Playing Favorites with Shareholders

Stephen J. Choi
Eric L. Talley, Columbia Law School


Many scholars agree that a robust market for corporate control provides a critical check on managerial opportunism within public corporations. Even prior to a tender offer, the specter of a takeover provides a powerful mechanism for aligning the incentives of managers and shareholders. Conventional wisdom, therefore, views with suspicion any practice that retards the takeover threat looming over managers who perform poorly. One such practice that has garnered particular attention of late is managerial "favoritism" towards influential block shareholders. Favoritism can take any number of forms, ranging from preferential stock subscriptions, to selective information disclosure, to outright cash payments. But regardless of its form, the argument goes, favoritism is potentially harmful to firm value, as it co-opts one of the most plausible monitors of management. Thus, many argue that corporate law should proscribe (or at least discourage) all forms of favoritism towards block shareholders. In this Article, we question whether the case for prohibiting favoritism is as compelling as conventional wisdom suggests. Our arguments are both practical and conceptual. From a practical standpoint, we raise doubts as to whether piecemeal regulation is even capable of curtailing favoritism writ large, rather than simply relocating it to less verifiable (and less efficient) domains. From a conceptual standpoint, we argue that permitting favoritism would likely enhance outsiders incentives to form a large block in order to extract patronage. Predicting this enhanced incentive, a rational manager would have to choose ex ante between (1) acquiescing to a division of her control benefits with outsiders; or (2) imposing significant constraints on her own self-dealing so as to deter the initial formation of any block. Using a game-theoretic model, we demonstrate that under many plausible circumstances, managers would prefer the latter option to the former. Consequently, playing favorites with block shareholders may, ironically, be in all shareholders interests.