Engine of wealth
by Jeffrey MacIntosh
This commentary was first published in the Financial Post on June 11, 2008.
Yesterday I suggested that the decision of the Quebec Court of Appeal involving a takeover bid for the shares of BCE was jurisprudentially flawed. Today I discuss whether, as a matter of policy, the courts ought to embrace the "shareholder primacy" rule - that is, that directors should focus exclusively on maximizing the wealth of shareholders, and remit fixed claimants solely to their contractual rights with the corporation.
The principle of shareholder primacy is, without question, an indispensable foundational element of the corporation's mission as the primary engine of wealth creation in our economy. The root of it all lies in the fact that shareholders are the only class of "residual" claimant. That is, shareholders are entitled to the residue of the corporation's profits (and assets on winding up) after all other claimants are paid. All other constituencies are "fixed claimants" whose upside is strictly limited by the nature of their contractual claims. Ideally, we want to adopt rules guiding director conduct that are likely to maximize the aggregate value of all corporate constituencies -i. e. the sum of residual claim and all of the fixed claims. Unfortunately, there is no rule that always does that. However, the shareholder primacy rule is most likely to achieve that goal in the great plurality of circumstances.
We could, as an alternative, instruct the directors to maximize the value of the fixed claims. But that would be disastrous. Fixed claimants simply want to ensure that their contractual claims are paid. Their strong preference is for the corporation to avoid taking risks, and to adopt a safe, secure, and low risk business strategy. Why? The high return that may result from a high risk strategy will not accrue to their benefit. Rather, it will enrich the shareholders, as residual claimants. Why take risks on someone else's behalf, particularly when it reduces the likelihood that you will get paid?
A rule that instructs directors to maximize the value of the fixed claims means nothing less than economic stagnation. Risk-taking is the lifeblood of a vibrant economy. A polity that creates incentives for its economic agents to be demure wallflowers that shun the limelight and hide from the possibility of failure is almost certainly doomed to failure. In an age in which low-skill, high labour work has migrated to offshore locates like China, the comparative advantage of a mature, industrialized economy like Canada's lies in what has become known as the "knowledge-based industries" (KBI). The root of KBI is innovation - the sacred mantra of today's policy Mandarins - and innovation is virtually synonymous with risk-taking. No risk, no innovation - and a hobbled economy that limps far behind its more spirited industrial competitors.
What about a rule that requires the directors to maximize the value of the residual claim (the shareholder primacy rule)? That too is imperfect, and following its dictates will sometimes prejudice the fixed claimants - as the BCE case illustrates. For example, adopting a promising but high risk business strategy, loading up on more debt (as in the BCE case), and paying dividends will all prejudice the value of the fixed claims. Nonetheless, to paraphrase Churchill's trenchant witticism regarding democracy, shareholder primacy is the worst form of economic organization - except for all the rest. Empirically, we have good evidence that the gains that accrue to shareholders as a result of the pursuit of wealth maximization are huge compared to the occasional losses of fixed claimants - perhaps as much as two orders of magnitude greater. Take the BCE case. Shareholders stand to gain on the order of $10 billion. The aggregate losses of the debenture holders are projected to be about $1 billion. Just a single order of magnitude - but nonetheless impressive. Moreover, given BCE's market cap, it is virtually certain that many - indeed probably most -of the institutions that hold BCE debt also hold BCE shares. What these investors lose as debenture holders, they more than make up for as shareholders.
In any case, if fixed claimants sometimes lose as a result of the pursuit of shareholder wealth maximization, they can protect themselves in at least two ways from the consequences of directors pursuing unvarnished wealth maximization. First, they can price their claims accordingly. Second, they can tailor the terms of their contracts to protect themselves from the consequences of opportunistic behavior. This applies with particular force to sophisticated institutional investors, who have financial and legal expertise up the ying-yang. If they fail to appropriately protect themselves, they have only themselves to blame. Another large constituency of fixed claimants - the employees -have highly elaborate common law and statutory regimes to protect them. It is difficult to argue that there are any major lacunae in this protective regime.
But what about a compromise principle that requires the directors to at least consider the welfare of the debenture holders (and other fixed claimants) before endorsing something like a takeover bid? That is the upshot of the decisions of the Supreme Court of Canada in Peoples Department Stores v. Wise and the Quebec Court of Appeal in the BCE case (discussed yesterday in this space). The idea of "consideration" is a chimerical middle-ground that is intellectually empty. How far must one go in "considering" or reconciling the positions of those whose economic interests are, when the consideration doctrine really matters, mutually destructive? Take this example. A directorial decision to vastly increase the risk of the business may be perfectly supportable given the net present value of the opportunity, but it will reliably prejudice the bond holders (and other fixed claimants). Two possibilities present. First, the content of the "consideration" doctrine is a mere procedural fillip that is substantively without substance. That is, the directors need merely go through the motions of "considering" to escape liability. If this is the case, there is obviously little point.
Second, the principle has substantive bite. If so, in the above example, it may force the directors to conclude that they cannot increase the risk of the business quite so much as they had initially planned, in order to strike a compromise between the shareholders and the fixed claimants. But suppose, as is plausibly the case, that it is impossible to adopt the new strategy by halves. That is, the directors either go whole hog, or they fail. In this case, the "consideration" doctrine is a strategic landmine that seriously impairs the vitality and adaptability of corporate enterprise.
Moreover, how much "consideration" is enough? That, unfortunately, is fundamentally unknowable by the board - or by anyone else. It rests on what a judge will decide, ex post facto. A judge, that is, who almost certainly has no training or experience in business or economics. A judge who might easily succumb to the illicit temptation to transpose concepts derived from the application of Canada's Charter of Rights and Freedoms to corporations. A judge who will bring to bear his or her own political prejudices about which of various classes of fixed claimants are most deserving of "protection".
The uncertainty of a "consideration" rule is thus an invitation for the board to do nothing, and abandon its promising business strategy. Alternatively, if the board should act - and regardless of what it does - the "consideration" principal provides the debenture holders with an incentive to sue, hoping to secure an advantageous settlement. Opportunistic litigation of this character has become a lively cottage industry in the U. S. "Strike suits" are routinely settled for millions of dollars - not because they have merit, but because they have nuisance value. In the end, because the cost of such suits will be built into the price that the debenture holders pay for their debt, the only winners are the litigation lawyers. A happy outcome for us lawyers, but an unhappy one for society.
Indeed, the Peoples/BCE doctrine--as expressed by the Quebec Court of Appeal -- is an invitation for every class of fixed claimant to sue. If the debenture holders have the right to the extra-contractual "fairness" top up, why not employees, suppliers, landlords, local communities, or the government as tax collector? There is no logical stopping point. Contracts become meaningless - a failure to negotiate (and pay for) protection against a particular eventuality can simply be remedied by ex post facto judicial fiat.
In the end, the "consideration" principle is not as pernicious as a rule that compels directors to maximize the size of the fixed claims. However, that is its greatest virtue. It is intellectually meaningless, palpably harmful, and clearly destructive of the core mission of the main engine of our economic prosperity - the corporation. Fixed claimants can and should find their protection exclusively in their contracts with the corporation. End of story.
This is the second of a two-part story. Read part I, "The Peoples corporate law: unsafe at any speed".
