Shareholders versus Managers: The Strain in the Corporate Web

Part I will seek to understand why firms trade in the stock market at a substantial discount from their asset value. It will answer that existing theories of the firm have not given adequate attention to a critical area where shareholders and managers have an inherent conflict, one that the existing structure of the firm does not resolve or mitigate. Despite the significant changes in the internal structure of the corporation over the last half century that have been described by business historians, there remains a deep internal strain between shareholders, on the one hand, and managers and employees, on the other. The central conflict involves the asymmetry in attitudes toward risk held by the typical manager and the typical shareholder. Put simply, the rational manager has good reason to be risk averse, while the fully diversified shareholder has every reason to be risk neutral. If we see the modern public corporation as - in the phrase currently fashionable among theorists - a "web of contracts, " this conflict over risk preferences is the strain in the corporate web that best explains the significant disparity between stock and asset values that invites bust-up takeovers. Based on this analysis, Part I will suggest that in its current operation the hostile takeover should be conceived less as a device by which "good" managements drive out "bad" than as a means by which shareholders can impose their own risk preferences on more risk averse managements. To be sure, this is not the exclusive role of the takeover. Takeovers also seek to realize a variety of synergistic gains. 31 Yet, for the last three years, the bust-up takeover has predominated (at least in terms of its impact on both the media and management), and its principal contemporary impact has been to serve as a coercive measure by which managers are induced to accept risks that they would resist on their own. Indeed, takeover competitions among various bidders and the incumbent management begin to look increasingly like contests that are determined by the relative willingness of the contestants to accept risk, as each side proposes in tum a radically more leveraged capital structure. Part I will develop this argument by first examining the ways in which the principal models of the firm have implicitly, but inadequately, recognized that shareholders and managers have conflicting attitudes toward risk. Then, it will survey the two recent developments that show the new impact of the takeover: (1) the movement towards "deconglomeration, " and (2) the increase in corporate leverage. II of this paper will then focus on the possible diseconomies associated with a higher tolerance for risk, in particular as the problem is compounded by the impact of increasing corporate leverage. Although no level of risk aversion or preference is necessarily optimal from a social perspective, Part II will decompose the corporation into its separate constituent interests and assess the changed positions of creditors, employees, and the state as the ultimate insurers of residual corporate liabilities. The practical question will be the extent to which visible flaws in the bargaining process justify regulatory intervention. III will then tum to this article's proposed policy of premium sharing, and Part IV will thereafter examine the other earlier-noted junctures at which the law can influence the pace and impact of the transition now in progress. Other alternatives also exist, including revised voting rules that reduce the voting power of large shareholders or a policy of encouraging greater employee ownership in the corporation. Recently, there have been movements in each of these directions, and the trade-offs among them need evaluation. In particular, these alternatives need to be examined because the one option on which much legal commentary has focused - enforcing a rule of managerial passivity in the face of a hostile takeover - seems an increasingly futile hope.