Behavioral finance and investor governance

Washington and Lee Law Review, Summer 2002 by Cunningham, Lawrence A

I. Introduction

Behavioral economics is emerging as an important new disciplinary adjunct to legal analysis. Encompassing a wide range of fields - from the meta territories of jurisprudence and judicial decisionmaking to the traditional zones of contracts and torts to the specialized areas of tax and health law -- behavioral economics shakes up thought and reorients scholarship laden by its progenitor, law and economics. Behavioral economics revises the received wisdom that assumed the bounded but substantial rationality of human actors and prescribed legal rules and social norms according to sterile abstractions that bore little resemblance to actual human beings, but which could be modeled in elegant and simple ways. As a result, the encrusted models have been injected with more realistic accounts of complex human behavior originally mapped in the field of cognitive psychology, subsequently adapted by economists, and lately imported by legal scholars.1

One corner of this behavioral orientation toward economics and law and the vast social domains those disciplines canvass examines the pricing of stocks in public capital markets. The knowledge being generated from this investigation has significant implications for the field of corporate governance. Corporate law and economics assume that prices of publicly traded stocks constitute the best estimate of the value of the ownership interest in the businesses they represent. Thousands of investors study relevant information about the cash flows that companies are expected to generate and price their stocks based on a risk-adjusted multiple. Some investors may act irrationally in the process, but there are enough rational investors to offset (and indeed take advantage of) such irrationality that the pricing mechanism works and the stock markets are efficient.

A set of cultural beliefs accompany the view that stock markets are efficient in terms of accurately pricing business value.2 Chief among these is the belief that the stock market itself operates as a disciplining device on corporate managers. The theory is that a company's stock price is an accurate and transparent report card on its performance: a manager who performs poorly will see his company's stock price fall and be held accountable.

Accountability could take the form of an unwanted takeover by a third party, through which the manager is ousted. It could come from the impairment of reputation that would diminish the manager's future job prospects. It also could come in the form of a cooled reception by investors to any future plans the manager may have to attract additional financing to run or expand the company's business. The efficient market's discipline also limits managerial discretion over major capital-structure and allocation decisions, such as the mix of debt and equity in the firm, the level of dividends, and the timing and extent of stock repurchases.

From these beliefs flow a set of legal principles. One principle holds that the market for corporate control should be unburdened by rules of timing, disclosure, payment, or other tilts in the playing field. Fiduciary duties could be relied upon in quite weak forms to police those rare managers who somehow escape the clutches of market discipline to act contrary to the corporation's and shareholders' interests. Broad deference could be given to director decisions on the whole range of capital decisions. Concern over the type and timing of company disclosure, and even the principles of accounting applied in preparing financial statements, could be limited because the activity of the efficient market and its participants will pierce these, getting at the real truth and reflecting it in market price. On the other side, investors could be presumed to rely upon misleading managerial statements when, in fact, they are relying solely on market price. When it turns out that managerial statements were false, judges could presume that an investor relied on stock price as a reflection of managerial statements without the need to ask whether the investor actually did rely on these statements.

The efficient market idea, and the set of cultural norms and legal principles that these examples typify, dominated thought and practice in the field of financial economics and corporate law, starting in the 1960s. This continued with undiminished zeal through the late 1980s. Although the zeal abated as the 1990s progressed, and today many more skeptics voice doubt as to the validity of these ideas, the theory of efficient markets and its implications remain widely embraced, and the legal culture that those ideas spawned remains endowed with its teachings.

Recently, a subdiscipline of behavioral economics has blossomed, enervating the thirty-year-old tenets of the efficient market story. Called behavioral finance, this discipline rests on two foundations. The first holds that a substantial amount of stock pricing is performed by investors who do not accurately perceive underlying business values and hence produce prices that do not reflect those values. Investor sentiment, rather than rational economic calculation, contributes significantly to price formation. The second holds that even those investors who do accurately perceive underlying business values will not always step in to offset the sentiments of those who do not because they face risks too great for such an undertaking. This limited arbitrage, when coupled with investor sentiment, yields pricing that does not equate to value, and the managerial report card seen in prices turns out often to be inaccurate, even if it remains translucent.