Arrow's theorem and the exclusive shareholder franchise

Vanderbilt Law Review

Volumn 62, Issue 4, 2009, Pages 1217-1243

  Hayden, Grant ^a   Bodie, Matthew ^b  

^a HOFSTRA UNIVERSITY   (United States)

^b SAINT LOUIS UNIVERSITY   (United States)

Author keywords

[No Author keywords available]

Indexed keywords

EID: 70149083457     PISSN: 00422533     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (144)

1. Shareholder primacy is generally viewed as the normative foundation for modern corporate law theory. See Stephen M. Bainbridge, Director Primacy in Corporate Takeovers: Preliminary Reflections, 55 STAN. L. REV. 791, 798 & n.35 (2002) ('Today, most corporate law scholars embrace some variant of shareholder primacy."). In some sense, shareholder primacy means nothing more than shareholder control of the corporation through the power to elect directors.
2. See D. Gordon Smith, The Shareholder Primacy Norm, 23 J. CORP. L. 277, 277 (1998) ("The structure of corporate law ensures that corporations generally operate in the interests of shareholders. Shareholders exercise control over corporations by electing directors...."). However, shareholder primacy is generally seen as meaning something more: namely, that the corporation's directors should strive to run the corporation solely for the financial benefit of the shareholders in order to maximize social utility.
3. See Stephen M. Bainbridge, In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green, 50 WASH. & LEE L. REV. 1423, 1423 (1993) [hereinafter Bainbridge, In Defense]. For that reason, it is sometimes called the "shareholder wealth maximization" norm.
4. Id. at 1423-25.
5. For some prominent examples, see lawrence e. mitchell, corporate irresponsibility: america's newest export 4-5 (2001) (arguing that shareholder wealth maximization keeps managers and stockholders focused on the short term);
6. Margaret M. Blair, Directors' Duties in a Post-Enron World: Why Language Matters, 38 WAKE FOREST L. REV. 885, 891-95 (2003) (criticizing shareholder primacy's focus on the maximization of short-term value);
7. Lynn a. Stout, Bad and Not-So-Bad Arguments for Shareholder Primacy, 75 S. cal. L. rev. 1189, 1208 (2002) (dismissing several key arguments for shareholder primacy and providing tepid support for one).
8. Gordon Smith might be considered one such observer. In an article examining the actual effects of the norm, Smith acknowledged that "[t]he assumption that the shareholder primacy norm is a major factor in the ordinary business decisions of boards of directors of modern, publicly traded corporations is pervasive in modern corporate law scholarship." Smith, supra note 1, at 280. However, he argued that "the shareholder primacy norm is nearly irrelevant to the ordinary business decisions of modern corporations" and that the norm may be "one of the most overrated doctrines in corporate law."
9. Id. at 279, 323.
10. See, e.g., Bainbridge, In Defense, supra note 1, at 1423-1425, 1446 (describing the shareholder wealth maximization norm as providing the basic logic from which modern corporate law rules have emerged).
11. Jill e. Fisch, Measuring Efficiency in Corporate Law: The Role of Shareholder Primacy, 31 J. CORP. L. 637, 639 (2006).
12. See, e.g., DEL. CODE ANN. tit. 8, §§ 211-212 (2002).
13. See infra Part I. A.
14. Kenneth J. Arrow, Social Choice and Individual Values (2d ed. 1963);
15. see also NORMAN FROHLICH & JOE A. OPPENHEIMER, MODERN POLITICAL ECONOMY 19-23 (1978) (summarizing the assumptions, conditions, and conclusions of the theorem);
16. PETER C. ORDESHOOK, GAME THEORY AND POLITICAL THEORY: AN INTRODUCTION 62-65 (1986) (providing a concise outline of a proof of the theorem).
17. See infra Part LA (discussing, inter alia, Frank H. Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J.L. & ECON. 395 (1983)).
18. Easterbrook & Fischel, supra note 9, at 405.
19. See, e.g., frohlich & oppenheimer, supra note 8, at 30-31 (stating that voting systems, according to the posits of social choice, "by themselves cannot lead to intuitively justifiable decisions," and, consequently, that corollary aspects of the decisionmaking process must be adjusted to achieve better group choices).
20. Grant M. Hayden & Matthew T. Bodie, One Share, One Vote and the False Promise of Shareholder Homogeneity, 30 cardozo L. rev. 445, 445-505 (2008).
21. See Smith, supra note 1, at 299 (describing the development of the principle of shareholder primacy as deriving in part from the fact of "the exclusive right of shareholders to vote").
22. For a version of this argument, see, e.g., Milton Friedman, The Social Responsibility of Business Is to Increase Its Profits, N.Y. times mag., Sept. 13, 1970, at 32-33, 122-126 (arguing that shareholders are "the owners of the business" and, therefore, that the only "social responsibility of business is to increase its profits").
23. For a version of this argument, see, e.g., frank H. easterbrook & daniel R. fischel, The Economic Structure of Corporate Law 67-70, 91 (1996).
24. For a critique of the argument based on shareholder ownership, see Lynn A. Stout, The Mythical Benefits of Shareholder Control, 93 Va. L. rev. 789, 804-805 (2007).
25. For an extended critique of the argument based on shareholders as sole residual claimants. Blair M.M. Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century, 1995, 227-234.
26. Easterbrook & Fischel, supra note 9, at 405.
27. EASTERBROOK & FISCHEL, supra note 15, at 70. Because the arguments in the article and book are identical, we will refer to the earlier article. Easterbrook & Fischel, supra note 9.
28. DUNCAN BLACK, THE THEORY OF COMMITTEES AND ELECTIONS (1958) [hereinafter BLACK, THEORY]).
29. Id.
30. Id.
31. This is also, they mention, the reason why the law makes little effort to require firms to pursue goals other than profit maximization.
32. Id. at 405-06.
33. Social choice theory and Arrow's theorem have mainly come into legal scholarship under the guise of public choice theory. For summaries of the literature, see DANIEL A. FARBER & PHILIP P. FRICKEY, LAW AND PUBLIC CHOICE: A CRITICAL INTRODUCTION 38-42 (1991);
34. Saul Levmore, Foreword to maxwell L. stearns, public choice and public LAW: readings and Commentary, at xii-xiv (1997).
35. See FROHLICH & OPPENHEIMER, SUPRA note 8, at 16.
36. ARROW, supra note 8, at 22-23, 51-60.
37. See id. (laying out the logical foundations and conclusions for the theorem);
38. see also FROHLICH & OPPENHEIMER, supra note 8, at 19-23 (summarizing the assumptions, conditions, and conclusions of the theorem)
39. PETER C. ORDESHOOK, supra note 8, at 62-65 (1986) (providing a concise outline of a proof of the theorem). This Essay will borrow terminology largely from WILLIAM H. RIKER, LIBERALISM AGAINST POPULISM: A CONFRONTATION BETWEEN THE THEORY OF DEMOCRACY AND THE THEORY OF SOCIAL CHOICE 293-98 (1982).
40. For a good, recent summary of the state of social choice theory and Arrow's theorem, see 1 handbook of social choice and welfare, at ix (Kenneth J. Arrow et al. eds., 2002) [hereinafter 1 handbook of social choice and welfare].
41. RIKER, supra note 25, at 295.
42. Id. at 117-118.
43. Id. at 116-117, 297.
44. Id. at 118.
45. The term "irrelevant" is not pejorative, but instead refers to an alternative outside the set from which a group must choose that does not alter the desirability of the other alternatives relative to each other. Grant M. Hayden, The Limits of Social Choice Theory: A Defense of the Voting Rights Act, 74 TUL. L. REV. 87, 101 (1999).
46. See RIKER, supra note 25, at 119, 297.
47. See Hayden, supra note 29, at 101-102 (describing intransitivity as a voting cycle and explaining the problems with a system displaying this characteristic);
48. Grant M. Hayden, Note, Some Implications of Arrow's Theorem for Voting Rights, 47 STAN. L. REV. 295, 299 (1995) [hereinafter Hayden, Note] (defining intransitivity and stating that it may in essence lead to dictatorial power being exercised in a social choice function by way of agenda control).
49. Easterbrook & Fischel, supra note 9, at 405.
50. See id.
51. Id. at 405-06.
52. HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE 44 (1996).
53. Id. at 41-42.
54. Id. at 42.
55. Gregory K. Dow, The New Institutional Economics and Employment Regulation, in GOVERNMENT REGULATION OF THE EMPLOYMENT RELATIONSHIP 57, 69 (Bruce E. Kaufman ed., 1997).
56. Id.
57. Though he relies on Arrow's theorem as part of a general argument against opening up corporate elections to additional constituencies, Dow seems most worried about cycling at the level of board decisionmaking
58. See id.
59. See, e.g., id.
60. Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 va. L. rev. 247 (1999). In their model, people who hope to profit from team production give up some of their rights to the corporation and, in return, the corporation coordinates the activities of the team members and allocates the resulting production in a way that minimizes shirking and rent-seeking.
61. Id. at 250-51.
62. Id. at 253.
63. Id. at 312-315.
64. Id. at 313. This is not, by the way, their only argument for this conclusion.
65. Id. at 314-15.
66. See Kotaro Suzumura, Introduction to 1 handbook of social choice and welfare, supra note 25, at 1, 18-25 (describing decades of work attacking Arrow's theorem, but reiterating its continued vitality).
67. See, e.g., Henry Hansmann & Reinier Kraakman, The Basic Governance Structure, in The Anatomy of Corporate Law: a Comparative and Functional Approach 33, 64 (Reinier Kraakman et al. eds., 2004)
68. Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439, 447-449 (2001).
69. The arguments are drawn, somewhat confusingly for our purposes, from Kenneth Arrow's other work on institutional design, THE limits OF organization (1974).
70. See Stephen M. Bainbridge, Participatory Management Within a Theory of the Firm, 21 J. CORP. L. 657, 725 (1996).
71. Blair & Stout, supra note 41, at 313.
72. This is certainly understandable because both arguments are related to potential breakdowns in collective decision making. This is not to say that the authors are conflating the two arguments, but just that it is difficult to see whether and to what degree they are relying upon the argument from Arrow's theorem when discussing reasons for limiting the franchise to shareholders.
73. See Bainbridge, supra note 48, at 667 n.51, 725 n.409.
74. See DEL. CODE ANN. tit. 8, § 141(b) (2002) ("The vote of the majority of the directors present at a meeting at which a quorum is present shall be the act of the board of directors unless the certificate of incorporation or the bylaws shall require a vote of a greater number.").
75. See Hayden, Note, supra note 31, at 305.
76. See ORDESHOOK, supra note 8, at 56-57 (discussing the Condorcet paradox and its argument that journalistic shorthand such as "the public interest" or "community goals" has no proper place in any adequate theory of political processes);
77. RlKER, supra note 25, at 119.
78. Easterbrook & Fischel, supra note 9, at 405. One assumes this means choices that are inconsistent with each other, as opposed to inconsistent with some hypothetically "correct" choice (which, as we now know, would not be possible to discern).
79. Or subject to dictatorial control, a state of affairs that is no better in this context. See Alan Gibbard, Manipulation of Voting Rules: A General Result, 41 ECONOMETRICA 587, 587 (1973)
80. Mark A. Satterthwaite, Strategy-Proofness and Arrow's Conditions: Existence and Correspondence Theorems for Voting Procedures and Social Welfare Functions, 10 J. econ. theory 187, 188 (1975).
81. See HANSMANN, supra note 35, at 41-42.
82. Jeffrey N. Gordon, Shareholder Initiative: A Social Choice and Game Theoretic Approach to Corporate Law, 60 U. CIN. L. REV. 347, 351-352 (1991).
83. Id. at 359-360.
84. See id. at 359-363.
85. See id. at 363.
86. Id. at 373.
87. Indeed, Gordon makes some of these distinctions between the cycling problem with initiatives and the potential cycling problem that may arise in board elections with a more heterogeneous shareholder electorate.
88. See id. at 372-373.
89. Shaun Martin & Frank Partnoy, Encumbered Shares, 2005 U. ILL. L. REV. 775, 778-781.
90. See Hayden & Bodie, supra note 12, at 477-499 (cataloguing the ways in which shareholder interests diverge).
91. See id. at 477-480.
92. See id. at 486-488.
93. See id. at 492-494.
94. Martin & Partnoy, supra note 64, at 778 (quoting Easterbrook & Fischel, supra note 9, at 405).
95. See Bainbridge, supra note 48, at 665 (discussing various explanations, such as investment time and tax bracket, for disagreement over how best to achieve the goal of wealth maximization). If there was complete agreement, there would, of course, be no reason to have board elections in the first place because we could just ask one of the shareholders to report the shared preference ranking.
96. If the merger was a cash-out merger offering the highest current cash value of the three options, this preference set would correlate with shareholders interested in short-term profit maximization.
97. This is not to say that it would be difficult to put together a scenario in which an expanded corporate electorate (that included constituencies other than shareholders) had a preference profile that led to an intransitive outcome. The point here is that devising such a scenario with shareholders alone is relatively easy, even assuming an identical interest in wealth maximization, and the burden is on those who advance the argument from Arrow's theorem that there is a marked difference in the probability of acyclic outcomes with an expanded electorate.
98. See Hayden, Note, supra note 31, at 299-304 (providing examples of how the Condorcet method, the amendment procedure, the Borda count, and cumulative voting systems all fall prey to Arrow's theorem).
99. See, e.g., Hayden, supra note 29, at 109-132 (arguing that the level of spectrum agreement required in Voting Rights Act claims, while not complete, is sufficient to reduce the incidence of cycling to near zero);
100. Hayden, Note, supra note 31, at 312 (arguing that the racial bloc voting requirements of certain claims under the Voting Rights Act may represent a case of "naturally occurring" spectrum agreement that decreases the incidence of cycling). As will be discussed infra, many groups of people associated through a polity or a corporation may have sufficiently common reference points to greatly reduce the incidence of intransitivities.
101. See Scott L. Feld & Bernard Grofman, Partial Single-Peakedness: An Extension and Clarification, 51 PUB. CHOICE 71, 71 (1986) (explaining that "empirical observations of a wide variety of actual collective decisionmaking processes indicate that cyclical majorities are very rare");
102. Bernard Grofman, Public Choice, Civic Republicanism, and American Politics: Perspectives of a "Reasonable Choice" Modeler, 71 TEX. L. REV. 1541, 1553 (1993) (noting that cycles are much harder to find than early social choice models had predicted).
103. See Richard G. Niemi & Herbert F. Weisberg, A Mathematical Solution for the Probability of the Paradox of Voting, 13 BEHAV. SCI. 317, 321 (1968).
104. See id. at 322 & tbl.2.
105. See Hayden, supra note 29, at 107-08;
106. Hayden, Note, supra note 31, at 306-07. Although the term "spectrum agreement" seems to imply some express understanding between voters, it is enough that voter preferences may be arrayed on a common continuum, regardless of whether the voters agreed ahead of time or, indeed, even knew about the agreement.
107. Hayden, supra note 29, at 107.
108. Id.
109. See RIKER, supra note 25, at 123-128
110. Id. at 126.
111. See BLACK, THEORY, supra note 19, at 19-25 (discussing proofs of theorems and examples involving single-peaked preference curves);
112. DUNCAN BLACK & R.A. NEWING, Committee Decisions with Complementary Valuation 19-28 (1951) (discussing group voting on two separate issues and proving there can be at most one majority decision);
113. Duncan Black, On the Rationale of Group Decision-Making, 56 J. pol. econ. 23, 23-24 & fig.l (1948) (explaining and depicting a single-peaked preference profile for a voter with one most desired alternative).
114. See BLACK, THEORY, supra note 19, at 125-129.
115. Id.
116. See Amartya K. Sen, A Possibility Theorem on Majority Decisions, 34 ECONOMETRICA 491, 492-495 (1966).
117. Id. at 492.
118. See Feld & Grofman, supra note 75, at 72-73 ("[1] f even one individual has non-single- peaked preferences then there can be a paradox of cyclical majorities.");
119. Richard G. Niemi, Majority Decision-Making with Partial Unidimensionality, 63 AM. POL. SCI. REV. 488, 488 (1969) (finding that for "majority voting [to] yield a transitive social ordering.... the preference ordering of every individual must be single-peaked").
120. See Hayden, supra note 29, at 125-126 (providing an example of a preference profile where sixteen of seventeen preference orders are single-peaked yet a majority vote produces an intransitive outcome).
121. Gerald H. Kramer, On a Class of Equilibrium Conditions for Majority Rule, 41 econometrica 285, 285 (1973).
122. See Niemi, supra note 88, at 488.
123. Id. at 493-94;
124. see also Hayden, supra note 29, at 127-28 (discussing Niemi's findings). This is counterintuitive because the likelihood of transitive outcomes decreases as you increase the number of individuals in a profile assuming an impartial culture.
125. See Niemi, supra note 88, at 493-94.
126. See, e.g., Peter C. Fishburn, Voter Concordance, Simple Majorities, and Group Decision Methods, 18 BEHAV. SCI. 364, 371-372 (1973);
127. Dean Jamison & Edward Luce, Social Homogeneity and the Probability of Intransitive Majority Rule, 5 J. econ. theory 79, 84-86 (1972);
128. see also Hayden, supra note 29, at 128-30 (discussing these two studies).
129. See Feld & Grofman, supra note 75, at 73-79 (extending Niemi's result and finding that a social preference order will be transitive if there is more than a fifty percent probability that a randomly chosen individual would align the alternatives along one existing continuum)
130. Niemi, supra note 88, at 494.
131. See FROHLICH & OPPENHEIMER, supra note 8, at 19-20.
132. Easterbrook & Fischel, supra note 9, at 405.
133. Id.
134. See Grofman, supra note 75, at 1552.
135. Joshua R. Mourning, Note, The Majority-Voting Movement: Curtailing Shareholder Disenfranchisement in Corporate Director Elections, 85 WASH. U. L. REV. 1143, 1144 (2007). Some shareholders have pressed corporations to change their voting rules so that a director must win a majority of the votes cast in order to win the seat.
136. See generally id. at 1143-46. However, even under such a "majority-vote" regime, a director who fails to get a majority will stay on until a replacement is chosen or until a majority of shareholders vote to remove the person.
137. See DEL. CODE ANN. tit. 8, § 141(b) (2002) (stating that "[e]ach director shall hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal"). However, some companies have established resignation policies that require directors to resign if they are not elected by the shareholders. Mourning, supra, at 1182-85. For criticism of majority voting as an ineffective reform
138. For criticism of majority voting as an ineffective reform, see Vincent Falcone, Note, Majority Voting in Director Elections: A Simple, Direct, and Swift Solution?, 2007 COLUM. BUS. L. REV. 844, 881-882
139. See, e.g., DEL. CODE ANN. tit. 8, § 141(d) (allowing such a staggered election procedure).
140. For some background on structure-induced equilibria, see, e.g., RIKER, supra note 25, at 188-192
141. Grofman, supra note 75, at 1561-1562.
142. See Gordon, supra note 58, at 372-373.
143. See generally ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND Private Property 119-152 (1932).
144. For an empirical examination of the power of incumbent boards to influence elections, see Yair Listokin, Management Always Wins the Close Ones, 10 Am. L. & ECON. REV. 159 (2008).