September 15, 2006
Shareholder Voting: The Case for Change
By Gordon Smith
In his most recent post, Steve refers to voting as an “accountability device of last resort.” Compare this appellation with Steve’s description of the shareholders’ voting rights:
Under the Delaware code, … shareholder voting rights are essentially limited to the election of directors and approval of charter or bylaw amendments, mergers, sales of substantially all of the corporation’s assets, and voluntary dissolution. As a formal matter, only the election of directors and amending the bylaws do not require board approval before shareholder action is possible. In practice, of course, even the election of directors (absent a proxy contest) is predetermined by the existing board nominating the next year’s board.
When Steve says that voting is a last resort, he really means last resort! Let’s make sure that we all understand this. Under state corporate law, shareholders can initiate only two votes: an election of directors and an amendment of the bylaws. (Actually, shareholders also can initiate shareholder proposals unrelated to director elections or bylaw amendments, but such proposals are not binding on the board of directors.) Director elections require a proxy context, which is still extremely expensive. Bylaw amendments would be less expensive if placed on the corporate ballot through Rule 14a-8, but many bylaw proposals fail to pass the SEC’s review process and are excluded by companies. Most importantly, as discussed in my first post above, the SEC has allowed companies to exclude any proposals that relate to the election of directors, including most bylaw amendments that change the rules governing director elections. In short, shareholders can initiate only certain bylaw amendments without incurring substantial expense, and casual observation suggests that shareholders rarely pursue the more aggressive course of action.
According to Steve, impotent shareholders make for good corporate governance: “shareholder voting must be constrained in order to preserve the value of authority.” And thus we return to the place where we started, drawing the line between authority and responsibility.
Why draw the shareholder voting line in a way that offers shareholders no meaningful voting rights? Could it have something to do with the fact that corporate executives are a powerful and well-organized political force, while shareholders traditionally have been diffuse? I suspect Steve would find this explanation unconvincing, given his views on the market for governance terms:
If those governance terms are unfavorable, investors will discount the price they are willing to pay for that firm's securities. As a result, the firm's cost of capital rises, leaving it, inter alia, more vulnerable to bankruptcy or hostile takeover. Corporate managers therefore have strong incentives to offer investors attractive governance arrangements, either via the corporation's own organic documents or by incorporating in a state offering such arrangements off the rack. Likewise, competition for corporate charters deters states from adopting excessively pro-management statutes.
Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 HARV. L. REV. 1735, 1736 (2006).
I am less sanguine about the ability of markets to produce optimal governance terms. As noted recently by Lucian Bebchuk, “I do not view the U.S. corporate governance system, nor that of many other countries with developed stock markets, as largely dysfunctional. But between the dysfunctional and the optimal lies a rather large gap, and a developed stock market that grows over time is consistent with a governance system that lies in that gap and could be significantly improved.” Lucian Bebchuk, Letting Shareholders Set the Rules, 119 HARV. L. REV. 1784, 1791 (2006).
Steve reasonably requests a statement of the affirmative case for increased shareholder power, so here it is in heavily abridged form. Though I share Steve’s upbeat assessment of capital markets, takeover markets, charter markets, product markets, and labor markets as corporate governance mechanisms, each of these markets is useful in that context primarily for creating positive incentives for shareholder wealth maximization. As I noted in my earliest work, these markets are not well-equipped to deal with the problem of managerial incompetence:
External forces solve managerial incompetence in only two instances: (1) when the market for corporate control directly attacks managerial incompetence by replacing the incompetent manager, and (2) when product markets directly attack managerial incompetence by forcing companies out of business. Both of these solutions to managerial incompetence are effective at replacing managers but are slow and costly responses when compared with action by the board of directors.
D. Gordon Smith, Corporate Governance and Managerial Incompetence: Lessons From Kmart, 74 N.C. L. REV. 1037 (1996).
In my view, increased shareholder initiation rights in the election of directors would go some distance toward addressing managerial incompetence and would also provide an additional incentive to avoid any residual managerial slack. Of course, the devil is in the details, and the design of such a reform is crucial. Vice-Chancellor Leo Strine recently offered some hopeful thoughts on director election reform. Leo E. Strine, Jr., Toward a True Corporate Republic: A Traditionalist Response to Bebchuk's Solution for Improving Corporate America, 119 HARV. L. REV. 1759, 1778-82 (2006).
Whether voting reforms should extend beyond director elections is more controversial. Lucian Bebchuk has made the most ambitious case for such reforms. Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833, 837 (2005). Though Lucian offers many ideas that I find appealing, my sense is that such reforms are very far off the radar for lawmakers.
Posted at 04:00 AM
| TrackBack (0)