Best Interests of the Corporation': Shareholder Voice and Directors' Duties

• Author: Christopher C. Nicholls
• Pages: 257-312

257

CHAPTER TEN

“Best Interests of the

Corporation”: Shareholder

Voice and Directors’ Duties

INTRODUCTION

Shareholders are often described, at least colloquially, as the “owners” of business

corporations. That description, as discussed in chapter 1, is not accurate as a matter of

law, and is rejected as fundamentally flawed by law and economics scholars. But,

although it may not, strictly speaking, be correct to characterize shareholders as “own-

ers” of the corporation, it cannot be denied that shareholders have important financial

interests in the corporations in which they hold shares. They occupy a unique position in

the corporate governance structure. Shareholders have the power to elect and to remove

the corporation’s directors, and they hold the residual economic interest in the corpora-

tion, a “claim” to whatever value might remain in the corporation after the corporation’s

fixed claimants have been paid.

This power to elect and remove directors, coupled with the general legal attributes of

share ownership prescribed by corporate statutes and developed at common law, provides

shareholders with an incentive to monitor the performance of a corporation’s managers,

and tools with which to try to discipline those managers. But, a number of practical

constraints frequently make it difficult for shareholders to perform an effective monitor-

ing or disciplinary role.

The corporation’s directors and officers, in turn, are subject to a specific set of

obligations intended to ensure that they remain accountable for their actions. Share-

holders are the direct beneficiaries of corporate managerial prowess and of the corpora-

tion’s financial success. Well-run, successful corporations also create employment

opportunities; purchase goods and services from other businesses—incorporated and

unincorporated, large and small; pay taxes; and contribute to universities, hospitals, and

other philanthropic causes. And, in a broader sense, it is hoped that by generating wealth

to meet people’s material needs, the operation of corporations will contribute to the

betterment of society generally. The recent series of corporate scandals in the United

States and elsewhere has provided a sobering reminder, however, that individual officers

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

258 Chapter 10 “Best Interests of the Corporation”

and directors may have significant incentives to mislead investors and to divert corporate

value to themselves.

Although this chapter focuses on the role of shareholders and the basic duties of

directors and corporate managers, it is important to remember from the outset that

scholars have identified a host of factors that might operate to constrain managers from

the temptation to shirk their duties or, worse, to divert corporate assets into their own

hands. These factors include:

•The capital markets:1 Corporations that are poorly managed, it is argued, will have

difficulty finding financing in the capital markets. The cost of capital for such

corporations will increase, making it difficult for them to remain competitive and

so, ultimately, placing their future in jeopardy.

•Product and labour markets:2 If a corporation is not competitive because of the

inefficiency or dishonesty of its managers, the cost of its products will increase, its

sales and so its revenues will decrease, and it may eventually be driven out of

business. Similarly, if poor profitability constrains the corporation’s ability to offer

its employees competitive wages and benefits, it will not be able to attract and retain

competent employees.

•The market for corporate managers:3 If a company underperforms or fails, this

failure will adversely affect the reputation of the corporation’s managers, and,

accordingly, adversely affect their ability to secure other positions except, perhaps,

at a significantly lower income level.

•The market for corporate control:4 If a corporation is poorly managed, the market

price of its shares will fall. Such a fall in price may then entice a bidder to seek to

acquire the corporation’s outstanding shares and replace its underperforming managers.

What is important to remember about these factors is that one may presume that

managers are well aware of them and, thus, it has been argued, managers have significant

incentives to perform their duties wisely and well, notwithstanding the well-known

obstacles that stand in the way of effective monitoring by shareholders. However, as

Easterbrook and Fischel note, “[t]hese mechanisms reduce but do not eliminate the

divergence of interests.”5 Nevertheless, these market and external constraints operate

within the context of the traditional shareholder/director relationship, and so we now turn

to consider some of the well-known general characteristics of “shareholder voice” and

directors’ and officers’ duties.

1See, e.g., Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law

(Cambridge, MA: Harvard University Press, 1991), 95.

2See, e.g., Eugene F. Fama, “Agency Problems and Theory of the Firm” (1980), 88 Journal of Political

Economy 288.

3See, e.g., Eugene F. Fama and Michael C. Jensen, “Separation of Ownership and Control” (1983), 26

Journal of Law and Economics 301, at 315.

4The seminal academic paper on this topic is Henry Manne, infra footnote 9.

5Supra footnote 1, at 91.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

Shareholder Voice 259

SHAREHOLDER VOICE

Introduction

The modern corporation—in particular the modern public corporation—is one in which

the directors (and, through them, the managers more generally) are clearly in control.

This consolidation of control in the hands of corporate managers has been praised by

many as a key virtue of the modern corporation because it allows for the development of

specialized professional managers and greater operating efficiency. However, in the view

of some shareholder activists, the increasing power and lack of effective accountability

of corporate directors is woefully anti-democratic.

Of course, shareholders do have the power to vote their shares,6 and may use this

voting power to elect and to remove corporate directors. In large, public corporations,

however, this theoretical power is subject to important practical restrictions. If a corpora-

tion’s shares are widely held, most shareholders will be total strangers to one another,

separated by large geographical distances. Coordinated action would be difficult enough

under such circumstances, and the likelihood of shareholders taking prompt collective

action to discipline underperforming managers is further reduced if each shareholder

holds only a small number of a corporation’s shares. There is little incentive for any small

shareholder to expend time and energy (and possibly money) in an attempt to communi-

cate with other shareholders with a view to crafting a strategic voting plan. The problem

is a classic example of “rational apathy,” and it makes effective collective action by

shareholders of widely held corporations problematic.

There are additional hurdles standing in the way of effective shareholder discipline of

managers of widely held corporations. The corporation’s managers, as it has often been

noted, control the proxy process.7 This means that the corporation’s existing managers

decide when and where to hold shareholders’ meetings. It is the managers who prepare

the information package (the information circular) and forms of proxy that are sent to

shareholders in connection with these meetings. And it is, effectively, the managers and

the existing directors who propose the names of the directors who are to be elected at the

meeting. It is the managers, too, that effectively set the agenda of the meeting itself.

6The concept of “one share, one vote” to which we are accustomed today was not always the norm. At

one time, evidently, it seems that “one shareholder, one vote” was the preferred method of conduct.

Indeed, an English statute was passed in 1767 explicitly to prevent

the most unfair and mischievous Practice … of splitting large Quantities of Stock, and making

separate and temporary Conveyances of the Parts thereof, for the Purpose of multiplying or

making occasional Votes immediately before the time of declaring a Dividend, or chusing [sic]

Directors, or of deciding any other important Question.

Such a practice was derided by the statute as “subversive of every Principle upon which the Establishment

of such General Courts is founded.” (See An Act for regulating the Proceedings of certain Public

Companies and Corporations carrying on Trade or Dealings with Joint Stocks, in respect to the

Declaring of Dividends; and for further regulating the Qualification of Members for voting in their

respective General Courts, 1767, 7 Geo. III, c. 48.)

7For a detailed description of the proxy solicitation process, see Jeffrey G. MacIntosh and Christopher C.

Nicholls, Securities Law (Toronto: Irwin, 2002), at 262ff.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.