Shareholders vs. Management: Split Decision
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Finance & Accounting Leadership Social Impact Feb 2, 2011

Share­hold­ers vs. Man­age­ment: Split Decision

Share­hold­ers should usu­al­ly — but not always — con­trol decisions

Shareholders wrestling with management for control is an agency problem

Based on the research of

Artur Raviv

Milton Harris

Are share­hold­ers bet­ter off if they direct­ly con­trol cor­po­rate deci­sions? New research shows that answer­ing this ques­tion requires con­sid­er­ing numer­ous fac­tors — and that intu­itive answers are not always right. Artur Raviv, a pro­fes­sor of finance at the Kel­logg School of Man­age­ment, and Mil­ton Har­ris, a pro­fes­sor at the Uni­ver­si­ty of Chica­go, say that some­times share­hold­ers who lack infor­ma­tion or are even mis­in­formed should con­trol deci­sions on mat­ters on which man­age­ment is bet­ter informed. The catch is that share­hold­ers need rec­og­nize their blind spots and the extent of management’s pri­vate information.

In the­o­ry, a corporation’s board of direc­tors rep­re­sents the inter­ests of the share­hold­ers. How­ev­er, it is com­mon­ly believed that board mem­bers do not exer­cise suf­fi­cient con­trol over self-inter­est­ed man­agers because direc­tors are typ­i­cal­ly hand­picked by man­age­ment insid­ers who con­trol the proxy process. Raviv explains, Even­tu­al­ly a con­flict devel­ops between the share­hold­ers, who are the own­ers of the cor­po­ra­tion, and the man­age­ment, which is sup­posed to rep­re­sent them, and the board, which is sup­posed to be super­vis­ing man­age­ment.” The con­flict has giv­en rise to the share­hold­er democ­ra­cy move­ment,” in which many stock own­ers seek a greater voice in cor­po­rate decision-making.

Gain­ing Momentum

Some promi­nent exam­ples of this move­ment have made head­lines. Carl Icahn was unsuc­cess­ful in forc­ing a breakup of Time Warn­er, but he won con­ces­sions in exchange for drop­ping his proxy fight. Although Kirk Kerko­ri­an suc­ceed­ed in plac­ing his rep­re­sen­ta­tive on the board of Gen­er­al Motors, he was unable to com­pel GM to enter into an alliance with Nis­san and Renault. On the oth­er hand, Nel­son Peltz suc­ceed­ed in get­ting him­self and an ally elect­ed to the board of H.J. Heinz Co. and in per­suad­ing man­age­ment to imple­ment accel­er­at­ed cost cut­ting and restructuring.

Even­tu­al­ly a con­flict devel­ops between the share­hold­ers, who are the own­ers of the cor­po­ra­tion, and the man­age­ment, which is sup­posed to rep­re­sent them, and the board, which is sup­posed to be super­vis­ing management.”

Pro­po­nents of increased share­hold­er par­tic­i­pa­tion say that, because of the con­flicts of inter­est that arise in many man­age­ment deci­sions, all the deci­sion pow­er should belong to share­hold­ers. In this view, when share­hold­ers have the pow­er to decide, they del­e­gate deci­sions about mat­ters in which they lack suf­fi­cient infor­ma­tion. Some chal­lenge the idea increased share­hold­er pow­er is a good idea, say­ing that share­hold­ers lack ade­quate knowl­edge and skill to make effec­tive deci­sions or that some share­hold­ers may not have the firm’s best inter­ests as their ulti­mate goal. For exam­ple, large insti­tu­tion­al share­hold­ers might try to inflate a firm’s stock price with short-term mea­sures that actu­al­ly reduced firm val­ue, or share­hold­ers might use their pow­er to fur­ther a polit­i­cal, social, or envi­ron­men­tal agen­da at the expense of profits.

Raviv and Har­ris used a math­e­mat­i­cal mod­el to inves­ti­gate fac­tors that might be over­looked in these argu­ments. Each group (man­age­ment and share­hold­ers) was assumed to act as if it were a sin­gle indi­vid­ual. Either group could con­trol the deci­sion, such as the size of a major invest­ment or exec­u­tive com­pen­sa­tion. The group in con­trol of a deci­sion could make the deci­sion itself or del­e­gate it to the oth­er par­ty. Oth­er assump­tions were that management’s deci­sions would be biased away from max­i­miz­ing share val­ue and that both sides would have pri­vate infor­ma­tion rel­e­vant to the decision.

Raviv stress­es that one impor­tant ele­ment of the mod­el con­cerns com­mu­ni­ca­tion: If I know some­thing, I might be able to com­mu­ni­cate it to you, but the com­mu­ni­ca­tion is not per­fect or com­plete. I know that you are biased, so I com­mu­ni­cate the infor­ma­tion with a twist. The mod­el accounts for that.”

The Pri­ma­cy of Information

The researchers found that if share­hold­ers have no pri­vate infor­ma­tion, they will del­e­gate the deci­sion to man­age­ment as long as management’s pri­vate infor­ma­tion is suf­fi­cient­ly valu­able that it out­weighs the agency prob­lem (the cost incurred when peo­ple entrust­ed to look after the inter­ests of oth­ers use their pow­er for their own ben­e­fit). How­ev­er, the mod­el did not sug­gest that share­hold­ers should con­trol all impor­tant cor­po­rate deci­sions. When share­hold­ers have pri­vate infor­ma­tion, they fail to del­e­gate deci­sions to man­agers in some sit­u­a­tions in which such del­e­ga­tion would increase share value.

Raviv and Har­ris used the mod­el to exam­ine the pos­si­bil­i­ty that share­hold­ers may be not only ill informed but also over­con­fi­dent in their abil­i­ty to under­stand the issues involved in a deci­sion. They also con­sid­ered share­hold­ers who want to use cor­po­rate resources for their own goals, such as envi­ron­men­tal­ly friend­ly pro­duc­tion tech­niques, wealth redis­tri­b­u­tion to work­ers, sup­port for par­tic­u­lar polit­i­cal can­di­dates, or boy­cotts of cer­tain prod­ucts or coun­tries. They deter­mined that in both cas­es, share­hold­er con­trol is opti­mal for some deci­sions. In their arti­cle in The Review of Finan­cial Stud­ies, they explain, This is due, in part, to the fact that share­hold­er bias­es, due to either mis­per­cep­tion or non-val­ue-max­i­miz­ing agen­das, may improve com­mu­ni­ca­tion from man­age­ment to shareholders.”

Real-World Deci­sions

In their paper the researchers give sev­er­al exam­ples of how their find­ings apply to actu­al deci­sions. One is a deci­sion about how much cash to dis­trib­ute to share­hold­ers. In this case man­age­ment will like­ly have per­ti­nent infor­ma­tion not avail­able to share­hold­ers and share­hold­ers will like­ly have lit­tle or no pri­vate infor­ma­tion. It might seem obvi­ous, then, that man­age­ment should con­trol this deci­sion. How­ev­er, the results from the mod­el sug­gest just the oppo­site, sup­port­ing what activist share­hold­ers are cur­rent­ly arguing.

When it is time to replace a man­ag­er, both man­age­ment and share­hold­ers are like­ly to have infor­ma­tion about the tal­ent avail­able, Raviv and Har­ris point out. Data from their mod­el sug­gest that share­hold­er con­trol of the deci­sion max­i­mizes share val­ue regard­less of the lev­el of pri­vate ben­e­fits of con­trol or the impor­tance of the par­ties’ pri­vate infor­ma­tion, as long as the two sides have infor­ma­tion of sim­i­lar importance.

A third exam­ple is a deci­sion about set­ting per­for­mance-based com­pen­sa­tion. In this case, management’s infor­ma­tion about the opti­mal com­pen­sa­tion scheme is like­ly to be more impor­tant than share­hold­ers’ infor­ma­tion about low-lev­el exec­u­tives. On the oth­er hand, for top exec­u­tives, the impor­tance of management’s infor­ma­tion may be rough­ly com­pa­ra­ble to that of share­hold­ers’ infor­ma­tion. The results from the mod­el imply that, assum­ing sim­i­lar agency costs for the two deci­sions, share­hold­er con­trol is more like­ly to be opti­mal for top-lev­el com­pen­sa­tion deci­sions than for lower-level.

Raviv and Har­ris con­clude that it is disin­gen­u­ous to protest that share­hold­ers should not have deci­sion-mak­ing author­i­ty because they lack infor­ma­tion — share­hold­ers can and do del­e­gate deci­sions to man­age­ment when nec­es­sary. On the oth­er hand, even if share­hold­ers seek to max­i­mize firm val­ue and can del­e­gate deci­sions, they should not con­trol all major decisions.

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Pro­po­nents of increased share­hold­er par­tic­i­pa­tion say that, because of the con­flicts of inter­est that arise in many man­age­ment deci­sions, all the deci­sion pow­er should belong to share­hold­ers. In this view, when share­hold­ers have the pow­er to decide, they del­e­gate deci­sions about mat­ters in which they lack suf­fi­cient infor­ma­tion. Some chal­lenge the idea increased share­hold­er pow­er is a good idea, say­ing that share­hold­ers lack ade­quate knowl­edge and skill to make effec­tive deci­sions or that some share­hold­ers may not have the firm’s best inter­ests as their ulti­mate goal. For exam­ple, large insti­tu­tion­al share­hold­ers might try to inflate a firm’s stock price with short-term mea­sures that actu­al­ly reduced firm val­ue, or share­hold­ers might use their pow­er to fur­ther a polit­i­cal, social, or envi­ron­men­tal agen­da at the expense of profits.

Raviv and Har­ris used a math­e­mat­i­cal mod­el to inves­ti­gate fac­tors that might be over­looked in these argu­ments. Each group (man­age­ment and share­hold­ers) was assumed to act as if it were a sin­gle indi­vid­ual. Either group could con­trol the deci­sion, such as the size of a major invest­ment or exec­u­tive com­pen­sa­tion. The group in con­trol of a deci­sion could make the deci­sion itself or del­e­gate it to the oth­er par­ty. Oth­er assump­tions were that management’s deci­sions would be biased away from max­i­miz­ing share val­ue and that both sides would have pri­vate infor­ma­tion rel­e­vant to the decision.

Raviv stress­es that one impor­tant ele­ment of the mod­el con­cerns com­mu­ni­ca­tion: If I know some­thing, I might be able to com­mu­ni­cate it to you, but the com­mu­ni­ca­tion is not per­fect or com­plete. I know that you are biased, so I com­mu­ni­cate the infor­ma­tion with a twist. The mod­el accounts for that.”

The Pri­ma­cy of Information

The researchers found that if share­hold­ers have no pri­vate infor­ma­tion, they will del­e­gate the deci­sion to man­age­ment as long as management’s pri­vate infor­ma­tion is suf­fi­cient­ly valu­able that it out­weighs the agency prob­lem (the cost incurred when peo­ple entrust­ed to look after the inter­ests of oth­ers use their pow­er for their own ben­e­fit). How­ev­er, the mod­el did not sug­gest that share­hold­ers should con­trol all impor­tant cor­po­rate deci­sions. When share­hold­ers have pri­vate infor­ma­tion, they fail to del­e­gate deci­sions to man­agers in some sit­u­a­tions in which such del­e­ga­tion would increase share value.

Raviv and Har­ris used the mod­el to exam­ine the pos­si­bil­i­ty that share­hold­ers may be not only ill informed but also over­con­fi­dent in their abil­i­ty to under­stand the issues involved in a deci­sion. They also con­sid­ered share­hold­ers who want to use cor­po­rate resources for their own goals, such as envi­ron­men­tal­ly friend­ly pro­duc­tion tech­niques, wealth redis­tri­b­u­tion to work­ers, sup­port for par­tic­u­lar polit­i­cal can­di­dates, or boy­cotts of cer­tain prod­ucts or coun­tries. They deter­mined that in both cas­es, share­hold­er con­trol is opti­mal for some deci­sions. In their arti­cle in The Review of Finan­cial Stud­ies, they explain, This is due, in part, to the fact that share­hold­er bias­es, due to either mis­per­cep­tion or non-val­ue-max­i­miz­ing agen­das, may improve com­mu­ni­ca­tion from man­age­ment to shareholders.”

Real-World Deci­sions

In their paper the researchers give sev­er­al exam­ples of how their find­ings apply to actu­al deci­sions. One is a deci­sion about how much cash to dis­trib­ute to share­hold­ers. In this case man­age­ment will like­ly have per­ti­nent infor­ma­tion not avail­able to share­hold­ers and share­hold­ers will like­ly have lit­tle or no pri­vate infor­ma­tion. It might seem obvi­ous, then, that man­age­ment should con­trol this deci­sion. How­ev­er, the results from the mod­el sug­gest just the oppo­site, sup­port­ing what activist share­hold­ers are cur­rent­ly arguing.

When it is time to replace a man­ag­er, both man­age­ment and share­hold­ers are like­ly to have infor­ma­tion about the tal­ent avail­able, Raviv and Har­ris point out. Data from their mod­el sug­gest that share­hold­er con­trol of the deci­sion max­i­mizes share val­ue regard­less of the lev­el of pri­vate ben­e­fits of con­trol or the impor­tance of the par­ties’ pri­vate infor­ma­tion, as long as the two sides have infor­ma­tion of sim­i­lar importance.

A third exam­ple is a deci­sion about set­ting per­for­mance-based com­pen­sa­tion. In this case, management’s infor­ma­tion about the opti­mal com­pen­sa­tion scheme is like­ly to be more impor­tant than share­hold­ers’ infor­ma­tion about low-lev­el exec­u­tives. On the oth­er hand, for top exec­u­tives, the impor­tance of management’s infor­ma­tion may be rough­ly com­pa­ra­ble to that of share­hold­ers’ infor­ma­tion. The results from the mod­el imply that, assum­ing sim­i­lar agency costs for the two deci­sions, share­hold­er con­trol is more like­ly to be opti­mal for top-lev­el com­pen­sa­tion deci­sions than for lower-level.

Raviv and Har­ris con­clude that it is disin­gen­u­ous to protest that share­hold­ers should not have deci­sion-mak­ing author­i­ty because they lack infor­ma­tion — share­hold­ers can and do del­e­gate deci­sions to man­age­ment when nec­es­sary. On the oth­er hand, even if share­hold­ers seek to max­i­mize firm val­ue and can del­e­gate deci­sions, they should not con­trol all major decisions.

Featured Faculty

Artur Raviv

Alan E. Peterson Professor of Finance

About the Writer

Beverly A. Caley, JD, is an independent writer based in Corvallis, Ore., who concentrates on business, legal, and science topics.

About the Research

Harris, Milton, and Artur Raviv. 2010. Control of corporate decisions: shareholders vs. management. The Review of Financial Studies 23(11): 4115–4147.

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