The case against shareholder empowerment

University of Pennsylvania Law Review

Volumn 158, Issue 3, 2010, Pages 653-728

  Bratton, William W ^a   Wachten, Michael L ^b  

^a GEORGETOWN UNIVERSITY LAW CENTER   (United States)

^b UNIVERSITY OF PENNSYLVANIA LAW SCHOOL   (United States)

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[No Author keywords available]

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EID: 77950310789     PISSN: 00419907     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (365)

1. See COMM. ON CAPITAL MKTS. REGULATION, INTERIM REPORT 93 (2006), available at http://www.capmktsreg.org/pdfs/11.30Committee-Interim-ReportREV2. pdf (arguing that enhanced shareholder rights in the areas of takeover defenses and remedy selection will reduce expected agency costs and incentivize entry into U.S. public markets). The Committee's report focused on shareholder ratification of poison pills adopted by a staggered board, majority voting for boards of directors, shareholder access to the director nomination process, executive pay, and contractual alternatives to litigation.
2. Id. at 16-18.
3. Id. at 16.
4. This is often referred to as the debate over "shareholder primacy." But shareholder primacy has two aspects, the first going to the objective of the corporation and the shareholders' place as legal beneficiary, and the second going to the allocation of power within the corporation. This Article takes the first aspect as settled in favor of the shareholders and focuses on the second aspect To avoid confusion, we avoid the term entirely, instead using the phrase "shareholder empowerment"
5. But see, e.g.. Press Release, Council of Institutional Investors, CII Applauds Introduction of Shareholder Bill of Rights Act (May 19, 2009), available at http://www. cii.org/UserFiles/file/ draft%20press%20release%20schumer%2005-19-09.pdf (quoting CII Chair and CALPers CIO Joseph A. Dear, who stated that the proposed act was needed "to promote market discipline and accountability").
6. See The Causes and Effects of the Lehman Brothers Bankruptcy: Hearing Before the H. Comm. on Oversight and Gov't Reform, 110th Cong. 4 (2008) (statement of Nell Minow, Editor, The Corporate Library) (connecting shareholder power with the restoration of credibility);
7. Luigi Zingales, The Future of Securities Regulation 2, 24-27 (Chi. Booth Sch. of Bus., Working Paper No. 08-27, 2009), available at http://ssrn.com/ abstract= 1319648 (connecting trust and accountability, and contending that shareholder nominations will channel shareholder inputs to long-term value and deter managing to the market);
8. Press Release, The Office of Senator Charles Schumer, Schumer, Cantwell Announce "Shareholder Bill of Rights" to Impose Greater Accountability on Corporate America (May 19, 2009), available at http://schumer.senate.gov/ new-website/ record.cfm?id=313468 [hereinafter Schumer Press Release] (emphasizing the need to restore confidence through greater accountability and shareholder empowerment);
9. cf. Roger Lowenstein, A Seat at the Table, N.Y. TIMES, June 7, 2009, (Magazine), at 11 (arguing that shareholder-nominated board members will cause shareholders to shift from a short-term view, in which exit is the primary means of expressing discontent, to a long-term view, in which "the less forceful, but more supple 'voice'" is used effectively). For a bank chairman's thoughts on the need to restore trust, see Stephen Green, Group Chairman, HSBC Holdings pic, Speech at the British Bankers' Association Annual International Banking Conference: Restoring Governance and Trust 3 (June 30, 2009), available at http://www.hsbc.eom/l/PA-1-1-S5/content/assets/newsroom/ 090630- speech-bba.pdf.
10. See Arthur Levitt, Jr., Op-Ed., How to Boost Shareholder Democracy, WALL ST. J., July 1, 2008, at Al 7 (advocating for the repeal of prior SEC decisions in order to increase shareholder control and accountability).
11. Id.
12. Id.
13. See, e.g., Deborah Solomon & Dan Fitzpatrick, Czar Blocks BofA Chiefs Pay, WALL ST. J., Oct. 16, 2009, at A1 (reporting that the Treasury Department's "special master" for compensation objected to Bank of America CEO Kenneth D. Lewis's 2009 compensation, pushing Lewis to agree to forego salary for the year).
14. Shareholder rights advocates often use this imagery. See, e.g., Lowenstein, supra note 5, at 11 ("[M]anagers cannot be trusted not to (grossly) overpay themselves....");
15. Schumer Press Release, supra note 5 ("[T] he leadership at some of the nation's most renowned companies took too many risks and too much in salary...." (internal quotation marks omitted) (quoting Senator Schumer));
16. cf. Zingales, supra note 5, at 23-24 (noting the image, but arguing against direct regulation of pay).
17. See Shareholder Bill of Rights Act of 2009, S. 1074, 111th Cong.§2 (describing legislative findings and noting that a lack of accountability "led to the loss of trillions of dollars in shareholder value, losses that have been borne by millions of Americans who are shareholders through their pension plans, 401 (k) plans, and direct investments").
18. See Emergency Economic Stabilization Act of 2008 (EESA), Pub. L. No.110-343, § 111(b)(2)(A), 122 Stat 3765, 3777, amended by American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, sec. 7001, §111, 123 Stat 115, 516-20 (to be codified at 12 U.S.C. §5221) (requiring sellers of troubled assets to have "limits on compensation that exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution"). Subsequent Treasury guidelines require that for all TARP recipients executive base pay be limited to $500,000 and that any incentive pay must be granted in the form of restricted stock, although these rules can be waived by shareholders except for those companies receiving "exceptional financial recovery assistance." Press Release, U.S. Dep't of the Treasury, Treasury Announces New Restrictions on Executive Compensation (Feb. 4, 2009), available at http://www.ustreas.gov/press/releases/tg15.htm;
19. see also American Recovery and Reinvestment Act of 2009 sees. 7000-7002, §§111, 109(a), 123 Stat at 516-21 (amending EESA and limiting incentive payments to the CEO and the twenty next-highest-paid executives of large TARP recipients to one-half of the executive's salary (other than payments required under earlier contracts and restricted stock), prohibiting golden parachutes and defined "luxury" expenditures, and mandating "say on pay" votes). The SEC has proposed a rule implementing the "say on pay" mandate. See Shareholder Approval of Executive Compensation of TARP Recipients, 74 Fed. Reg. 32, 474 (proposed July 8, 2009) (to be codified at 17 C.F.R. pt 240) (amending proxy rules to help implement EESA requirements).
20. See Shareholder Bill of Rights Act of 2009, S. 1074 § 3 (amending prior acts to require that proxies "include a separate resolution subject to shareholder vote to approve the compensation of executives").
21. See U.S. DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM: A NEW FOUNDATION 29-30 (2009), available at http://www.financialstability.gov/docs/ regs/ FinalReport-web.pdf (expressing the Department's intent to support increased transparency in compensation practices and supporting "say on pay" legislation).
22. Facilitating Shareholder Director Nominations, 74 Fed. Reg. 29,024 (proposed June 18, 2009) (to be codified in scattered parts of 17 C.F.R.) (proposing to "require companies to include shareholder nominees for director in the companies' proxy materials" in certain circumstances). In addition, the New York Stock Exchange has amended its rules to eliminate broker discretionary voting for election of directors (for companies not registered under the Investment Company Act of 1940). N.Y. STOCK EXCH., LISTED COMPANY MANUAL §402.08(B) (19) (2009), available at http:// nysemanual.nyse.com/ LCM/sections (follow "Section 4" hyperlink).
23. Cf. William J. Abernahy & Kim B. Clark, Innovation: Mapping the Winds of Creative Destruction, 14 RES. POLY 3, 6 (1984) (describingJoseph Schumpeter's theory that innovation acts as a force of "creative destruction," reducing the value of existing competence and inspiring new growth).
24. People ex rei. Manice v. Powell, 94 N.E. 634, 637 (N.Y. 1911) (internal quotation marks omitted)
25. (quoting Hoyt v. Thompson's Ex'rs, 19 N.Y. 207, 216 (1859)).
26. See DEL. CODE ANN. tit. 8, §141 (k) (2001) (providing for removal of the boards of directors of Delaware corporations).
27. See, e.g., Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439, 439-440 (2001) (asserting that legal regimes worldwide have converged on corporate law systems characterized by "shared ownership by investors" and "delegated management" to a board).
28. ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (William S. Hein & Co., Inc. 1982) (1932).
29. See id. at 124 ("The concentration of economic power separate from ownership has, in fact, created economic empires, and has delivered these empires into the hands of a new form of absolutism, relegating 'owners' to the position of those who supply the means whereby the new princes may exercise their power.").
30. See Eugene F. Fama & Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 301-02 (1983) [hereinafter Fama & Jensen, Separation] (rebutting Berle and Means's analysis by arguing that organizations where ownership and control are separated survive because they benefit from specialization of these roles and are able to control agency problems by separating "the ratification and monitoring of decisions from initiation and implementation of the decisions");
31. see also Eugene F. Fama & Michael C. Jensen, Agency Problems and Residual Claims, 26 J.L. & ECON. 327, 331-32 (1983) [hereinafter Fama & Jensen, Agency Problems] (recapping the thesis of Fama & Jensen, Separation of Ownership and Control, supra, and noting that devices for separating these roles include "decision hierarchies," boards of directors, and "incentive structures that encourage mutual monitoring among decision agents").
32. Fama & Jensen, Separation, supra note 22, at 302. Note that this two-part division of functions precisely identifies the two contested zones in corporate law's political economy.
33. See id. at 313 (explaining that shareholders vote on "auditor choice, mergers, and new stock issues" in addition to board membership)
34. Fama & Jensen, Agency Problems, supra note 22, at 328.
35. Id. at 330.
36. Fama & Jensen, Separation, supra note 22, at 309.
37. See id. at 312 (commenting that, because managerial skills are not necessarily tied to wealth or willingness to bear risk, specialization enhances a complex organization's ability to adapt to changes in the economic environment and lowers the cost of risk-bearing services).
38. Id. at 309.
39. See id. at 303-304 (defining the activities involved in decision initiation and implementation).
40. See id. at 307-308 (noting that this model reduces agency costs).
41. Id. at 308-309
42. Id. at 304.
43. See id. at 313, 315 (discussing the incentives of outside directors).
44. Id. at 313.
45. See id. at 309 ("Separation and diffusion of decision management and decision control-in effect, the absence of a classical entrepreneurial decision maker-limit the power of individual decision agents to expropriate the interests of residual claimants.").
46. Id. at 312-313
47. Hansmann & Kraakman, supra note 19, at 440-441
48. The phrase "ultimate control" is imprecise. The assertion in the text reflects our interpretation. The legal model already vests the franchise in the shareholders and directs the board to manage in their interests. Arguably, this amounts to an allocation of "ultimate control." Hansmann and Kraakman accordingly imply more in the way of shareholder authority. To see why, compare Hansmann and Kraakman's conception to that of Fama and Jensen, who assign "ultimate control" to the board of directors, subject to the shareholder vote. See Fama & Jensen, Separation, supra note 22, at 313.
49. This would not suffice for Hansmann and Kraakman, for whom "ultimate control" at a minimum means shareholder choice on tender offers, as they consider trustbased outcomes favoring management discretion to be inefficient See Hansmann & Kraakman, supra note 19, at 467. Even as today's shareholder agenda goes much farther, the term "ultimate control" easily accommodates it.
50. See COMM. ON CAPITAL MKTS. REGULATION, supra note l, at 16 (asserting that "[shareholder rights serve the critical function of reducing... agency costs" and that inadequate shareholder rights cause shares to trade at a discount to fundamental value).
51. See Bengt Holmstrom & Steven N. Kaplan, Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s, J. ECON. PERSP., Spring 2001, at 121, 138 (" [I] f resources are to shift... the market may have a role to play in funneling capital toward the new companies.").
52. See Hansmann & Kraakman, supra note 19, at 449 ("[I]f the control rights granted to the firm's equity-holders are exclusive and strong, they will have powerful incentives to maximize the value of the firm.").
53. Holmstrom & Kaplan, supra note 41, at 138;
54. see also George W. Dent, Jr., Academics in Wonderland: The Team Production and Director Primacy Models of Corporate Governance, 44 HOUS. L. REV. 1213, 1225 (2008) ("Although share prices do not exactly match fundamental value, no measure is better.").
55. This Article continues a line of analysis that begins in Michael L. Wachter, Takeover Defense When Financial Markets Are (Only) Relatively Efficient, 151 U. PA. L. REV. 787 (2003).
56. See COMM. ON CAPITAL MKTS. REGULATION, supra note 1, at 16 (asserting that strengthened "shareholder rights go hand in hand with reduced regulation [and] litigation").
57. See Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833, 840, 850 (2005) (noting that, in the absence of shareholder intervention, management tends not to adopt "game-ending decisions" because such decisions also end the managers' control).
58. See Holmstrom & Kaplan, supra note 41, at 138-139 (explaining that long-term management effects, especially in times of change, are difficult to measure absent share prices).
59. See Hansmann & Kraakman, supra note 19, at 451 ("The ability of standardmodel firms to expand rapidly in growth industries is magnified... by access to institutional investors and the international equity markets.... Over time, then, the standard model is likely to win the competitive struggle on the margins.... As the pace of technological change continues to quicken, this competitive advantage should continue to increase.").
60. See Bernard Black & Reinier Kraakman, Delaware's Takeover Law: The Uncertain Search for Hidden Value, 96 Nw. U. L. REV. 521, 522 (2002) (explaining that intrinsic or "hidden" value can be assessed by a board but is invisible to shareholders).
61. In the view of shareholder proponents, accountability suffers under the prevailing regime, leading to inefficient regulatory responses, including shareholder litigation. See COMM. ON CAPITAL MKTS. REGULATION, supra note 1, at 16, 93-96. Therefore, systemic reform designed to facilitate shareholder intervention is appropriate because the inherited model affords management discretionary space to disregard the price directive.
62. See Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, 59 STAN. L. REV. 1465, 1548-63 (2007) (discussing the factors that have narrowed the scope of information asymmetry and thereby increased stock price information, but not suggesting perfect symmetry).
63. For a description of the empirical literature, which focuses on an increase in idiosyncratic volatility, see infra notes 156-159 and accompanying text
64. See Gordon, supra note 51, at 1548-1563 (attributing stock prices' increased information value to SEC and Financial Accounting Standards Board (FASB) disclosure regulations, as well as to the rise in investment analysts and information-dissemination mechanisms).
65. This response raised questions about the terms of fiduciary duty. It took a decade and four famous cases before the Delaware courts delivered a definitive answer respecting the scope of the fiduciary duty. See Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1388 (Del. 1995) (ruling that refusal to redeem a poison pill survives review if it is neither "preclusive" nor "coercive" and falls within a 'range of reasonableness");
66. Paramount Commc'ns, Inc. v. Time Inc., 571 A.2d 1140, 1154 (Del. 1989) (sustaining the "just say no" defense based on a business plan implemented by the board of directors);
67. Moran v. Household Int'l, Inc., 500 A2d 1346, 1351-57 (Del. 1985) (sustaining the poison pill as a structural matter and applying Unocal scrutiny);
68. Unocal Corp. v. Mesa Petroleum Co., 493 A2d 946, 955-56 (Del. 1985) (applying proportionality scrutiny to management defense tactics). When the answer finally came, trust trumped agency, forcing hostile offerors to resort to the shareholder franchise in the form of a proxy fight for board control in order to put to the shareholders the choice between the offer price and management's claim that its business plan held out greater value on a longterm basis. That is, the board was left with the power to block offers to protect the business plan, thereby remitting the exercise of shareholder choice not to the market for shares but to the exercise of the franchise. See Ronald J. Gilson & Alan Schwartz, Sales and Elections as Methods for Transferring Corporate Control, 2 THEORETICAL INQUIRIES L. 783, 788 (2001) (emphasizing that, because of the ubiquity of the poison pill, corporate control changes occur principally by election rather than through the market).
69. See supra text accompanying notes 30-37.
70. The Delaware courts disagreed even so, channeling the contested control transaction into the even richer information environment of the proxy contest See Paramount Commc'ns, 571 A2d at 1154-1155 (permitting a corporation's board of directors to forgo unsolicited tender offers it perceives as threats to corporate policy despite shareholder support, thereby forcing a bidder to use alternative means of acquiring control).
71. See Holmstrom & Kaplan, supra note 41, at 122 ("The real drivers behind the increased dominance of capital markets ... can be traced to deregulation... and to new information and communication technologies---").
72. We note that while Holmstrom and Kaplan expect the 1980s experience of market advantage to persist over time, they also acknowledge the possibility of changed conditions under which market price guidance could lose its productive quality.
73. See id. at 140-141 (suggesting that if stock markets slow, reliance on them may also decrease).
74. See id. at 137-38 ("Markets are more effective than managers when it comes to moving capital from declining industries to emerging industries.");
75. cf. Hansmann & Kraakman, supra note 19, at 450-451 (noting that shareholder input will favor aggressive development of new product markets and abandonment of inefficient investments).
76. Shareholders can be counted on to vote against antitakeover amendments and in favor of redeeming poison pills. See Marcel Kahan & Edward B. Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to Takeover Law, 69 U. CHI. L. REV. 871, 898 (2002) (noting that when possible, shareholders prevented the adoption of "takeoverinhibiting charter amendments" while voting in favor of proposals to redeem poison pills).
77. see Gordon, supra note 51, at 1511 (noting the "increasingly tight link between thindependent board and thpriority of shareholder value").
78. The post-takeover era began with a vision of direct institutional investor control through aggressive use of the shareholder franchise. See Bernard S. Black, Shareholder Passivity Reexamined, 89 MlCH. L. REV. 520, 525, 585-89 (1990) (discussing shareholder monitoring as a concept that had not yet come to fruition and analyzing factors that influence whether shareholders remain apathetic or not). It was hoped that institutional holdings had reached a level of concentration that would render collective action barriers surmountable, with U.S. institutions stepping into the role played by blockholders in other governance systems.
79. See, e.g., Ronald J. Gilson & Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 STAN. L. REV. 863, 884-88 (1991) (suggesting that institutional investors could organize on a subscription basis and fund correctly incentivized candidates for board seats). But no such movement to self-help by spontaneous order occurred. Far from yielding, collective action barriers instead emerged much reinforced in the new environment. The free-rider problem continued to discourage investment managers from incurring the costs of governance challenges-gains that must be shared with competitors who do not share the costs do not advance investment managers' careers.
80. See Jill E. Fisch, Relationship Investing: Will It Happen? Will It Work?, 55 OHIO ST. L.J. 1009, 1019-25 (1994) (discussing the free-rider problem as disincentivizing investors from monitoring because the benefits spread to competitive investors but the cost is only borne by the monitor) ;
81. Edward B. Rock, The Logic and (Uncertain) Significance of Institutional Shareholder Activism, 79 GEO. L.J. 445, 473-74 (1991) (acknowledging that money managers have no selective incentives to actively improve diversified funds because doing so would simultaneously benefit the managers to whom they are compared).
82. At the same time, many fund advisors sell services to managers, importing an independent business reason to stay cooperative. See, e.g, Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 HARV. L. REV. 1735, 1751-54 (2006) (describing the incentive problems of financial institutions). Finally, mutual fund investors can redeem at any time, inhibiting investment in large, illiquid blockholder positions that would carry boardroom influence.
83. See CLAUDIA H. ALLEN, STUDY OF MAJORITY VOTING IN DIRECTOR ELECTIONS, at viii (2007), http://www.ngelaw.com/files/upload/majoritystudy111207.pdf (demonstrating that majority voting has become standard practice among large public companies).
84. See Lucian A. Bebchuk, The Myth of the Shareholder Franchise, 93 VA. L. REV. 675, 700-704 (2007) (suggesting these election reforms as part of a broader reform scheme to make directors accountable to shareholders).
85. See id. at 696-700 (noting that threshold requirements would be needed).
86. For the SECs recent proposal, see Facilitating Shareholder Director Nominations, 74 Fed. Reg. 29,024 (proposed June 18, 2009) (to be codified in scattered parts of 17 C.F.R.),
87. and supra note 15 and accompanying text.
88. See, e.g., DEL. CODE ANN. tit. 8, §109 (2001) (granting shareholders the power to adopt, amend, or repeal bylaws even when directors share this power).
89. See CA, Inc. v. AFSCME Employees Pension Plan, 953 A, 2d 227, 231-240 (Del. 2008) (answering questions certified from the SEC regarding a proposed bylaw that improperly sought to "remove the subject of election expense reimbursement" from the board's discretion).
90. See Bebchuk, supra note 63, at 707-11 (arguing that shareholder-adopted bylaws should be facilitated while boards' power to adopt bylaws should be constrained).
91. The SECs current proposed rules include a limited bylaw access provision, keyed to "shareholder proposals that would amend, or that request an amendment to, a company's governing documents regarding nomination procedures or disclosures related to shareholder nominations ...." Facilitating Shareholder Director Nominations, 74 Fed. Reg. at 29,024.
92. See CA, Inc., 953 A.2d at 232 (noting that shareholders lack the broad management power statutorily allocated to the board of directors).
93. See DEL. CODE ANN. tit. 8, §242(a) (2) ("[A] corporation may amend its certificate of incorporation ... [t]o change, substitute, enlarge or diminish the nature of its business or corporate powers and purposes ....").
94. See id. §242(b)(1) ("Every amendment authorized by subsection (a)... shall be made ... in the following mannen ... [the] board of directors shall adopt a resolution setting forth the amendment proposed....").
95. See Bebchuk, supra note 46, at 865-870 (suggesting that shareholders should be empowered to change things like the corporate charter and the state of incorporation).
96. See id. at 895-901 (addressing the effects on agency costs of shareholder power to participate in "game-ending" decisions).
97. See id. at 901-908 (analyzing the impact of shareholder power to make "scalingdown" decisions).
98. Initiatives presently on Washington reform agendas fall into the first, narrower category addressed to the shareholder franchise. See supra note 12 and accompanying text
99. See Black, supra note 61, at 608 (noting that shareholder voice is an idea that has never been tried, rather than an idea that has failed).
100. See Bebchuk, supra note 46, at 878 ("Introducing the [shareholder] power to intervene would induce management to act differently in order to avoid shareholder intervention.").
101. In making this projection, shareholder proponents effectively respond to a point made by their critics, who warn that pure financial incentives posited by shareholder proponents will not obtain efficiency in all cases and that empowered activists may have private agendas. See Iman Anabtawi, Some Skepticism About Increasing Shareholder Power, 53 UCLA L. REV. 561, 586-93 (2006) (explaining how the interests of certain types of shareholders may differ from the interests of others). Since the bite lies in the threat any problems of self-dealing can be dealt with by fiduciary law, and any incentive misalignments in actual contests will come out and impact the vote. Note also that if the bite lies in the threat, any shareholder incentive problems will be minimal because the shareholders who actually wield the power will be the market price setters, actors who do indeed act with undiluted incentives to maximize value.
102. The critics make two additional points. First they project governance incoherence in the move from oligarchic to democratic governance, citing information asymmetries and conflicting interests within the group of newly empowered constituents. See, e.g., Bainbridge, supra note 61, at 1745
103. (citing KENNETH J. ARROW, THE LIMITS OF ORGANIZATION 68-70 (1974)) (arguing that authority-based decisionmaking structures, grounded in central agencies empowered to make binding decisions, are necessary when the organization's constituencies suffer from information asymmetries and have differing interests). Second, they predict hat shareholder empowerment will impose a short-term time horizon with consequent perverse effects.
104. See, e.g., Anabtawi, supra, at 579-80 (noting how pressure from short-term shareholders can cause companies to neglect long-term focus). Shareholder proponents similarly rely on the market price to rebut the first criticism. They pose the market price as the focal point for decisionmaking, thereby obviating any coherence problem. If the market price is indeed suited to guide business policymaking, the shareholder proponents win this point. Emphasis accordingly needs to be directed away from theories of government to financial economics, where the inquiry should focus on the interplay between information asymmetry, investor expectations, and market pricing. We conduct this inquiry in Part III. This analysis also applies to the short-term time-horizon objection. Under basic principles of valuation, short-term and long-term investors both have incentives to maximize long-term value, and the market price subsumes all time horizons-short intermediate, and long.
105. See Black & Kraakman, supra note 49, at 532-533 (asserting that "even short-term investors have an incentive to maximize the firm's long-term value, because only by doing so can they maximize the price at which long-term investors will buy the shares that the shortterm investors will soon want to sell"). If the market price does so accurately, then there should be no perverse effects. Thus, the shareholder proponents rely entirely on the robustness of the market price of the stock as a predictor of fundamental value.
106. See Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3J. FIN. ECON. 305, 308 (1976).
107. See id. (explaining how many agency costs can be avoided through principal monitoring and agent bonding expenditures, and referring to the remaining agency costs as the "residual loss").
108. See, e.g., Reinier Kraakman, Taking Discounts Seriously: The Implications of "Discounted" Share Prices as an Acquisition Motive, 88 COLUM. L. REV. 891, 897-901 (1988) (offering two hypotheses on the sources of discounted share prices).
109. Holmsrrom & Kaplan, supra note 41, at 122-123
110. See id. at 137 (suggesting that "markets have come to play a bigger role not because they have become better at allocating capital and not because managers misbehaved, but rather because the market's comparative advantage has been favored by economy-wide trends in deregulation, globalization, and information technologies").
111. In discussing potential future developments, Holmstrom and Kaplan stated, We have argued that at least some of the efficiency gains associated with these changes can be traced to the comparative advantage of markets in undertaking large-scale change. Since these effects are temporary, it is possible that the current level of market influence on the governance and organization of firms is going to abate. It is not hard to build a scenario in which the pursuit of shareholder value becomes a less important guideline to managers in the next few years.... If the stock markets are flat or down for the next few years, then the extensive reliance on stock options may again dissipate, leading managers to have less focus on stock prices. Id. at 140.
112. See Marcel Kahan & Edward Rock, Embattled CEOs 37-46 (Eur. Corp. Governance Inst, Law Working Paper No. 116/2008, 2008), available at http://ssrn.com/abstract= 1281516 (surveying the range of pertinent empirical measures of changes in boards of directors). We make the same assertion respecting section 162(m) of the Internal Revenue Code, enacted in 1994, which limits the corporate tax deductability of salaries to $1 million. I.R.C. §162(m) (2006). Had the governance system not changed its views first we doubt it would have occurred to Congress to add the section.
113. See Jonathan R. Macey, The Transformation of the American Law Institute, 61 GEO. WASH. L. REV. 1212, 1218 (1993) (describing conflicting views between the American Law Institute and corporate management).
114. The stock exchange rules mandating committees arrived only after Enron. These, for the first time, hard-wire the majority-independent board of directors. N.Y. STOCK EXCH., LISTED COMPANY MANUAL §303A.01 (2009), available at http:// nysemanual.nyse.com/LCM/Sections (follow "Section 3" hyperlink). Not only is an independent director majority now mandated, but independence is formally defined. Id. §303A02. Accompanying mandates include separate meetings for outside directors and for all independent nominating, compensation, and audit committees.
115. Id. §§ 303A03-.06.
116. Thus did Hansmann and Kraakman declare an end to corporate law history at the new century's start See Hansmann & Kraakman, supra note 19, at 439 ("There is no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value.").
117. See Kahan & Rock, supra note 59, at 878-880, 879 tbl.2 (detailing trends in M&A activity from 1988 to 2000).
118. See id. at 881-884 (describing the effects of having independent board members).
119. See G. William Schwert, Hostility in Takeovers: In the Eyes of the Beholder., 55 J. FlN. 2599, 2600 (2000) (suggesting that "the thstinction between hostile and friendly offers is largely a reflection of negotiation strategy").
120. Kahan & Rock, supra note 84, at 21-22. The trend of decline is also evident in smaller firms, but the magnitude is less-in 2007, 58% of S&P 400 mid-cap firms and 55% of S&P 600 small-cap firms had staggered boards.
121. Id. at 22.
122. See Brian Cheffins & John Armour, The Eclipse of Private Equity 9 (Eur. Corp. Governance Inst, Law Working Paper No. 082/2007, 2007), available at http:// ssrn.com/abstract=982114 (noting that "management will be forced to adhere to strict, results-oriented financial projections").
123. See id. (observing that "[t]he overall result is a more dynamic and challenging boardroom style than prevails in public companies").
124. William W. Bratton, Private Equity's Three Lessons for Agency Theory, 9 EUR. BUS. ORG. L. REV. 509, 513 fig.1 (2008).
125. See Bengt Holmstrom & Steven N. Kaplan, The State of U.S. Corporate Governance: What's Right and What's Wrongt 7-8 (Eur. Corp. Governance Inst, Finance Working Paper No. 23/2003, 2003), available at http://ssrn.com/abstract= 441100 ("[T]he accomplishments of the 1980s were by no means forgotten. By the 1990s U.S. managers, boards, and institutional shareholders had seen what LBOs and other market-driven restructurings could do.").
126. See Kahan & Rock, supra note 59, at 897-899 (observing theat "the use of adaptive devices seems to work reasonably well").
127. We note, however, that empirical results on the economic effects of takeover defenses across the board are mixed. The literature on takeover defenses provides a good example of the empirical back-and-forth. Many assert theat takeover vulnerability influences stock prices even today. Gompers, Ishii, and Metrick compared portfolios made up of firms withe "strong" and "weak" shareholder protections (with "Weak" inclutheng antitakeover protection) and showed theat between 1990 and 1998, a long position in strong-protection firms and a short position in weak-protection firms would have earned an annual abnormal return of 8.5%.
128. Paul Gompers, Joy Ishii & Andrew Metrick, Corporate Governance and Equity Prices, 118 Q.J. ECON. 107, 144 (2003). Bebchuk and Cohen conducted a subsequent test focused on the staggered board, which, together with the ubiquitous poison pill, makes for a state-of-the-art defensive barrier. They show a statistically significant reduction in firm value at the 99% confidence level.
129. Lucian A. Bebchuk & Alma Cohen, The Costs of Entrenched Boards, 78 J. FlN. ECON. 409, 421 (2005). They also test for economic significance, fintheng theat a staggered board lowers Tobin's Q by 17 points. Id. at 424. A number of complementary stuthes show connections between antitakeover provisions and specific undesirable results-bad mergers, higher wages, and low management turnover.
130. See Kennethe A Borokhovich, Kelly R. Brunarski & Robert Panino, CEO Contracting and Antitakeover Amendments, 52 J. FlN. 1495, 1496 (1997) (correlating antitakeover adoption and higher levels of compensation);
131. Ronald W. Masulis, Cong Wang & Fei Xie, Corporate Governance and Acquirer Returns, 62 J. FlN. 1851,1883 (2007) (studying 3333 acquisitions from 1990 to 2003 and showing lower abnormal bidder returns for firms with antitakeover provisions, controlling for product market competition, equity-based pay, institutional ownership, and board characteristics);
132. Wayne H. Mikkelson & M. Megan Partch, The Decline of Takeovers and Disciplinary Managerial Turnover, 44 J. FlN. ECON. 205, 206 (1997) (comparing management turnover in two periods, 1984-1988 and 1989-1993). None of this is conclusive. Endogeneity problems prevent the stuthes from proving conclusively that antitakeover provisions cause lower stock prices. Gompers, Ishii, and Metrick's abnormal positive returns could represent unanticipated benefits of good governance or may reflect environmental changes unrelated to governance.
133. See Marco Becht, Patrick Bolton & Ailsa Röell, Corporate Governance and Control 43 (Eur. Corp. Governance Inst, Finance Working Paper No. 02/2002, 2005), available at http://ssrn.com/abstract=343461 (warning of the limitations of Gompers, Ishii, and Metrick's finthngs). In adthtion, the market may take antitakeover provisions as a signal of poor management quality or a lack of shareholder orientation.
134. See John C. Coates IV, Takeover Defenses in the Shadow of the PiIt A Critique of the Scientific Evidence, 79 TEX. L. REV. 271, 301-02 (2000) (acknowledging that market reaction to antitakeover measures will depend on investors' prior beliefs about management and shareholder orientation). Other unobservable variables may be in play. Market actors may simply overestimate the salience of the takeover threat Chief executives may do the same tiling. Finally, a study of the performance of the Gompers, Ishii, and Merrick portfolio after 2003 reverses the performance result suggesting that the original result was sensitive to the thstinct performance patterns of technology firms during the study period.
135. John E. Core, Wayne R. Guay & Tjomme O. Rusticus, Does Weak Governance Cause Weak Stock Returns* An Examination of Firm Operating Performance and Investors' Expectations, 61 J. FlN. 655, 681-84 (2006) (showing that the poor-govemance-performance portfolio outperformed the good-governance-performance portfolio during 2000-2003, and finthng no evidence of a causal relationship between governance and operating performance). It should also be noted that other stuthes of takeover defenses reach the opposite conclusion. One study of the subsequent performance of firms adopting takeover defenses finds no performance decline.
136. See Mark S. Johnson & Ramesh P. Rao, The Impact of Antitakeover Amendments on Corporate Financial Performance, 32 FlN. REV. 659, 660, 669 (1997) (surveying a range of financial measures with respect to more than 600 antitakeover amendments adopted between 1979 and 1985 and finthng no adverse effect). Later performance improvement has even been detected.
137. See Laura Casares Field &Jonathan M. Karpoff, Takeover Defenses ofIPO Firms, 57 J. FlN. 1857, 1883 (2002) (comparing initial public offering (IPO) firms with and without takeover defenses and finthng that defenseless firms underperform for the first two years but that there are no significant performance thfferences tiiereafter).
138. See MARK J. ROE, STRONG MANAGERS, WEAK OWNERS: THE POLITICAL ROOTS OF AMERICAN CORPORATE FINANCE 223-24 (1994) (discussing how U.S. concentration trends slowed in the early 1980s and how, in the 1990s, they were only moving slighdy toward the large blocks present in Japan and Germany);
139. Ronald J. Gilson & Reinier Kraakman, Investment Companies as Guarthan Shareholders: The Place of the MSIC in the Corporate Governance Debate, 45 STAN. L. REV. 985, 1006-09 (1993) (mentioning several empirical stuthes that show a "mildly positive relationship between active large-block shareholders and corporate performance"). It turned out that the incentives that supported blockholthng abroad could not be replicated domestically. Path dependencies within the system retarded its adaptability. At the same time, blockholthng in other countries followed from their thfferent political environments, particularly their stronger social democratic systems.
140. See Lucian Arye Bebchuk & Mark J. Roe, A Theory of Path Dependeria in Corporate Ownership and Governance, 52 STAN. L. REV. 127, 169 (1999) (positing that path dependence causes advanced economies to thffer in their ownership structure, despite pressures to converge);
141. Mark J. Roe, Chaos and Evolution in Law and Economics, 109 HARV. L. REV. 641, 644-46 (1996) (describing how both path dependence and chaos theory account for variations in institutions, witiiin a range of acceptable economic efficiency).
142. See, e.g., Alon Brav et al., Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J. FIN. 1729,1739-1745 (2008) (listing and thscussing five motives for hedge fund activism and describing two examples of activist events).
143. Id. at 1739.
144. See, e.g., Josh Hyatt Getting Smaller, But Not Quieter, CFO, Feb. 2009, at 17 (thscussing how, despite decreasing hedge fund assets, the hedge fund industry still appeals to risk-taking activist investors looking for undervalued companies);
145. Ken Squire, A Golden Age for Activist Investing BARRON'S, Feb. 16, 2009, at 30 (describing the perfect situation for activist shareholders: enthusiasm for shareholder rights and thstressed equity markets);
146. Gregory Zuckerman, Activists Must Adjust Their Aim, WALL ST. J., Apr. 27, 2009, at ClO (noting that while the flow of new activist engagements continues, funds have lost value in lockstep with market averages, leathng to investor withdrawals).
147. See supra text accompanying note 80.
148. See William W. Bratton, Hedge Funds and Governance Targets, 95 GEO. L.J. 1375, 1390-1401 (2007) (listing and describing four ways in which an activist investor widi influence can get an immediate return on investment: get the target to sell itself, get the target to sell a major asset get the target to pay out spare cash, or have the target change its long-term business plans).
149. Id. at 1413-1415
150. Id. at 1426-1427
151. Id. at 1428. At the same time, activist hedge funds rely on trathng-market liquithty to facilitate exit at a time of their own choosing.
152. Id. at 1412-1413
153. Id. at 1384.
154. Id.
155. Id. at 1383.
156. See Kahan & Rock, supra note 84, at 14-17 (discussing changes in mutual funds, such as more activist behavior, which is usually expected from hedge funds, and cooperation with hedge funds designed to pressure a target's management).
157. Private equity, which carries blockholthng to its logical conclusion, presents a telling comparison case. It has had a mesmerizing effect on some agency theorists, who have proposed ownership by private equity funds as a strong-form solution to the problem of separated ownership and control.
158. See Ronald J. Gilson & Charles K. Whitehead, Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets, 108 COLUM. L. REV. 231, 231-32 (2008) (theorizing that private owners can transfer risk in thscrete slices to parties who can manage or thversify away those risks, which serves as a lower-cost substitute for trathtional risk capital);
159. Michael C.Jensen, Eclipse of the Public Corporation, HARV. BUS. REV., Sept-Oct 1989, at 61 (encouraging private equity ownership as a solution to "the conflict between owners and managers over the control and use of corporate resources").
160. It also should be noted that agency costs at target companies do not by themselves necessarily trigger the requisite financial incentives for outside intervention. Buyouts thrive on cheap, available cretht and occur cyclically with its availability.
161. Bratton, supra note 94, at 521-23. Unsurprisingly, "[p]rivate equity volume plummeted 69 percent in 2008 because of the lack of cretht" Lindsay Fortado, Linklaters Tops Deal Advisers as M&A Volume Plummets 38 Percent, BLOOMBERG, Jan. 2, 2009, available at http://www. bloomberg.com/apps/news?pid= 20601109&sid=aNZBdBiog9-0&refer=home. Since then, many deals have been restructured, with equity swapped for debt
162. See Jason Kelly & Jonathan Keehner, Private Equity Inthgestion Comes with Bain Bloomin' Onion Debts, BLOOMBERG, Mar. 11, 2009, available at http://www.bloomberg.com/apps/newsPpid= 20601109&sid=apUN4GkGPA.I&refer= home (thscussing firms' employment of tools such as debt exchanges and equity infusions to restructure and save deals).
163. Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 323 (1986).
164. Compare Henri Servaes, Do Takeover Targets Overinvest?, 7 REV. FIN. STUD. 253, 254 (1994) (looking at over 700 takeover targets during the period of 1972 to 1987 and finthng overinvestment only in the larger firms in the sample and in the oil and gas industry), with Sheridan Titman et al., Capital Investments and Stock Returns 13 (Nat'l Bureau of Econ. Research, Working Paper No. 9951, 2003), available at http:// www.nber.org/papers/w9951 (showing a negative connection between high levels of investment and stock returns). 115 The crash of 1987 amounted to an external shock that moved payout policy in the threction of repurchases.
165. See William W. Bratton, The New Dividend Puzzle, 93 GEO. LJ. 845, 871 (2005) ("[The] OMR [(open market repurchase)] advantage was first thscovered in the wake of the stock market crash of 1987. The crash brought an unprecedented increase in OMR programs....") .
166. The pattern changed in other respects as well. Prior to 2004, numbers of outstanthng shares tended to remain constant even as repurchase activity increased, with new issues of shares incident to merger activity and employee stock option exercises matching or exceethng numbers repurchased. From 2004 to 2007, in contrast 65.1% of S&P 500 repurchasers reduced numbers of shares outstanthng.
167. STANDARD & POOR'S, S&P 500 BUYBACKS: THREE YEARS AND $1.3 TRILLION LATER 6 (2007), available at http:// www2.standardandrxx)re.com/spf/ pdf/index/121307-SP500-TTlREE-YEARS-OF-BUY BACKS.pdf.
168. The financial crisis materially chilled buyback activity in 2008, when "S&P 500 buybacks reached $339.6 billion-a 42.3% drop from the record setting $589.1 billion spent during 2007." Press Release,
169. Standard & Poor's, S&P 500 Stock Buybacks Retreat 66% in Fourth Quarter; Off 42% in 2008 (Mar. 26, 2009), available at http:// www2.standardandpoors.com/spf/pdf/index/032609-Buyback-PR.pdfPvregion= us&vlang=en.
170. A second factor also should be noted. As between thvidends and repurchases, managers holthng unexercised stock options have a financial incentive to make repurchases.
171. Bratton, supra note 115, at 872-876
172. Even as the pattern began to change in 2004 and 2005, Wall Stfeet analysts were complaining that corporations were husbanthng cash at historically high levels.
173. See, e.g, Bratton, supra note 103, at 1394 (noting that in 2006 "the S&P 500's cash accounts stood at the highest point since the early 1980s" and that shareholders maintained the position that free cash flow should be paid out).
174. These studies focus on sentiment, investment styles, and asset tastes. For a review of the behavioral finance literature, inclutheng stuthes in tratheng activity, research in corporate finance, and analyses of stock returns,
175. see Avanidhar Subrahmanyam, Behavioural Finance: A Review and Synthesis, 14 EUR. FlN. MGMT. 12 (2007). Trathetional pricing theory holds theat the prices of two assets move together as a result of comovement in fundamental value. But given market frictions, limits to arbitrage, and irrational (or "sentimental") investors, comovement might have other causes. Coorthenated demand, then, influences prices.
176. See Malcolm Baker & Jeffrey Wurgler, Investor Sentiment and the Cross-Section of Stock Returns, 61J. FlN. 1645, 1648-50 (2006) (examining sentiment's impact on the cross section of stock returns from 1963 to 2001 and showing theat high-sentiment investors gravitate to young, small, unprofitable growthe stocks or thestressed issues, while low-sentiment investors like large, profitable thevidend payers, and theat abrupt changes in sentiment result in demand shocks for sensitive stocks);
177. Nicholas Barberis et al., Comovement, 75 J. FIN. ECON. 283, 284 (2005) (showing theat investors group assets into categories);
178. Nicholas Barberis & Andrei Shleifer, Style Investing 68 J. FlN. ECON. 161, 162-64 (2003) (examining the impact of style investing on institutional and inthevidual investors);
179. Paul A Gompers & Andrew Metrick, Institutional Investors and Equity Prices, 116 QJ. ECON. 229, 230-36, 244 (2001) (showing theat institutions like large, liquid stocks withe relatively low returns in the year prior to purchase, and theat institutional demand for large issues accounted for nearly fifty percent of the issues' relative price appreciation of large over small stocks across the period 1980 to 1996);
180. Alok Kumar & Charles M.C. Lee, Retail Investor Sentiment and Return Comovements, 61J. FlN. 2451, 2453-54 (2006) (showing that retail investors tend to nest in small firms, lower-price firms, firms withe relatively low levels of institutional ownership, and value firms)
181. See, e.g., STEPHEN A. Ross ET AL., CORPORATE FINANCE 359 (6th ed. 2002) ("Even the strongest adherents to the efficient-market hypothesis would not be surprised to find that markets are inefficient in the strong form.").
182. See Burton G. Malkiel, Efficient Market Hypothesis, in 1 THE NEW PALGRAVE DICTIONARY OF MONEY AND FINANCE 739, 739 (Peter Newman et al. eds., 1992). ECMH asserts that the stock market possesses efficiency attributes in terms of three alternative, progressively more inclusive information sets.
183. See, e.g., id. at 739-741 The first or weak form, defines market efficiency in terms of past market prices. The market is efficient accorthng to the weak form if investors cannot prethct future stock price movements based on an information set containing all past price movements. As noted in the text the second, or semi-sttong form, defines market efficiency in terms of all publicly available information. The third, or strong form, includes nonpublic information as part of the information set Markets are efficient accorthng to the strong form if stock prices include all nonpublic information as well as public information. Consequendy, if the strong form were to hold, an investor who was privy to both private and nonprivate information could not consistendy earn abnormally large investment returns.
184. See id. at 739 (asserting that under the "semi-strong form of EMH ... an analysis of balance sheets, income statements, announcements of thvidend changes or stock splits or any other public information about a company... will not yield abnormal economic profits").
185. See Lisa K. Meulbroek, An Empirical Analysis of Illegal Insider Trathng 47 J. FlN. 1661, 1696 (1992) ("The analysis suggests that insider trathng increases stock price accuracy by moving stock prices significandy.");
186. see also Dirk Jenter, Market Timing and Management Portfolio Decisions, 60 J. FlN. 1903, 1906 (2005) (showing that managers trade as contrarians and earn excess returns on their trades, but that the excess returns thsappear after controlling for size and book-to-market effects).
187. See JOHN Y. CAMPBELL ET AL., THE ECONOMETRICS OF FINANCIAL MARKETS 24-25 (1997) (thscussing reasons why "perfect [stock] efficiency is an unrealistic benchmark that is unlikely to hold in practice").
188. RICHARDA. BREALEY et al, PRINCIPLES OF CORPORATE FINANCE 333-341 (8thed. 2006).
189. See John Lintner, The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, 47 REV. ECON. & STAT. 13, 27 (1965) ("The analysis thus justifies viewing market values as riskless-rate present values of certaintyequivalents of random future receipts...." (italics omitted));
190. William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium Under Conthtions of Risk, 19 J. FlN. 425, 436-42 (1964) (describing the "consistent relationship between... expected returns and what might best be called systematic risk").
191. See Sharpe, supra note 127, at 433-434 (assuming "homogeneity of investor expectations" as a condition for equilibrium in capital markets).
192. See Gordon, supra note 51, at 1548-1563 (describing the increase in the content and scope of mandated thsclosures over the last fifty years and suggesting a causal role in the rise of the independent board).
193. For a presentation of the range of positions taken in the literature, see William W. Bratton, The Academic Tournament over Executive Compensation, 93 CAL. L. REV. 1557, 1562-1575 (2005) (reviewing LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004)).
194. See supra text accompanying note 76.
195. See Malcolm Baker et al., Behavioral Corporate Finance (asserting that "corporate managers have superior information about their own firm," which "is underscored by the evidence that managers earn abnormally high returns on their own trades"), in 1 HANDBOOK OF CORPORATE FINANCE: EMPIRICAL CORPORATE FINANCE 145, 149 (B. Espen Eckbo ed., 2007).
196. It bears noting that the informational imbalance impacts both sides of the valuation exercise-the ascertainment of the thscount rate as well as the projection of future free cash flows.
197. See Wachter, supra note 44, at 792-93 (thscussing the inability of existing models to accurately estimate the thscount or market capitalization rates). CAPM provides the most common approach for accessing the risk premium in the discount rate. More specifically, it employs an empirically derived single risk factor, beta (β), that measures a given stock's contribution to the systematic risk in the market portfolio. Although betas customarily are estimated from market data, the true underlying beta depends on the covariance of the firm's free cash flows with the overall market's free cash flows, factors that may be better known by the managers than the market.
198. We have seen that this is Fama and Jensen's basic point
199. See supra text accompanying note 31.
200. See S.J. Grossman & O.D. Hart, Disclosure Laws and Takeover Bids, 35 J. FlN. 323, 323-24 (1980) (illustrating formally that full thsclosure presupposes three conthtions: (1) that investors know that firms possess the information; (2) that affirmative misrepresentation does not occur; and (3) that thsclosure is cosdess).
201. See John E. Core, A Review of the Empirical Disclosure Literature: Discussion, SlJ. ACCT. & ECON. 441, 442-444 (2001) ('This choice involves trathng off the reduction in the information asymmetry component of the cost of capital that results from increased thsclosure quality against the costs of reduced incentives, litigation costs, and proprietary costs." (citations omitted)).
202. See Jeremy C. Stein, Agency, Information and Corporate Investment (noting that even as governance processes, capital structure, incentive contracts, intermethation, and the mandatory thsclosure regime reduce informational thstortions, some remain unresolved and relevant in equilibrium), in IA HANDBOOK OF thE ECONOMICS OF FINANCE 111, 115 (George M. Constantinides et al. eds., 2003).
203. For example, a long-established business with no growth opportunities confronts a relatively small information asymmetry problem. It accorthngly, will have litde incentive to go beyond mandated thsclosure items. In contrast a firm with abundant growth opportunities and a more complicated information set has a more serious information asymmetry problem. Depenthng on the interplay of costs and benefits, its managers may find it advantageous to make adthtional voluntary thsclosures.
204. See Core, supra note 136, at 443 (examining which firms will find it optimal to make voluntary thsclosures) ;
205. see also Paul M. Healy & Krishna G. Palepu, Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature, 31 J. ACCT. & ECON. 405, 420-25 (2001) (examining the motives behind voluntary thsclosure). Investor relations also influence these choices-firms with large analyst followings and large populations of institutional investors tend to thsclose more.
206. See Healy & Palepu, supra, at 416-18 (suggesting that management might voluntarily thsclose where analysts give favorable ratings);
207. Paul M. Healy et al., Stock Performance and Intermethation Changes Surrounthng Sustained Increases in Disclosure, 16 GONTEMP. ACCT. RES. 485, 489-90 (1999) (noting that a multivariate analysis demonstrated that "increased thsclosure is related to... growth in institutional ownership and analyst coverage"). Finally, as the shareholder proponents assert, agency costs also play into the mix. Managers have incentives to make self-serving thsclosures.
208. See Healy & Palepu, supra, at 421, 425 (explaining that managers have incentives to make capital-cost-lowering thsclosures). Ultimately, the crethbility of any firm's thsclosures (and hence the firm's proximity to the optimal level and quality of thsclosure) depends on the effectiveness of its governance.
209. See Core, supra note 136, at 444 ("[I]t is the governance structure that constrains the manager to follow optimal policy."). Empirical literature supports all of the foregoing points.
210. See Christian Leuz & Peter Wysocki, Economic Consequences of Financial Reporting and Disclosure Regulation: A Review and Suggestions for Future Research 23-38 (Mar. 2008) (unpublished manuscript), available at http://ssrn.com/abstract= 1105398.
211. See, e.g., Hayne E. Leland & David H. Pyle, Informational Asymmetries, Financial Structure, and Financial Intermethation, 32 J. FlN. 371, 372 (1977) (noting that while an entrepreneur may not be able to threcdy convey inside information, she may be able to signal that information to potential shareholders based on the fraction of equity that she retains);
212. Merton H. Miller & Kevin Rock, Dividend Policy Under Asymmetric Information, 40 J. FlN. 1031, 1031 (1985) (arguing that "managers know more than outside investors about the true state of the firm's current earnings");
213. Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 BELL J. ECON. 23, 27-31 (1977) (developing a model that establishes a signaling equilibrium based on the assumption that managers have inside information).
214. See Baker et al., supra note 132, at 159-60 (surveying literature that suggests equity issuance is correlated with overvaluation);
215. Joshua Lerner, Venture Capitalists and the Decision to Go Public, 35 J. FlN. ECON. 293, 293-94, 299 (1994) (finthng, in a comparison of the number of IPOs and a biotechnology equity index, that venture capitalists time IPOs and that "IPOs coincide with the peaks in equity valuations");
216. Tim Loughran et al., Initial Public Offerings: International Insights, 2 PAC.-BASIN FlN. J. 165, 166 (1994) (finthng that, in fourteen of the fifteen countries examined, "IPO volume is positively correlated with the inflation-adjusted level of the stock market");
217. Marco Pagano et al., Why Do Companies Go Public? ; An Empirical Analysis, 53 J. FlN. 27, 28 (1998) (finthng that "the main factor affecting the probability of an IPO is the market-to-book ratio at which firms in the same industry trade").
218. See Baker et al., supra note 132, at 159 ("Several lines of evidence suggest that overvaluation is a motive for equity issuance.... [Two-tiiirds] of CFOs of public corporations ... state that 'the amount by which our stock is undervalued or overvalued was an important or very important consideration' in issuing equity." (citations omitted) ).
219. See Jay R. Ritter, The Long-Run Performance of Initial Public Offerings, 46 J. FlN. 3, 3 (1991) (contenthng that "in the long-run, initial public offerings appear to be overpriced," and finthng that "in the 3 years after going public these firms significandy underperformed a set of comparable firms matched by size and industry"). Several empirical stuthes have also found that for IPOs declining profitability and investment after the IPOs suggest that the issuances were incidences of market timing.
220. See Pagano et al., supra note 140, at 28-29 ("Our finthng that investment and profitability decrease after the IPO points to the [attempt-to-time-the-market] explanation.").
221. See Baker et al., supra note 132, at 160 ("[O]n average, US equity issues underperform the market somewhere in the ballpark of 20-40% over five years.");
222. see also Malcolm Baker & Jeffrey Wurgler,the Equity Share in New Issues and Aggregate Stock Returns, 55 J. FlN. 2219, 2219 (2000) ("When equity prices are too high, existing shareholders benefit by issuing overvalued equity. When equity prices are too low, issuing debt is preferable. Consistent with this timing hypothesis, firms issuing equity have poor subsequent performance.").
223. Managers who believe their stock to be correcdy priced or underpriced will avoid selling new equity, financing with debt or internal cash flow.
224. See Stein, supra note 137, at 118-19 (examining models of debt financing or cash-flow financing). Managers of firms with good potential investments but constraints on these sources of financing must sell new equity or forego the investments. They are forced to time their financing, and hence their investment to the underinformed market price, with a sacrifice of flexibility.
225. See Malcolm Baker et al., When Does the Market Matter* Stock Prices and the Investment of Equity-Dependent Firms, 118 QJ. ECON. 969, 986-990 (2003) (showing that investment by firms with financing constraints is sensitive to the market price).
226. See Armen Hovakimian et al., The Debt-Equity Choice, 36 J. FIN. & QUANTITATIVE ANALYSIS 1, 3-4 (2001) (determining that "firms with higher current stock prices (relative to their past stock prices, book values, or earnings) are more likely to issue equity rather than debt and repurchase debt rather than equity" and that this finthng is "consistent with agency and information asymmetry models where managers are either reluctant to issue equity at low prices or have an incentive to boost their leverage when the stock prices are low");
227. Paul Marsh, The Choice Between Equity and Debt: An Empirical Study, 37 J. FlN. 121, 133 (1982) (finthng that the total amount of U.K. companies' equity and debt issues is related to the performance of the stock and bond markets)
228. See David Ikenberry et al., Market Underreaction to Open Market Share Repurchases, 39 J. FlN. ECON. 181, 184 (1995) ("Beginning in the month following the repurchase announcement, the average buy-and-hold return over the next four years is more than 12% above that of a control portfolio.").
229. See id. at 184 ("The most striking finthng ... is that the information conveyed by open market share repurchases is largely ignored.").
230. See Andrei Shleifer & Robert W. Vishny, Equilibrium Short Horizons of Investors and Firms, 80 AM. ECON. REV. (PAPERS & PROC.) 148, 148 (1990) ("The time to thsappearance of mispricing depends on how fast... investor misperceptions are cor- rected...."). There are numerous articles provithng empirical confirmation of this mi- spricing.
231. See, e.g., Craig W. Holden & Leonard L Lundsrrum, Cosdy Trathng, Managerial Myopia and Long-Term Investment 34 (Sept 16, 2005) (unpublished manuscript), available at http://ssrn.com/abstract=809507 (showing that firms selected for long-term traded options (and hence a lower cost of trathng on long-term information) increased their research and development (R&D) to sales ratios twenty-three percent to twentyeight percent compared to matching firms not selected for long-term traded options in the two years following selection);
232. see also Jeremy C. Stein, Takeover Threats and Managerial Myopia, 96 J. POL. ECON. 61, 63-67 (1988) (showing formally that even absent agency costs, managers of a firm threatened by a takeover will sell an underpriced asset) We note that threct empirical testing of these assertions is thfficult This follows from the nature of the phenomenon prethcted-underinvestment tends to be unobservable by the market
233. See Stein, supra note 137, at 131 (noting that models of investment can be thfficult to test because underinvestment occurs in "activities that are not threcdy observable by the market" (emphasis omitted)). Market-timing stuthes showing that firms issuing equity have strong operating numbers two years prior to the issuance and weak numbers thereafter provide inthrect evidence, with underinvestment prior to the offering as a possible cause of the earnings pattern.
234. See id. at 132 (examining stuthes where circumstantial evidence of underinvestment results from such an earnings pattern).
235. See Richard E. Kihlstrom & Michael L. Wachter, Corporate Policy and the Coherence of Delaware Takeover Law, 152 U. PA. L. REV. 523, 551-56 (2003) (showing formally that managers vulnerable to a hostile offer and having better information about prospective investments will forego unpopular investment opportunities and fail to maximize the value of the corporation);
236. Jeremy C. Stein, Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior, 104 QJ. ECON. 655, 667 (1989) (modeling suboptimal investment where managers maximize a weighted average of near-term stock prices and long-run value);
237. see also Miller & Rock, supra note 139, at 1031-33 (presenting a model of shareholder investment and management decisionmaking where asymmetric information leads to suboptimal levels of investment);
238. M.P. Narayanan, Managerial Incentives for Short-Term Results, 4OJ. FlN. 1469,1469-70 (1985) (showing that reputational incentives can lead to underinvestment).
239. See Philippe Aghion & Jeremy C. Stein, Growth Versus Margins: Destabilizing Consequences of Giving the Stock Market What It Wants, 63 J. FlN. 1025,1025 (2008) (creating a model in which managers can devote resources to either increasing sales growth or improving per-unit profit margins and arguing that devoting resources to one end necessarily means sacrificing the other). As modeled, the market puts more weight on growth metrics when it sees a growth firm and more weight on cost-cutting metrics when it sees a business plan focused on profit margins.
240. Id. at 1032-35. Problems arise for a manager who decides, as events unfold in the product market to move from a growth posture to present-profit maximization. The manager devises strategies in a two-way feedback process with the market and so delays shifting resources from growth to cost cutting until such time as the market can appreciate the business wisdom of the shift
241. Id. at 1027, 1042-43. The delay is suboptimal, and the later change of threction is abrupt The more the manager cares about the stock price, the more dramatic the oscillation.
242. Id. at 1035.
243. See Lucian Arye Bebchuk & Lars A Stole, Do Short-Term Objectives Lead to Underor Overinvestment in Long-Term Projects*, 48 J. FlN. 719, 720 (1993) (demonstrating that where information about long-term investment is available to investors, overinvestment may result because long-term investment may be seen as a signal of a positive long-term outlook). Carrying this out a step, similarly situated managers with reputational concerns may "herd" into a subset of favored but suboptimal investments.
244. See Stein, supra note 137, at 132-33;
245. see also Jill E. Fisch, Measuring Efficiency in Corporate Law: The Role of Shareholder Primacy, 31J. CORP. L. 637, 672 (2006) (describing the connection between overvalued stock and value-destroying decisionmaking).
246. See Alfred Rappaport, The Economics of Short-Term Price Obsession, FlN. ANALYSTS J., May-June 2005, at 65, 65 (thscussing investors' and managers' "mutually reinforcing obsession with short-term performance"). In adthtion, those who actively manage their portfolios tend to hold stocks for short periods.
247. Id. at 66-68.
248. Managers have been shown to be more sensitive to accounting earnings than to cash flows.
249. See John R. Graham et al., The Economic Implications of Corporate Financial Reporting 40 J. ACCT. & ECON. 3, 6 (2005) ("[A]ccounting earnings matter more to managers than cash flows for financial reporting purposes...").
250. Investment activity can negatively impact near-term earnings because the amount funded must be expensed, as is the case with R&D costs. Prioritizing earnings can also mean delaying other expenses, such as maintenance or advertising, even though management believes that present action enhances long-term firm value. Alternatively, managers making a capital investment decision can face a choice between one project with higher later cash flows and higher present value (but lower near-term earnings) and a project with higher earlier cash flows and lower present value (but higher near-term earnings). For one study which examines such choices,
251. see Sanjeev Bhojraj & Robert Libby, Capital Market Pressure, Disclosure Frequency-Induced Earnings/Cash Flow Conflict, and Managerial Myopia, 80 ACCT. REV. 1, 2 (2005). Maximizing long-term value signals the first investment while maximizing near-term EPS signals the second. Numerous scholars have tested this empirically.
252. See Brian J. Bushee, The Influence of Institutional Investors on Myopic RàrD Investment Behavior, 73 ACCT. REV. 305, 306-07, 319-30 (1998) (showing that a responsive reduction of R&D spenthng is likely in firms with low institutional holthngs, but that in firms whose predominant owners are institutions with high portfolio turnover and momentum trathng strategies ("transient" institutions), earnings management through R&D cuts is very likely);
253. Brian J. Bushee, Do Institutional Investors Prefer Near-Term Earnings over Long-Run Value? 2-3 (Apr. 1999) (unpublished manuscript), available at http://ssrn.com/abstract=161739 (showing a weak institutional preference for near-term earnings amongst institutions as a whole, but a strong preference for near-term earnings within the transient subset along with a concomitant tendency to hold companies whose stock is mispriced);
254. see also Mei Cheng et al., Earnings Guidance and Managerial Myopia 1-4 (Nov. 2005) (unpublished manuscript), available at http://ssrn.com/absrract= 851545 (using voluntary earnings guidance as a proxy for managing to the market). There is also survey evidence of this phenomenon.
255. See Graham et al., supra note 153, at 32-35, 35 fig.5 (surveying 401 chief financial officers and reporting that nearly eighty percent said that they would decrease thscretionary spenthng on R&D or advertising to meet earnings targets, and just over fifty-five percent said that they would delay a new project despite a small sacrifice in value);
256. see also John R. Graham et al., Value Destruction and Financial Reporting Decisions 9-10 (Sept 6, 2006) (unpublished manuscript), available at http://ssrn.com/abstract=871215 (reporting that only fifty-nine percent of the same group of executives would approve a high net present value project if it entailed missing earnings by $0.10).
257. See Daniel Bergstresser & Thomas Philippon, CEO Incentives and Earnings Management, 80 J. FlN. ECON. 511, 512-513 (2006) (finthng evidence that CEOs whose compensation is more closely tied to share price "more aggressively use thscretionary components of earnings to affect their firms' reported performance"). Otherwise, the underinvestment problem can be expected to be at its most acute when management has particularly strong incentives to please the market as happens when new equity finance is needed or with takeover pressure.
258. Accorthng to one study, it was thirty times higher in 1997 than in 1962.
259. See John Y. Campbell et al., Have Inthvidual Stocks Become More Volatile? An Empirical Exploration of Ithosyncratic Risk, 56 J. FlN. 1, 20, 24 fig.5 (2001) (showing that variance for a typical firm was thirty times higher in 1997 than in 1962, while the equally weighted average R statistic of a market model declined from 0.26 to 0.08 across the same period).
260. 2, 43 J. FlN. 541 (1988), which showed that market models could explain a lesser quantum of daily volatility than previously had been assumed.
261. Id. at 542-543
262. If that is the case, then the information asymmetry problem has been ameliorated to some extent Carrying this point a step further, some proponents posit that good managers look to the stock price to get good instructions for business policy, claiming not only well-informed but accurate stock prices.
263. 2 and the informativeness of the stock price, and, by implication, its accuracy);
264. Art Durnev et al., Value-Enhancing Capital Budgeting and Firm-Specific Stock Return Variation, 59 J. FlN. 65, 89 (2004) [hereinafter Durnev et al., Value-Enhancing Capital Budgeting] (finding better-quality investment decisionmaking at low R firms, thus suggesting that informative stock prices facilitate efficient investment);
265. see also Qi Chen et al., Price Informativeness and Investment Sensitivity to Stock Price, 20 REV. FlN. STUD. 619, 620-23 (2007) (showing a further correlation between stock price variation and the sensitivity of the firm's level of investment to its stock price).
266. Even the stuthes' authors point to their weaknesses: The evidence as to price informativeness is only inthrect the implications are a matter of "theoretical conjecture," and other factors could be involved.
267. Durnev et al., Value-Enhancing Capital Budgeting supra note 157, at 69;
268. see also Chen et al., supra note 157, at 625 ("Admittedly, it is ... possible that our measures are correlated with other factors....We believe that our extensive robustness tests mitigate this concern to a large extent But it remains possible that something else is behind our results."). Ithosyncratic volatility, then, does not prove that the price has become better informed and more accurate-it only suggests such.
269. The stepped-up volatility could also reflect (1) trathng "frenzy unrelated to concrete information," Roll, supra note 156, at 566; (2) increased cash flow volatility within the companies,
270. Campbell et al., supra note 156, at 37-40;
271. speether information thssemination over time, id. at 39; or
272. increased volatility in investor thscount rates, id. at 39-40. Empirical evidence has been marshaled to support each of the four alternatives.
273. See Steven X. Wei & Chu Zhang, Why Did Inthvidual Stocks Become More Vo-latile?, 79 J. BUS. 259, 261-62 (2006) (showing that a decline in return on equity and, hence, greater uncertainty explain the increase in volatility, and attributing two-thirds of the increased volatility to newly listed firms) ;
274. Yexiao Xu & Burton G. Malkiel, Investigating the Behavior of Ithosyncratic Volatility, 76 J. Bus. 613, 614 (2003) (finthng from cross-sectional regressions that ithosyncratic volatility is related to trathng volume, institutional ownership, and a growth posture);
275. Michael W. Brandt et al., The Ithosyncratic Volatility Puzzle: Time Trend or Speculative Episodes* 13-14 (Univ. of Tex. McCombs Sch. of Bus., Research Paper No. FIN-02-09, 2008), available at http://ssrn.com/abstract= 1141219 (conjecturing that ithosyncratic volatility is related to speculative euphoria);
276. Jason Fink et al., IPO Vintage and the Rise of Ithosyncratic Risk 12-17 (Feb. 4, 2005) (unpublished manuscript), available at http://ssm.com/abstract= 661321 (showing a significant rise in ithosyncratic risk stemming from a drastic increase in the number of younger, riskier IPO firms in the market and demonstrating that after Controlling for the proportion of young firms there is no time trend respecting ithosyncratic risk). Other stuthes have begun to undermine some of the literature's basic assumptions. The conclusion that prices have become better informed is refuted by a study that ties the stepped-up volatility to increased opacity due to deteriorating accounting practices and increased thspersion of analysts' forecasts.
277. See Shiv Rajgopal & Mohan Venkatachalam, Financial Reporting Quality and Ithosyncratic Return Volatility over the Last Four Decades 1-6 (Sept 2008) (unpublished manuscript), available at http://ssrn.com/abstract=650081. The consistent upward trend of volatility has also been challenged.
278. See Brandt et al., supra, at 6-8, 37 fig.2 (showing that the ithosyncratic volatility trend spiked during the period 2002-2004 and declined sharply thereafter through 2007, and identifying an earlier but shorter-lived trend toward increased volatility during the period 1926-1933); Paul Brockman & Xuemin (Sterling) Yan, The Time-Series Behavior and Pricing of Ithosyncratic Volatility: Evidence From 1926 to 1962, at 12-14 (Sept. 2006) (unpublished manuscript), available at http://ssm.com/ absdact=l 117284 (documenting a downward trend in ithosyncratic volatility from 1926-1962).
279. For the original model, see Edward M. Miller, Risk, Uncertainty, and Divergence of Opinion, 32 J. FlN. 1151, 1151 (1977). We do not claim to be the first to introduce this work in the legal literature. For two papers that have previously thscussed its implications,
280. see Lynn A Stout, How Efficient Markets Undervalue Stocks: CAPM and ECMH Under Conthtions of Uncertainty and Disagreement, 19 CARDOZO L. REV. 475, 482-91 (1997), and
281. Lynn A. Stout, The Mechanisms of Market Inefficiency: An Introduction to the New Finance, 28 J. CORP. L. 635, 639-50 (2003). For heterogeneous- expectations approaches to merger pricing,
282. see Richard Booth, Discounts and Other Mysteries of Corporate Finance, 79 CAL. L. REV. 1053 (1991), and Lynn A Stout, Are Takeover Premiums Really Premiums? Market Price, Fair Value, and Corporate Law, 99 YALE L.J. 1235 (1990)
283. For a heterogeneous-expectations analysis of the Japanese bubble,
284. see Robert B. Barsky, The Japanese Bubble: A 'Heterogeneous' Approach (Nat'1 Bureau of Econ. Research, Working Paper No. 15052, 2009), available at http://www.nber.org/papers/wl5052.
285. This is frequendy framed in terms of Tobin's marginal Q.
286. See José A. Scheinkman & Wei Xiong, Overconfidence and Speculative Bubbles, 111 J. POL. ECON. 1183, 1185 (2003) (noting that optimists and pessimists oscillate, changing their forecasts as information flows).
287. For the original model of speculative behavior in a marketplace,
288. see J. Michael Harrison & David M. Kreps, Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations, 92 QJ. ECON. 323, 325-328 (1978).
289. The more pronounced the thfferences of opinion among investors, the more salient the speculative element
290. See Patrick Bolton et al., Executive Compensation and Short-Termist Behaviour in Speculative Markets, 73 REV. ECON. STUD. 577, 578-580 (2006) (explaining the effects of thfferences of opinion on speculative behavior and thus fluctuating stock valuation).
291. If CAPM's assumption of homogeneous expectation is relaxed, and some investors are well-informed while others are misinformed, the theory's prethction no longer holds.
292. See Eugene F. Fama & Kenneth R. French, Disagreement, Tastes, and Asset Prices, 83 J. FIN. ECON. 667, 669 (2007) (concluthng that thsagreement between thssimilarly informed investors moves pricing away from CAPM).
293. See Stavros Panageas, The Neoclassical Theory of Investment in Speculative Markets 22-23 (Apr. 16, 2005) (unpublished manuscript), available at http://ssrn.com/ abstrae t=720464.
294. For example, then-Federal Reserve Chairman Alan Greenspan made his famous speech on "irrational exuberance" in December 1996. Alan Greenspan, Chairman, Fed. Reserve Bd., Remarks at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research: The Challenge of Central Banking in a Democratic Society (Dec. 5, 1996), available at http://www.federalreserve.gov/ boarddocs/speeches/1996/19961205.htm. The stock market would come close to doubling over the next several years, with the bubble only bursting in late 2000.
295. Trathtional ECMH proponents never denied that many investors are uninformed and that their trathng activities push the market price away from fundamental value. They instead posited that mispricing presents a risk-free arbitrage opportunity and that the arbitrage corrective will be complete, assuring that stocks have flat demand curves and insulating market prices from shocks stemming from shifts in supply and demand having no relation to fundamental value.
296. See Myron S. Scholes, The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices, 45 J. BUS. 179, 179-182 (1972) (thscussing various hypotheses regarthng arbitrage opportunities resulting from market imperfections).
297. Arbitrage in corporate stocks is risky. Inthvidual stocks do not have perfect substitutes. Arbitrage hedges accorthngly carry the risk that the two streams of returns do not cancel out
298. See Jeffrey Wurgler & Ekaterina Zhuravskaya, Does Arbitrage Flatten Demand Curves for Stocks?, 75 J. BUS. 583, 585-86 (2002) (reporting the results of an empirical test of stocks that join the S&P 500 and finthng that no substitutes that would hedge away more than twenty-five percent of the daily return variance could be located). That risk must be compensated for by adthtional returns, which in turn cause a reduction in the number of attractive plays and reduce the volume of corrective trading. The smaller the number of corrective traders, the more risky their plays become. Moreover, even if an arbitrageur's fundamental-value analysis is flawless, a given play succeeds only when the rest of the market comes to share the analysis and moves the stock in the prethcted threction. As the time to correction lengthens, so does the play's duration and risk. AU of this calls for a substantial base of capital, which further depresses the number of potential players. Regulatory and institutional constraints also dampen demand for shorting activity.
299. See Ronald J. Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias, 28 J. CORP. L. 715, 725-31 (2003) (analyzing the thfficulties of successfid arbitrage in financial markets);
300. see also Andrei Shleifer & Robert W. Vishny, The Limits of Arbitrage, 52 J. FlN. 35, 38-43 (1997) (positing a model for agency constraints on arbitrage activity).
301. But cf. Paul Asquith et al., Short Interest, Institutional Ownership, and Stock Returns, 78 J. FlN. ECON. 243, 245 (2005) (showing empirically that only a handful of stocks on the U.S. markets are short-sale constrained due to an unavailability of loanable shares). The average ratio of short interest to shares outstanding in February 2000 was only two percent
302. See Eli Ofek & Matthew Richardson, DotCom Mania: The Rise and Fall of Internet Stock Prices, 58 J. FlN. 1113, 1118 (2003) (calculating average short interest to be approximately two percent of shares outstanding as compared to almost three percent for Internet stocks). This is an increase from a less than one-percent average during the period 1973-1979.
303. See Stephen Figlewski, The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence, 16 J. FlN. & QUANTITATIVE ANALYSIS 463,471-72, 472 tbl. 1 (1981) (listing the average short interest for stocks on the S&P 500 from 1973-1979 as a percentage of total stock outstanthng)
304. See Panageas, supra note 167, at 17 (noting that new investment does not increase long-run fundamental value but rather short-term resale price).
305. Id. (emphasis added).
306. See id. (noting that the speculative element arises because of thsagreement over the fundamental valuation of the corporation and captures the current owners' resale premium).
307. Their focus is on management self-interest and they find that managers may themselves profit by adopting strategies that boost the option or speculative component.
308. See Scheinkman & Xiong, supra note 163, at 1208 ("Firm managers may be able to profit by adopting strategies that boost the speculative component").
309. Id. at 1184.
310. See Bolton et al., supra note 165, at 578 ("The holder of a share then has not only a claim to future thvidends but also an option to sell the stock to a more optimistic investor in the future.").
311. See id. at 579 (explaining managers' short-term behavior in terms of the speculative component).
312. M at 578.
313. Id. at 597.
314. See Christopher Polk & Paola Sapienza, The Stock Market and Corporate Investment: A Test of Catering Theory, 22 REV. FlN. STUD. 187, 187-190 (2009) (arguing that managers may rationally make investments that decrease long-term value in order to secure short-term gains).
315. See id. (arguing that shorter-term investors will benefit from "catering" on the part of management).
316. What of the impact of the shareholder franchise in the hypothetical? More facts would be needed. If the threctors approve the merger, the subsequent shareholder vote will be in favor of the merger, but only so long as the bubble has not yet burst Indeed, if the pessimistic shareholders are not locked into their shareholthngs, they will vote yes on the ground that the best course in the wake of board approval is to vote yes and sell. Only shareholders that, for whatever reason, cannot sell will vote no. If the board turns down the merger, no shareholder vote occurs. The shareholder franchise comes into play at the next annual meeting. If the bubble has not burst the threctors presumably will be punished. Indeed, even if the bubble has burst shareholders may still be inclined toward punishment due to the missed opportunity to sell.
317. SeePanageas, supra note 167, at 21 ("Long-termism is just the extent of 'entrenchment' of current 'major* shareholders in the firm.").
318. The controller might also face insider trathng restrictions under Rule 10b-5. 17 C.F.R. §240.10b-5 (2009).
319. See Bolton et al., supra note 165, at 595 (explaining that during speculative episodes, "the cost of capital is below the firm's long-run value"). The reduction in the cost of capital is consistent with the controller's belief that the expected return on the shares will be lower in the future. Note that the controlling shareholder's time horizon lengthens to the extent that access to the trathng markets is restricted. Given a partial constraint on liquidation of its position, the firm's investment policy would be partially open to short-term incentives-the controlling shareholder would determine invesunent using "some weighted average between share price and long term value."
320. Panageas, supra note 167, at 22.
321. See Stavros Panageas, Speculation, Overpricing, and Investment-Theory and Empirical Evidence 17 (Nov. 15, 2003) (unpublished manuscript), available at http:// icf.som.yale.edu/pdf/seminar03-04/stravros.pdf (noting that if managers do not have frictionless access to markets, investment decisions are based on fundamental value).
322. See Bolton et al., supra note 165, at 578-579 (explaining that an incentive compensation scheme keyed to short-term stock price enhancement at the sacrifice of long-term value can be optimal for a group of speculative shareholders).
323. Short-termist incentives will not however, be entirely absent A controlling shareholder retains the incentive to sell adthtional shares into the overpriced market in order to reduce the cost of capital, an incentive shared with all managers of all companies.
324. See Tor-Erik Bakke & Toni M. Whited, Which Firms Follow the Market? An Analysis of Corporate Investment Decisions 3 (Nov. 18, 2006) (unpublished manuscript), available at http://ssrn.com/abstract=891570 (finding "that investment does respond to legitimate information in price movements, but only for firms diat rely on outside equity financing and whose shares are not mispriced" (emphasis added)).
325. See supra notes 1-15 and accompanying text
326. See supra text accompanying note 8.
327. The correlation of the two number series is 0.48.
328. Bespoke Investment Group, Current and Historical Sector Weightings of the S&P 500 (Apr. 24, 2008), http://bespokeinvest.typepad.com/bespoke/2008/04/ current-and-his.html.
329. Select Sector SPDR Trust Sector Returns by Year 1999-2009, at 2, http:// www.sectorspdr.com/shared/pdf/SPDR-Periodic-table-web.pdf (last visited Jan. 15, 2010).
330. See generally Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 STAN. J.L. BUS. & FlN. 133 (1994) (explaining how securitization works and how companies benefit from it).
331. See, e.g., Floyd Norris, Market Shock: AAA Rating May Be Junk, N.Y. TIMES, July 20, 2007, at Cl (explaining the riskiness of AAA securities backed by subprime mortgages).
332. See, e.g., Andrey Pavlov & Susan Wachter, Subprime Lending and House Price Volatility 3 (Univ. of Pa. Inst for Law & Econ., Research Paper No. 08-33, 2009), available at http://papers.ssni.com/sol3/papers.cfm?abstract-id= 1316891 (linking recent use of aggressive mortgage lending instruments and the underlying house price volatility).
333. In 2003, Countrywide was the star of its sector, having returned 23,000% on its equity between 1982 and 2003. See Shawn Tully, Afeei the 23,000% Stock, FORTUNE, Sept 15, 2003, at 204 ("Most amazing of all is that Countrywide boasts the best stock market performance of any financial services company in the FORTUNE 500...."). Countrywide built itself into an industry leader with a stricdy prime-lenthng operation, entering the subprime market only in 1999. Between 1999 and 2003, Countrywide got its growth in earnings and market share from an aggressive mortgage refinancing operation. That strategy depended on historically low interest rates. When rates climbed in 2003, it had to look elsewhere to continue its stellar performance. See Christine Richard & David Feldheim, Asset-Backed Securities Gain Favor, WALL ST. J., May 25, 2004, at C5 (concluthng that investors were moving money into asset-backed securities, creating a possible "bonanza" for consumer borrowing). Subprime lenthng was a part of the solution but only undertaken with a view to securitizing all mortgages originated. Prime lenthng remained a much greater part of the business. But here the company took a notably aggressive approach, originating adjustable-rate mortgages highly exposed to declines in real estate prices. See James R. Haggerty, Do Countrywide's Loans Stack Up?, WALL ST. J., July 25, 2006, at C3 (raising the possibility that Countrywide was less cautious than rivals in granting adjustable-rate mortgages). The right side of Countrywide's balance sheet also changed. Shareholders' equity, sixteen percent of total assets in 1999, declined to seven percent of total assets in 2006. Compare Countrywide Cretht Indus., Inc., Annual Report (Form 10-K), at F-4 (Feb. 29, 2000), with Countrywide Fin. Corp., Annual Report (Form 10-K), at F-3 (Feb. 28, 2008). In 1999, the overwhelming portion of Countrywide's outside borrowing was methum term. By 2006, it was relying on short-term cretht in the form of repurchase obligations and commercial paper. See Countrywide Fin. Corp., Annual Report (Form 10-K), at F-3 (Feb. 28, 2008) (reporting that repurchase obligations, while constituting 0% of liabilities in 1999, were 23% in 2006, while longer-term "notes payable" declined from 79% of liabilities in 1999 to 39% in 2006) .
334. See supra note 133 and accompanying text
335. For a description of tile process by which banks went from regulatory constraint to high-risk investing,
336. see RICHARD A. POSNER, A FAILURE OF CAPITALISM: THE CRISIS OF '08 AND THE DESCENT INTO DEPRESSION 41-74 (2009).
337. For a smaller bank, that meant becoming an attractive merger target as the industry concentrated.
338. See KATE KELLY, STREET FIGHTERS: THE LAST 72 HOURS OF BEAR STEARNS, THE TOUGHEST FIRM ON WALL STREET 194-96 (2009) (describing JPMorgan Chase CEO Jamie Dimon's approach as "steerfing] the bank away from risky holthngs");
339. GlLUAN TETT, FOOL'S GOLD: HOW THE BOLD DREAM OF A SMALL TRIBE AT J.P. MORGAN WAS CORRUPTED BY WALL STREET GREED AND UNLEASHED A CATASTROPHE 110-142 (2009) ("Dimon believed strongly that risks must be properly managed....").
340. TETT, supra note 202, at 125-142
341. Id. at 120.
342. Id. at 121-128
343. See To Burst or Not to Burst, ECONOMIST, Sept. 7, 2002, at 68 (warning thenFederal Reserve Chairman Alan Greenspan to look out for a boom in share prices or house prices combined with a big increase in debt and overinvestment by firms). The warning became more focused by 2004. See Will It Be Different This Time?. ECONOMIST, Oct. 9, 2004, at 22 (prethcting a crash of the U.K. housing market).
344. TETT, supra note 202, at 122-124
345. Cf. Kara Scannell & John R. Emshwiller, Countrywide Chiefs Charged with Fraud, WALL ST. J., June 5, 2009, at Cl (reporting SEC allegations that Countrywide executives saw warning signs and decided not to thsclose that information to investors).
346. Stephen Kotkin, A Bear Saw Around the Corner, N.Y. TIMES, Jan. 4, 2009, at BU2 (reviewing and quoting from JAMES GRANT, MR. MARKET MISCALCULATES: THE BUBBLE YEARS AND BEYOND (2008) ).
347. A recent empirical study of executive compensation at financial companies compares those that did badly in the financial crisis (such as AIG, Bear Stearns, Citigroup, Countrywide, and Lehman) against diose diat did better (such as Berkshire Hathaway, Goldman Sachs, JPMorgan Chase, and Wells Fargo).
348. Ing-Haw Cheng et al., Yesterday's Heroes: Compensation and Creative Risk-Taking 5-10, 22-26 (Oct 2009) (unpublished manuscript), available at http://ssrn.com/abstract=1502762. The study finds (a) a statistically and economically significant connection between executive compensation and price-based measures of risk such as beta and stock return volatility; (b) that higher-paying firms were more likely to be in die tails of performance; and (c) a positive relation between residual compensation and subprime exposure.
349. Id.; see also Rüdiger Fahlenbrach & René M. Stulz, Bank CEO Incentives and the Credit Crisis 1, 12 (Eur. Corp. Governance Inst, Finance Working Paper No. 256/2009, 2009), available at http://ssm.com/abstract=1439859 (reporting on an empirical study and showing "that there is no evidence that banks with a better alignment of CEOs* interests with those of their shareholders had higher stock returns during the crisis and some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity").
350. See, e.g., William D. Cohan, Op-Ed., A Tsunami of Excuses, N.Y. TIMES, Mar. 12, 2009, at A23 (criticizing the testimony of financial executives to Congress who alleged that the financial crisis was unavoidable).
351. The mix among stock options, restricted stock, and cash bonuses varied from company to company and from executive to executive within each company. For example, in 2006, Citibank thsclosed a heavier weighting to cash bonuses, whereas Bank of America relied more on stock options. Compare Citigroup Inc., Definitive Proxy Statement (Schedule 14A), at 39-52 (Mar. 14, 2006), with Bank of Am. Corp., Definitive Proxy Statement (Schedule 14A), at 22-27 (Mar. 20, 2006).
352. See supra text accompanying notes 186-188
353. Sanjai Bhagat & Roberta Romano, Reforming Executive Compensation: Focusing and Committing to the Long-Term 7, 12-13, 15-16 (Yale Law & Econ., Research Paper No. 374, 2009), available at http://ssrn.com/abstract=lS36978. The audiors reasonthat a two-year minimum suffices tothffusethe incentive to manage earnings; by the end of four yearsthe intermediate-term effects of the manager's contribution will have workedtheir way intothe stock price.
354. Id at 7.
355. See FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 30 (1991) ("[T]he vast majority of investments are held by people widi diversified portfolios.");
356. Kevin J. Murphy, Explaining Executive Compensation: Managerial Power Versus the Perceived Cost of Stock Options, 69 U. CHI. L. REV. 847, 858-859 (2002) (factoring free transferability and hedging into the opportunity cost of a stock option).
357. See generaUy Michael C. Jensen & Kevin J. Murphy, Performance Pay and TopManagement Incentives, 98 J. POL. ECON. 225, 261-262 (1990) (finthng the relation between executive wealth and shareholder wealth to be small, pardy because executive compensation structures were not highly sensitive to performance at the time).
358. Critics of compensation plans have questioned this analysis in part, recommending resale restraints that balance the long-term time horizon with the executive's interest in liquithty and thversification.
359. See BEBCHUK & FRIED, supra note 130, at 174-76 (concluding that the efficient balance between restrictions on cashing out vested options and executives' interest in liquithty and thversification will vary from firm to firm).
360. But cf. William W. Bratton, Supersize Pay, Incentive Compatibility, and the Volatile Shareholder Interest, 1 VA. L. & BUS. REV. 55, 75 (2006) (recommenthng across-the-board resale constraints).
361. See Green, supra note 5, at 3 ("Public trust depends on a responsible, measured attitude to compensation.").
362. Bhagat & Romano, supra note 214, at 3-4.
363. Lucian A. Bebchuk & Holger Spamann, Regulating Bankers' Pay 3-4 (John M. Olin Ctr. for Law, Econ. and Bus., Discussion Paper No. 641, 2009), available at http://ssrn.com/abs tract=1410072.
364. Id. at 5-6;
365. see also Viral V. Acharya et al., Corporate Governance in the Modem Financial Sector (recommenthng a focus on return on assets rather than return on equity), in RESTORING FINANCIAL STABILITY: HOW TO REPAIR A FAILED SYSTEM 185, 193-194 (Viral V. Acharya & Matthew Richardson eds., 2009).