Share Price as a Poor Criterion for Good Corporate Law

Abstract

Academics, reformers, and business leaders all yearn for a single, objective, easy-to-read measure of corporate performance that can be used to judge the quality of public corporation law and practice. This collective desire is so powerful that it has led many commentators to grab onto the first marginally plausible candidate: share price. Contemporary economic and corporate theory, as well as recent business history, nevertheless warn us against unthinking acceptance of share price as a measure of corporate performance. This Essay offers a brief reminder of some of the many reasons why stock prices often fail to reflect true corporate performance, including the problem of private information; obstacles to effective arbitrage; investors\u27 cognitive defects and biases; options theory and the problem of multiple residual claimants; and the problem of corporate spillover effects that erode diversified shareholders\u27 returns. These considerations argue against assuming there is a tight connection between stock prices and underlying corporate wealth generation. A corporation or a corporate law system designed around the philosophy that anything that raises share price is good is likely to produce a firm that cooks its books; that avoids long-term projects that won\u27t appeal to unsophisticated investors; that chases after investment fads and fancies; that tries to opportunistically exploit creditors, employees, and customers; and that pursues business strategies that harm its diversified shareholders\u27 other investment interests. The Essay concludes that, if we allow our desire for a universal performance measure to blind us to the fallibility of share price, we court costly error. The Essay examines three recent examples of just such erroneous triumphs of hope over experience: the rise and fall of the Revlon doctrine; the 1990s infatuation with options-based executive compensation; and academics\u27 current preoccupation with event studies, regressions on Tobin\u27s Q, and other forms of empirical scholarship that attempt to judge the quality of corporate law and practice according to changes in share price