Private profits and public business

A common justification for shareholder primacy is that shareholders' financial interests give them an incentive to pursue projects that increase social welfare. This alignment of interests occurs because shareholders hold a residual claim on firm value: Because they receive only what remains after the firm has met its contractual and regulatory obligations, they have a unique incentive to pursue innovative projects, increase profits, and keep costs down. According to the conventional view, third parties protect their interests through external mechanisms such as regulations and contracts negotiated against the backdrop of competitive markets. This Article builds on the relational contracting literature to identify a class of situations in which government interventions cause some of these assumptions break down. In many industries, including electric utilities, defense contracting, financial services, and pharmaceuticals, the government sets firm profits, establishes demand for a good or service, or protects counterparties from the negative consequences of excessive risk-taking. Whether justified or not, these interventions can put firms in a position to hold up the government. For example, if an intervention ensures that only the regulated firm can provide an essential service, the government may be unable to credibly threaten to resolve the firm and may therefore be unable to force the firm to accept lower earnings. (Or course, similar bargaining dynamics arise without a government intervention when the government feels compelled to bail out firms that provide systemically important goods and services.) As a result, the firm can demand additional revenues to cover unexpected costs or pass the costs of regulatory noncompliance onto customers. That, in turn, weakens shareholders' financial incentives to pursue socially beneficial projects. The implication is that outside stakeholders, particularly the government, should participate more directly in corporate governance in these industries. Potential interventions include heightened merger review; a say in personnel decisions such as hiring, firing, and executive compensation; expanded fiduciary duties; and perhaps wider board representation.