One economically undesirable consequence of directors embracing the fictional undiversified shareholder concept, discussed in the academic literature (33) and addressed to a limited extent by the case law as well, (34) is that it may lead to corporations making inefficient investments that have very low or even negative overall expected returns when the corporation's preferred shareholders and bondholders, as well as the common shareholders, are taken into account.
The burdens of negotiating such contractual protections are a social cost at least partially attributable to the embrace of the fictional undiversified shareholder concept.
But what is the wealth-maximizing risk/return combination that such a risk-averse fictional undiversified shareholder would most favor, and that would consequently maximize the share price in a market for the corporation's common shares that is implicitly assumed by the fictional undiversified shareholder concept to consist solely of such persons?
The fictional undiversified shareholder concept thus has a certain incompleteness and even weirdness to it with regard to providing guidance to directors as to how to weigh risk considerations against expected returns in their deliberations regarding how to maximize shareholder wealth.
Use of the fictional undiversified shareholder concept to make the hypothetical investment choice presented at the beginning of Part II of this Article would, for example, allow the directors to justify choosing either of the options presented on shareholder wealth maximization grounds simply by ascribing the appropriate degree of risk-aversion to the hypothetical shareholder.
It is immediately apparent that this changed conception of the fictional shareholder solves the vicinity of insolvency inefficient investment incentives problem that is inherent in the use of the fictional undiversified shareholder concept. Fully diversified shareholders would own the corporation's common shares, preferred shares and bonds in proportion to those securities' relative proportions of overall firm capitalization.
The fictional diversified shareholder concept is also more complete than the fictional undiversified shareholder concept in that it implies that the shareholders are risk-neutral with regard to the unsystematic risks posed by various corporate investments, although it does also have some indeterminacy in that it does not specify any particular shareholder attitude towards systematic risk.
For the hypothetical investment choice presented at the beginning of Part II.B of this Article, if the directors utilized the fictional diversified shareholder concept they would first have to determine what portion of the return variability associated with each of the two investment options was due to unsystematic factors, and what portion instead reflected a systematic correlation with overall market returns.
This freedom to postulate a particular attitude towards systematic risk on the part of the fictional diversified shareholder clearly has the potential to be a "fudge factor" that undercuts the constraining effect of the shareholder wealth maximization norm, and thus is comparable in some regards to the freedom to postulate the shareholder's attitude towards overall risk in applying the fictional undiversified shareholder concept. However, there is a significant difference in this regard between these two fictional shareholder characterizations.
With the attribution of attitudes towards systematic risk probably not relevant to the choice in most instances, the use of the fictional diversified shareholder concept will therefore in practice generally support the choice of the investment alternative that will have the largest positive impact on the expected returns to a fully diversified shareholder's portfolio, without regard to the investment's degree of systematic risk.
The major difficulty posed by use of the fictional diversified shareholder concept is of course the extraordinary breadth of the interests of such posited shareholders that would have to be considered in assessing the various investment alternatives.
Assume now that this hypothetical shareholder wealth-maximizing board of directors is utilizing the fictional equity-only diversified shareholder concept as its yardstick.
Finally, assume that this hypothetical board of directors is using the fictional corporation-specific diversified shareholder concept to make its decisions.
On the other hand, the fictional corporation-specific diversified shareholder concept simply ignores the implications of the subject corporation's investments on the values of securities issued by other corporations, or on the values of other, non-corporate assets that its actual shareholders may own.
Both are also inferior to the fictional corporation-specific shareholder concept in aligning director incentives with the interests of corporation-specific diversified shareholders.