1

THE POWER OF LIMITED SHAREHOLDER

LIABILITY:

______________________________

HOW SHAREHOLDER EMPOWERMENT

CONSOLIDATED OWNERSHIP

AND CONTROL

TO BOLSTER RISKY INVESTMENT

AUTHOR: MICHAEL LIS

MENTOR: ERDEMOGLU, E

2015-2016

2

Table of Contents

Introduction……………………………………………………………………………………...3

1. Chapter 1 – Limited Liability & the Corporate Form…………………………………... 5

I. 1.1 Limited Shareholder Liability……………………………………………………… 5

II. 1.2 Corporate Governance……………………………………………………………... 6

2. Chapter 2 – Shareholder Activism & the Consignment of Liability…………………… 8

I. 2.1 Shareholder Empowerment……………………………………………………….... 8

II. 2.2 Evolution of Shareholder Liability………………………………………………… 9

3. Chapter 3 – Breaking down the Barriers……………………………………………….12

I. 3.1 Deregulation and the Liberalization of the Market……………………………….. 12

II. 3.2 The Great Transfer of Power………………………………………………………13

4. Conclusion……………………………………………………………………………... 15

5. Bibliography…………………………………………………………………………… 17

3

_____________________Introduction____________________

Limited shareholder liability has not always been the standard practice. Prior to the paradigm

shift, the financial market protected itself from exploitation and unsound business practices by invoking

the use of double liability to maintain a system of checks and balances to prevent the financial system

from collapsing. Overtime, the doctrine of limited liability in US corporate law emerged to dominate the

scene and replaced the earlier 20th century doctrine of risk aversion.

Coupled with a newly emerging paradigm shift, engendering shareholder empowerment and

activism as a mechanism of executive regulatory oversight, specific trends began to emerge which

manifested as an encroaching of the division of ownership and control. Without a clear division of

“ownership” and “control”, shareholders began undertaking risky initiatives to increase short-term profits

while shielding themselves from accountability behind the doctrine of limited liability. This movement

was endorsed throughout the Regan administration which fueled deregulation and the restructuring of

financial and non-financial firms to promote share price maximization and facilitate in new forms of

corporate organization and financing.

This author argues that the doctrine of limited liability in US corporate law, coupled with the new

paradigm shift in shareholder empowerment blurred the lines of distinction separating ownership and

control, resulting in unmitigated risky investment. This dramatic shift was preceded by a series of events

following the Golden era of America’s corporate boom in the wake of WW2. Corporate practices and

legislative intervention sought to restructure the financial sector in an attempt to bolster new investment

schemes meant to “revolutionize” the market. However, the impetus of financial reform inadvertently had

the effect of redistributing power to shareholders and facilitated in undercutting the hegemony of the

“Imperial CEO”.

The aim of this article is to provide an analysis of the regulatory trends and corporate practices

which developed following the Great Depression and how the transition from double liability to limited

liability schemes in the financial sector resulted in shareholders having an almost unlimited latitude in

promoting corporate initiatives meant to accrue short-term wealth generation.

The primary question addressed by the author is to what extent has the development of limited

liability coupled with deregulation of the financial market, and the emergence of the “shareholder

4

movement” employed in corporate governance models, resulted in the promulgation of surreptitious

shareholder influence cultivating risky investment practices with impunity ascribed to the veil of limited

shareholder liability.

In order to answer this question, this article will provide a description of what is shareholder

limited liability and the purpose of its application within the law of corporations. This will be assessed in

light of the historical development of how unlimited liability and double liability schemes were replaced

by the doctrine of limited liability to facilitate in corporate growth. Thereafter, the introduction of

corporate governance mechanisms will be assessed in reference to shareholder empowerment and its

divergence from the Berle-Means 1932 paradigm of separation of ownership and control which resulted

in a system characterized by indirect shareholder participation in corporate management affairs.

The assessment of the shareholder value paradigm will also include a review of quasi financial

institutions, characterized by Financial Holding Companies, and how they provided an institutional

conduit for shareholders to exercise ownership and indirect control of executives through the use of strict

oversight mechanisms and performance standards. This explanation will elaborate on how the nexus

between limited shareholder liability, newly instituted corporate governance regimes and the emergence

of quasi-financial institutions gave shareholders the ability to practice banking in “corporate form” which

availed them to unlimited discretion to engage in risky investment practices while being protected by the

veil of limited liability.

The structure of this critical examination will be as follows: section 3 will address the definition

of limited shareholder liability and its purpose and commercial application; section 4 will address

corporate governance and the impact of its application within the commercial arena; section 5 will

address how the development of shareholder empowerment beginning in the late 20th century diverged

from the Berle-Means 1932 paradigm of separation of shareholder ownership and managerial control;

section 6 will address how shareholder liability evolved in financial firms and how these new trends

triggered shareholders to take larger risks; section 7 will address how the influences of quasi-financial

firms precipitated risky shareholder investment practices; and section 8 will provide a conclusion.

5

____________________Chapter One____________________

1. Limited Shareholder Liability

The purpose of limited liability is to shield shareholders from the debts of a corporation. The focal

concept expresses that persons (independent entities) are not personally liable for the obligations arising

out of the conduct of a business [corporation]1. According to sec. 6.22 of the Model Business Act “a

shareholder cannot be held personally liable for the acts or debts of the corporation. He may however

become personally liable by reasons of his own acts or conduct”2. This oration rests on premise of limited

liabilities two core aspects. Firstly, the association of capital and the partners of these associations

[corporations] are independent entities. Secondly, based on the principle of personalisation of debt, as

separate entities, each person is responsibly only for his own debt and is not affect personally from the

relationships between the corporation and its creditors3.

The application of this doctrine in corporate law has its roots in the Convention Finance Theory

according to which, the basic corporate law principle of limited liability is to insulate shareholders from

the downside risks of corporate activity by allowing some portion of the corporation’s total risk exposure

to be externalized to creditors while the remainder is internalized by the corporation as its own separate

legal entity4. Limited shareholder liability therefore operates as a buffer between the debt obligations of a

corporation whereby the liability of a shareholder is restricted to the nominal value of his shares5 –

precluding liability beyond that threshold6.

The purpose and function of limited shareholder liability constitute a two-prong interdependent

mechanism of utility. As will be discussed in more depth in sec. 6, this mechanism7 allows shareholders

to compensate risk aversion by shielding themselves from debt obligations arising from business related

1 Limited Liability (1991), Uni. Kan. L. R. 39(4) 2 Model Business Corporation Act 2002 (2nd edn) s. 6.22(b) 3 Wendy B.E. David & Serdar Hizir, Dance of Corporate Veils: Shareholder Liability in the United States of

American and in the Republic of Turkey [2008] Ankarabar REV 2008/2 4 Stephan M. Bainbridge, Corporate Governance after the Financial Crisis (1st edn, Oxford Uni. Press 2002) 174 5 William P. Hackney, “Shareholder Liability for Inadequate Capital” [1982] U. Pitt. L. Rev. 43(4) 837 6 This is not to be mistakenly understood that the apportioned nominal value of shares represents a percentage of

debt obligation which must be met by the shareholders but rather that his exposure is limited to the amount invested

denoted by the nominal value of the shares purchased. 7 Referring back to the two core aspects of limited liability

6

risk exposure. This in turns allows shareholders to capitalize on high-profile risky investments in order to

maximize corporate profit and increase corporate growth. This “yellow-brick road” approach is necessary

because as a firm’s residual claimants, shareholders are not entitled to returns on their investment until all

other claims on a corporation have been satisfied. All things being equal, shareholders therefore prefer

high return projects8. This entails choosing riskier projects. Based on this two-prong mechanism, it

becomes apparent how limited shareholder liability drives corporate industrialization – higher risk yields

higher reward without have to internalize associated costs.

2. Corporate Governance

As the 20th century drew to a close, shifting market conditions and financial deregulation cultivated a

corporate atmosphere where directors were granted unprecedented discretion in company management910.

Corporate executives had become privy to greater managerial latitude which could in turn be exercised in

a manner prejudicial to the interests of shareholders11. This asymmetrical relationship between corporate

executives and shareholders became a power struggle in increasingly need of oversight. Consequently, in

this corporate milieu, corporate governance provided the means by which to oversee and maintain checks

and balances on U.S. executives.

A willingness to engage in corporate governance began to proliferate following the rise of

shareholder activism in the late 1970’s through the late 80’s. This was engendered by increased lobbying

for the relaxation of rules that created obstacles to shareholder intervention in corporate affairs12. The

lobbying effort was deeply rooted in the Berle-Means paradigm of the separation of ownership and

control in the modern corporation. The foregoing regulated the relationship between the principal

(shareholders) and agent (managers) by means of interdependent oversight so one body could not act

autonomously in disregard of the others – similar to the trias politica 3-tier structure of government.

However, due to the propagation of deregulation in the financial sector during the 20th century,

instability in the business environment was induced due to a lack of governmental constraints. Managerial

8 Stephan M. Bainbridge, Corporate Governance after the Financial Crisis (1st edn, Oxford Uni. Press 2002) 174 9 Possible explanation as to how shifting market conditions and deregulation of the financial sector gave

Directors increased autonomy and greater managerial latitude? 10 Brian Cheffins, “The Corporate Governance Movement, Banks and the Financial Crisis (2014) (Uni. Camb L. S.

Res Paper 56/2013) 11 Bengt Holmstrom, Steven N, Kaplan, “The State of U.S. Corporate Governance: What’s Right and What’s Wong?

(2005) J. APP. CORP. FIN vol 15(3) 12 Ibid, supra note at 9

7

discretion was no longer tempered by any concrete regulatory framework. The Berle-Means paradigm

became effectively devoid of the instrumentation necessary to regulate newly founded managerial

autonomy. What followed suit was a dramatic increase in agency costs13. The need for a monitoring

mechanism became desideratum. Without regulatory constraints, managerial latitude in decision making

would intensify without adherence to any regulatory intermediary beyond a Corporation’s Bylaws and

Articles of Incorporation. Absent this mechanism, agency problems would occur where the principle

lacked the necessary power or information to monitor and control the agent14. Thus the need for corporate

governance mechanisms to “fill the void” emerged to keep executives in check. Subsequently, succeeding

measures manifested as a response to these higher agency costs deregulation had precipitated.

In the end, what sparked the final transitory step which revolutionized corporate governance

followed in the wake up Enron and WorldCom scandals. The government, in an attempt to overhaul the

corporate regulatory institution, enacted Sarbanes-Oxley Act (SOX) 2002. This act imposed new

governance related requirements on publicly traded companies15. This “corporate cultural change” was

oriented around tougher boards and increasingly active shareholders16. In the aftermath, the power of the

Corporate CEO was diminished and that of the shareholders was enhanced. What is important to point out

is that the SOX Act did not encumber financial firms to the same extent as nonfinancial firms.

Consequently, financial firms were indirectly granted considerable leeway in the execution of business

activities which operated on the periphery of “sound” business practices.

13 Jonathon R. Macey & Maureen O’Hara, “The Corporate Governance of Banks” (2003) ECO. P. REV 9(1) 14 Burkhart, M.D. Gromb, & F. Panunzi, “Large Shareholders, Monitoring and the Value of the Firm” (1997) Q. J.

ECO 112(3) 15 Sarbanes-Oxley Act (2002) Title III 16 Jonathon R. Macey & Maureen O’Hara, “The Corporate Governance of Banks” (2003) ECO. P. REV 9(1)

8

____________________Chapter Two____________________

1. Shareholder Empowerment

As shareholders gained momentum during the late 20th century as the overseers of managerial

conduct, the days of the Imperial CEO were all but a distant memory. The Berle-Means paradigm of

separation of ownership and control became somewhat of a relic of a system now characterized by the

notion of “breaking down barriers” and “bridging gaps” between a corporation’s principals and agent.

The premise of managerial hegemony had become replaced by managerial subservience. Shareholder

empowerment equipped shareholders with a new instrument of control – corporate incentive.

Under the new market for corporate control, poorly managed companies which suffered low

valuations on the stock market would attract entrepreneurs who would buy control of the company, fire

the underperformers and renovate the firm for quick profit17. In theory, this placed directors in a

disenfranchised position where they could no longer to “play it safe” and avail themselves to risk

aversion. This in turn ramped up shareholder control by allowing the principal to “incentivize” the agent

to engage in riskier investment practices to increase valuation on the stock market and prevent hostile

takeovers. From the mid 1980’s through the 1990’s Executives boards became strengthened, executive

pay was restructured to align pay more closely with performance and shareholders became increasingly

willing to influence managerial turnover18. This new pattern was evidenced by the dramatic increase in

executive dismissals occurring in the early 1990’s19 – forever changing the balance of power between

shareholders at big American firms and the corporate governance landscape.

The new Anglo-American system of corporate governance, now in full swing as of the late 1990’s,

endorsed the view that the exclusive focus of corporate governance should be to maximize shareholder

value20. This corporate philosophy became institutionalized in the later 1990’s where a mutual agreement

among corporate managers, directors and shareholders emerged that the corporation existed to created

17 Gerald Davis, “The Twilight of the Berle and Means Corporation” Shareholder Empowerment: A New Era in

Corporate Governance (Palgrave Macmillan US 2015) 18 Brian Cheffins, “The Corporate Governance Movement, Banks and the Financial Crisis (2014) (Uni. Camb L. S.

Res Paper 56/2013) 19 Davis, G.F., & Cobb, J.A. “Corporations and Economic Inequality around the World: The Paradox of Hierarchy”

RES ORGAN BEHAV 30 20 Jonathon R. Macey & Maureen O’Hara, “The Corporate Governance of Banks” (2003) ECO. P. REV 9(1)

9

shareholder value21. Share price maximization came to supersede all other considerations originally

enshrined in Berle-Means paradigm. This proposition has its basis in Gevurtz (2010) hypothesis that

“shareholders with only a short-term planning horizon will be favourably disposed towards excessively

risky behaviour”22. A prime example of this contemporary was of corporate thinking was evinced by the

Mortgage meltdown subprime scandal. Banks granted mortgages with the intent of holding them until

maturity. After the housing market had been securitized, banks no longer ran the risk of running a loss if

mortgage holders defaulted because the risk had been dissolved23. Subsequently banks became only

concerned with the short-term returns from the sale of loans. Essentially, according to Dowd (2009) “the

absence of deferred remuneration institutionalized short-termism and undermined the incentive to take

more responsible long-term views”24. In other words, large financial gains were privatized while losses

would be socialized meaning, shareholders would be indemnified by limited shareholder liability.

The underlying premise of the corporation as a social institution where the paramount interests of the

community would trump those of both shareholders and managers were replaced by new unicameral

forms of organization and financing. The barriers once dividing the dichotomy of ownership and control

began to be bridged by the concept of profit maximization which corporate managers inaugurated as their

new creed, becoming the new standard of measure of managerial performance. This new “shareholder

value” movement had appeared to have ostensibly been indoctrinated into the rubric of corporate

governance. What can be said is that the corporate governance mechanism envisioned by Berle and

Means became a disillusion characterized by a puppet and puppeteer relationship where the hypothetic

line separating control and ownership became the string controlling directors and ultimately their noose

when shareholder value was not maximized.

2. Evolution of Shareholder Liability

Prior to the great depression, the American government took significant measures in order to

safeguard the financial system against hazardous investment. Security measures were invoked under a

protectionist regulatory framework to impute liability to shareholders in order to prevent risky investment

21 Kenneth A. Carow, Gayle R. Erwin & John J. McConnell, “A Survey of U.S. Corporate Financing Innovations:

1970-1997 (1999) J. APP. CORP. FIN 5; Raghuram G. Rajan & Luigi Zingales, “Saving Capitalism from the

Capitalists” (2nd edn Princeton University Press 2004) 22 Franklin A. Gevurtz, “The Role of Corporate Law in Preventing a Financial Crisis: Reflections on In Re

CitiGroup Inc. Shareholders Derivative Litigation” (2010) GLOBAL. BUS. DEV. L. J. 23(1) 23 Marie-Laure Djelic & Joel Bothello, “Limited Liability and Moral Hazard Implications – An Alternative Reading

of the Financial Crisis” (2014) <http://www.maxpo.eu/downloads/djelic.pdf> accessed February 17, 2015 24 Dowd K., “Moral Hazard and the Financial Crisis” (2009) Cato Journal 29, 141-166

10

and unscrupulous business activities. Pursuant to such laws, bank shareholders were subject to double

liability schemes – liability for corporate obligations in an amount equal to the par value of their shares25.

This was provided for in the National Banking Act of 1863 whose purpose was to prevent banks from

engaging in excessively risky operations26. The logic was simple – by making shareholders liable to the

amount of the par value of their shares in addition to the amount invested in such shares, bank creditors

had something more than stock to fall back upon. By providing for liability to an amount equal to the

stock, in addition to the stock, you will have ample security to cover any potential losses27.

In the years to follow, a wave of bank failure occurred between 1929 and 1933 notwithstanding

double liability. Shareholders faced a lapse in financial capacity to covers the losses which accrued due to

the heavy strains imposed by the double liability system and the National Banking Act of 1863. Support

for the double liability quickly feigned as dissenters rhapsodized how innocent shareholders were

effectively bankrupted without having any management or control of the banks28. The transition for

limited liability became primed and developed on the basis of the “fairness” rationale whereby the

judiciary moved in favour of limited liability in order to protect innocent shareholders who did not

possess the capacity to influence management decisions29.

Following the dismantling of double liability systems after 1930, shareholders gained a new

advantageous position. Gevurtz (2010) points out that “the effectiveness of shareholder’s capital

investment in curbing shareholder’s appetite for excessive risk depends upon forcing shareholders to

internalize the societal costs of the financial institutions failure”30. The birth of the limited liability regime

was considerably bereft of internalizing mechanisms31 whose effect conversely incentivized shareholders

to take larger and more risky investments. The losses incurred would consequently be externalized to 3rd

parties rather than internalized by shareholders. This new inverse in liability was the commercial niche

capitalized on by quasi-financial firms. For example, the following which will be discussed in greater

depth in the forthcoming section, Financial Holding Companies (FHCs) utilized a form of “organization”

25 C.D. Howe Institute, “Shareholder Liability: A New (Old) Way of Thinking about Financial Regulation” (2014)

Commentary No. 401 <https://www.cdhowe.org/pdf/Commentary_401.pdf> accessed 11 Feb 2016 26 Jonathan R. Macey & Geoffrey P. Miller, “Double Liability of Bank Shareholders: History and Implications”

(1992) Wake Forest L. REV. 27, 36 27 CONG GLOBE, 37th Cong., 3d Sess. 824 (1863) 28 Perry L. Greenwood, “Banks: Liability of Stockholders of Holding Company on National Bank Stock held by

Company” (1944), 7 U. DET. L.J. 123 29 Hearings on H.R. 141 before the House Committee on Banking and Currency, 71st Cong., 2d Sess. 17 (1930) 30 Franklin A. Geuvurtz, “The Role of Corporate Law in Preventing a Financial Crisis: Reflections on In-Re

CitiGroup Inc. Shareholder Derivative Litigation (2010) GLOB BUS DEV L. J. 23(1) 31 The term internalized is meant to refer to “personal liability”

11

which circumvented dispersed ownership facilitating in enhanced (yet limited) direct shareholder’s

involvement, precipitating a more active role in the management of financial subsidiaries. The result was

that shareholders, protected by limited liability, could influence the direction of managerial performance

and pocket the benefits generated by their firms risky activities while the costs of those risky activities are

passed on to the government through bailouts32.

32 Peter Conti-Brown, “Elective Shareholder Liability” (2012) STAN. L. REV. 64, 409

12

___________________Chapter Three____________________

1. Deregulation and the Liberalization of the Market

With limited liability at the forefront of corporate policy, America’s financial stability was

burgeoning from the end of the 1970’s through the mid 80’s33. However, capital accumulation,

specifically in the banking sector, began to stagnate due to limitations imposed by regulatory statutes.

Corporations began to search for ways to increase profitability. A deviation beyond the standard

competence of commercial banks manifested as financial firms shifted away from the traditional methods

of banking and deferred into “extra-financial” activities which lacked strict regulatory ascendency.

Deregulation was at the forefront of liberating market – dispensing with restrictions which had

previously been imposed to control the ambit of financial activities within the sphere of banking. The

prudential measures once in place to govern banking practices had lost their cause and effect in the new

market34. In response to the macro economic conditions of the 20th century, deregulation became the fast

track to breaking down financial barriers and facilitating in the accelerated accumulation of wealth.

The deregulation phenomenon was preceded by the repealing of the Monetary Control Act of 1980

followed by the Modernization Act of 1999 allowing for increased diversification of financial activities

which could be undertaken by institutions35. In 1999, the Glass-Steagal Act, delineating the separation

between commercial and investment banks, was repealed – the result of which functioned as one of the

primary deregulating precursors for such quasi-financial institutions to take shape. In its place the

enactment of the Gramm-Leach Bliley Act (GLBA) finalized the dismantling of the barriers between

commercial and investment banking – permitting the creation of Financial Holding Companies36. Banks

were no longer cordoned off from the market forces and were given the freedom to engage in business

activities completely unrelated to banking37.

33 Ozgur Orhangazi, “Financial Deregulation and the 2007-08 US Financial Crisis” (2014) FESSUD Working Paper

Series No. 49 34 Banking regulation had traditionally sought to mitigate the social costs of banks underpricing financial risks by

adopting prudential measures such as deposit insurance and capital adequacy requirements. These were prudential

measures were largely absent in quasi-financial firms. Refer to Mark Fagan, “Shadow Banking: The Past, Present,

Future (2012) Rev. Banking & Fin. L, 31(2) 591 35 Ozgur Orhangazi, “Financial Deregulation and the 2007-08 US Financial Crisis” (2014) FESSUD Working Paper

Series No. 49 36 Jonathon R. Macey & Maureen O’Hara, “The Corporate Governance of Banks (2003) 12 INT REV. FIN 7, 27 37 Ibid p. 96

13

2. The Great Transfer of Power

The deliberate intention of deregulation was meant to provide senior executives of major financial

firms with the expanded managerial latitude to capitalize on the genesis of financial diversification. In

turn, corporate governance should have theoretically counteracted managerial discretion by means of

prudential internal countermeasures strengthening shareholder oversight. These countermeasures were

fundamentally flawed in their application because the structure of Financial Holding Companies did not

resemble the Berle-Means model of ownership divorced from control. In terms of FHC’s, banks became

organized in such a way that some of the largest U.S. banks like Citibank and Bank of America became

wholly owned subsidiaries of holding companies. These holding companies were not governed by the

two-tier structure of corporate governance whereby dispersed ownership facilitated in limited direct

shareholder’s involvement. FHC’s were structured in such a way that shareholders yielded executive

control of the subsidiary firm38. Moreover, at the subsidiary level, the proportion of board seats held by

outside directors of large banks allowed banks to substantially increase their use of incentive-oriented

executive compensation. Corporate governance became nothing more then a tool re-engineered by the

shareholder class to execute their own interests even at the expense of the firm’s value.

The confluence of these events culminated the what can be termed “the great transfer of power”. This

power shift hypothesis coincides with Useems proposition that institutional stockholders have become the

dominant center of power in U.S. business. This is the result of their continued increase in their holdings

over the last three decades and also the size of their holdings39, subsequently endowing them with the

ability to display their dissatisfaction with corporate policy by replacing executives with those whose

corporate policies align with their personal interests40. The wave of dismissals occurring in the 1990’s

reaffirmed the usurpation of control and the change in the balance of power between shareholders and

boards at big American firms41

38 Craig H. Furfane, “Banks as Monitors of Other Banks: Evidence from the Overnight Federal Funds Market”

(2001) J. BUS 74(1) 39 FHC’s such as JPMorgan Chase, Bank of American Corporation and CITIGROUP Inc. have holdings exceeding

two billion 40 Mark S. Mizruchi, “Berle and means Revisited: The Governance and power of Large U.S. Corporations (2004)

Theory and Society 41 “Thank You and Goodbye”, ECONOMIST, Oct. 28, 1999 <http://www.economist.com/node/254154> accessed

January 27 2016

14

In the end, the corporate governance overture of “supervision” came to be completely bereft of a

modicum of influence relative to FHC’s. This is because such institutions did not operate within the same

structure encapsulated in the Berle-Means paradigm. The capital structure of these firms or institution

rests on consolidation of dispersed ownership under the authority of a single parent company. The

dynamic underpinning the division of ownership and control becomes subsidized by a few dominant

shareholders who can employ the tactic of subsidiarization, or “ring-fencing”, to maintain a legal façade

of separation between parent and subsidiary while retaining the power of influence over their subsidiaries

boards of management42. Moreover, despite their ostensibly financial nature, their corporate function

differs from that of banks whereby their purpose is characterized as more industrial or “non-financial” by

nature. By this I mean, unlike banks whose integral role is the operation of the national economy, FHC’s

do not share this macro-economic function but rather operate relative to wealth maximization in the

micro-sector of the economy. By this very token, the increased liability of exposure for bank directors and

shareholders had been abated by externalizing risk onto society because the benefits to corporate

industrialization outweighed the risks to society43, even though FHC’s were far removed from the

principles of traditional banking characterized by the safety and soundness of the financial sector and the

protection of depositors44.

42 Anat R. Admati, Peter Conti-Brown & Paul Pfleiderer, “Liability Holding Companies” (2012) 59 UCLA L. REV.

852 43 Louise Gullifer & Jennifer Payne”, Corporate Finance Law: Principles and Policy (2nd edn Hart Publishing ltd.

2015) 44 Mark Fagan, “Shadow Banking: The Past, Present, Future” (2012) REV. Banking FIN. L. 31(2) 591

15

_____________________Conclusion_____________________

The premise underpinning doctrine of limited liability was meant to insulate shareholders from

the downside risks associated with commercial practice. By being shielded themselves from debt

obligations arising from business related risk exposure, shareholders possessed the means by which they

could undertake riskier investments in order to increase corporate growth. However, with limited liability

came an increased level of discretion among managerial executives. Shareholders became at risk where

their interests could be superseded by the newly broadened managerial latitude in decision making.

Combined with the deregulation of the financial market, there were no longer any external control

mechanisms which could effectively temper managerial discretion.

The need for corporate governance as an internal mechanism of oversight emerged as lobbying

efforts prompted the relaxation of rules that created obstacles to shareholder intervention in corporate

affairs. The traditional Berle-Means paradigm of separation of ownership and control no longer was

effective at managing the evolving relationship between shareholders, executives and the market forces

driving the economy. As corporate governance emerged as the countermeasure to assuage managerial

discretion in decision making, it also facilitated as an instrument utilized by shareholders to bridge the

division between ownership and control.

In the aftermath of the deregulation of the financial market and the Enron and WorldCom

scandals, a corporate cultural change ensued praising the need for tougher boards and increasingly active

shareholders. This became known as the era of shareholder activism. Shareholder empowerment

effectively turned the tide of managerial hegemony and ushered in the new doctrine of managerial

subservience. Their new weapon of choice was corporate incentive. What corporate governance had

effectively done was give shareholders the leeway, within the new playing field of the principal and agent

relationship, to “instruct” the boards of executives to perform in certain way. In other words, executive

pay was restructured to align pay for closely with performance. Where performance was not met,

shareholders had the authority to influence managerial turnover.

In essence, shareholders now possessed the indirect means to manipulate corporate decision

makers to engage in riskier investment practices while maintaining the distinction between ownership and

control as required by US Statute. This “division” became even more blurred with the introduction of

legislative changes which repealed limitations which had previously cordoned banks off from certain

16

market forces – those of the non-financial sector. The introduction of the Gramm-Leach Bliley Act

allowed firms to create Financial Holding Companies – financial institutions engaged in nonbanking

activities that offer financial services. This new corporate form – quasi-financial firms - was robust that

it’s structure completely departed from the Berle-Means division of ownership and control, as well as

corporate governance mechanisms. Shareholders of the parent financial holding company were granted

direct involvement of the subsidiary financial institutions. All in all, the division between ownership and

control was completely obscured. Shareholders could now effectively govern the decision making of it’s

subsidiary firms and hire owners of Banks as “oversight committees” to supervise executive boards.

Investment practices were became exclusively geared towards profit maximization while societal costs

were marginalized.

The corporate form had evolved into a nearly an impenetrable flak jacket. Shareholders were

granted unprecedented latitude to pursue riskier investment practices within an unregulated market.

Combined with the influx of incentive based practices meant to “strong-arm” directors to pursue riskier

investment, while remaining sheltered under the protection of the business judgement principle – the shift

in the commercial finance sector provided the impetus for shareholders to exert significant influence

without impunity under the safety of limited liability.

17

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