Voting in Company Law

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The University of Chicago

Voting in Corporate LawAuthor(s): Frank H. Easterbrook and Daniel R. FischelSource: Journal of Law and Economics, Vol. 26, No. 2, Corporations and Private Property: AConference Sponsored by the Hoover Institution (Jun., 1983), pp. 395-427Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/725110 .

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VOTING IN CORPORATE LAW*FRANK H. EASTERBROOK and DANIEL R. FISCHEL

University of Chicago Northwestern Universityand University of Chicago

I. INTRODUCTION: VOTING AND CORPORATEDEMOCRACY

ONE of the themes of The Modern Corporation and Private Property isthat managersuse the machineryof voting to seize control of corpora-tions. Managersname the slates of candidatesandcontroltheagentswhocastproxyballots. Shareholders reapathetic n the bestof timesbecauseit is so unlikelythat theirvotes would make a difference,but managers'dominationof the proxy machineryis the coup de grace. "The proxymachineryhas thusbecomeone of theprincipalnstrumentsnotby whicha stockholderexercises powerover management f theenterprise,butbywhich his power is separated rom him."'Hundredsof people, writingin what they take to be the Berle andMeans tradition,have arguedthat the machineryof votingmust be re-formed so that the firm's "owners" may reclaim"powerover manage-ment." Theycall formanagers o disclose fullytheirowninterestsandthestatus of the firm at the time of solicitation;for corporationsto giveshareholdersreeaccess to theproxymachinery o thatshareholdersmaymake theirown proposals;for corporateboardsto establishnominatingcommitteesof directorsunaffiliatedwithmanagement,andfor these com-mittees to controlaccess by both managersand shareholdersat largetothe election machinery.Otherproposalscall for shareholders o makemore decisions themselves, includingselection of the firm'saccountants,andfor legalrestrictionson the abilityof directorsto spendfirms'fundscampaigningor reelection.Implementation f these proposals,it is said,* The authors thank Douglas G. Baird, Sanjai Bhagat, Walter J. Blum, Dennis W. Carl-ton, Victor P. Goldberg, Sanford J. Grossman, Leo Herzel, Henry G. Manne, Bernard D.Meltzer, Merton H. Miller, and Richard A. Posner for helpful comments on earlier drafts.Adolf A. Berle & Gardiner C. Means, The Modern Corporation and Private Property129 (rev. ed. 1967). See also id. at 71-82, 129-31.

[Journal of Law & Economics, vol. XXVI (June 1983)]? 1983 by The University of Chicago. All rights reserved. 0022-2186/83/2602-0008$01.50395


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396 THE JOURNAL OF LAW AND ECONOMICSwill revive the shareholders' ontroland restoreto corporationshe"legitimacy"heylack whenmanagersrenotaccountable.2

Althoughmanyof theseproposals avebeenadoptednone formoranother, hareholderstill do notpaymuchattention o elections,savefor thosethatengender rganized roxycontests.Thereare ewerproxycontests than ever before.3Managers ontinue o dominate lections:theirslates of officersare routinely lected,theirauditors ndorsed.Shareholders'roposalsare routinelydefeated.Faced withthis over-whelminghowof apathy,manyof thosewhoinitially oughto curethediseasediagnosed y BerleandMeanshavea readyanswer: here s notyet enoughdisclosure, otenoughparticipation,ointerest hesharehold-ers. As the SECputit, "Whilecommentatorsaveassertedhatshare-holders o notwantgreater pportunities,hismaybebecauseherehavenot beenmeaningful aysforshareholderso participaten thepast."4If thediseasedoes notrespondo themedicine,heexplanationies notinflaws nthe medicament utininsufficientosage, nwantof time,inwantof "commitment"o thetreatment. hingswillgetbetter fwe stepuptheefforts o attain ealcorporate emocracy.Therearedissentingoices.Anumberf scholars avepointed utthatcorporationsre notparticipatoryemocracies governing"he share-holders utarebusiness ntitiesaffected ythemarketortheirproducts.Shareholdersreno more he"owners" f thefirmhanarebondholders,othercreditors, ndemployees includingmanagers) hodevotespecial-ized resources o theenterprise, et bondholdersndemployeesdo notvoteatall. Allof theseparticipantsntheenterpriseegotiateontracts,explicitly rimplicitly,with he otherparticipants,nd heyobtain otingrights nly o theextent hoserights rebeneficialo thewholeenterprise.Theargumentontinues: emocraticroceduresredesignednpart oelicit heviewsof thegoverned nd o limitpowerfultates.Shareholdersexpressviewsby buyingandselling hares;heyhavenoreason o ham-stringheir irmsorimposeothercosts thatmake he firmsesseffectivecompetitors. heyareunlikelyo knowbetter han hemanagersowtorun hefirms nd huscannot ithermakegooddecisions rrecognize ad

2 For example, SEC Staff Report on Corporate Accountability, Committee Print, SenateCommittee on Banking, 96th Cong., 2d Sess. (1980) ("SEC Report"); J. WillardHurst, TheLegitimacy of the Business Corporation in the Laws of the United States 1780-1970 (1970);Daniel M. Friedman, SEC Regulation of Corporate Proxies, 63 Harv. L. Rev. 796 (1950).3 Compare Peter Dodd & Jerold B. Warner, On Corporate Governance: A Study of ProxyContests, 11 J. Financial Econ.- (1983) (data on contests since 1962), with D. Austin,Proxy Contests and Corporate Reform (1965).4 SEC Report, supra note 2, at 68. There are other arguments, in a similar vein, by writerstoo numerous to list. Many are collected in the SEC Report.


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VOTING IN CORPORATELAW 397ones. The more shareholdersgovern,the morepoorlythe firmsdo in themarketplace.Shareholders' nterestsare protectednot by votingbut bythe market for stock (andthe managers'need to raise new capital),themarket or goods, and the market or managers'services. It would makelittle differenceif shareholders, ike bondholders,could not vote at all.Funds spent providing shareholderswith a more effective voice arewasted at best and harmfulbeyond theircosts if they hamperthe firms'effective pursuitof profits.On this view it is a puzzle that shareholdershave, or exercise, votes.Neither the regulatoryapproachto corporatedemocracynor the re-sponsethatvotingis unimportantorharmful) apturesmuch of the Berleand Meansargument.Berleand Meansthought heyhaddiagnosedafataldisease. They had no interestin palliativesof the sort the SEC has sinceadopted; they would have called them costly but pointless. Berle andMeansthoughtthat shareholders'powerlessnessis a necessaryresultofthe diffusion of ownership. No shareholderhas the rightincentives toparticipate n governance,because none could influence the outcome ofthe election. Moreover,the passive investorshaveneither he willingnessnor the abilityto manage.5Berle and Meansprescribednot reformof theelection machinery,the better to have investors rulemanagers,but socialcontrolof corporations.Once shareholders ost control,theyalso lost anyrightto directthe firm or receive the profits.Society wouldgrantinves-tors a return "sufficient" to leave them "satisfied"; managerswouldbecome a "neutraltechnocracy";and "public policy rather hanprivatecupidity"wouldmakeimportant orporatedecisions anddecree what todo with the profits.6Neither Berle and Means nor the hundreds of later commentators-withthe important xceptionof HenryManne'-have askedwhy the law

5 Berle & Means, supra note 1, at 76-82, 129-31. See also Edward S. Herman, CorporateControl, Corporate Power 152-53, 265-29, 278-83 (1981) (the author of this self-consciousrepetition of the Berle & Means study dismisses voting as wasteful or, at best, an excuse formore disclosure or social pressure on corporations to change their exclusive devotion toprofits); Russell B. Stevenson, Jr., Corporations and Information (1980) (similar conclu-sion).6 Berle & Means, supra note 1, at 301, 312, 313. See also Abram Chayes, The ModernCorporation and the Rule of Law, in The Corporation in Modern Society 25 (E. Mason ed.1959) (attacking the "corporate democracy" movement by using the original Berle & Meansarguments, and coming to Berle & Means's conclusion).7 Henry G. Manne, Some Theoretical Aspects of Share Voting, 64 Colum. L. Rev. 1427(1964); Henry G. Manne, Our Two Corporation Systems: Law and Economics, 53 Va. L.

Rev. 259, 273-75 (1967). Manne's work appears to be the only attempt to date to analyze theeconomics of the legal rules and prevailing practices concerning shareholders' voting.Manne argues that voting is a way to effect changes of corporate control with less than amajority of the stock, and thus at a lower cost than a tender offer entails. He is skeptical that


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398 THE JOURNAL OF LAW AND ECONOMICSand the practiceof corporatevotingare the way theyare. Presumablyhepractices and legal rules determiningwho votes, on what issues, afterwhat disclosure, serve some function. If investorsgain from additionalparticipation,one might expect legalrules or privatecontractsto reflectthat fact. If voting is useless, one might expect it to go away, again bycontract or by legal rule, as corporationsthat reduced the amountofvoting prospered relative to others. Yet it has not gone away. Largecorporationsconduct votes, often in additionto those requiredby law;the votingmachineryof public corporationspredatesandhas shapedthelegaldoctrines.And the rules of votingareremarkablyonsistentfirmtofirm,state to state.We examine the legal rules and contractualarrangementshat deter-mine who votes, on what issues, and using whatprocedures.We arguethat the states' legal rules generally provide investors with the sort ofvoting arrangementshey would finddesirable if contractscould be ar-rangedandenforcedat low cost. Votingis neitherpointlessnor,givenitspoint,a failure.Ourconclusionson federalrulesareotherwise,reflecting,perhaps,the power of competitionamongjurisdictionsto producelegaldoctrinesbeneficialto shareholders.The discussion proceeds as follows. Section II inquireswhy there isvotingby anyclass of investorsandwhy, givenvoting,only shareholders(ratherthan bondholders,other creditors,or employees)have the fran-chise. SectionIII examinesthe structureof the rules forvotingon corpo-rate offices. We look at the treatmentof vote buying,the prohibitiononirrevocableproxies, the regulationof votingtrusts, the disappearance fcumulative voting, the stock exchanges' ban on nonvoting commonstock, the shareholders'rightto removedirectors n mid-term,andsomerelatedsubjects. Section IV takes up questionsconcerning ssue voting.Why,for example, does state law requireshareholderso vote on certain"fundamental orporatechanges," and why do corporationsgo beyondtheir legal obligations in putting other questions, such as matters ofofficers' compensation, to the shareholders?In Section V we look atfederalregulationof the proxy machinery.Section VI is a conclusion.

II. WHY Do SHAREHOLDERSVOTE?"Whydo shareholdersvote?" is threequestionsin one. First,why doany investors have voting rights? Second, why do shareholdersalone

voting is useful elsewhere, such as in approving fundamental corporate changes, and he doesnot emphasize (as we do, below) the relation between the rules of voting, residual claims,and agency costs. Although our approach thus reflects some disagreement with Manne's,that should not disguise either the substantial debt we owe to his pioneering work or thesubstantial degree of congruence in the analysis.


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VOTINGIN CORPORATELAW 399have voting rights?Third, why do shareholdersexercise their votingrights?We examine these questionsin this part.8

A. An Overview of the Rules and PracticesThe statutes of most states allow firmsto establishalmostany votingpracticestheyplease. Forexample,Delawarepermits irms o give sharesany numberof votes (includingnone)andto give votes to bondholdersnaddition o (orinsteadof) shareholders.9The votes maycumulateor not,at the optionof the firm.(Cumulativevotingpermitsshareholders o castmultiplevotes for a singlecandidate,so that a candidatemaybe electedby less thana majorityof the shares.)10Thosewiththe powerto vote may

do so in person or by proxy. They may choose managersdirectly orthroughthe mediationof a board of directors." They may permitdirec-tors (or managers)to serve full terms or may oust them for any or noreasonin mid-term.12The necessaryquorummaybe set at less thanhalfof the votes, and the firmmay requiresupermajoritypprovalon selectedquestions.13Any of these rulesmaybe set or alteredat anytimeby thosewith power to vote. The situationis much the same in other states. Al-thoughdifferentstates create differentpresumptiverules (for example,votes are cumulativeunless providedotherwise), this does not detractfrom the status of the enactmentsas enablingstatutes.14There are, nonetheless, recognizable patterns in corporate choiceunder these states. Almost all shares have one vote, and only sharespossess votes. Preferred haresor, rarely,bondsmayacquirevotes whenthe firm s infinancialdifficulty.Cumulativevotingis almostunheardof inpublicly-heldcorporations,as is nonvotingstock or stock with seriously8 One caveat. Our concern, like that of Berle & Means, is with the large publicly heldcorporations, those with 500 or more shareholders. We are aware that most firms are not sobroadly held, and that the incentives of shareholders-indeed the functions of voting-insuch firms are different in degree if not in kind from those in larger firms. See Alfred E.Conrad, Corporations in Perspective 94-123, 318-66 (1976); Melvin Aron Eisenberg, TheStructure of the Corporation (1976). We omit these firms not because they are unimportantbut because the free-riding problems that make the understanding of voting such a challengedo not apply with the same force to closely held firms.9 8 Del. Code ??151(a), 221. Unless the articles of incorporation provide otherwise, onlyshareholders vote, and each share has one vote.1o 8 Del. Code ??102(b)(3), 214." 8 Del. Code ?? 102(b)(1), 109(b), 141(a) & (f), 228(a).12 8 Del. Code ? 141(k). The only exception concerns directors elected by a minority ofshares with cumulative voting. These directors may be fired only for good reasons or by amajority large enough to have prevented their election initially."38 Del. Code ? 216.14 See Model Bus. Corp. Act ?? 15, 26, 32, 33, 39. Summaries of voting provisions ofmany states may be found in William L. Cary & Melvin Aron Eisenberg, Corporations:Cases and Materials 208-364 (5th ed. 1980).


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400 THE JOURNAL OF LAW AND ECONOMICSlimitedvoting rights. Shareholdersdo not select managers; hey insteadselect boards of directors,which in turnchoose managers.There are nospecial elections between the scheduledyearly ones; directors are notrecalledfromoffice. Shareholdersvote by proxy,not in person,andelectthe slateof candidatesproposedby theincumbents.Thequorums halfofthe availablevotes, and issues aredecidedby a majorityof thevotes cast.Thereareexceptionsto all of these statements,of course, but the excep-tions are very infrequent.There are a numberof statutory imits on the abilityof firmsto createthe voting structuresthey prefer.For example, although nvestorsmaysell their votes by sellingthe instruments o whichthe votes areattached,they may not sell the vote independentof the instrument.15tatutescon-trol evasion of the no-sale rule by limitingthe abilityof shareholders ogrant rrevocableproxies.A proxy-that is, the voter'sgrantof authorityto someone else to cast his votes-is revocable by the grantof a newproxy to someone else; even a proxy purporting o be irrevocable isbindingonly if coupledwithan "interest" n the stock, such as a pledgetosecure a loan.16The voting trust-a formof irrevocableproxy in whichseveral shareholdersconvey their shares and the attached votes to atrustee who must vote them as a bloc in accordancewith instructions-was unlawful at common law. When it was authorizedby statute, theauthorizationwas accompaniedby rules settingtime limits andrequiringperiodicrenewalsof the trustee'spowers.17 The statutoryvotingtrust isemployedonly in close corporations.Statutes n every staterequirevotes to be taken on certain "fundamen-tal" transactions,such as mergersandsales of substantially ll the assetsof the firm.18Statutes also require he board of directorsto submitotherproposalsto voters when, for example, a sufficientnumberof voters ordirectorsrequestsuch a submission.19 There are a few morerestrictions,but these are of substantially ess importance.

15 Some statutes ban sales of votes, for example, N.Y. Bus. Corp. Law ? 609(e), andother states by judicial decision, for example, Macht v. Merchants Mortgage & Credit Co.,22 Del. Ch. 74, 194 A. 19 (1937). Compare Schreiber v. Carney, 447 A.2d 17 (Del. Ch. 1982)(discussing the situations in which vote selling is prohibited).16 For example, 8 Del. Code ? 212.17 For example, 8 Del. Code ? 218 (ten years' duration).18 For example, 8 Del. Code ? 251(c) (requiringvote of a majority of all stock, not just of aquorum, to approve a merger).19 For example, 8 Del. Code ? 109(a) (although the board of directors may be given thepower to amend the by-laws, this "shall not divest the shareholders or members of thepower" to adopt, alter, or repeal by-laws); ? 211(b), (d) (meetings and special meetings to beheld as provided in by-laws); ? 228 (voters may act without meeting by obtaining signaturesof a majority). See also SEC v. Transamerica Corp., 163 F.2d 511 (3d Cir. 1947), cert.


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VOTING IN CORPORATELAW 401B. Voting as an Aspect of Contracting

We are now in a position to offer some explanations or the observedrules and practices. We start with an explanationof voting.Froman economic perspective,a corporationsjust a name for a greatweb of contractualarrangements.20 he manyfactors of productionas-semble under the corporateumbrella: nvestors contributecapital,man-agersentrepreneurialkills, engineerstheir distinctiveskills, and so on.Theavailabilityof the corporate orm of doingbusiness makes iteasier forpeople to achieve the benefits of the division of labor, with those whohave money but not managerial killsjoiningforces with those who havemanagerial killsbut not capital.The plentitudeof firmsmakes it possiblefor investors to diversifytheirportfolios,obtainingreturnsat lower totalrisk.In any undertakingof this nature it is impossibleto specify fully bycontract he duties of and limitationson each actor. It is also inefficient ospell thingsout; the savingsin contractingcosts availableby substitutingcontinuingrelationsfor detailedcontractsare amongthe benefits of thefirm.21Muchwill be left to discretion.The items left unspecifiedby con-tract-who is to do which tasks and work with whom, whatproductstomake,how to sell them,and so on-often willbe moreimportanthan theitems capableof specification.Legal rules serve several functionsin connectionwith this process ofcontracting.The code of corporatelaw is a standard orm contractforissues of corporatestructure.To the extent they anticipate he desiresofthe contractingparties,these off-the-rackprinciplesreduce the numberofitems to be negotiatedand the costs of negotiating hem.Onmanyoccasions the legalruleswill not be sufficientlydetailed.Thestandbyrule of corporatelaw, the fiduciaryprinciple, requiresactors tobehave in the way that they would have agreed to do by contract, ifdetailedcontracts could be reached and enforced at no cost.22 Yet thedenied, 332 U.S. 847 (1948) (construing Delaware law as requiring directors to submitshareholders' proposals to a vote at a meeting).20 Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, 3 J. Financial Econ. 305 (1976). See also ArmenAlchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62Am. Econ. Rev. 777 (1972); Eugene Fama, Agency Problems and the Theory of the Firm. 88J. Pol. Econ. 288 (1980).

21 See Clifford W. Smith & Jerold B. Warner, On Financial Contracting: An Analysis ofBond Covenants, 7 J. Financial Econ. 117 (1979), for a discussion of some of the costs ofwriting detailed contracts.22 See Frank H. Easterbrook & Daniel R. Fischel, Corporate Control Transactions, 91Yale L. J. 698 (1982), for an analysis of the nature and functions of fiduciary principles incorporate law.


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402 THE JOURNAL OF LAW AND ECONOMICSstructuralrules and the fiduciaryprincipletogethercover only the out-lines of the relationsamongcorporateactors. Somethingmust fill in thedetails.Voting serves that function. The rightto vote is the rightto make alldecisions not otherwise providedby contract-whether the contractisexpressor suppliedby legalrule. Therightto make thedecisionsincludesthe rightto delegatethem. Thus voters mayelect directorsandgive themdiscretionarypowers over thingsvoters otherwise could control.Becausevotingis expensive, theparticipantsnthe venturewillarrangeto conserve on its use. It could be employedfrom time to time to selectmanagersand set the groundrules for their performanceand not usedagainunless the managers' performancewere seriously inadequate.In-deed, the collective choice problemsthat attend voting in corporationswithlargenumbersof contractingpartiessuggestthatvotingwouldrarelyhave any functionexcept in extremis. When manyare entitledto vote,none of the voters expects his votes to decide the contest. Consequentlynone of the voters has the appropriatencentive at themargin o studythefirm'saffairs and vote intelligently.23If, for example, a given election could have a $1,000 effect on eachvoter, then each voter's optimal nvestment n information s zero if eachis sure that the election will come out the same way whether or not heparticipates.And even if a voterthinkshis vote will be dispositive,so thatan investmentup to $1,000is warranted, hatmaybe insufficient. f thereare 1,000 voters, the effect on them as a groupwill be $1 million. Aninvestmentin $1,000 worth of informationmay be quite insufficienttomake a $1milliondecision;worse still, 1,000peopleinvesting$1,000eachmay mean that all of them are acting on inadequate nformation,eventhougha single investmentin $10,000worthof knowledgemightbe ade-quate.Now votersare notfungible.Thosewho have moreshares,suchasinvestmentcompanies, pensiontrusts,and some insiders,do not face thecollective action problem to the same extent. Nonetheless, no share-holder, no matter how large his stake, has the right incentives at themarginunless that stake is 100percent.These collective actionproblemsmaybe overcomeby aggregatingheshares(andthe attachedvotes) throughacquisitions,such as mergersandtender offers. We expect voting to serve its principalrole in permittingthose who have aggregatedequity claims to exercise control. Short ofaggregating,however, some sort of collective information-generating

23See Anthony Downs, An Economic Theory of Democracy (1957); Mancur Olson, TheLogic of Collective Action (1965). See also Frank H. Easterbrook & Daniel R. Fischel, TheProper Role of a Target's Management in Responding to a Tender Offer, 94 Harv. L. Rev.1161, 1170-71 (1981), for an application to corporations.


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VOTING IN CORPORATE LAW 403agency is necessary. In a firm, the managersserve this function, andconsequently it is unlikely that voters would think themselves able todecide issues for themselves with greater insightthan the managersdo.No wonder voters delegate extensively to managersand almost alwaysendorsetheir decisions. Butthisacquiescenceshouldnot obscurethefactthat managersexercise authoritydelegated by voters.

C. Voting as Part of Risk BearingVotingexists in corporationsbecause someonemust have the residualpower to act (or delegate)when contracts are not complete. But, on the

discussion so far, voting rightscouldbe held by shareholders,bondhold-ers, managers,or otheremployeesin any combination.Giventhe collec-tive choice problem,one might expect votingrightsto be heldby a smallgroupwith good access to information-the managers hemselves. Yetvoting rights are universallyheld by shareholders,to the exclusion ofbondholders,managers,and other employees. When a firm's founderstake the firmpublic, they always find it advantageous o sell claims thatincludevotes, and thus ultimatelythe rightto remove the insiders.Whydo the insiders sell such claims?Why do investorspay extrafor them?(Theymustpay something,or the insiders wouldnot expose themselvesto the risk of removal.)The reason, we believe, is that shareholdersare the residualclaimantsto the firm's ncome. Bondholdershave fixedclaims,andemployeesgen-erallynegotiatecompensationschedulesin advanceof performance.Thegainsandlosses fromabnormallygood or badperformancearethe lot ofthe shareholders,whose claims standlast in line.As the residualclaimants,the shareholdersare the groupwith the ap-propriateincentives (collective choice problemsto one side) to makediscretionarydecisions. The firmshould invest in new products,plants,etc., until the gains and costs are identicalat the margin.Yet all of theactors, except the shareholders, ack the appropriatencentives. Thosewithfixedclaims on the incomestreammayreceive onlya tinybenefit(inincreasedsecurity)fromthe undertaking f a newproject.Thesharehold-ers receive most of the marginalgains and incur most of the marginalcosts. Theythereforehavethe right ncentivesto exercisediscretion.Andalthoughthe collective choice problempreventsdispersedshareholdersfrommaking he decisionsday by day, managers'knowledge hattheyarebeingmonitoredby those who have the right incentives, and the furtherknowledge hat the claimscould be aggregatedandvotes exercisedat anytime, tends to cause managers o act in shareholders'nterest in ordertoadvancetheirown careersand to avoid beingousted.


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404 THE JOURNAL OF LAW AND ECONOMICSThis is not, of course, a completeexplanation.The interestsof share-holdersmayconflictwiththe interests of bondholders.Shareholders ave

an incentive to adopt various strategieswith the effect of transferringwealth frombondholders o shareholders,such as choosingriskyinvest-ment projects and withdrawingassets from the firm. Creditors seek tocontrol this conduct, almost always by exquisitelydetailedcontracts.24Creditors become residualclaimantswhen equity holders' conduct ex-poses them to unanticipatedrisk. Thus we expect to observe, and doobserve,creditorswhopossess rightsto approveespecially riskytransac-tions, such as substantial constructionprojects, mergers,and the like.Approvalrightsof this sort are routinelybuilt into bondindenturesandmajorbank loans, and the lending instrumentsalso contain conditionsthat define certain risk-creatingconditions as defaults and thus conferother approval powers on lenders. Nonetheless, because shareholdersusuallybear the risk at the margin, hey aremorelikelythanbondholdersto have the appropriate ncentives and thus are the more appropriateholders of discretionarypowers.The rightto vote (that is, the rightto exercise discretion) ollows theresidualclaim. Ownersof commonstock havethe voting rightmost of thetime. But when the firmundertakesprojectsthat alterits risk, exposingcreditors o losses, they too haveapprovalrights.Too, when thefirm s introuble and, for example, omits dividends to preferredstockholders,these stockholderscommonly acquirethe rightto cast controllingvotes.Whenthe firmis insolvent, the bondholdersand other creditorseventu-ally acquire control, through provisions in bond indenturesand othercreditagreementsor throughoperationof bankruptcyaws.Whenthe firm s indistress,the shareholders' esidualclaimgoes underwater, and they lose the appropriatencentives. Othergroups, such aspreferred tockholdersor creditors,will receive the benefits of newdeci-sions and projectsuntil their claims are satisfied;the shareholdersgetonlywhat is left over. There is littlereason for shareholders,or managersanswerable o shareholders, o invest the moneyandenergynecessarytomakeimprovementswhen someoneelse reapsthe gain.Thus sharehold-ers lose the controllingvotes when their sharesare underwater;managersbecome answerable to other investors. They may choose to leave themanagersin office, through"workout" agreements,but this does notobscurethe fact that the discretionarypower has passed. Because man-agerstryto enhance their ownreputations,we wouldexpectthem to be as

24 See Smith & Warner, supra note 21. See also Richard A. Posner, The Rights of Cred-itors of Affiliated Corporations, 43 U. Chi. L. Rev. 499 (1976), for a discussion of monitoringby creditors.


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VOTINGIN CORPORATELAW 405faithful n thepursuitof creditors' nterestsas theyonce were inpursuitofshareholders' nterests.

The fact that voting rightsflow to whichevergroupholds the residualclaim at any given time stronglysupportsour analysisof the functionofvoting rights.It also suggests why, ordinarily,only one groupholds vot-ing rightsat a giventime. Theinclusionof multiplegroups(sayemployeesin additionto shareholders)would be a source of agency costs. Peoplewho did not receive the marginalgains would be influencingcorporatediscretion, and the influence would not be expected to maximize thewealthof the participants s a group.Thusthejointparticipation f differ-ent classes of participants n voting is rarely seen unless compelledbylaw-as, for example, "codetermination" the participationof employ-ees) has been in Germanyand "good faithbargaining"with unions hasbeen in the United States.25Thereis anotherreasonwhy only one class of participantsn the ven-ture commonlyholds dispositive voting rightsat one time. The voters,and the directorsthey elect, must determineboth the objectives of thefirm and the generalmethods of achievingthem. It is well known, how-ever, that when voters hold dissimilarpreferencesit is not possible toaggregate heirpreferences nto a consistentsystemof choices.26 If a firmmakes inconsistent choices, it is likely to self-destruct.Consistency ispossible, however, when voters commonly hold the same rankingofchoices (or when the rankingsare at least singlepeaked).Thepreferencesof one class of participants relikelyto be similar f notidentical.This is trueof shareholders specially,forpeoplebuyandsell inthe marketso that the shareholdersof a given firmat a given time are areasonablyhomogeneousgroupwithrespectto theirdesires forthefirm.27So firms with single classes of voters are likely to be firmswith singleobjectives, and single-objectivefirms are likely to prosper relative toothers. This suggests not only why only one class holds the controllingvotes at a time but also why the law makes no effortto requirefirms to

25 See Michael Jensen & William Meckling, Rights and Production Functions: An Appli-cation to Labor-managed Firms and Codetermination, 52 J. Bus. 469 (1979).26 Kenneth J. Arrow, Social Choice and Collective Values (2d ed. 1963); Duncan Black,The Theory of Committees and Elections (1958).27 Merton Miller & Franco Modigliani, Dividend Policy, Growth, and the Valuation ofShares, 34 J. Bus. 411 (1961); Myron Scholes, The Market for Securities: Substitutionversus Price Pressure and the Effects of Information on Share Prices, 45 J. Bus. 179 (1972).See also Harry DeAngelo, Competition and Unanimity, 71 Am. Econ. Rev. 18(1981), for theformal conditions of shareholders' unanimity, and Easterbrook & Fischel, supra note 22, at711-15, 726-27, for an application to corporate law.


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406 THE JOURNAL OF LAW AND ECONOMICSadhereto any objectiveotherthanprofitmaximizationas constrainedbyparticularegal rules).28One final point on the relationbetween voting and residualclaims.Shareholdersdo not always have equal power. Sometimesstable coali-tions (a groupof inside shareholdersand some institutionalallies) mayhold effective control for long periods.This is beneficial,for reasons wehave explained,because it alleviates the collective action problem.It isnot troublesome if the gains from corporateaction are dividedpropor-tionallyamongall shareholders.Even when gainsare not proportionallydivided, the aggregationof "votingpower" is uninterestingf coalitionscanchange.So longas eachshare has anequalchanceof participatingn awinningcoalition,the gainsfrommonitoringwill be apportioned o as topreserveappropriatencentivesat the margin.

D. Does VotingMatter?Berle and Meansmightbe able to concede the argument o this pointand ask, So what? Their book asserted that shareholdershad lost anyauthoritynominallyconferredby voting.Untiltheendof his career,Berlemaintained hatvotingwas useless.29 Whethervotingserves thefunctionswe have assigned it is necessarilyan empiricalquestion. There are noconclusiveanswers, but severalconsiderationsare suggestive.One is simply the survival of voting. If it is not worth the costs ofrunning lections, firms hateliminatedvotingwould haveprosperedrela-tive to others. That has not happened,and one may inferthat voting isbeneficial.Second, voting facilitatestakeovers. A tenderoffer for stock enablesthe buyerto assumecontrol of the targetby exercisingthe votes attachedto the acquiredshares. Such acquisitionsare associatedwith substantialpricepremiums,andtactics thatmaketakeoversmoredifficultareassoci-ated with price reductions.30

28 See Easterbrook & Fischel, supra note 23, at 1070-71; Frank H. Easterbrook & DanielR. Fischel, Antitrust Suits by Targets of Tender Offers, 80 Mich. L. Rev. 1155, 1175-78(1982); David Engel, An Approach to Corporate Social Responsibility, 32 Stan. L. Rev. 1(1979); Wilbur G. Katz, Responsibility and the Modern Corporation, 3 J. Law & Econ. 75(1960).29 Adolf A. Berle, Power without Property (1959); Adolf A. Berle, Modem Functions ofthe Corporate System, 62 Colum. L. Rev. 433 (1962). See also Adolf A. Berle, Non-VotingStock and "Bankers' Control," 39 Harv. L. Rev. 673 (1926).30 Compare Michael Bradley, Interfirm Tender Offers and the Market for Corporate

Control, 53 J. Bus. 345 (1980), with Harry DeAngelo & Edward M. Rice, AntitakeoverCharter Amendments and Stockholder Wealth, 11 J. Financial Econ.- (1983), andLarry Y. Dann & Harry DeAngelo, Standstill Agreements, Privately Negotiated StockRepurchases, and the Market for Corporate Control, 11J. Financial Econ.- (1983). On


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VOTING IN CORPORATELAW 407Third,votingcontests produceprice increases-presumably reflectingreal increases in the value of the firm-whether or not they lead to

changes in control.3"The price increase takes place when the marketlearns of the contest, and it persistseven if the insurgentsare defeated.This sequence is explicable only if voting and the prospect of futuremonitoringproduces pressureon managers o act in the interest of inves-tors.Fourth,because the collective choice problem s the principal imitonthe abilityof the residual claimants o influencedecisionsby voting, onewould expect that if votes are valuable then a reduction n the costs ofcollective action-as, for example, by the assembly of a large bloc ofshares-would be associatedwith an increasein the priceof all shares.Berleand Means wouldpredict,incontrast,thattheassemblyof a blocofshares would enable "the control" to exploitotherinvestors. The avail-abledatasuggestthat bloc assemblyis associated withpriceincreasesforshares outside the bloc. Tender offers assemble the largest blocs andproducethe largestincreases, but smaller blocs produceprice increasestoo.32Fifth, in the rarecases in whichfirmshave outstandingssues of stockwith identicalrightsto shareintheprofitsbutsignificantlydifferentvotingrights,the stock with the strongervotingrights radesata premiumof 2-4percentrelativeto the otherseries of stock. Similarly, n proxycontests,the priceof all stockfalls on the recorddate,afterwhichstockgenerally ssold without the buyer acquiringa rightto vote in the impendingelec-tion.33Althoughthe explanationfor this premiumfor voting rights isunclear, it probably representsthe anticipated(and fully diluted)valueattributableo the opportunityof those withvotes to improvethe perfor-the consequences of managers' defense against takeovers, see Easterbrook & Fischel, supranote 23; Frank H. Easterbrook & Daniel R. Fischel, Auctions and Sunk Costs in TenderOffers, 35 Stan. L. Rev. 1 (1982). The role of voting in facilitating monitoring is particularlyimportant, because this may explain many of the effects discussed below. See Manne, SomeTheoretical Aspects of Share Voting, supra note 7.31 Dodd & Warner, supra note 3.32 Bradley, supra note 30, finds increases of some 30 percent in the price of shares notacquired by the bidders. Dann & DeAngelo, supra note 30, find that when blocs of 10percent or so are dissipated by being acquired by the firm, the price of other shares declinesby some 5 percent. Proxy contests usually involve the assembly of large blocs of stock,whether by the managers or the insurgents, and the finding of Dodd & Warner, supra note 3,that stock prices do not return to prior levels even after insurgents are defeated may reflectthe importance of the residual blocs of stock. See Scholes, supra note 26, for evidence thatstock prices increase as the size of the largest bloc holding increases.

33 Ronald C. Lease, John J. McConnell, & Wayne H. Mikkelson, The Market Value ofControl in Publicly-Traded Corporations, 11 J. Fin. Econ.--(1983); Dodd & Warner, supranote 3. See also Haim Levy, Economic Evaluation of Voting Power of Common Stock, 38 J.Finance 79 (1983) (voting premium averaging 45 percent in Israel).


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408 THE JOURNAL OF LAW AND ECONOMICSmance of the corporation. t is notpossibleto attribute hepremiumo theprivilegeof those with votes to "divert" profitsto themselves, becausesuch diversions accrue (if at all) to insiders,while publicinvestorswhocould not expect to get such diversionsare willingto pay the premium.Finally,thereis some evidence about theperformance f firms nwhichthere are no residual claimantsor in which the residualclaimantsdo notvote. Firms without shareholdersdo poorly comparedwith other firms,and firms whose structureprevents the formation of a control bloc ofshares also do relativelypoorly.34 Thus the evidence stronglysuggeststhat votes are importantdespite the collective action problem,and thevotingprocess enables firmsto operatemoreefficiently.It remains,how-ever, to understand he structureof the practicesandlegalrulesconcern-ing voting. We turn to that task in the following partsof this paper.

III. AN ANALYSIS OF STATE RULES CONCERNINGELECTIONSIn this partwe examine the rules of state law thatconstrainvotingforcorporateoffices. We analyze issue votingin Section IV and the federalrules in Section V.

A. The Presumption of One Share-One VoteThe most basic statutoryrule of votingis the same in every state. It isthis: All common shares vote, all votes have the same weight, and nootherparticipantn the venturevotes, unlessthere is someexpressagree-mentto the contrary.Such agreementsareexceedinglyrare.Although herearehundredsofdifferentvotingarrangements,uch as classifiedboards o whichdifferentshareselect to differentposts, andpreferred tockwithcontingentvotingrights,almost allpubliclytradedshares in substantial irmshaveone voteeach, and that vote may be cast for positions on an unclassifiedboard.Therehave been persistent arguments hat this is not "democratic"be-cause some people (those with more shares) have more votes thanothers .3Thepresumptivelyequalvotingrightattachedto sharesis, however,a

34 See, for example, Maureen O'Hara, Property Rights and the Financial Firm, 24 J. Law& Econ. 317 (1981) (mutual banks, in which voting power depends on deposits rather thantransferable shares, do poorly relative to banks with transferable shares); David G. Davies,The Efficiency of Public versus Private Firms: The Case of Australia's Two Airlines, 14 J.Law & Econ. 149 (1971) (firm with identifiable residual claimants prospers relative to firmwithout them). Note that we limit this comparison to firms operating for profit.35 For example, David Ratner, The Government of Business Corporations: CriticalReflections on the Rule of "One Share, One Vote," 56 Cornell L. Rev. 1 (1970). Ratner


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VOTING IN CORPORATE LAW 409logical consequence of the function of votingwe have discussedabove.Votingflows with the residual interest in the firm,and unless each ele-ment of the residualinterest carriesan equal voting right,therewill be aneedlessagencycost of management.Those withdisproportionate otingpower will not receive shares of the residualgains or losses from newendeavorsandarrangements ommensuratewith theircontrol;as a resultthey will not make optimaldecisions.This also explains why there is so little nonvoting stock and is ajustification or the New York StockExchange's policyof notlistingfirmswith nonvotingissues.36The greaterthe departure romequalweightingof votes amongresidualclaimants,the greaterthe (unnecessary)agencycosts. Nonvoting bonds and nonvoting employees are not troublesome,however, because neithergrouphas a residualclaim.It explains, too, why cumulativevoting has all but vanished amongpubliclytradedfirms and why most state statutes contain a presumptionagainst cumulative voting. Cumulative voting gives disproportionateweight to certain "minority" shares, and the lack of proportiononcemore creates an agency cost of management.It makes realignmentsofcontrol blocs very difficultby distributing form of holduppowerwidely;althoughevery share has the sameholduppotential,the aggregateholdupvalue exceeds the value of the firm and thus makes negotiationverydifficult.Cumulativevoting (or any other method of requiringa supermajorityconsent to certaincorporateactions)hasthe furtherpropertyof impedingchangesof controland thus supporting he positionof managersvis-a-visresidualclaimants. Cumulativevoting thus producesthe same costs asany otherstratagemby whichmanagersseek to insulatethemselves fromthe displeasure of shareholders.37 nstitutionalinvestors, which com-monlyvote withmanagement lmostwithoutthinking,havebegunto votesystematicallyagainst any proposed alterationsof the equal-weightingand ordinary-majorityrinciplesof corporatevoting. The brief flurryofbelieves that equal weighting of shares gives excessive power to the holders of blocs, whichis especially bad when it leads to takeovers by conglomerates. He also argues that equalweighting violates the Constitution, an argument that is untenable in light of later develop-ments. For example, Ball v. James, 451 U.S. 355 (1981) (local electricity district may adopt arule under which landowners vote by acreage).

36 New York Stock Exchange, Inc., Company Manual ? A15, at A-280 (policy of notlisting the shares of a corporation that has nonvoting common stock outstanding). See alsoLease, McConnell, & Mikkelson, supra note 33 (finding only thirty issues of nonvoting orunequally weighted voting common stock traded on any exchange or over the counter at anytime between 1940 and 1978).37 See Dann & DeAngelo, supra note 30; Easterbrook & Fischel, supra note 23.


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410 THE JOURNAL OF LAW AND ECONOMICSshark-repellent harteramendments,which commonlycontainedsomesupermajority otingrules, has accordinglyabated.

Becausecumulativevoting permitsrepresentation f "minority" nter-ests in the firm'sgovernance,moreover, t increasesthe chance thattherewill be multipeakedpreferencesamongthe membersof the board. Thuscumulativevotingandotherminorityrepresentation chemes expose thefirm to an uncompensatedrisk of makinginconsistentor illogical de-cisions.Finally, the same considerations underliethe statutorylimits on theestablishmentand durationof votingtrusts, and the fact that in practicesuch trusts are used only in closely heldfirms.Votingtrustsaredesignedto inhibit ransfersof control. The separationof control fromthe residualinterest introducesa substantial,and in publicfirmsunnecessary,agencycost.B. The Prohibition of Vote Buying

It is not possible to separatethe voting rightfrom the equity interest.Someone who wantsto buya vote mustbuythe stock too. Therestrictionon irrevocableproxies, which are possible only when coupled with apledgeof the stock, also ensures thatvotes go with the equity interest.These rulesare, at firstglance,curious imits on the abilityof investorsto make their own arrangements.Yet they are understandable n muchthe same basis as the equal-weighting ule. Attachingthe vote firmlytothe residualequity interest ensuresthat an unnecessaryagency cost willnot come intobeing. Separationof shares from votes introducesa dispro-portionbetweenexpenditureand reward.For example,if the ownerof 20 percentof the residualclaimsacquiresall of the votes, his incentiveto take steps to improvethe firm(orjust tomakediscretionarydecisions)is only one-fifthof the value of those deci-

sions. The holder of the votes will invest too little. Andhe will also havean incentive to consume excessive leisure andperquisitesand to engagein othernon-profit-maximizingehaviorbecause muchof the cost wouldbe borne by the other residual claimants.38The risk of such shirkingwould reduce the value of investmentsin general, and the risk can beeliminatedby tying votes to shares.Onepossible response is thatthe agencycosts created would be elimi-38 We therefore disagree with Clark's argument that vote buying should be permitted, ifthe purchaser has a substantial equity interest and hopes to profit solely by appreciation inthe value if that interest. Robert Charles Clark, Vote Buying and Corporate Law, 29 CaseWest. L. Rev. 776 (1979). Clark does not discuss the agency-cost problems associated withsuch vote buying, and he does not try to explain why vote buying is universally condemned.


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VOTING IN CORPORATELAW 411nated f the owner of 20percentof theresidualclaims couldobtainreturnsdisproportionateo his equity interest. So long as there is a market invotes thatparallelsthe market n shares,competitionamongvote-buyerscould be sufficient to compensateequity investors for the value of thedilutionof their interests.This is intriguingbut, we think, unsatisfactory.Transactions n voteswouldpresentdifficultproblemsof valuationandcreateothercosts with-out conferringany apparentbenefit over transactions in votes tied toshares.39Moreover, the collective choice problemwould exert a stronginfluence over the marketprice of votes. Because no voter expects toinfluence he outcome of theelection,he would sell thevote (whichto himis unimportant)or less than the expected dilution of his equity interest.He would reasonthatif he did not sell, otherswould;he would then loseon the equity side but get nothingfor the vote. Thus any nonzeropricewouldpersuadehim to sell.40Competitionamongthose biddingfor votes mightdrive the price up,but not ordinarilyall the way to the value of the expected equitydilution.Eachpersonbidding or votes would be concernedthathe wouldend upwithless thana majority,and unless he obtaineda majorityhe wouldhavenothingat all. Thus he would offer less thanthe prospectivevalue of theequitydilution.41One cannot exclude the possibilitythat competitionamong buyers ofvotes would fully compensate the sellers. In that event, however, thebidderswouldsee no differencebetweenbuyingvotes andbuyingshares,which, after the votes had been cast, could be held or resold to theirformer owners. The only time buying the votes without the shares isadvantageous s when the buyeris planning o dilute the interests of theother equity owners. As we have argued elsewhere, investors wouldagreeto prohibitsuchdilutions n order to ensurethat all controlchangesare value increasing.42Thusthe legalrulestyingvotes to sharesincreasethe efficiency of corporateorganization.

39 In vote-selling games there is no core solution when gains are not equally apportioned,and there may be no core solution even when they are equally apportioned. See Lester G.Telser, Voting and Paying for Public Goods: An Application of the Theory of the Core, 27 J.Econ. Theory 376 (1982), for a related discussion.4 See also Easterbrook & Fischel, supra note 22, at 722-23 (similar analysis of agents'sale of offices).41 This concern obviously does not apply to one who buys shares the day before theelection, votes them, and sells the day after the election-and so "buys" votes in commonparlance. Such a person bears the gains or losses attributable to the election, and his conductis not unlawful in any state as vote buying.42 Id. at 703-15.


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412 THE JOURNAL OF LAW AND ECONOMICSC. The Absence of Tenure of Office

Although members of boards of directors typically are elected forspecificterms,they do nothave tenureof office. Votersmaycallelectionson short notice andoust the directorsfor any reason or none. Delaware,which writers in the Berle and Means traditionsay has won a "race forthe bottom"inadoptingpromanagementules,has theleastsecure tenureof all.43These rules denyingtenure to the boardput the voters firmlyin con-trol-should they choose to exercise it-at any timeandensure that theresidualclaimantshave the finalsay. Managersmaybe givena quickbootif agencycosts becomeunacceptable.It is true that inpubliccorporationsdirectorsarerarelyevicted in mid-term,but the possibilityof oustermaybe sufficientto ensure that directorsact as faithfulagentsof the residualclaimants.The abilityto changedirectorsat once wouldbe most impor-tant incontestedtakeovers,in whicha bidder hathadacquireda majorityof the stock wanted to install its own team.It is interestingto comparethe politicalsystem's treatmentof tenure.Most elected officeholdershave tenure for definedperiods. Even statesthat allow recall of officeholders n theorydo not recallthemin practice.Whydo politicalofficeholdershave more secure(ifmorelimited) enure?Onepossibleexplanation s thatmanagersdo not needtenureto motivatethemto act in investors'interests. Because the consequencesof theiractsarereflected n stockpricesandintheir own futuresalaries,they strive tomaximize the firms'discountedfuture returnseven if they have insecuretenure. There is no similarmonitoringand rewardsystem for politicalofficeholders,who therefore end to discountthe futuremoresteeplythantheir constituents. Tenure of office may be a partialantidote to this dis-counting problem.

D. The Common Law Rules for the Conduct of ElectionsUnlike federal law, which we discuss in Section V, state law usuallyimposes no restrictionson the conduct of elections apartfromrequiring43 See note 12, supra, and, for example, Campbell v. Loew's, Inc., 36 Del. Ch. 563, 134A.2d 852 (1957). Compare Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (Del. 1971)(board may not change the date of meeting so as to disadvantage the opposition). Provisionsin by-laws purporting to furnish tenure of office through supermajority vote requirements forouster sometimes are sustained, but they are of questionable effectiveness in many states.See Texas Partners v. Conrock Co., 685 F.2d 1116 (9th Cir. 1982) (Delaware law); RonaldJ.Gilson, The Case against Shark Repellent Amendments: Structural Limitations on theEnabling Concept, 34 Stan. L. Rev. 775 (1982). See also Eisenberg, supra note 8, at 66-68(arguing against provisions that impede transfer of control at voters' behest).


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414 THE JOURNAL OF LAW AND ECONOMICSinsurgentsprevail,46t could be arguedthat the firmshouldpick up theexpenses of those who seek election to at least the same extent as it picksup the incumbents'expenses.Thereis nonetheless a substantialproblemwith allowingchallengesatthe firm'sexpense. The firm'soffer to pay for the contestmaybecomeanattractivenuisance. There are always publicityseekers willingto standfor office on someone else's money. An offer to pay for the contest isworthwhile only if, in its absence, significantnumbers of otherwise-beneficialcontestswillbe stifled,and even thenonlyif there is agoodwayto distinguishplausiblechallengers romfrivolousones.47We may put the difficultyof weedingout frivolous candidatesto oneside. The implausibilityhat therewill be a seriouschallenge n anygivenelection is a sufficientexplanation or the lack of corporate inancingn allelections. Challengesare rarenot onlybecauseof the free-ridingproblembut also because of the operationof capitalmarkets.Thecorporationsabout which Berleand Meanswrote, and aboutwhichwe are concernedhere, have liquidpublicmarkets or theirstock. Manyparticipantsn such publicmarketsconstantlymonitor he firmsand ad-just theirportfolios.Those who thinkthe stock overpricedrelative to thefirm'sprospectssell out. At any giventime, a firm's stock willbe heldbyactive traderswithfairly homogeneousexpectationsabout the firm'sper-formance and passive investors with no expectationsat all (other thanthatthey will receive the price set by activetraders f they shouldsell). Ifholdingsare widely dispersed,this process of portfolioadjustment ouldlead to price adjustments hat are as effective in discipliningmanagersasthe (remote) likelihood of an election contest.48At the same time, thehomogeneityof expectations among investors would make it difficult,

46 See Dodd & Warner, supra note 3.47 The same problem occurs in the financing of elections for public office, and Congresshas addressed it by minimum-support and matching-contribution rules. See Buckley v.Valeo, 424 U.S. 1, 85-109 (1976).48 A lower price increases the likelihood of a takeover bid. It also diminishes the man-agers' wealth directly if, as is commonly true, a substantial portion of the managers' com-pensation is determined by price movements of the stock in the firms they direct. For studiesof this, see George J. Benston, Conglomerate Managerial Motivation towards Mergers: ATest of the Salary Maximization Hypothesis, draft 1981 (finding that most of managers'compensation comes from appreciation in stock prices); Wilbur G. Lewellen & BlaineHuntsman, Managerial Pay and Corporate Performance, 60 Am. Econ. Rev. 45 (1970)(reporting that managers' salary and bonuses are strongly tied to their firms' performance).See also Douglas W. Diamond & Robert E. Verrecchia, Optimal Managerial Contracts and

Equilibrium Security Prices, 37 J. Finance 275 (1982) (demonstration that movements insecurities prices should be included in optimal managerial contracts in publicly tradedfirms).


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VOTING IN CORPORATELAW 415perhaps mpossible,for a dissentinggroupto attractvotes. Thusit wouldbe a waste of corporatefunds to subsidizeelection challenges.

If, however,one personholdsa largepartof his wealth in the securitiesof a single firm,he would be much less likely to sell to the market f hethoughtthe price of the stock did not express the firm's value underoptimalmanagement.He would be more likely to fight,not switch. Al-most all proxy contests are waged by owners of substantialblocs or byformerofficeholders,49 andit is preciselysuchpeoplewhodo notneed thelure of automaticcompensationby the firm n order to make the contestworthwhile.IV. ISSUEVOTINGShareholders' otingis notlimited o the electionof directors.Statelawtypically requires that certain actions such as fundamentalcorporatechanges(i.e., mergers, liquidations,sales of assets) and charteramend-ments be approvedby a specified percentageof outstandingshares.50Moreover,a varietyof other actions are commonlysubmitted or share-holders' vote even though not requiredby statute. We consider theseaspects of issue votingbelow.51

A. Fundamental Corporate ChangesThe corporatelaw of every state provides that the business of thecorporation hall be managedby, or underthe directionof, the boardofdirectors.52 Shareholdersdo not typically vote on matters of ordinarybusinessjudgment. All statutes provide, however, that in situations of"extraordinary"action-fundamental corporate changes-the issuemust be submitted o shareholderswherea requisitepercentageof share-holdersmust approve.Althoughthis dichotomyis so well establishedincorporate aw thatit is neverquestionedoranalyzed,thejustifications orit are obscure.

49 Dodd & Warner, supra note 3. Ownership of a large bloc of shares is a logical prerequi-site to holding office because it is more difficult to reduce the value of the firm without alsoinjuring yourself in the process.50 8 Del. Code ? 242 (shareholders' approval required for amendments to the certificate ofincorporation); ? 251 (shareholders' approval required for mergers); ? 271 (shareholders'approval required for sales of assets); ? 275 (shareholders' approval required for dissolu-tions).51 We consider the shareholders' proposal rule, another type of issue voting, at text andnotes at notes 79-83 infra.52 For example, 8 Del. Code ? 141 (a).


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416 THE JOURNAL OF LAW AND ECONOMICSLike the legalrulesgoverningelections for office, reductionof agencycosts is the most probableexplanation or shareholders'votingon funda-

mentalcorporatechanges. Shareholders,as residualclaimants,have themost to lose (or to gain) as a result of fundamentalcorporate changes.Moreover, the possibility of large gain or loss in these transactionsbe-cause of their size is sufficient to overcome the collective action prob-lems, particularlyor institutional nvestors, that would make votingonordinarybusiness decisions meaningless.The vote on the mergercan beviewed as a mid-term election of directors, a vote of confidence on amajordecision. The statute requiresthe mid-termelection as a partialresponseto the collectiveactionproblems hatmake it difficult or share-holders to organizeto oust directorsbetween elections. Therightto voteis simplyan additionalmonitoringdevice possessed by the residualclaim-ants in the situationwhere it is most needed. Althoughshareholdersap-prove almostall mergers,this maybe attributable o advance consentbyinstitutionalnvestors, consent that wouldnot be necessaryif therewereno rightto vote.There is a counterargument.Shareholders,the argumentruns, aremerelypassive financial nvestorswho lackthe expertiseandincentivetobecome involvedin makingbusiness decisions. That fundamental orpo-rate changes are majorbusiness decisions is all the more reason whyuninformed hareholderspreferto delegatethese decisions to managers.Moreover,empiricalstudiesof mergersand otheracquisitionshave con-cluded, in the main, that takeovershave resultedin positive sharepriceperformance, uggesting hatrealgainshave beenprovided.53Thus thereis little need for an additional andcostly) monitoringdevice that share-holders are ill equippedto providein any event.Thecompetingargumentsareimpossibleto resolve on ana prioribasis.Perhapsall that can be said is thatthe common law rulerequiring hare-holders'approvalof fundamental orporatechangeshas enduredfor thepast centuryacross alljurisdictions.It is unlikelythatthis patternwouldbe observed if the rule did not produce gains. At the very least, thedurabilityand uniformacceptanceof the rule creates a presumptionofefficiencythat has not been overcome by any contraryevidence.B. CharterAmendments

Theother areainwhich shareholders'approval s commonlyrequiredscharter amendments. Of particularinterest in this regard are shark-repellentamendmentsdesignedto deterpotentialbidders rommakinga53 For a summary of the evidence, see Michael C. Jensen & Richard S. Ruback, TheMarket for Corporate Control: The Scientific Evidence, 11 J. Financial Econ.- (1983).


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VOTINGIN CORPORATELAW 417tender offer.54 Because these amendments reduce the probability that thefirms' shareholders will be the beneficiaries of a tender offer at asignificant premium over market price, they reduce shareholders' wel-fare.55 If shareholders' voting serves as a monitoring device on self-interested behavior by management, shareholders should vote againstthese amendments.The evidence is consistent with this hypothesis. Many institutional in-vestors depart from their customary adherence to the Wall Street Rule(vote with management or sell your shares) and vote against shark-repellent amendments.56 This opposition, perhaps, explains the decreasein the number of these types of amendments being proposed.

C. Shareholders' Voting When It Is Not RequiredOur analysis thus far has focused on voting by shareholders that isrequired by law. But managers routinely submit a wide range of issues toshareholders including stock option plans, the selection of an independentauditor, and mergers where no vote is required. What explains this pat-tern?Managers submit issues for approval because legal rules encouragethem to do so. Under established common law rules, shareholders' ap-

proval of a transaction decreases the probability of a successful judicialattack. Transactions between a director or officer and a corporation willnot be void or voidable, despite the conflict of interest, if the transactionis approved by a vote of the shareholders." Similarly, a merger will morelikely survive a judicial challenge under the "entire fairness" test if it isapproved by a majority of the minority.5854 For a comprehensive discussion, see Gilson, supra note 43.55 One empirical study has found that companies adopting shark-repellent amendmentsexperience a decrease in returns, but the decrease was not statistically significant. D'Angelo& Rice, supra note 30. The absence of significant negative returns probably is attributableboth to the ineffectiveness of shark-repellent amendments and to the fact that they maysignal an impending bid. Gilson, supra note 43. See also Scott C. Linn & John J. McConnell,An Empirical Investigation of the Impact of "Antitakeover" Amendments on CommonStock Prices, 11 J. Financial Econ.- (1983) (monthly data show positive, but not statis-tically significant, returns to shark-repellent amendments).56 Gilson, supra note 43 at 826-27.57 8 Del. Code ? 144(a)(2).58 Weinberger v. UOP, Inc.,- A.2d- (Del. Supr. Feb. 1, 1983). Under Dela-ware law, a merger must be approved by a majority of the oustanding shares of each classentitled to vote. 8 Del. Code ? 251. In many mergers, such as parent-subsidiary mergers, thevote is a formality. The decisions, however, consider the percentage of the minority share-holders that vote in favor of the merger. If a majority of the minority approves, a challengerfaces almost insuperable hurdles.


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418 THE JOURNAL OF LAW AND ECONOMICSThe effect of these rules is unclear.Legal rulesencouragingmanagersto submit ssues to a vote wherethe need for monitorings high-such as

in situationsinvolvingself-interested ransactions-may increaseshare-holders'welfare. The collective action problem,however, suggests thatratificationwill typicallybe given as a matter of course. The risk thatwealth-reducingransactionswill be permittedbecause of shareholders'ratifications minimized,however, by the commonlaw rule that share-holders cannot ratify fraud59and the tendency of courts to scrutinizewhetherself-interested ransactionsare beneficial o thefirm.60Again,thesurvivorshipprinciple(althoughthe rules here are less well entrenchedand consistent than in the case of fundamentalcorporate changes) sug-gests that there is a net benefit of legal rules encouraging hareholders'approvalof certain transactions.

V. FEDERAL REGULATION OF THE PROXY MACHINERYOne of our themes is thatfirmshave incentivesto locate in states thatenable them to adopt voting proceduresthat maximize the welfare ofinvestors. The practiceof firms in allowingshareholders o vote on cer-tain types of issues, and to disclose certain types of informationwhenvotes are taken, is good evidence of whatconstitutes the optimalalloca-

tion of resourceson voting procedures.61Berle and Meansdidnot view the worldthisway. Themoderncorpora-tion, they believed, was characterizedby a separationof ownershipandcontrol whereby omnipotentmanagerscould, throughcontrol over theproxymachinery,perpetuate hemselvesin officeindefinitelywithnofearof discipline from impotent shareholders. Section 14 of the SecuritiesExchangeAct62was believed to rectifythisperceived mbalanceby guar-anteeingshareholdersa meaningfulrightto have a voice in the manage-mentof theirproperty.6359 For example, Kerbs v. California Eastern Airways, 33 Del. Ch. 474, 184 A.2d 602(1962); Continental Securities Co. v. Belmont, 206 N.Y. 7, 99 N.E. 138 (1912).60 Fliegler v. Lawrence, 361 A.2d 218 (Del. Supr. 1976).61 For arguments that the firm has strong incentives to disclose the optimal amount ofinformation, see Sanford J. Grossman & Oliver Hart, Disclosure Laws and Takeover Bids,35 J. Finance 323 (1980); Sanford J. Grossman, The Informational Role of Warranties andPrivate Disclosure about Product Quality, 24 J. Law & Econ. 461 (1981); Daniel R. Fischel,The Law and Economics of Dividend Policy, 67 Va. L. Rev. 699 (1981).62 48 Stat. 895, 15 U.S.C. ? 78n (1976).63 The legislative intent of Section 14 was clearly expressed in the House Report: "Man-agements of properties owned by the investing public should not be permitted to perpetuatethemselves by the misuse of corporate proxies. Insiders having little or no substantialinterest in the properties they manage have often retained their control without an adequate


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VOTING IN CORPORATELAW 419Theproxyrules have fourprincipalcomponents: 1)generaldisclosureprovisionsdesigned to keep shareholders nformed even if there is no

contestedelection;642)provisionsrequiringdisclosureby rivalgroups nthe event of a proxy fightto ensure that shareholderswill be adequatelyinformedand able to vote intelligently;653)a generalantifraudprovisionprohibitinghe use of false or misleading tatements n cases whereprox-ies are solicited;66 and (4) a provisionallowingshareholders,subjecttocertainexceptions, to communicatewith other shareholdersby placingaproposalin the proxy materials.67Theproxyrules thusdisplaceprivatearrangementswithrespecttoboththe issues on which shareholdersare entitledto vote and the amount ofdisclosurethat mustbe madewhen a vote is held. Thistype of regulationby fiat is not entitled to the same presumptionof efficiency as long-standingvoluntaryarrangements odifiedby commonlaw rules. The op-posite is true. Because federalregulationof votingis not the productof acompetitionbetween states to providerulesthatmaximizethe welfareofinvestors,butratherdisplacesthose rules,the presumptions that federalregulation s welfaredecreasing.At the very least, there is no presump-tion of betterment.In this partwe analyzesome of the salientfeatures ofthe federalregulatoryapparatus.

A. The BehavioralAssumptionsof the ProxyRulesThe criticalbehavioralassumptionsunderlyinghe proxyrulesarethatshareholdersdemand more information about corporate matters thanmanagersprovidevoluntarilyand desire to be more involved in settingcorporatepolicy than allowed under state law. A corollaryassumption sthatshareholders reeasilymisledand willvote contrary o their nterests(their "true" wishes) unless the type and accuracy of informationpro-vided to them is carefully regulated.These assumptionsare not supportedby any evidence. Indeed, bothcasual empiricismand economic theory contradict the behavioralas-sumptionsthat underliethe federalproxy rules. Shareholders' nvolve-

disclosure of their interest and without an adequate explanation of the management policiesthey intend to pursue. Insiders have at times solicited proxies without fairly informing thestockholders of the purposes for which the proxies are to be used and have used suchproxies to take from the stockholders for their own selfish advantage valuable propertyrights." H. R. Rep. No. 1383, 73d Cong., 2d Sess. 13-14 (1934).64 17 C.F.R. ? 240.14a-3, -4, -5 (1981).65 Id. at ? 240.14a-11.66 Id. at ? 240.14a-9.67 Id. at ? 240.14a-8.


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420 THE JOURNAL OF LAW AND ECONOMICSment in the voting process has not increasedwith the adoptionof theproxy rules. Managers still are rarely displaced by voters; managers'recommendations n fundamental orporatechanges,amendmentsof by-laws, or othermattersareroutinely ollowed;shareholders'proposalsdowell if they have 5 percentof the vote. In those raresituationswhere aproxy fight for control develops, the insurgent'schance for success islikely determinedby the amountof shares he owns ratherthan by theforce of his arguments.68Proponentsof the need forgreatershareholders' nvolvementthroughthe proxy machinerydo not so much dispute the fact of shareholders'apathyas arguethat this indifference s attributable o lack of a meaning-ful opportunity o participate.69 husif moreinformationwere disclosed,if shareholderswere given a more "meaningful"opportunity o partici-pate, the argument uns, theywould assume theirproperroleas decision-maker-owners of the corporation.The far more plausible explanationfor the disparity between therhetoric of shareholders'democracyand the conduct of shareholders,however, is that the behavioralassumptionsunderlyinghe proxy systemare unfounded. As we have emphasized,there is no reason why share-holders who supply capitalto the firmshouldhave any interest or exper-tise in managing he firm'saffairs.Because of the easy availabilityof theexit optionthrough he stock market,the rationalstrategy or dissatisfiedshareholders n most cases, given the collective action problem, is todisinvest rather than incur costs in attemptingto bring about changethroughthe votingprocess.70It is interestingto compare the regulationof proxy voting with theregulationof union elections in laborlaw. The National LaborRelationsBoard has longregulatedparties'statements n unionelections, actingonthe belief thatemployeesare attentive to electioncampaignsand that theexercise of their free choice is easily affectedby campaignpropaganda.Researchstronglysuggests, however, thatemployeesdo not pay careful

68 Bayless Manning, Review of J. A. Livingston, The American Stockholder, 67 YaleL. J. 1477, 1483 (1958).69 The staff of the Securities and Exchange Commission, for example, has recently ex-pressed its view that indifference toward voting is attributable to a lack of "meaningful waysfor shareholders to participate in the past," that shareholders' apathy is a "reflection offrustration with the powerlessness of the role of the shareholder/investor," and that share-holders would welcome "meaningful participation" if they believed that their votes or viewswould have any effect on corporate policy. SEC Report, supra note 2 at 66-68.70 The greater the availability of the sale or exit option, the less desirable is the voting orvoice option. See Albert O. Hirschman, Exit, Voice and Loyalty (1970). It is difficult toimagine a more effective exit option than the market in shares.


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VOTING IN CORPORATELAW 421attentionto election campaignsandare not easily misledby rhetoric.71fwords do not misleademployees-if, indeed,they do noteven pay atten-tionto campaigns hatstronglyaffect their futures-how much less is theconcernforsophisticated nvestorsin stocks, investors forwhombecauseof the exit option voting is muchless important hanfor the employees?This is not at odds with the observations n SectionII aboutthe role ofvotinginmonitoringmanagers.There s anoptimalamountof monitoring,which firms would facilitate in their own interest. As we pointed out,votingis used only for largeevents (mergersandthe like),whenthe gainsexceed the substantialcosts of informationandaggregation f blocs. Theexistence of these gains is no warrant or inferring,as the SEChas done,that if some voting is good, more disclosure and more voting must bebetter still. Because it is so easy to sell one's shares, and because man-agers must set attractive terms for new securities (includingterms forvoting)if they are to maximizetheirreturns,thereis no good reasonforbelievingthat the voting rules designedby the firmsthemselves will beinferiorto those the SEC can thinkup.

B. Implications of the Behavioral AssumptionsUnderlying the Proxy SystemMany specific legal rules and doctrines are based on the behavioralassumptionof the interestedandattentiveshareholder. n this section wediscuss some of these rules and doctrines and also analyze them undermore reasonableassumptionsof shareholders'behavior.Under the accepteddefinition,anallegedmisrepresentationrwithheldpiece of information s immaterial f thereis "a substantialikelihood hata reasonableshareholderwouldconsiderit importantn decidinghow tovote.",72 The difficultywith this definition s that it providesno guidanceon what the "reasonable shareholder"considers importantwhen vot-

ing.73One possibilitywould be not to regulatethe contentof speechand71 JuliusG. Getman,StephanB. Goldberg,& JeanneB. Herman,UnionRepresentationElections:LawandReality(1976).Although he Boardhasbecomemoreresponsive o thisview, see MidlandNational Life Ins. Co., 263 NLRB No. 24 (Aug.4, 1982),the researchitself has not escaped question. Compare he articlesquestioning he methodology n 28Stan.L. Rev. 1161-1207 1976)withthe authors'defense, StephenB. Goldberg,JuliusG.Getman,& JeanneM. Brett, Union RepresentationElections:Law andReality:The Au-thorsRespondto the Critics,79 Mich. L. Rev. 564(1981).72 TSC Industries,Inc. v. Northway,Inc., 426 U.S. 438, 449(1976).73 Fora discussionof theproblemsof definingmaterialitynconnectionwithinvestment,as opposedto voting,decisions,and a proposedsolution,see DanielR.Fischel,TheUse ofModernFinanceTheory n SecuritiesFraudCasesInvolvingActivelyTradedSecurities,38Bus. Law. 1 (1982).


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422 THE JOURNAL OF LAW AND ECONOMICSrely instead on the marketplaceof ideas and the incentives of partiestodisclose the optimalamountof information.Corporateelections wouldthen approachpoliticalelections, where the value of the vote is greatergiven the lesser availabilityof the exit option yet speech is unregulated.The Securities and Exchange Commission and the courts, however,have not followed this approachbut have gone to the oppositeextreme.Thus the SEC has long taken the position that informationregardingforeignpayments, environmentalcompliance,and backgrounddata onmanagementmust be disclosed even if there is no pretensethatthe infor-mation s relevantto assessing the riskor expectedreturnof a particularinvestment.74Therationaleof this approach s thatshareholders,n exer-cisingtheirrightof corporatesuffrage,are entitledto information egard-ing the qualityand integrityof management o they will be able to voteintelligently."Obviously,this rationale s convincingonly if one acceptsthe behavioralassumptionof the interestedand attentive shareholder.The influenceof this behavioralassumptionalso is evident in the regu-lation of elections. Alleged misrepresentations r nondisclosures nvolv-inginformationhatappeared o be marginally elevantat most havebeengroundsfor settingaside the results of elections, includingnoncontestedelections.76 The effect has been to increase costs with no apparentcorre-spondingbenefit. In proxy fightsfor corporatecontrol, the proxy rulesrequireparticipants o disclose voluminous nformationncludingany fu-ture plans if control is shifted.77Again, the effect is to increase costs,whichin turn decreasesthe incentiveof potential nsurgents o engageinproxyfightsin the firstplace. Because a decreasein the effectiveness ofproxyfightsmeans less monitoringandhigheragencycosts, shareholdersare the losers.78

74 For a discussion and critique of the policies of the SEC in this regard, see Roberta S.Karmel, Regulation by Prosecution, The Securities and Exchange Commission vs. Corpo-rate America 230-51 (1982).

75 It has been suggested that the standard for materiality of information in voting deci-sions is broader than the standard in investment decisions because of the need of sharehold-ers to decide whether directors "are qualified to exercise stewardship of the company."Maldonado v. Flynn, 597 F.2d 789 (2d Cir.), on remand, 477 F.Supp. 1007 (S.D.N.Y. 1979),on remand, 485 F.Supp. 274 (S.D.N.Y. 1980).76 See, for example, Weisberg v. Coastal States Gas Corp., 609 F.2d 650 (2d Cir. 1979)(nondisclosure of bribes held not immaterial in uncontested election of directors); Gladwinv. Medfield Corp., 540 F.2d 1266 (5th Cir. 1976) (contested election overturned for themaking of false statements); Rafal v. Geneen, Fed. Sec. L. Rep. (CCH) ? 93,505 (E.D. Pa1972) (proxies granted to vote for three directors declared void in uncontested electionbecause of failure to disclose existence of lawsuits alleging insider trading violations).77 17 C.F.R. ? 240.14a-11 (1981).78 See Dodd & Warner, supra note 3 (concluding that both successful and unsuccessfulproxy contests are associated with positive share price performance).


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VOTINGIN CORPORATELAW 423The behavioralassumptionsunderlyingfederal proxy regulationaremost clearlyevidentin the shareholders'proposalrule. Rule 14a-8of the

federalproxy rules79provides that a publiclyheld corporationmust in-clude a shareholder'sproposalin its proxy materialswithout cost to theshareholder unless the proposal fits within one of the exceptionsenumerated n the rule.soWhat could be more democratic hanallowingeach interestedandattentiveshareholder o submitproposalsto be care-fully consideredby otherinterestedand attentive shareholders?The reality, however, is that the shareholders'proposalrule is a pro-foundlyantidemocraticdevice. Because shareholdersare typically pas-sive investors, the vast majorityshow no interest in other shareholders'proposalswhich areroutinelydefeatedby huge margins.Yet the majoritymust subsidize the activities of the minoritywho are allowed to makeproposalswithoutincurring he costs.8'Supporters f therule,however,are unfazedby costs orlack of successof shareholders'proposals.They arguethat the rule is beneficialnever-theless because it has a "healthyindirectimpact"on corporatebehav-ior.82What this presumablymeans is that the proposal,because of thepublicitygeneratedor otherwise, causes the firmto abandon a profit-maximizing strategy in favor of one that some find more "moral" or"socially responsible."But this argument tandsthe rationale or share-holders'voting-and federalproxy regulation-on its head. If the pur-pose of the federal proxy rules is to enable shareholdersto influencecorporatepolicy, it is difficultto find merit in a device that forces themajorityof shareholders o subsidize conduct of a minoritythat is con-traryto theirpresumptivegoal of profitmaximization.83

C. Proposed Reforms of the Proxy SystemBecauseproponentsof federalregulation gnorethe economicrealities

of shareholders'voting,and insteadsteadfastlyassumethat shareholdersdemand more involvement in the corporatedecision-makingprocess,79 17 C.F.R. ? 240.14a-11 (1981).80 The principal exceptions allow management to exclude a shareholder's proposal if theproposal is not significantly related to the issuer's business or if it concerns the ordinarybusiness operations of the corporation.81 It is interesting to compare this subsidy under federal law with the situation under statelaw where candidates for election, who surely have a stronger claim, are not subsidized. Seetext and notes at notes 44-45 supra.82 Donald Schwartz & Elliot Weiss, An Assessment of the Shareholder Proposal RuleProposal, 65 Geo. L. J. 635 (1977); David Vogel, Lobbying the Corporation (1978).83 Daniel R. Fischel, The Corporate Governance Movement, 35 Vand. L. Rev. 1259(1982).


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424 THE JOURNAL OF LAW AND ECONOMICSthey also assume that the indifferenceto votingdemonstratedby share-holdersis attributable o defects in the regulatoryprocess.84 A varietyofreforms have been proposedincluding ncreaseddisclosure,greaterac-cess to the proxy machinery,and increased regulationof institutionalinvestors.We consider each of these reformsandconclude that all wouldreduce shareholders'welfare.1. Increased Disclosure. One explanation or the lack of sharehold-ers' involvement s that investorslack the informationnecessaryto voteintelligently.Thus it has been argued hat the firmbe required o disclosemore informationabout its activities and the backgroundand qualifica-tions of management.85

As we have emphasized,there is no evidence, and no reason to con-clude, that shareholdershave any interest in this information.Since dis-closure is costly, and these costs must be borne by the firms'existinginvestors, increasedmandatorydisclosure of this type makessharehold-ers worse off. Shareholders' welfare may be reduced in another, andperhapsmore fundamental,respect. Mandatorydisclosure of the kindcommonlyproposedmayhave theeffect, andperhaps heintendedeffect,of deterringprofit-maximizing ehavior.86 Requiringfirms to disclosetheir policy with respect to compliancewith the environmental aws,violationsof regulatory tatutes,orquestionable oreignordomesticpay-ments all mayaffect the willingnessof the firmto undertake he conductat issue. Due to a fearof litigation,adversepublicity,or regulatorynter-vention, managers may simply decide that the costs of disclosuremayexceed the expected benefits from the activity.2. Greater Access to the Proxy Machinery. Another common expla-nation for shareholders'apparent ack of interest in corporatedecisionmakingis that they lack the ability to participatemeaningfully n theelectoralprocess. Underthe currentsystem, the incumbentboardnomi-nates directorswho are thenroutinelyelected by shareholders.Thissys-tem of self-perpetuatingmanagements anathema o those who believethat shareholders should have the rightto control the nominationandelection process. To remedythis perceiveddefect, a numberof reforms84 The alternative explanation is that proponents of federal regulation fully understand theeconomics of shareholders' voting and are using the rhetoric of shareholders' democracy tofurther goals other than wealth maximization. For an argument to this effect, see Fischel,supra note 83. The shareholders' proposal rule and the proposed reforms discussed beloware entirely consistent with this theory.85 See, for example, Ralph C.Ferrara, Richard M. Starr, & MarkI. Steinberg, Disclosureof Information Bearing on Management Integrity and Competency, 76 Nw. U. L. Rev. 555(1981).86 Fischel, supra note 83.


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VOTING IN CORPORATELAW 425have been proposedranging romgrantingshareholdershe rightto havetheir nomineesfor directors ncluded n the proxymaterials87o a require-ment that all corporationshave nominatingcommittees composed en-tirelyof independentdirectorswho would select nomineesafterconsider-ation of proposalsby shareholders.8The only defect thatproponentsof greatershareholders'access to theproxymachineryhaveidentifiedwiththecurrentsystem, however,is thatit is inconsistent with the behavioralassumptionof the interestedandinformedshareholder.If, as we have demonstrated,this behavioralas-sumption s incorrect, there is no basis for concludingthat shareholdersshould have control over the nominationprocess. On the contrary, afundamentalpremise of the economics of shareholders'voting is thatshareholders,becauseof the collective actionproblem, ack the expertiseand incentive in most cases to identifyand evaluate differentpotentialcandidates for the purposeof decidinghow to vote.Moreover,adoptionof these proposedreformsmayimposesubstantialcosts. Apartfromincreasedadministrative osts generatedby complicat-ing the proxy machineryand creatinga new bureaucraticayer, agencycosts wouldincrease. Unless they have no effect whatsoever(otherthanincreasingadministrative osts), the proposedreforms ncreasetheabilityof small investors, or even those with no financialstake in the firm,toplace theirnominees on the boardat the expense of largeinvestors.Thisviolationof the one share-one vote principlewouldincreaseagencycostsforthe reasons thatwe have discussed. The result s lowersharepricestothe detrimentof all shareholders.3. Increased Involvement by Institutional Investors. The largestshareholdersof many corporationsare financial nstitutionsthat investandmanagefundsfor the benefitof smaller nvestors. These institutionstypically possess sole or sharedauthority or the votingof shares.In thiscapacity,institutional nvestorshave been criticizedfor investinginsuffi-cient resources in decidinghow to vote.89 The staff of the SEC, for ex-ample,has "urged"institutions o "discontinue hepracticeof categoriz-ingan uncontestedelection of directorsas a routinematterwarranting n

87 Eisenberg, supra note 8 at 113.88 The concept of nominating committees composed entirely of independent directors hasattracted widespread support. For example, The American Law Institute, Principles ofCorporate Governance and Structure: Restatement and Recommendations, Tent. Draft No.1 at 97-106 (proposing that publicly held corporations be required to have nominatingcommittees).89 See, for example, Staff Report, supra note 2, at 379-429; Myron P. Curzan & Mark L.Pelesh, Revitalizing Corporate Democracy: Control of Investment Managers' Voting onSocial Responsibility Proxy Issues, 93 Harv. L. Rev. 670 (1980).


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426 THE JOURNAL OF LAW AND ECONOMICSautomaticvote for the entire slate of nominees,bearing n mindthat moreexacting udgmentswithrespectto the elections ofdirectorsmayimprovecorporateaccountabilityand long-termprofitability."90To achieve thisobjective, proposalshave been made to requireinstitutionsto establishvotingcriteriaand disclose theirvotingpolicies to beneficiaries.91'Othershave gone furtherand suggestedthat institutionsbe required o pass thevote through o beneficiarieswho could then vote themselves.92Theimpressionone gets from this ratherdismal iteratures that institu-tionalinvestors are somehow disservingtheir beneficiariesby not takingtheirvotingresponsibilitiesmoreseriously.Butthis notion s implausible.Professionalmoney managers operate in a highly competitiveindustrywhere the liquidityof assets makesit relativelyeasy to assess managers'performanceand shift from one investment to another.Moneymanagerswho are unable to make sound decisions regardinghe costs of establish-ing more elaboratevoting proceduresin relation to the benefitof suchproceduressimplywould notbe able to attract nvestmentdollars. Institu-tional investors thus have every incentive to expendthe optionalamountof resourceson voting procedures.Theirperceivedunwillingnesso make"moreexacting judgments"is no doubt rationalbehaviorin lightof theeconomics of shareholders'voting discussed above. The problem s thebehavioralassumptionsof the regulatorsand reformers,not the votingpracticesof institutional nvestors.93Pass-throughvoting raises additionalproblems.The costs of locatin

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Voting in Company Law