In U.S. corporation law, it is very, very difficult for shareholders to challenge the decisions made by the board of directors of their portfolio companies. Perhaps this difficulty is a vestige of some evolutionary deadend, like the appendix, but when one sees the same sort of difficulties cropping up in rule after rule and context after context, it becomes fair to at least ponder the possibility that it has some sort of survival benefit.
Director Primacy is Pervasive
In his latest post, Gordon complains that "every example of director primacy in [Steve's] post was drawn from the context of shareholder litigation." But so what? I'm not sure how we would measure degrees of difficulty in this context, but it's fair to say that shareholders have a hard time holding directors to account via the vote, just like they do via the lawsuit.
The vast majority of corporate decisions are made by the board of directors acting alone, or by persons to whom the board has properly delegated authority. Shareholders have virtually no right to initiate corporate action and, moreover, are entitled to approve or disapprove only a very few board actions.
Under the Delaware code, for example, 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 dissolu�tion. 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.
The statutory decision-making model thus is one in which the board acts and shareholders, at most, react.
As I detail in my article, The Case for Limited Shareholder Voting Rights, 53 UCLA L. Rev. 601 (2006), corporation law�s direct restrictions on shareholder power are supplemented by a host of other rules that indirectly prevent shareholders from exercising significant influence over corporate decision making. Three sets of statutes are especially important: (1) disclosure requirements pertaining to large holders; (2) shareholder voting and communication rules; (3) insider trading and short swing profits rules. These laws affect shareholders in two respects. First, they discourage the formation of large stock blocks. Second, they discourage communication and coordination among shareholders.
Indeed, Harvard law professor Lucian Bebchuk, perhaps the leading proponent of shareholder empowerment, says that under the current regime the shareholder franchise is just a "myth." (See also my friend and UCLA law school colleague Lynn Stout's new paper, The Mythical Benefits of Shareholder Control, which compares shareholder control to "vampires" and "alligators in sewers.")
Gordon suggests that I "must contend that" voting and litigation "like the human vermiform appendix, either have no function or have a function that is hidden from our understanding." I decline to do either. Instead, as I explained in The Case for Limited Shareholder Voting Rights:
... like all accountability mechanisms, shareholder voting must be constrained in order to preserve the value of authority. As Arrow observes:
To maintain the value of authority, it would appear that [accountability] must be intermittent. This could be periodic; it could take the form of what is termed �management by exception,� in which authority and its decisions are reviewed only when performance is sufficiently degraded from expectations. . . .
The function of shareholder voting thus should be apparent. Like shareholder litigation, it "is properly understood not as an integral aspect of the corporate decision-making structure, but rather as an accountability device of last resort to be used sparingly, at best."
In sum, it strikes me as eminently fair to conclude that �Corporate governance is best characterized as based on �director primacy.�� Larry Ribstein, Why Corporations?, 1 Berkeley Bus. L.J. 183, 196 (2004). Cf. Harry G. Hutchison, Director Primacy And Corporate Governance: Shareholder Voting Rights Captured By The Accountability/Authority Paradigm, 36 Loy. U. Chi. L.J. 1111, 1194 (2005) (�Although 'Delaware has not explicitly embraced director primacy,' the relevant statutory provisions and the Unocal/Revlon/Unitrin paradigm have largely intimated that directors retain authority and need not passively allow either exogenous events or shareholder action to determine corporate decision-making.�); Kevin L. Turner, Settling The Debate: A Response To Professor Bebchuk's Proposed Reform Of Hostile Takeover Defenses, 57 Ala. L. Rev. 907, 927-28 (2006) ("Delaware jurisprudence favors director primacy in terms of the definitive decisionmaking power, while simultaneously requiring directors to be ultimately concerned with the shareholders' interest. ... The Delaware jurisprudence, while not explicitly affirming "director primacy," does implicitly leave the directors to make decisions with shareholders expressing their views only in specific and limited situations.").)
Establishing that director primacy is the status quo, of course, does not dispose of the question of whether it ought to be the status quo.
The Argument from the Status Quo
Proponents of Intelligent Design content that "there are natural systems that cannot be adequately explained in terms of undirected natural forces and that exhibit features which in any other circumstance we would attribute to intelligence." I express no opinion on the biological science of Intelligent Design, but when I look at corporate law I see a clockmaker. The system is so pervasively tilted in one direction that it one plausibly infers it was designed to do so. (Cf. Hollinger Inc. v. Hollinger Int'l, Inc., 858 A.2d 342, 374 (Del. Ch. 2004), in which Leo Strine referred to "the director-centered nature of our law, which leaves directors with wide managerial freedom subject to the strictures of equity, including entire fairness review of interested transactions. It is through this centralized management that stockholder wealth is largely created, or so much thinking goes.")
Even if the difficulties shareholders face in holding directors to account are mere evolutionary accident, moreover, it was a very happy accident. Gordon complains that I reason "from the status quo." I admit it freely.
Organizational structures that survive over time deserve the benefit of the doubt. Presumably, they offer features that contribue to their survival.
In fact, of course, the American corporation has not simply survived, it has thrived. John Micklethwait and Adrian Wooldridge opined that the corporation is �the basis of the prosperity of the West and the best hope for the future of the rest of the world.� John Micklethwait & Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea xv (2003). A comprehensive review of the evidence by Holmstrom and Kaplan is temperate only by comparison:
"Despite the alleged flaws in its governance system, the U.S. economy has performed very well, both on an absolute basis and particularly relative to other countries. U.S. productivity gains in the past decade have been exceptional, and the U.S. stock market has consistently outperformed other world indices over the last two decades, including the period since the scandals broke. In other words, the broad evidence is not consistent with a failed U.S. system. If anything, it suggests a system that is well above average." Bengt R. Holmstrom & Steven N. Kaplan, The State of U.S. Corporate Governance: What�s Right and What�s Wrong? (Sept. 2003).
My colleague Lynn Stout's new paper argues that the evidence "suggests shareholders in public firms reap net benefits from board control." In the various articles I've written on director primacy, I've reached the same conclusion and made similar arguments.
Yet, even if the evidence doesn't prove director primacy is a contributing factor in the success of the US corporation, at the very least I can insist on a much stronger showing that we have seen to date from the "reformers."
Political thinkers from Plato to Edmund Burke have taught that prudence is the chief virtue of true statesmen. If nothing else, the law of unintended consequences must be given its due. The prudent legislator is hesitant to promulgate reforms that may give rise to new and unforeseen abuses worse than the evil to be cured.
Consider Sarbanes-Oxley, the great triumph of corporate governance reformers. When it was faced with voter unrest arising from the bursting of the tech stock bubble and high-profile misconduct by corporate directors and officers (Enron et al.), Congress decided that Something Must be Done. So Congress put together a package of reforms of varying provenance that had been kicking around Capitol Hill for ages and sent them up to President Bush for signing. And, ever since, it has been one unintended consequence after another.
Roberta Romano calls SOX "quack" corporate governance. Henry Butler and Larry Ribstein call it a "debacle."
The prospect of more such "reform" is precisely why I think we ought to assume that legal changes designed to promote "increased shareholder participation" are presumptively bad." Guilty until proven innocent by clear and convincing evidence.
What's the Case for Change?
Where is the proof? The observant reader will note that Gordon's posts have been mainly a critique of my "approach to the corporate governance system." What is the affirmative case for reforms to promote "increased shareholder participation"? Or, for that matter, the negative case against the status quo?