate Darwinism: Disciplining Managers in a World with Weak Shareholder Litigation

Corporate legal scholarship largely focuses on addressing managerial agency costs. As part of this paradigm, legal scholars examine how effectively representative litigation, whether class actions or derivative suits, control managerial agency costs. While most corporate law academics believe that there are benefits created by these suits, they are qualified by the litigation agency costs that surround them. In recent years, concerns about litigation agency costs have resulted in many legislative and judicial actions that restrict shareholder litigation.

In our recent article (available here), we claim that recent corporate governance developments are a natural consequence of both the ineffectiveness and inefficiency of shareholder suits to address certain genres of managerial agency costs. As representative shareholder litigation has been constrained by numerous legal developments, our corporate governance system has developed new mechanisms as alternative means to address these forms of managerial agency costs. We further argue that these new governance responses are themselves becoming stronger because, in part, of the rising concentration of share ownership of public companies.

Activist hedge funds are among the most obvious manifestation of developments that have changed ownership of American public companies and reduced managerial agency costs. Private equity firms assist them in their efforts and act as strong managerial monitors as well by introducing better risk management systems among other things. 

But other forces are at work, too. For example, the passage of the Dodd-Frank Act further armed investors, both large and small, by mandating a non-binding Say on Pay vote. This new vote on executives’ pay fills a corporate governance hole created by the failure of derivative suits to regulate compensation. Say-on-pay resolutions enable shareholders, especially small institutional shareholders, to engage in direct monitoring of executive compensation.

We next consider the rising role of the appraisal remedy that is moving to fill a monitoring gap created by the decline in the efficacy of shareholder litigation focused on acquisitions. As we will show, the appraisal proceeding, an old and previously largely defunct form of litigation, has been resuscitated by a few hedge fund investment groups, who have begun filing these actions in an effort to engage in what some have called “appraisal arbitrage.” They target underpriced acquisition transactions to recover substantial value which pressures bidders to improve prices.

Finally, we conclude by examining how managerial oversight failures may be addressed using securities fraud class actions after the Supreme Court’s most recent antifraud decision in Omnicare Inc. v. Laborer’s Dist. Council Const. Indus. Pension Fund. This monitoring gap is also targeted by private equity firms and their superior risk management techniques and improved board structures for portfolio companies.

James D. Cox is the Brainerd Currie Professor of Law at Duke University School of Law and Randall S. Thomas is the John Beasley Professor of Law and Business at Vanderbilt University School of Law