Since Professors Adolf A. Berle and Gardiner C. Means’s classic book of 1932, the agency costs of corporate governance have played a central role in discussions about corporate law. Berle and Means observed that in the modern publicly held corporation, shareholders cannot realistically control managers, which means that managers can take a range of actions that transfer the corporation’s wealth to themselves rather than to the shareholders. In modern terms, corporations are beset with agency problems. Large portions of corporate law can be understood as an attempt to minimize agency costs.
The central problem is that the managers of the corporation exercise control over its activities and have inside information about which activities are profitable and which are not. Large corporations have thousands or millions of shareholders because shareholders seek to diversify their holdings and so avoid buying all or nearly all of a firm’s shares. But by the same token, shareholders lack information about the workings of a corporation and thus have trouble judging the managers’ decisions. As a result, managers can take actions that fail to maximize the value of the corporation and instead transfer value to the managers themselves.
Examples of such managerial opportunism are well known. At the extreme, managers can simply expropriate some of the firm’s assets. This is unusual in advanced countries, but managers can accomplish the same goal sub rosa by overpaying themselves, diverting corporate opportunities to independent entities that they control, overinvesting in perquisites like fancy office suites, building empires so as to enhance their sense of importance, and so on. Some commentators have blamed the financial crisis of 2007–2008 on poor corporate governance at major financial institutions.
There are two direct mechanisms for controlling managers. First, shareholders enjoy voting rights with respect to major actions like mergers, elections of members of the board of directors, amendments to corporate charters, and stock issuances. Second, the law provides remedies when managers engage in the worst forms of self-dealing, like appropriating assets. Managers are also, of course, indirectly constrained by other factors, such as product-market competition and the threat of takeover.
Our focus is on the voting system. The idea behind voting is that if shareholders can exercise the vote, they can block transactions that do not maximize shareholder value. But there is also an obvious problem with shareholder voting. A voter (or coalition of voters) with a majority of shares (and hence votes) can outvote the minority and so cause the corporation to make decisions that transfer value from minority to majority, including decisions that do not maximize firm value. Since investors can anticipate such majority opportunism, they will pay less for equity than they otherwise would.
We propose a superior form of corporate voting known as Quadratic Voting (QV), which is based on theoretical work by Weyl. Under QV, shareholders do not obtain voting rights along with their shares. Instead, everyone interested in a corporate outcome that is subject to a vote may buy as many votes as he wants for the purpose of casting them in that particular election. The price of the votes is a quadratic function of the number of votes purchased. For example, one can buy one vote for $1, two votes for $4, and three votes for $9. One can also buy fractions of votes, again for the square of the fraction. The proposal subject to the vote is approved if the number of votes in favor exceeds the number of votes against. The money collected from the voters is transferred to the corporate treasury, and thus ultimately distributed to the shareholders, except that large shareholders (with more than 1 percent of stock) would receive back only 1 percent of the money collected from the votes they personally buy. Any excess thus generated would be distributed pro rata by shares directly to the rest of the shareholders. The voting process is confidential, and collusive arrangements and side payments would be illegal and subject to enforcement under antitrust law.
Under reasonable conditions, QV guarantees an efficient outcome, which reduces agency costs by preventing managers from implementing major decisions that benefit them at the expense of the firm, and preventing large shareholders from directing the corporation to enrich themselves at the expense of minority shareholders. There are also a number of positive secondorder effects. QV increases the value of corporate votes, so that more will be held; and this further constrains managers and large shareholders, reducing agency costs. QV may improve the incentive of investors to gather information about firms and to vote. Finally, as we will discuss, QV may render unnecessary certain legal protections of shareholders, such as the appraisal remedy and poison pills, which scholars have long regarded as costly and imperfect. For all these reasons, QV should lower the cost of capital.