Shareholder Preferences and Corporate Behavior

Abstract

The preferences of equity investors are not monolithic. While some equity investors prefer that companies singularly focus on the pursuit of profit and share value maximization, others see things differently and prefer that companies sacrifice profit and share value in service to some other objective. In particular, as our country’s social and environmental problems have grown in both scope and depth, and as faith in the curative abilities of the political process has waned, a meaningful portion of investors appear willing to trade at least some corporate profit for corporate decisions that can aid in the correction of the many social and environmental problems that are now commonplace. Others continue to prefer that corporations solely seek to maximize share value. And yet others prefer that corporations in which they invest deviate from share-value-maximizing behavior in ways that further the investors’ own personal advantage.

To what extent will the existence of this willing-to-sacrifice bloc of investors translate into changes in firm behavior? This article applies the teachings of corporate governance and the tools of financial economics to bring some analytical clarity to resolution of this increasingly important question of firm behavior. The article focuses its attention on the country’s dominant form of productive enterprise—the dispersed ownership publicly traded for-profit corporation with shareholders as its residual claimant—and inquires whether heterogeneity in the preferences of the economy’s equity investors regarding the extent to which firms should pursue share value maximization will cause firm behavior to be different than in the counterfactual world in which investors uniformly prefer that firms focus only on share value maximization. 

Given current law and the typical corporate charter, the decision as to how such a firm operates is in the first instance made directly by the firm’s managers, not by its equity investors, whether actual or potential. Rather, the presence of investors with preferences other than share value maximization can affect firm behavior in only one of two ways. One is directly through the election of directors pledged to make the firm conform with these preferences. The other is in some more indirect fashion through the effect of these preferences on the multiple elements that go into the incentive structure within which a firm’s managers operate, something the article works through.

Our analysis raises significant doubts that investor preference heterogeneity under existing corporate governance arrangements will cause firms to behave any differently than if all investors desired share value maximization. Under these arrangements, the only binding shareholder votes of relevance concern who will be the directors, and our analysis shows that this will be an ineffective means of translating the preferences of profit-sacrificing shareholders to real corporate change. Certain modifications to these governance arrangements championed by some commentators might cause managers to be more receptive to the preferences of such shareholders. These changes in governance arrangements, however, would come with costs that might well overwhelm any social gain. Specifically, they will divert political energy from its focus on the public political process where that energy can be applied more efficiently in attaining results. And they are likely to lead to changes in corporate behavior that benefit managers with no social gain. 

Some investors clearly compose their portfolios taking into account whether they approve of the behavior of the firms in which they invest, while others do not. This sorting represents a second potential pathway by which investors with profit-sacrificing preferences may affect corporate behavior. There are both theoretical and empirical grounds for believing that sorting has some impact on share prices and through this on firm behavior, though neither proposition is close to being resolved with any certainty. Relative to altering existing governance arrangements for the purpose of giving the economy’s profit sacrificers a chance to alter corporate behavior, reliance on a price-based mechanism for reforming corporate behavior has clear advantages. This process can be promoted through more socially oriented mandatory securities disclosure. The difficult question is whether if such mandates were imposed, the likelihood of an effect on behavior is great enough to justify their costs.