The New Corporate Governance
In the last few years, there has been a dramatic increase in shareholder engagement on environmental and social issues. Consider two examples from 2021. Eighty-one percent of DuPont shareholders approved a proposal requiring the company to disclose how much plastic it releases into the environment each year and to assess the effectiveness of DuPont’s pollution policies. Sixty-four percent of ExxonMobil shareholders approved a proposal requiring the company to describe ‘if, and how, ExxonMobil’s lobbying activities … align with the goal of limiting average global warming to well below 2 degrees Celsius…’
It is hard to explain this behavior using the dominant corporate governance paradigm, according to which shareholders have a single objective: shareholder value maximization (SVM). In the above examples, shareholders seem to be pushing companies to do things that might reduce value. Many scholars have criticized the SVM paradigm, arguing that managers should act in the interest of other stakeholders—workers, consumers, the community—or that companies should have a social purpose over and above making money. These criticisms are normative. But a further criticism is positive: The paradigm cannot explain what shareholders are actually pressuring companies to do.
In a new paper, we examine the intellectual case for SVM. In a classical world of perfect competition, complete markets, and no externalities, SVM will be unanimously favored by shareholders and will lead to a socially efficient outcome. These results still hold in the case of externalities as long as these externalities are perfectly regulated by the government. But what happens if the government has not regulated optimally, a particular concern when an externality is global, as with climate change, and coordination by many governments is required for optimal mitigation? There is then no reason to think that SVM will be unanimously favored by shareholders or be socially efficient. Consider the above DuPont example. Some shareholders may favor a less-polluting technology, even if it is more costly, because plastic waste affects them directly or they care about the effect of the waste on others. Other shareholders may not be personally affected or may care less about the welfare of others and so would like to stick to the current technology.
There is also no reason to think that SVM achieves a socially efficient outcome among shareholders. If environmentally sensitive shareholders experience harm from Dupont’s plastic waste that exceeds the profit the waste generates, SVM leads to the production of the plastic waste even though it would be efficient for the shareholders as a group to eliminate the waste. (And Coasian bargaining is unlikely to resolve the issue given free-rider problems.)
Our paper discusses why SVM became the norm despite its fragile foundations. Most shareholders own their shares through intermediaries such as BlackRock. Both ERISA law regulating private pensions and standard practice have enshrined the idea that asset managers must support only policies that increase the long-run financial return of their clients. To prevent abuses, the 1974 ERISA Law required that a fiduciary should discharge his duties ‘for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries.’ In 2014 the U.S. Supreme Court stated that, ‘[r]ead in the context of ERISA as a whole, the term ‘benefits’ in the provision just quoted must be understood to refer to the sort of financial benefits … that trustees who manage investments typically seek to secure for the trust’s beneficiaries.’
ERISA applies to the pension managers of 401k plans, eg Harvard University, not to the fund managers themselves. Nevertheless, there is an indirect effect on fund managers. The fear of potential liability makes 401k plan managers reluctant to include in their investment options a fund that explicitly states that it will pursue nonfinancial goals. Thus, any fund manager who wants to achieve economies of scale has little incentive to offer a fund with a broader purpose since this runs the risk of being excluded from 401k plans.
Besides the law, a major role in enforcing SVM is played by business norms. Directors are routinely confronted with complex business decisions. Unless they are purely self-interested, they need some principle to guide them. Decades of academic thinking, both in the law and in finance, have enshrined the idea that the fiduciary duty owed to shareholders means the pursuit of shareholder value maximization. In other words, SVM has become the business norm.
As an example of this, consider what Larry Fink, the CEO of BlackRock, said in 2016:
‘We live in a world where the Department of Labor gave us this guidance about what is our fiduciary responsibility as investors. We only have one responsibility as investors: to maximize return. That’s it. So basically we can tell a company to fire five thousand employees tomorrow, and if that maximizes return for the company we did something well. We can tell that company to do something that maybe is bad for the environment. There is nothing right now that guides, other than a maximization of return behavior.’
But things are changing, as the Dupont and Exxon examples indicate. We argue that shareholder welfare maximization (SWM) should replace SVM. We suggest that one way to implement SWM is to allow shareholders to vote on company strategy. We show that, in a number of cases, if shareholders are even slightly socially responsible, voting by shareholders can lead to outcomes that are not only good for them but also socially efficient.
Most investors own stock via a financial intermediary, generally a mutual fund. Currently, these institutions vote on behalf of their investors. But shareholders can become more involved in the voting process, and that seems to be happening.
At least three approaches are possible. The first is to push down the voting decision to the level of individual investors. This is a strategy that BlackRock is trying to implement now with its major investors. The strategy might work well for major pension funds and endowments, but we cannot expect individual shareholders to express an opinion on the ballots of all the companies they own. Fortunately, Institutional Shareholder Services (ISS) has six sets of ‘specialty’ proxy voting guidelines—each geared toward a specific special interest group. It would be relatively simple for each investor to choose one type of guideline and ask that her shares be voted accordingly.
The second strategy would be for mutual funds to elicit investors’ preferences and then cast their votes based on an aggregation of these preferences. This may be challenging since shareholders may not report their preferences truthfully, but a shortcut would be for mutual funds to ask their investors how they would vote and then aggregate these votes.
The third strategy is for mutual funds to offer investors funds with a very clear and predetermined voting strategy and let investors choose among them. For example, Vanguard could offer an S&P500 light (dark) green fund, ready to vote in favor of all shareholder resolutions that promote a greener economy, as long as their cost of reducing CO2 emission does not exceed $100 ($200) per ton.
One concern with SWM is that the controversies corporations are pushed into may explode. We show that SWM diverges from SVM when a company has a comparative advantage in achieving a social goal. Thus it seems reasonable to limit shareholder engagement to such cases. Our paper provides the beginnings of a taxonomy concerning when comparative advantage is likely to exist and when it is not.
There are also ways to limit the number of shareholder resolutions. The first is to set a minimum amount of stock required to file a proposal. The second is to request an SEC no-action letter covering the exclusion of a proposal from the ballot. In the future, the SEC could allow only proposals that pertain to a company’s comparative advantage. The third method is to decline to act on shareholder proposals because they are precatory. Our view is that it would be better to make shareholder resolutions binding since this would make it easier for shareholders to get managers to follow SWM. However, if the main reason to oppose the SWM approach is the fear of making corporations ungovernable, having a transitory period where proposals remain precatory may make sense.
This post was first published on Columbia Law School’s Blue Sky Blog here.
Oliver Hart is a Professor at Harvard University.
Luigi Zingales is a Professor at the University of Chicago.
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