Keep Your ‘Invisible Hands’ to Yourself: Freeing the Corporation from the Cult of the ‘Efficient Market’

At the turn of the last century, a fantastic characterization of stock exchange efficiency looked to a powerful, supernatural force referred to simply as ‘the market’, which was an oracle of true corporate value and perfect incentive. As prices of shares were assumed precisely to reflect the objective value of the company—because reached by the rational decisions of informed traders—it was thought that perfect behavioural incentives would be created by binding management tightly to share price. Executive directors were tied to this market perfection by paying them in stock and stock options, and other, less well remunerated (independent) directors were appointed to the board to ensure that market participants received the information they needed for trading. The company as a whole was understood to be something that should be bought and sold in market trading through hostile takeovers if management behavior caused share price to drop, and a similar drop in share price could finance a shareholder action against the directors via contingent fees for lawyers. Corporate governance was thus bound firmly to the needs and views of traders in the secondary market for corporate shares.

While this adjustment of company governance and purpose helped the financial industry to balloon in size and profitability, the result for the real economy was not attractive. Industrial and commercial companies diverted their attention to finance, so that innovation lagged. Executive directors came to embody a new class of ultrawealthy while the pay of ordinary workers stagnated. The resulting economic and social inequality led to serious political instability. Previously innovative companies were sliced up by aggressive institutional investors and blended into smoothies of liquidity, which was then diverted to mostly unproductive assets. Established firms with fading business models borrowed heavily, not to reinvent themselves, but to put their stock on steroids through repurchases—simultaneously overleveraging the company and bettering its image in ‘the market’—while inflating executive compensation. Innovative firms protected themselves against the leading model of corporate governance through selling nonvoting shares, using staggered boards and even by remaining private. In short, some firms embraced the whirl of speculation and assisted traders to score goals by kicking their share price up and down with millions of bid and ask orders, while others sheltered productive activity by isolating themselves from the fury of this speculation.

As this era was coming to a close, however, work in behavioral psychology, financial economics, market microstructure and clear historical evidence consistently showed that securities markets do not usually produce objectively grounded stock prices. The fantastic idea of a perfectly efficient market rested on assumptions of fully informed rational actors seeking the underlying value of firms while trading on equal terms within a seamless market environment. Those assumptions were gradually replaced by detailed facts painstakingly uncovered about actual human behavior, the actual strategic motivations of securities traders, and the actual market mechanisms used to trade, so that historical evidence of real market behavior gradually came into clearer view.

With the cult of mystical market perfection fading under the light of science, it is time to disentangle governance from the logic of securities trading and reorient it toward productive management and innovative research. It is also time to build corporate finance informed by data regarding a corporation’s actual performance and potential in the market for its products or services. The capture of corporations by the needs of securities trading, the corporation’s need to flee the cult of market perfection, and a possible and more rational alternative future are the focus of my recent paper, ‘Keep Your “Invisible Hands” to Yourself: Freeing Corporate Governance from the Cult of the “Efficient Market”,’ forthcoming in Innovation, Technology and Corporate Law, Godwin, Lee and Langford (eds) (Edward Elgar, 2021).

We can certainly do better than we have to finance the productive activity of business enterprises. Intermediated, relationship-oriented channels of finance, like venture capital investment and bank lending, have long achieved a more informed, articulated view of a corporation’s productive activity than has the speculative game of open trading. Such direct investment suffered, however, from the risk of institutionally constricted vision because it lacked the multiplicity of views and opinions found in the secondary market. Progress in data analytics now permits thousands of datapoints to be evaluated against models using broad and dynamic views of historical performance, enabling objectively informed lending and investment. Machine learning also allows complementary but nonidentical valuation models to be applied simultaneously to company data in ‘ensemble’ mode. Such an ‘ensemble’ or ‘forest’ of layered processing models permit an investor or syndicate of investors to achieve a view of a company comparable to the multifaceted evaluation Hayek praised in secondary markets. Moreover, the analysis would look to profitability of the company qua business enterprise rather than the behavior of other lenders or the price of a share as a unit among others circulating amidst rising and falling currents of sentiment and price momentum.

Existing networking methods should allow orderly and profitable exit by early investors, as other investors with different interests and liquidity horizons enter the community of finance or syndication. This would both allow financial nurture of early business activity and permit the stock corporation to return to its purpose as a vehicle for conducting productive activity—enabling it to escape a strange period of captivity in which its shares have served mainly as chips in a game of securities poker.

David C. Donald is a Professor in the Faculty of Law at the Chinese University of Hong Kong