Socially Minded Investors and Corporate Behavior

The primary focus of the contemporary study of corporate governance is minimizing agency costs. Standard models assume that the principal—a firm’s shareholders—all seek to maximize risk-adjusted returns and thus uniformly wish their agent—the firm’s managers—to maximize share value. In reality, many equity investors, at least if fully informed, would be willing to sacrifice a portion of their returns to advance one or more socially-oriented objectives, particularly given our worsening social and environmental problems and waning faith in government’s ability to cure them.

In a new paper, we apply the teachings of corporate governance and financial economics to answer two questions, one positive and one normative: (1) given existing law, are these willing-to-sacrifice equity investors actually affecting firm behavior; and (2) should there be legal reform that makes firms more sensitive to these investors’ preferences?

While there are certainly situations in which a firm’s change in behavior would both advance some social objective and increase its share value, we analyze the more challenging and more frequent circumstance in which advancing a social objective requires diminishing the firm’s profits and share value.  Our focus is on the dispersed ownership, publicly-traded for-profit corporation dominant in the United States, a subject that has been the subject of intense scholarly study, but almost always with the assumption the equity investors all want firms to seek share-value-maximization.

Under existing legal arrangements, a firm’s behavior is in the first instance determined by the firm’s managers, not its shareholders. Thus, if willing-to-sacrifice investors are to have any effect on this behavior, it will be through some indirect means.  One such indirect means by which these shareholders might influence corporate behavior is by electing directors pledged to pursue their preferred social ends. A second would be through the effect of their presence on the workings of the various elements making up the managers’ incentive structure. This incentive structure consists of both sticks (hostile takeovers, activist campaigns, block sales, and fiduciary suits) and carrots (share-price-based compensation and managerial share ownership). The third indirect means of influence is identity investing, which is when investors exclude from their portfolios the shares of issuers whose behavior they disapprove. To the extent that this behavior reduces the share prices of the disapproved firms relative to those of the approved ones, it can influence what activities firm managers have their firms engage in.

Answering the positive question of whether willing-to-sacrifice equity investors currently affect firm behavior proceeds in two stages. In the first stage, all investors, willing-to-sacrifice or not, compose their portfolios based on ordinary financial considerations unrelated to their views on the issuers’ social impact. Under this assumption, each firm’s shareholder base will be roughly representative of the overall economy’s equity investors in terms of shareholders willing to sacrifice for various social ends.

This setup allows a first cut at answering whether the presence of willing-to-sacrifice shareholders will, under current law, significantly affect the behavior of the typical firm through either of the first two indirect means: ordinary director elections and the managerial incentive structure.  We conclude that they will not: the firm will act no differently than if all its shareholders preferred share value maximization. As for ordinary director elections, shareholders are rationally apathetic. Thus, electing directors pledged to a particular set of policies requires interested individuals to expend large amounts of resources and political energy to inform and mobilize these shareholders. This is generally an insurmountable barrier for persons seeking to change a firm’s behavior in furtherance of some social end.   Moreover, candidates need to be judged by many other criteria as well, including, most importantly, their ability to manage the firm efficiently as a more general matter.  This means their stance on social issues can get lost in the noise.  Our conclusion is similar regarding the effect of willing-to-sacrifice shareholders on the workings of the managerial incentive structure’s sticks and carrots. We show that only in narrow circumstances will their presence lead to the firm making decisions differently from where all shareholders prefer share value maximization.

The second stage of the positive analysis recognizes that some investors – identity investors – confine their stock portfolios to firms whose behavior they approve.  Recognizing identity investing reinforces our first-cut conclusion regarding the first two channels. This is because the disapproved firm will have a smaller percentage of willing-to-sacrifice shareholders than otherwise and so, in general, their presence is even less likely to affect firm behavior through these channels.  On the other hand, theory shows that identity investing depresses the price of the excluded firms’ shares, which would potentially affect managerial decisions in the direction of avoiding disapproved activities. Empirical evidence, however, is mixed as to whether, at current levels, identity investing’s price impact is more than negligible and big enough to affect firm behavior.

Our normative analysis assesses whether the law should be reformed to make firms more sensitive to the preferences of the economy’s willing-to-sacrifice equity investors. This inquiry addresses the fundamental question of how members of society in their various capacities – citizens participating in the public political process, consumers, suppliers of labor and other factors of production, and investors – participate in the processes that shape corporate behavior. A portion of society’s members are equity investors, and some part of those have willing-to-sacrifice preferences. Should legal reform, in the form of changes to corporate, securities, or pension law, be undertaken in ways that would give the preferences of these particular members of society greater weight than they currently have?

Two very prominent economics scholars – Oliver Hart and Luigi Zingales – believe so, suggesting that firms should allow shareholders to propose and vote on binding resolutions mandating specific share-value-reducing corporate behaviors.  See Hart & Zingales (2017); Hart & Zingales (2022).   If such a proposal came before the shareholders in isolation, it will not risk getting lost in the noise the way it would if it were an additional issue at play in a general election for directors. As a result, some such proposals would likely pass, leading to socially beneficial changes in corporate behavior. Still, this may not happen often. Each firm whose behavior is changed would need its own particularized political system. As in the governmental political system, the process by which voters become informed and their votes mobilized would consume substantial resources and require considerable energy from public-spirited persons, which are of finite availability. Although various methods of delegating voting power might ameliorate these problems somewhat, they would likely remain significant. Moreover, to the extent that the reform proves successful at changing corporate behavior, the energy and resources needed to bring about these changes would otherwise likely have been devoted to reforming the governmental political system to better control corporate externalities and achieve greater equity in society.  This diversion of resources and energy would be unfortunate.  Resources channeled into the public sphere can be concentrated to affect the behaviors of a broad swath of firms, rather than being dispersed among piece-meal battles relating to hundreds or more individual, sometimes even competing, firms.

Additionally, for a binding shareholder vote to change firm behavior, managers must implement what the vote calls for. Without a general weakening of the managerial incentive structure’s current push to maximize share value, managers will drag their heels. Such a weakening, while helping to implement whatever binding resolutions are adopted, will, for the rest of the time, result in higher agency management costs: corporate behaviors that simply benefit managers at a cost to the larger economy.

A different reform – requiring more disclosure concerning the social impact of issuer behavior – is more promising, enough so to be at least worthy of serious further consideration and experimentation. These disclosures might lead to a substantial increase in identity investing, with the potential to change corporate behavior through the resulting price effects. Changing corporate behavior through identity investing avoids both the diversion of resources and political energy from the public sphere. It also avoids the increased agency costs of management that would be associated with changing corporate behavior through binding shareholder votes. It relies instead on information-cost and agency-cost economizing market mechanisms. Managers, who would continue to work within the existing incentive structure that encourages them to enhance share value, would seek to identify and implement changes in behavior that will increase share price by attracting identity investors. The difficult policy question, and one that selective experimentation might help answer, is whether the new disclosures, and accompanying changes in pension law and investment company law, would lead to changes in firm behavior socially valuable enough to justify their considerable costs.