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‹ FEATURED DISCUSSION

September 11, 2006

The Case for Increased Shareholder Participation in Corporate Governance

By Gordon Smith

Many thanks to PointofLaw.com for organizing this debate between me and my friend, Steve Bainbridge. Over the course of this week, we will discuss one of the most important contemporary issues in corporate law: the relative control rights of directors and shareholders. In this post, I will set the stage for the debate, and offer some arguments in favor of increased shareholder participation in corporate governance.

In our prior scholarship, Steve and I have relied on the work of economist Kenneth Arrow in analyzing shareholder participation in corporate governance, and this common starting point will prove useful in highlighting areas of disagreement. Arrow argued that centralized decision making in organizations – which he called "authority" – was valuable because it coordinates the activities of members of the organization, thus economizing information costs. The board of directors is the central decision making body of the corporation.

While authority offers many benefits, it also has costs. Recognizing this, Arrow suggested that a necessary counterweight to authority was "responsibility." Directors may be held responsible via elections or shareholder litigation. In addition, various markets – including capital markets, takeover markets, charter markets, product markets, and labor markets – are said to monitor director performance. One key to organizational success is striking the proper balance between authority and responsibility. Arrow describes the tension between authority and responsibility that animates the present corporate governance debate:

"To serve its functions, responsibility must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of responsibility can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem. To maintain the value of authority, it would appear that responsibility must be intermittent." KENNETH J. ARROW, THE LIMITS OF ORGANIZATION 77-78 (1974).

The task of the corporate governance system, therefore, is to draw the line between authority and responsibility. Though boards of directors generally are said to favor shareholders over other corporate constituencies, the formal powers of shareholders to demand such favored treatment are meager. Shareholders elect directors, but contested elections are extraordinary, and in most corporations, boards of directors are self-perpetuating. Shareholders also vote on other matters – including fundamental transactions, like mergers – but only after the board of directors has recommended such matters to the shareholders. Shareholder lawsuits are more common than contested director elections, but lawsuits tend to arise in a narrow band of cases involving securities frauds or corporate acquisitions. The bottom line is that the power to initiate corporate change lies almost exclusively with the directors or officers of the corporation.

In a series of articles published over the past four years, Steve has defended the status quo, in the process coining the term "director primacy." His neologism was a play on "shareholder primacy," the widely accepted notion that corporations should be operated for the benefit of shareholders rather than other corporate constituencies. D. Gordon Smith, The Shareholder Primacy Norm, 23 J. CORP. L. 277 (1998). According to Steve, however, the notion of "shareholder primacy" is not only about the ends of corporate law, but about the means. In his words, "shareholder primacy contends not only that shareholders are the principals on whose behalf corporate governance is organized, but also that shareholders do (and should) exercise ultimate control of the corporate enterprise." Stephen M. Bainbridge, Director Primacy: The Means and Ends of Corporate Governance, 97 NW. U. L. REV. 547, 563 (2003).

Steve embraces shareholder wealth maximization as the appropriate "end" of corporate law, but he rejects the notion that shareholders control directors in any meaningful way. Perhaps more importantly for present purposes, Steve rejects the notion that shareholders should control directors in any meaningful way. This is the point at which Steve and I diverge.

In my view, shareholders should be allowed to participate meaningfully in director elections and in certain fundamental business decisions. The motivation for my position is my view that the various market mechanisms listed above, though powerful within their domains, do not adequately monitor the competence of corporate directors, and in other instances, do not protect shareholders from the costs of managerial slack.

Last week, in AFSCME v. AIG, the United States Court of Appeals for the Second Circuit opened the door slightly for increased shareholder participation in director elections, though the Securities and Exchange Commission may be positioning itself to slam the door shut. AFSCME involved a shareholder challenge to the SEC’s interpretation of its own Rule 14a-8, also known as the "shareholder proposal rule." Under Rule 14a-8, shareholders are allowed to place certain proposals on the corporate ballot. The rule also contains a long list of "exclusions" – reasons why a corporation might exclude a shareholder proposal from the ballot. Among the reasons is that the proposal "relates to an election for membership on the company's board of directors." Because of this exclusion, shareholders cannot use the shareholder proposal rule to nominate candidates for the board of directors. But can shareholders force the inclusion of proposals that change the rules of the game?

AFSCME wants the shareholders of AIG to amend the company’s bylaws to provide that 3% shareholders may nominate one candidate for election to the board of directors and have that nominee placed on the corporation’s ballot. According to the Court, this sort of bylaw "would simply establish a process for shareholders to wage a future election contest," and thus, it is distinguishable from a proposal that "would result in an immediate election contest." While this language (which was suggested by the SEC’s brief in this case) may need some refinement, the gist of the opinion is sound, despite Steve’s judgment that the Court’s reasoning is "hogwash." According to Steve, "The language is clearly sweeping, encompassing any proposal related to the process by which directors are elected." Nevertheless, as noted by the Second Circuit, the SEC has long allowed shareholder proposals relating to cumulative voting rights or general qualifications for directors, and this practice undermines the argument that the exclusion is "sweeping." (By the way, even the SEC did not take that position, preferring to argue that the exclusion covered some election-related proposals but not others.)

If the SEC does not amend Rule 14a-8 to prohibit AFSCME-like bylaws, we can expect to see company-by-company reform of the election process. Global reform of the director nomination process died – at least for the foreseeable future – when the SEC proposed, then quietly dropped, a controversial rule that would have allowed director nominations by shareholders under limited circumstances.

Director elections are an important part of the debate over increased shareholder participation in corporate governance, but they do not exhaust the debate. Perhaps the most visible academic proponent of increasing shareholder power has been Harvard law professor Lucian Bebchuk, who has argued forcefully that shareholders should be allowed to adopt charter provisions that would give them power to pass binding resolutions regarding business issues, such as "decisions to merge, sell all assets, or dissolve the company, [or] decisions [to reduce] the company's size by ordering a cash or in-kind distribution." Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833, 837 (2005). This proposal expands a proposal that Bob Thompson and I made in 2001 to allow shareholders to "initiate action that would put the company up for sale, leaving it to the board to conduct the auction." Robert B. Thompson & D. Gordon Smith, Toward a New Theory of the Shareholder Role: "Sacred Space" in Corporate Transactions, 80 TEXAS L. REV. 261, 308 (2001).

The brevity required by this forum does not allow for a complete explication of the case for increased shareholder participation in corporate governance, but I hope that this post will serve as a useful starting point for our debate. As noted above, the central issue of contemporary corporate governance debates is whether the current regime of "director primacy" should be modified. Arrow identified the tension between authority and responsibility, but this is only a starting point, not a conclusion. Acknowledging that tension does not tell us where to draw the lines.

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