Shareholder votes are not the backbone of modern capitalism

Some of the lessons that we've learned from the post-1979 move towards neoliberalism and markets have been wrong. Competition is good on the margins where it just happens, not when you have to shoehorn it in at great cost. High pay improves efficiency; it doesn't indicate higher moral worth or stem from greater desert. And shareholder capitalism doesn't require close votes over every executive pay packet to work.

Consider shareholders' impotent rejection of BP boss Bob Dudley's £14m pay packet, which came as around a quarter was cut off the oil behemoth's market capitalisation. Now, it's perfectly possible that the board does not need to pay Dudley so much to retain his talents, or that they could do better without him at the helm, as the majority of shareholders appear to believe. It's also possible that the board is right, and relative to very difficult conditions, Dudley did well—with someone else they might have lost more money and had yet more shaved off their stock price.

But the real question is this: should BP's shareholders vote be binding; should we force all firms to adhere to a corporate form where owning a right to a share of the returns of the firm also means a right to controlling important firm policies directly, as well as merely electing representatives to the board?

I don't think that anyone should have a purely principled perspective here. In principle, we can write any sort of investment contracts, structuring obligations in any sort of way. In practice, we adhere to a limited variety of standards, because for the most part people want to take on only a discrete number of specific risk-reward bundles. But equities are simply a financial security, like bonds. No one suggests bondholders should regularly get a say in a firm's management; no one suggests that firms shouldn't be able to issue equity which gives holders a binding say on pay; no one suggests investors should be required to buy into firms which give them no say. The question is merely should firms be allowed to issue a security structured in a specific way: you own the firm's returns but don't get a vote on every issue directly.

I say yes because there is a growing wealth of evidence that this corporate form was one of the reasons Western capitalism has been so successful. One recent test of the hypothesis comes from "The Shareholder Value of Empowered Boards" by Martijn Cremers and Simone M. Sepe. Previous studies of board power had tended to look cross-sectionally: do firms with staggered boards do better than firms without? But this question ignores the confounding factor that these firms might already be fundamentally different. So Cremers & Sepe look at decisions within firms and their effects—does giving boards more power make firms more or less successful, within a huge dataset of firms, 1978-2011. They find that "[more powerful] boards are associated with a statistically and economically significant increase in firm value". Other recent papers back this result up.

Their hypothesis for why staggering board elections—and hence making it more difficult to overturn director majorities—makes firms do better chimes closely with the examples of market misunderstandings above. Shareholder democracy, insofar as it is indeed useful, is useful because it monitors and polices director activity, in order to resolve the principal-agent problem—the divergence in interest between an employee and employer.

However, if shareholders can immediately boot out directors when their short-term performance underwhelms, directors have an incentive to focus on short-term investment projects and plans. Lower risk of removal ameliorates this problem and allows directors to commit—a market mechanism solving an apparent market failure. Other odd or surprising features of corporate capitalism often have similar explanations.

The real way that shareholders police boards is by taking their money out of the firm: this directly punishes directors, who usually hold large shares in the firms whose boards they sit on; and it redistributes capital away from badly-run firms and toward well-run firms. It's quick, efficient, clean, and doesn't even require any shares to actually change hands—share price moves do the job just as well. Voting works best with your feet. The lesson we should have learned from Thatcherism, neoliberalism and the drift towards markets is that markets just work when you let them exist, not that you need to try and make them exist everywhere.