class actions, disabled rights, copyright, attorneys general, online speech, law schools, obesity, New York, mortgages, legal blogs, safety, CPSC, pharmaceuticals, patent trolls, ADA filing mills, international human rights, humor, hate speech, illegal drugs, immigration law, cellphones, international law, real estate, bar associations, Environmental Protection Agency, First Amendment, insurance fraud, slip and fall, smoking bans, emergency medicine, regulation and its reform, dramshop statutes, hotels, web accessibility, United Nations, Alien Tort Claims Act, lobbyists, pools, school discipline, Voting Rights Act, legal services programs
 Subscribe Subscribe   Find us on Twitter Follow POL on Twitter  
   
 
   

 

FEATURED DISCUSSION
WHO'S THE BOSS?


The Case for Increased Shareholder Participation in Corporate Governance

By Gordon Smith
Posted on September 11, 2006, 02:13 AM

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.


Drawing Lines Between Authority and Accountability

By Stephen Bainbridge
Posted on September 11, 2006, 02:42 PM

My thanks to PointOfLaw.com for organizing this debate and to my friend Gordon Smith for getting us off to such a great start. Gordon did an excellent job of laying out the basic divide between us; i.e., we both start with Kenneth Arrow's authority versus consensus model, but diverge in its application to the question of shareholder primacy.

I agree with Gordon's observation that:

"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."

A complete theory of the firm requires one to balance the virtues of discretionary fiat on the part of the board of directors against the need to ensure that the power of fiat is used responsibly. Neither fiat nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, however, because the power to hold to account differs only in degree and not in kind from the power to decide, fiat and accountability also are antithetical. As Kenneth Arrow explained:

"[Accountability mechanisms] 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 [accountability] 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."

So, on second thought, perhaps the tension between authority and accountability in fact does tell us something about where to draw the line.

One of the striking things about American corporate law (by which, of course, I mean Delaware corporate law) is the extent to which it consistently draws that line in favor of authority.

Indeed, judicial recognition of the proposition that directors cannot be held accountable without undermining their authority pervades many aspects of corporation law. The business judgment rule, for example, substantially insulates director decisions from being challenged by shareholders in litigation. According to the Delaware Supreme Court, the rule in fact exists precisely to prevent shareholders from holding boards of directors to account:

"... the business judgment rule is the offspring of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors. ... The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors." Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985).

The New York Supreme Court likewise opined that:

"To encourage freedom of action on the part of directors, or to put it another way, to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the 'business judgment rule.'" Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944).

(I advanced this understanding of the business judgment rule in Stephen M. Bainbridge, The Business Judgment Rule as Abstention Doctrine, 57 Vanderbilt L. Rev. 83 (2004). Former Delaware Supreme Court Chief Justice Veasey recently cited that article’s analysis, deeming it to be "approach is consistent with the Delaware doctrine that the rule is a presumption that courts will not interfere with, or secondguess, decision making by directors." E. Norman Veasey & Christine T. di Guglielmo, What Happened in Delaware Corporate Law and Governance From 1992–2004? A Retrospective on Some Key Developments, 153 U. Penn. L. Rev. 1399, 1422 (2005).)

In many cases, of course, the defendants never need invoke the business judgment rule because plaintiff's case founders on the procedural limitations on derivative litigation, which thus further insulate boards of directors from shareholder litigation. Again, however, as the New York Court of Appeals seemingly recognized, these limitations follow precisely because corporate law must strive to balance authority and accountability:

"By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate boards. . . . Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation’s affairs should be 'exercised with restraint.'" Marx v. Axers, 644 N.Y.S.2d 121, 124 (1996).

See also Pogostin v. Rice, 480 A.2d 619, 624 (noting that "the derivative action impinges on the managerial freedom of directors").

We observe similar restrictions designed to protect the board of director's authority with respect to statutory provisions such as those governing interested director transactions. Similar restrictions also may be observed with respect to management buyouts, which involve a significant conflict of interest and therefore tend to get close judicial scrutiny, but which will receive judicial deference in appropriate cases. Stephen M. Bainbridge, Independent Directors and the ALI Corporate Governance Project, 61 Geo. Wash. L. Rev. 1034, 1075-79 (1993). Likewise, corporation statutes grant the board sweeping authority with respect to negotiated acquisitions, which the business judgment rule then largely insulates from judicial intervention. Stephen M. Bainbridge, Mergers and Acquisitions 162-65 (2003). As a final example, the Delaware courts allow the target’s board of directors a substantial gatekeeping role in unsolicited tender offers, which again is attributable to the courts' recognition of the importance of preserving the board's authority. Id. at 352-53.

Given the pervasiveness in corporate law of rules that (a) strike a balance between authority and accountability and (b) are biased towards deference to the board’s authority rather than accountability, it would be surprising if the rules on shareholder voting rights were any more empowering than they are. Put simply, corporate law is designed from the ground up to make holding directors to account very difficult. Proponents of expanded shareholder power thus need to explain why the voting rules need to be changed to create an exception to this general rule.


Questioning the Theory of Director Primacy

By Gordon Smith
Posted on September 13, 2006, 06:31 AM

In my introductory post in this debate, I observed that acknowledging the tension between “authority” and “responsibility” does not tell us where to draw the lines in the corporate governance system. Steve initially seemed to agree, but “on second thought,” he suggested that “the tension between authority and accountability in fact does tell us something about where to draw the line.” Reasoning from existing corporate law – which “consistently draws that line in favor of authority” – he concluded with a challenge:

Put simply, corporate law is designed from the ground up to make holding directors to account very difficult. Proponents of expanded shareholder power thus need to explain why the voting rules need to be changed to create an exception to this general rule.

In this post, I will challenge Steve’s challenge. That is, rather than accepting the premises of the challenge, I will offer two responses that undermine those premises.

First, the lesson that Steve draws from Arrow’s analysis of authority and responsibility might be summarized as follows: introducing any (additional) quantum of responsibility via shareholder oversight into the corporate governance system risks obliterating authority. This may be a bit of a caricature, but not much. In his most recent article on this subject, Steve wrote:

Boards of directors are subject to a pervasive network of accountability mechanisms that are more or less independent of shareholder oversight. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. [T]hese incentive structures induce directors to behave generally in ways consistent with shareholder wealth maximization.

Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735, 1746-47 (2006).

The problem with reasoning from the status quo, as Steve does in his last post and throughout his work on director primacy, is that the status quo contains two mechanisms of direct shareholder oversight: shareholder litigation and shareholder voting. To sustain his argument in favor of director primacy, Steve must contend that these mechanisms, like the human vermiform appendix, either have no function or have a function that is hidden from our understanding. (Perhaps shareholder litigation and shareholder voting are vestigial organs of an ancient corporate governance system?)

Why should we prefer this account of shareholder litigation and shareholder voting to an alternate account? We might view shareholder litigation and shareholder voting as potentially useful mechanisms that have been crippled by misguided legislatures, agencies, and courts. Or we might view each mechanism as highly specialized and appropriate for use only in extreme circumstances. For example, shareholder litigation may be useful in policing conflict-of-interest transactions, but may be relatively unhelpful in policing negligence, while voting may be important for effecting changes in control, but not for charting new corporate strategies.

My point is simply that shareholder oversight may be valuable, even if it operates only at the margins of the corporate governance system. And if we perceive instances when shareholder oversight improves corporate governance, we should remain open to the possibility of value-enhancing reforms. Despite the phrasing of Steve’s challenge quoted above, the theory of director primacy is more than just a call for rigorous justification of reforms. Steve uses director primacy as a basis for arguing against reform, which leads to my second response to Steve’s challenge: the theory of director primacy does not support the notion that increased shareholder participation in corporate governance is presumptively bad.

In my initial post, I focused on director elections, and Steve’s challenge mentions “voting rules.” But every example of director primacy in his post was drawn from the context of shareholder litigation. Of course, arguments in favor of increased shareholder participation in corporate governance sometimes extend to shareholder litigation – this has been particularly noticeable in connection with the recent Disney litigation in the Delaware courts – but my focus and the recent proposals made by Lucian Bebchuk relate to shareholder voting.

Obviously, Steve recognized this, and I don’t intend to imply that he missed the point. Instead, I think his decision to focus on litigation rules reveals something important about his approach to the corporate governance system. Steve could have approached the issue of shareholder voting directly by pointing to numerous legal rules that limit the efficacy of shareholder voting as a monitoring device and suggesting that such rules bolster his case for director primacy. Instead, he chose to observe that directors are rarely held accountable in shareholder litigation, then to assert, “[g]iven the pervasiveness in corporate law of rules that (a) strike a balance between authority and accountability and (b) are biased towards deference to the board’s authority rather than accountability, it would be surprising if the rules on shareholder voting rights were any more empowering than” the rules relating to litigation.

Hmm.

Steve wants us to believe that “deference to the board’s authority” is the defining characteristic of corporate law. He perceives such deference in the litigation rules, and suggests that similar deference should be reflected in voting rules. I see two problems with this line of reasoning: (1) the notion of deference is too diffuse to be a useful analytical tool, and (2) one cannot justifiably infer a policy of "deference to authority" merely from the fact of shareholder disablement. I elaborate on each point in turn.

What constitutes “deference”? Delaware courts are quite reluctant to impose personal liability on directors in any circumstance, but they are much more willing to grant injunctive or other equitable relief, especially in cases involving managerial conflicts of interest. Thus, the deference to directors displayed by the Delaware courts varies depending on the remedy sought and the duty that is alleged to have been breached. Are the courts being "deferential" in all of these circumstances? Or are they being intrusive to different degrees?

Another fundamental objection relates to Steve’s attempt to compare “deference” in litigation to “deference” in elections. Limits on shareholder litigation have different origins and rationales from limits on shareholder voting. As a result, assuming one could compare the respective levels of shareholder power in litigation and elections, one might reasonably hold the view that judicial interventions on behalf of shareholder litigants should be less expansive than direct shareholder interventions through elections. (Or vice versa?) The fact – if it is a fact – that shareholders are substantially hindered in both litigation and voting is not necessarily evidence of an overriding policy of “deference to authority” in the corporate governance system.

In this post, I have argued that Steve’s account of the corporate governance system seems unrealistic to the extent that it depends on the existence of elaborate and costly mechanisms of shareholder oversight that have no meaningful function. In addition, I have argued that “deference to authority” is not necessarily the defining characteristic of corporate law, even if we observe that shareholders are relatively impotent to influence most business decisions. Obviously, these are arguments against the theory of director primacy, rather than an affirmative case for shareholder participation. More in that latter vein in another post.


Corporate Governance: In Praise of the Status Quo

By Stephen Bainbridge
Posted on September 13, 2006, 04:48 PM

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?


Shareholder Voting: The Case for Change

By Gordon Smith
Posted on September 15, 2006, 04:00 AM

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.

 

 

 

 

FEATURED DISCUSSION ARCHIVE:


Obamacare Decision: Reactions, July 2012
Law School Faculty Diversity, May-June 2012
Class Actions, May 2012
Constitutionality of Individual Mandate, March 2012
Human Rights and International Law, February-March 2012
The constitutionality of President Obama's recess appointments, January 2012
Do caps on medical malpractice damages hurt consumers?, December 2011
Trial Lawyers Inc.: State Attorneys General, October 2011
Wal-Mart v. Dukes, April 2011
Kagan Supreme Court nomination, May-June 2010
Election roundtable, November-December 2006
Who's the boss, September 2006
Medical judgement, July 2006
Lawyer Licensing, May 2006
Contingent claims, April 2006
Smoking guns, July 2004

Isaac Gorodetski
Project Manager,
Center for Legal Policy at the
Manhattan Institute
igorodetski@manhattan-institute.org

Katherine Lazarski
Press Officer,
Manhattan Institute
klazarski@manhattan-institute.org

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.