September 5, 2018
Please note, this piece was originally published in the Delaware Corporate & Commercial Litigation Blog.
The Main Street Investors Coalition is the first organization trying to deal with a relatively new phenomenon that Professors Gilson and Gordon would call the “agency costs of agency capitalism.” Agency capitalism refers to the dominance of institutional investors as shareholders of record of the voting stock of publicly traded companies. They are the ones doing the voting not the retail investors who provide the funds. Agency capitalism has given rise to new “agency costs” that must not only be addressed by the leaders of public companies, participants in the capital markets and the Securities and Exchange Commission, but also by corporate law. Why corporate law must address these agency costs is the focus of this blog post.
The Agency Costs of Agency Capitalism
As I discussed in a recent Pensions & Investments op-ed,
[a]gency costs are generated when an institutional investor acts based on its own preferences, not the preferences of those who provide it with the funds to purchase securities. That is, there is a divergence between the objective of shareholder wealth maximization, the default objective of those 100 million plus retail investors in the United States who invest in mutual funds either directly or through retirement accounts, or are the beneficiaries of public pension funds, and the preferences of institutional investors who manage those funds. The result is that these agency costs may significantly harm the efficiency of corporate governance and lead to lower returns for investors.
These agency costs include a public pension fund disregarding the preferences of its beneficiaries and approaching shareholder advocacy and voting through the lens of shareholder empowerment, not wealth maximization. Or, when an institutional investor uses voting recommendations from proxy advisors that are based on data errors, bias (simply making the recommendation based on what a type of institutional investor wants to hear), or … a one-size-fits-all approach. In addition, when a mutual fund advisor, in its desire to bring more public pension fund assets under management, supports and votes for proxy access proposals initiated by public pension funds. Or, in order to appease shareholder activists who are part of its own stockholder base, the mutual fund adviser may be more supportive of social responsibility proposals, such as those dealing with climate change, than they would otherwise.
Agency costs of agency capitalism reflect a divergence from the institutional investor’s fiduciary duty to act exclusively in the best interests of those who provide it with funds to manage, namely retail investors. How these new agency costs impact corporate law is through both a court’s understanding of a board’s fiduciary duties and what it means when there is a shareholder vote.
Agency Costs of Agency Capitalism and the Board’s Fiduciary Duties
According to Leo Strine, Chief Justice of the Delaware Supreme Court, “broadly, directors may be said to owe a duty to shareholders as a class to manage the corporation within the law, with due care and in a way intended to maximize the long run interests of shareholders.” That same understanding is found when we generalize the dicta of former Chancellor William Chandler in eBay Domestic Holdings, Inc. v. Newmark:
Having chosen a for-profit corporate form, … directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders. The “Inc.” after the company name has to mean at least that. Thus, I cannot accept as valid … a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-profit Delaware corporation for the benefit of its stockholders – no matter whether those stockholders are individuals of modest means or a corporate titan of online commerce.
This directive to maximize shareholder wealth comes not from statutory corporate law but through the board of directors’ fiduciary duties as applied by the courts. According to the Delaware Supreme Court in NACEPF v. Gheewalla, “The directors of Delaware corporations have ‘the legal responsibility to manage the business of a corporation for the benefit of its stockholder owners.’ Accordingly, fiduciary duties are imposed upon the directors to regulate their conduct when they perform that function.”
Most importantly, the Gheewalla court also said,
When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its stockholders by exercising their business judgment in the best interests of the corporation for the benefit of its stockholder owners.
Arguably this statement was made under the presumption that institutional investors were meeting their own fiduciary duties. But what if the facts demonstrate that the board is faced with institutional investors who are generating agency costs? That is, the institutional investors are demanding that the board act to satisfy their own preferences, as stockholders of record, rather than the preferences of those who provide them with the funds to purchase the company’s stock?
Such a fact pattern calls for a change in how a board’s fiduciary duties are understood. If not, then the board will always be under pressure to adhere to a duty to institutional investors who may be violating their own fiduciary duties. Boards should not be forced to be complicit in this breach.
In order to rectify this problem, it is recommended that the statement in Gheewalla be modified with the following italicized language:
When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its stockholders by exercising their business judgment in the best interests of the corporation for the benefit of its stockholder owners and the investors and beneficiaries such ownership represents.
Such language would help empower a board to say no to those institutions creating agency costs by providing it with the argument that to do otherwise would be a breach in the fiduciary duties it owes to the retail investors whose interests the institutional investor is actually representing, such as mutual fund shareholders or public pension fund beneficiaries.
Agency Costs of Agency Capitalism and Shareholder Voting
The Delaware Supreme Court said in Crown Emak Partners, LLC v. Kurtz, “[w]hat legitimizes the stockholder vote as a decision-making mechanism is the premise that stockholders with economic ownership are expressing their collective view as to whether a particular course of action serves the corporate goal of stockholder wealth maximization.”
This is a beautiful statement, but what if the premise is wrong? It is quite possible that courts will from time-to-time face fact patterns where the agency costs of agency capitalism make it clear that the premise does not hold. If so, what is a court to do? Should a court determine that the shareholder vote is no longer legitimate to the extent that the votes provided by institutional investors generating agency costs must be thrown out? This is an issue that the courts need to identify and address.
Former Chancellor William T. Allen was prescient when he stated in the famous 1988 Delaware Chancery Court case of Blasius Industries, Inc. v. Atlas Corp., that “[i]t may be that we are now witnessing the emergence of new institutional voices and arrangements that will make the stockholder vote a less predictable affair than it has been.” However, it is doubtful that he was including in this “less predictable affair” language the additional uncertainty and, most importantly, the inefficiency created by the agency costs of agency capitalism. It is now up to corporate law to respond.
Bernard S. Sharfman is the Chairman of the Main Street Investors Coalition Advisory Council and a member of the Journal of Corporation Law’s editorial advisory board