The view that corporations should be run for the financial benefit of shareholders is based on two related assumptions. The first is that shareholders hold the residual claim on the firm’s assets. Residual claimants are entitled to whatever value is left after the firm has met its legal and contractual obligations to creditors, suppliers, and employees. If a firm develops a useful product, shareholder profits increase. If an investment does not work out, shareholders are the first to incur a loss. Shareholders therefore have a financial interest in pursuing projects that will efficiently meet people’s demand for goods and services.

The second assumption is that market and regulatory mechanisms are capable of causing the firm’s revenues and costs to reflect the interests of non-shareholder constituents. Stakeholders who do not own shares have numerous ways to express their preferences. Consumers select products that appeal to them. Employees pick jobs based on pay, flexibility, or location. The government can tax or ban harmful activities. These market, contractual, and regulatory interventions create financial incentives for shareholders and managers to account for non-shareholder interests such as protecting the environment and worker welfare.

Our forthcoming article, Private Profits and Public Business, explores a class of situations in which one or both these assumptions break down. In many critical industries, including electricity, defense contracting, financial services, and the development of pharmaceuticals, the government stipulates the demand for a good or service (electricity, defense, and pharmaceuticals), limits shareholder and managerial discretion to pursue profitable activities (electricity and financial services), or guarantees some of the firm’s contractual obligations (financial services, perhaps electricity). In these markets, the government discerns (or attempts to discern) the socially optimal outcome and creates incentives for investors to manufacture or develop a product. These mechanisms can include setting firm profits, guaranteeing returns, reimbursing costs, limiting competition, purchasing a dominant portion of the firm’s output at stated prices, or bailing out a firm whose liquidation would impose excessive societal costs.

When this kind of intervention is pervasive, or when a firm’s failure will have devastating economic consequences, shareholder-focused firms often have the ability and incentive to hold up the government. One reason that the government may be vulnerable to holdup is that the underlying policy rationale driving the government’s intervention may create opportunities for exploitation by profit-seeking managers. If a bank failure would cause enormous economic and social harm, the bank’s managers can engage in risky behavior knowing that it will be bailed out. Another reason is that the intervention itself may facilitate opportunism. If the government must purchase a good from a contractor, and only one firm can sell due to limits on competition, the government is vulnerable if the firm demands price or quality concessions. A final reason is that the scope of the government’s intervention might oblige it to assume responsibility for protecting the financial health of firms in the space. The government simply has no choice but to ensure that firms do not exit systemically important businesses. Although orderly liquidation mechanisms have an important place in these industries, government officials often feel compelled to bail out such firms rather than let them file for bankruptcy.

In these situations, the government has only limited ability to protect its interests or those of non-shareholder constituents through contract and regulation. The government’s first challenge is that ex ante interventions are difficult to implement and administer and are vulnerable to exploitation. The clearest example of this is public utility regulation, where regulators protect firms from competition, cap returns, and authorize a return on investments. As we have previously argued, these types of interventions transform shareholders from residual claimants into fixed claimants. Once the government establishes an incentive structure, shareholders do not receive additional profits for welfare-enhancing investments that were not incorporated into the rate schedule. Shareholder-focused managers are therefore unlikely to pursue innovations whose benefits become apparent after the regulator has reviewed the firm’s costs and authorized its revenues.

The second challenge is that the government’s threats and promises often lose credibility after a project is underway or a threat has materialized. Although the governance implications of this phenomenon are well-studied in the relational contracting literature, these insights have been applied primarily to private markets and not to situations in which the government is an intermediary or counterparty. When parties enter into an arrangement that will create a bilateral monopoly, they become vulnerable to exploitation. To use one famous example, once General Motors designed its cars around parts from suppliers like Fisher Body or Delphi, it had made relationship-specific investments that made it more difficult for General Motors to switch suppliers. As a result, those suppliers were in a position to demand new concessions from General Motors.  This is a familiar observation in private markets: challenges with long-term contracting often facilitate holdup and therefore require governance solutions.

Because external mechanisms such as contract and regulation fail to protect societal interests in these spaces, it may be appropriate for regulators and other stakeholders to protect their interests by participating directly in corporate governance decisions. The resulting system would take a context-specific approach: corporate governances that vary to fit the nature of the intervention rather than a one-size-fits-all corporate governance arrangement.

At a conceptual level, these insights open up a new space for policy interventions. The academic literature typically assumes a sharp distinction between private firms and public ownership and suggests that where contract and regulation cannot induce profit-seeking firms to discharge a public function, the only alternative is to assign the function to an arm of the government. Our analysis reveals that there need not be a simple binary between public control and private ownership, and that there are a variety of intermediate solutions that would empower the government to influence corporate decisionmaking without taking complete control of private firms.

Policymakers could use numerous reforms to push firms in this direction. For example, policymakers could take a more robust approach to competition issues in government dominated markets. They should account not only for the effect a merger has on consumer welfare, but also look at whether the merger will leave the government more vulnerable to holdup by producers of essential goods and services. Similar logic might suggest extending fiduciary duties to protect non-shareholders, expanding board representation, and giving non-shareholders some authority to determine executive compensation and weigh in on whether to hire or fire high-level managers.

Because of the difficulties in navigating the trade-offs that arise when trying to extend our insights into the real world, the Article presents a menu of potential governance reforms, recognizing that all these proposals involve unavoidable trade-offs that may vary in different contexts. The point is not that any reform provides a panacea, or even that it is viable in any particular case, but rather that the government often has an incentive to intervene in ways that disrupt the assumptions that underlie shareholder primacy, which in turn provides support for taking a context-specific approach to corporate governance.