ProfessorBainbridge.com

Director Primacy and Shareholder Disempowerment

Senator Chuck Schumer's proposed Shareholder Bill of Rights would, inter alia:

[Affirm] the U.S. Securities and Exchange Commission's authority to grant shareholders access to the corporate proxy for nominations to the board of directors. ...
The bill requires public companies to create a separate risk committee in order to ensure that risk management is given appropriate oversight. Companies would be required to separate the duties of the chief executive and board chairman -- such as what happened at Bank of America. In April, shareholders voted to strip Chief Executive Officer Kenneth Lewis of his position as chairman of the board.
Schumer's bill would require companies to obtain shareholder approval for executives' so-called golden parachutes, or the hefty pay packages given to executives when they leave the company.
It also requires corporate directors to be subject to annual shareholder votes and to receive a majority of votes cast by shareholders in order to remain on board.

Count me as a skeptic. Several years ago, I published a pertinent paper entitled Director Primacy and Shareholder Disempowerment.  You can down load it here.

Abstract: This essay is a response to Lucian Bebchuk's recent article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow "shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements."

In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm’s organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights.

Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule.

Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.

Keywords: corporations, corporate governance, shareholders, stockholders, institutional investors, board of directors, managers, voting

JEL Classifications: K22

Beneficial Corporations

In my corporate governance seminar this past semester, a couple of students wrote papers on the emerging phenomenon of so-called beneficial corporations (a.k.a. for benefit corporations). As Inc explained:

Public companies are legally obligated to maximize returns to shareholders, according to a widespread interpretation of corporate law. For private firms, it's more a matter of withstanding pressure from investors. Hannigan and Marx, for example, fear their social mission could be threatened if an investor changed his mind about Give Something Back's penchant for charity. They want to avoid the fate of ice cream maker Ben & Jerry's, which received a buyout offer from the Dutch conglomerate Unilever (NYSE:UL) in 2000. Founders Ben Cohen and Jerry Greenfield didn't want to sell, so Cohen assembled a group of investors to make a counteroffer. When they couldn't offer as much as Unilever, shareholders sued, and the company, then publicly traded, was forced to relent. In April 2000, Ben & Jerry's was acquired by Unilever for $326 million.

That's exactly the situation that B Lab, a new nonprofit organization, aims to prevent. The group is creating a new kind of company--the B Corporation. (The B stands for "beneficial.") It's less a legal designation than a certification system that will allow businesses to define themselves as socially responsible to consumers and investors. To become a certified B Corporation, a company must amend its articles of incorporation to say that managers must consider the interests of employees, the community, and the environment instead of worrying solely about shareholders. Those amendments, according to B Lab, will let entrepreneurs like Hannigan take on outside investors without worrying that their values will be compromised. "For us, this is a huge step forward," says Hannigan, whose company recently became one of about two dozen certified B Corporations.

I'm considering writing a law review article on this phenomenon and therefore have been doing some research on it. In the course of that research, I ran across a blog post by Geoffrey Manne on the Community Interest Company, which is a relatively new form of business organization in the UK. 

While there might be some benefit here in providing an off-the-rack form that could have been difficult to contract into otherwise (or not -- more on this in a later post), the form surely seems tailor made to deal with the CSR problem. (On which see here, here, here and here). If corporate directors want to maximize something other than shareholder interests, let them. But why not also make them (permit them to?) identify their organizations accordingly -- call it Whole Foods, CIC –- and subject them to dividend monitoring by regulators (and see how well that goes over).

Part of the stated purpose with the CIC is, in fact, branding, and this might be its real appeal: “The CIC legal form was specifically designed to provide a purpose-built legal framework and a ‘brand’ identity for social enterprises that want to adopt the limited company form.” It’s a way for “socially-conscious” corporations cheaply to identify their consciousness (and a way for the rest of us cheaply to avoid investing in them). (But I will note that some fascinating recent research by Anup Malani and Guy David has suggested that there may be less value in nonprofit branding than we might have thought, and the benefits of a CIC designation may be accordingly limited).

Larry Ribstein commented:

The CIC clarifies ... that the key csr question concerns the extent of managers’ control over the cash.  In a standard publicly held corporation, managers significantly control corporate cash subject only to shareholders’ fairly weak voting, selling and fiduciary rights.  In a CIC, the managers have even more control over the cash. 

... the main effect of opting into the CIC form is that the governing statute would then limit the extent to which the firm's governance ever could be changed through a takeover or similar device to restrict the manager’s control over the cash.

If US corporation law codes were more clearly understood to be enabling statutes, there is nothing the CIC buys you (other than the label) that could not be done via the articles of incorporation of a standard business corporation. The articles of an aspiring US CIC would include:

1. A nonshareholder constituency interest shark repellent. These provisions permit, and in some cases require, directors to consider a variety of nonprice factors in evaluating a proposed acquisition. A typical one allows directors to consider "the social, legal and economic effects of an offer upon employees, suppliers, customers and others having similar relationships with the corporation, and the communities in which the corporation conducts its business."
2. Restrictions on payment of dividends.
3. Strong takeover defenses. Perhaps a combination of a poison pill, a classified board, and a dual class capital structure in which management holds supervoting shares. Although changes to the articles require board approval, a belt-and-suspenders corporate social responsibility advocate would want to further protect these provisions by requiring some sort of supermajority vote to amend them.(All of these devices, by the way, are discussed at length in my book Mergers and Acquisitions.)

Unfortunately, it's not at all clear that US corporate law is sufficiently enabling to achieve this result. State law arguably does not permit corporate organic documents to redefine the directors' fiduciary duties. In general, a charter amendment may not derogate from common law rules if doing so conflicts with some settled public policy. In light of the well settled shareholder wealth maximization policy, nonmonetary factors charter amendments therefore appeared vulnerable. This problem seems especially significant for Delaware firms, as Delaware law became increasingly hostile to directorial consideration of nonshareholder interests in the takeover decisionmaking process.

The question of whether corporate law is sufficiently enabling strikes me as one of the two big issues. The other is how to give a B corp teeth.

Manne's Primer on Corporate Governance

Several years ago, famed law and economics scholar Henry Manne published a very fine essay on corporate governance in the WSJ($), which is perhaps even more timely today in light of Senator Schumer's proposed Shareholder Bill of Rights. 

Manne's essay begins with an analysis of proposals to increase disclosure of executive compensation and to enhance the power of shareholders, which are two key aspects of Schumer's bill, concluding:

Only in the make-believe world of SEC regulation could anything like the proxy fight be seen as a significant solution to the agency-cost problem of exorbitant salaries.

I agree, for the reasons detailed at length in my article The Case for Limited Shareholder Voting Rights.

Henry's proposed alternative solution to the ills of corporate governance will come as no surprise to those who know him; namely, a reinvigorated market for corporate control.

Henry writes:

... free markets do not tolerate economic inanities for long, even in the case of large, publicly held companies. Contrary to the popular liberal shibboleth, markets do not often fail on their own. It usually requires help from the government. In the late '50s and '60s, we witnessed the early development of the hostile tender offer -- the most powerful market tool ever devised for dealing with non-profit-maximizing managers in publicly held companies. It did not appear before this time for the simple reason that there were very few companies that had the wide diffusion of stock ownership prerequisite to hostile tender offers. Tax laws and a growing understanding of the virtues of share diversification changed all that, and hostile takeovers were not slow then in making their appearance.

But their appearance was, for incumbent managers, a terrifying thing: surprise offers for almost all outstanding shares at a huge premium over current market price -- and with little time for shareholders or the corporation to shop the offer, or for the incumbents to mount a counterattack or defense. The opportunity for affording such a premium, of course, was created by the low stock market value generated by the policies of the incumbent managers. There were no inefficiencies in the stock market that generated incorrectly low prices for these companies' shares.

... Until we return to something like the pre-Williams-Act market for corporate control, we shall continue to see egregious salaries, crazy option grants, and golden handshakes and parachutes. Disclosure as a solution to that problem is a bit like a New Orleans levee faced with Katrina. A return to the takeover law of the '60s would substantially solve the compensation problem without ungainly regulation, and it would also deliver us from vacuous and harmful notions of corporate social responsibility. All that is required is a little guts from Mr. Cox, confidence in free markets from the managers of large corporations, and some humility about economic regulation from the U.S. Congress.

I would quibble with Henry on a couple of points. First, I don't entirely share his faith in the efficiency of the stock market. As I detail in my book Mergers and Acquisitions (at 54-56): In standard economic theory, a control premium is not inconsistent with the efficient capital markets hypothesis. The pre bid market price represented the consensus of all market participants as to the present discounted value of the future dividend stream to be generated by the target—in light of all currently available public information. Put another way, the market price represents the market consensus as to the present value of the stream of future cash flows anticipated to be generated by present assets as used in the company's present business plans. A takeover bid represents new information. It may be information about the stream of future earnings due to changes in business plans or reallocation of assets. In any event, that pre bid market price will not have impounded the value of that information. To the extent the bidder has private information, moreover, the market will be unable to fully adjust the target's stock price.

Some commentators contend that the demand curves for stocks slope downwards and may even approximate unitary elasticity. If so, buying 50% of a company's stock would require a price increase of 50%. If so, little or no new wealth is created by takeovers. Instead, takeover premia are largely an artifact of supply and demand.

Put another way, the downward sloping demand curve hypothesis takeover premium implies that many investors have a reservation price higher than the pre-bid market price of the target corporation’s stock. Indeed, because investors with a reservation price below the prevailing market price should already have sold, most investors’ reservation price will be near or above the prevailing market price. Accordingly, a bidder must offer a control premium simply to induce those investors to sell. As to those investors, however, the portion of the control premium reflecting their reservation price really should not be considered new wealth.

Second, I find the notion that takeovers are driven by disciplinary concerns unpersausive. If there are alternative explanations of how takeovers create value, the market for corporate control loses some of its robustness as a policy engine. Put another way, awarding the lion's share of the gains to be had from a change of control to the bidder only makes sense if all gains from takeovers are created by bidders through the elimination of inept or corrupt target managers and none of the gains are attributable to the hard work of efficient target managers.

The empirical evidence suggests that takeovers produce gains for many reasons, of which the agency cost constraining function of the market for corporate control is but one. Studies of target corporation performance, for example, suggest that targets during the 1980s generally were decent economic performers. Second, studies of post takeover workforce changes find that managers are displaced in less than half of corporate takeovers. Third, as already noted, acquiring company shareholders frequently lose money from takeovers. If displacing inefficient managers was the principal motivation for takeovers, acquiring company shareholders should make money from takeovers. Finally, there is little convincing evidence that acquired firms are better managed after the acquisition than they were beforehand. In sum, displacement of inefficient managers is a plausible way in which takeovers create value, but it is hardly the only way—and it may not even be a particularly important way. (I cite these studies at pages 48-49 of my Mergers and Acquisitions text.)

Finally, there is a very strong argument for allowing incumbent target managers to at the very least compete to retain control. (I discuss this argument in my recent paper Unocal at 20: Director Primacy in Corporate Takeovers, which also makes a number of other arguments for granting target management a gatekeeping function in takeover fights.)

Michael Dooley has suggested that management resistance to unsolicited tender offers may not deserve the opprobrium to which it is usually subjected. Michael P. Dooley, Fundamentals of Corporation Law at 561-63. Observing that it would be naive to assume that takeovers displace only “bad” or “inefficient” managers, while acknowledging that blamelessness does not eliminate the managers’ conflict of interest, he suggests that “resistance may not deserve the opprobrium usually attached to self-dealing transactions.” Id. at 562.

Indeed, Dooley observes, it may often be shareholders rather than managers who act opportunistically in the takeover context. Id. Much of the knowledge a manager needs to do his job effectively is specific to the firm for which he works. As he invests more in firm specific knowledge, his performance improves, but it also becomes harder for him to go elsewhere. An implicit contract thus comes into existence between managers and shareholders. On the one hand, managers promise to become more productive by investing in firm specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. In return, shareholders promise job security. See Stephen M. Bainbridge, Interpreting Nonshareholder Constituency Statutes, 19 PEPPERDINE L. REV. 971, 1004-08 (1992).

Viewed in this light, the shareholders’ decision to terminate the managers’ employment by tendering to a hostile bidder “seems opportunistic and a breach of implicit understandings between the shareholders and their managers.” DOOLEY at 562. Shareholders can protect themselves from opportunistic managerial behavior by holding a fully diversified portfolio. By definition, a manager’s investment in firm specific human capital is not diversifiable. Shareholders’ ready ability to exit the firm by selling their stock also protects them. In contrast, the manager’s investment in firm specific human capital also makes it more difficult for him to exit the firm in response to opportunistic shareholder behavior. See John C. Coffee, Jr., Shareholders versus Managers: The Strain in the Corporate Web, 85 MICH. L. REV. 1, 73-81 (1986).

Dooley concedes that this analysis certainly helps explain the courts’ greater tolerance of conflicted interests in this context than in, say, garden variety interested director transactions. But he also argues that the possibility that the shareholders’ gains come at the expense of the managers does not justify permitting management to block unsolicited tender offers. Rather, he argues, the managers’ loss of implicit compensation appears to be a particularly dramatic form of transaction costs, which could be reduced by alternative explicit compensation arrangements, such as payments from shareholders to managers who lose their jobs following a takeover. It thus may be that courts tolerate management involvement in the takeover process not because they perceive management as having a right for management to defend its own tenure, but rather a right to compete with rival managerial teams for control of the corporation. By allowing management to compete with the hostile bidder for control, the courts provide an opportunity for management to protect its sunk cost in firm-specific human capital without adversely affecting shareholder interests. Indeed, allowing them to compete for control will often be in the shareholders’ best interests. There is strong empirical evidence that management-sponsored alternatives can produce substantial shareholder gains. See Michael C. Jensen, Agency Costs of Free Cashflow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 324-26 (1986) (summarizing studies of shareholder gains from management-sponsored restructurings and buyouts). A firm’s managers obviously have significant informational advantages over the firm’s directors, shareholders, or outside bidders, which gives them a competitive advantage in putting together the highest valued alternative. Management may also be able to pay a higher price than would an outside bidder, because to a firm’s managers’ the company’s value includes not only its assets but also their sunk costs in firm specific human capital. Shareholders thus have good reason to want management to play a role in corporate takeovers, so long as that role is limited to providing a value maximizing alternative.

It is certainly true that any management response to an unsolicited tender offer, other than pure passivity, triggers a competition between two or more rival managerial teams for control of the corporation. The competition is obvious when an unsolicited tender offer is made to the shareholders of the target of a locked-up negotiated acquisition. But a competition also results when management defends against a standard hostile takeover bid by putting forward a management-endorsed white knight bid, a management-sponsored leveraged buyout proposal, a restructuring of the corporation’s control structure transferring effective voting control to management and its allies, a restructuring preserving management’s incumbency by making the target unpalatable to hostile bidders, or even merely a management statement urging shareholder to reject the bid. Revlon’s progeny appear to encourage this sort of competition, so long as it is conducted fairly, by making it clear that the board in conducting an auction must have a very good reason for skewing the auction in favor of one of the competing bidders. Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1993); Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1286 (Del. 1989); Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1286-87 (Del. 1989).

Yet, to focus on competition between incumbent management and the outside bidder would obscure the critical role played by the board of directors. The Delaware courts have rejected formalistic and formulaic approaches to takeovers. Instead, they have adopted a case-by-case search for conflicted interests. Where the facts suggest that the directors have allowed self-interest to affect their decisions, they have lost, but where the directors pursued the shareholders’ interests, Delaware courts have deferred to their decisions, even where the court might not have made the same decision.

Arianna Huffington

On our way to DC.

arianna huffington 1
Originally uploaded by ProfessorBainbridge.com

Centralized Planning

In the latest issue of The Nation, Max Fraser asked "Who's Afraid of Industrial Policy?"

We need a bold industrial policy aimed at bridging the gap between older industries and emerging ones, revitalizing the moribund manufacturing sector, supporting an economy based on high-wage union jobs and attending to the crucial climate concerns that impact us all.

What puzzles me about people like Fraser is how anyone can persist in believing in the efficacy of central planning. Centrally planned economies tend to be less efficient than free ones. Examples abound to confirm that thesis. The Great Leap Forward failed. Saudi five year plans have failed to deliver. Centrally controlled forests in Tanzania didn't work. Even some fans of the New Deal will admit that it was not the New Deal but rather World War II that finally got the economy going again after the Depression. To the contrary, as Milton Friedman demonstrated, it was government that caused the Great Depression.

Canon Digital Rebel XT Kit for Sale

Over on eBay, I'm selling my Canon Rebel XT DSLR:

This extensive set includes:

• Canon EOS Digital Rebel XT 8 MP Camera body
• EFS 18-55 MM zoom lens
• EFS 17-85 MM zoom lens with image stabilization w/ 67mm UV lens filter attached
• Ultrasonic 70-300 MM lens with image stabilization and 58 mm circular polarizer attached
• Lens case for 70-300 MM lens
• EFS 60 MM macro lens w/ 52 mm UV lens attached
• spare battery
• 3 lens hoods of assorted sizes
• Manuals for camera and macro lens included
• Assorted 58mm and 67mm lens filters
• Camera bag
• Tamrac rolling CyberPro Flyer camera kit carry on bag
• Charlotte K Lowrie's Canon EOS Digital Rebel Field Guide (250+ page guide)

Battery charger NOT included 

Bonus item:

• Canon Powershot SD950 IS w/ battery charger

Condition: All items used but in very good to excellent condition

How much do you want bet that Al Davis tries to sign Michael Vick? What a pair they'd make. Ugh.

The Many Roles of the Board of Directors

The SEC's proposed shareholder access rules are premised on the monitoring model of the board of directors. We see this, for example, in SEC Chairman Mary Shapiro's comments that:

The nation and the markets have recently experienced, and remain in the midst of, one of the most serious economic crises of the past century. This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors, to the interests of shareholders. These concerns have included questions about whether Boards are exercising appropriate oversight of management, whether Boards are appropriately focused on shareholder interests and whether Boards need to be more accountable for their decisions regarding such issues as compensation structures and risk management.

The trouble with this argument (or, more precisely, one of many problems with it) is that the monitoring model is a terribly incomplete understanding of the board's role.

In my article Why a Board?, I puzzled over the fact that corporation law expects the corporation to governed not by a single autocrat but by a committee acting by consensus. In the course of teasing out the rationale for this structure, I noted that boards have several different functions:

What then does the board produce and how does it produce it? First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital.

... At the core of the board’s service role is providing advice and counsel to the senior management team, especially the CEO. At the intersection of the board’s service and monitoring roles is the provision of alternative points of view. Put another way, most of what boards do requires the exercise of critical evaluative judgment, but not creativity. Even the board’s policymaking role entails judgment more than creativity, as the board is usually selecting between a range of options presented by subordinates. The board serves to constrain subordinates who have become wedded to their plans and ideas, rather than developing such plans in the first instance.

As an admittedly anecdotal example, consider the saga of RJR Nabisco’s efforts to develop a smokeless cigarette. As the story goes, management spent millions of dollars on the project. When the board was finally informed, many directors were reportedly angered by management’s failure to consult with them beforehand. Their anger was wholly justified, for the smokeless cigarette flopped. Those responsible resigned to avoid being fired. The corporation would have been better served if the board had been advised of the project early in its development. Those responsible seem to have been wedded to the project, a tendency the board might have been able to counteract.

I also noted that Congress in Sarbanes-Oxley and the stock exchanges in their corporate governance listing standards have been pushing for ever more independent boards of directors and to focus the board on its monitoring role. Although there is much that is commendable about greater board independence, a focus on the board's monitoring role can become counterproductive if it results in an adversarial relationship between the CEO and the board. In such a case, even if the board remains able to monitor effectively the CEO, the board's ability to fulfill its other roles may be compromised.

My argument found support in a paper by economists Renee Adams and Daniel Ferreira:

This paper analyzes the consequences of the board's dual role as an advisor as well as a monitor of management. As a result of this dual role, the CEO faces a trade-off in disclosing information to the board. On the one hand, if he reveals his information, he gets better advice. On the other hand, a more informed board will monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, our model shows that management-friendly boards can be optimal. Using the insights from the model, we analyze the differences between a sole board system, such as in the United States, and the dual board system, as in various countries in Europe. We highlight several policy implications of our analysis.

The current shareholder access proposal reflects a moronic mindset on the part of its drafters that one size fits all. As someone with my, shall we say, "robust" physique can attest from long experience, that is always a lie. Even so, the SEC seems determined to further increase board independence, with no regard to the impact of the proposal on the board's other functions. 

Whatever incremental enhancement the proposal provides in board monitoring is likely to be swamped by the deleterious impact on the board's other functions.

Meetings and Dominance Rituals

Because I fancy myself something of a student of how groups make decisions, during meetings I devote much of my time not to the agenda but to observing how the group is behaving. As the owner of three dogs over the years, I'm also necessarily something of a student of pack behavior and dominance rituals. Lately, I've been thinking about how the two lines of inquiry overlap. After all, effective boards of director meetings presumably promote effective corporate governance.

It is well-established that persons of higher stature within the group tend to talk more than persons of lower stature. Where the group is a new one, and status relations are undefined, however, the competition for speaking time becomes a critical part of the larger competition for dominance within the group. In turn, this leads to filibustering, cross-talk, and other dysfunctional behaviors that may prevent the meeting from accomplishing anything substantive.

You can usually identify the would-be alpha dogs pretty easily. They will start talking and simply not stop. Typically both their volume and speaking speed will be high. They will not meet anyone in the eye for an extended period and will ignore "I want to talk" body language. Anything said by anyone else will be immediately woven back into the filibustering speaker's line of argument, including express disagreement or even non sequiturs.

There are several ways of managing this sort of competition. One is to define a group hierarchy pre-meeting, perhaps by establishing a chairman as a presiding officer, who becomes the alpha dog by definition. An effective chairman can keep control of the agenda and keep the meeting on course. Unfortunately, just as a weak-minded owner invites his/her dog to compete for dominance, an ineffectual chairman can actually make the situation worse by inviting nominal subordinates to compete for control.

Alternatively, you can believe that people are not pack animals and hope to set up an egalitarian, non-hierarchical, consensus-building atmosphere. Personally, I don't believe it is possible to do so. Humans are pack animals. We are hard-wired by evolution to establish dominance relationships, which is probably one reason we were able to so successfully domesticate dogs. Studies of chimpanzees, for example, find that "high-ranking females were shown to have significantly higher infant survival, faster maturing daughters, and more rapid production of young." Our ancestors thus got a significant reproductive and genetic reward for successfully competing for dominance.

Competition for dominance, moreover, is arguably socially beneficial. Once a clear dominance hierarchy (pecking order) is established, aggression within the group becomes less likely, because less dominant individuals will not incur the high costs of challenging more dominant individuals. The resulting social stability facilitates subsequent cooperation between group members.

Hence, for effective meetings, it likely will be best if the group has a dominance hierarchy imposed on it from the outside at the outset or collectively establishes one at the earliest opportunity, so as to minimize the amount of time spent on non-constructive dominance rituals. (The benefits of such competition, after all, follow mainly from the establishment of the hierarchy rather than the competition itself.)

(Or, you can do what I often do, which is to slip out the back door and go for a drive.)

If I'm right about the way dominance rituals affect group decision making in meetings, it suggests that one function of the board of directors is providing a set of status equals for top managers. We know, for example, that higher status group members are more inclined to propound initiatives and exercise greater influence over the group’s ultimate decision. As such, corporate law’s insistence on the superiority of the board to management begins to make sense. To the extent law shapes social norms, admittedly a contested proposition, corporate law may empower the board to constrain top management more effectively by creating a de jure status relationship favoring the board.

Break up California?

As I watch the California economy crumble into the sea, pondering whether the state will default first on my municipal bonds, my salary, or my pension, I'm struck by the absurdity that the world's eighth largest economy (we used to be seventh, BTW) is essentially ungovernable. There's a radical solution floating around, upon which Joe Weisenthal comments:

... the state's uber-democratic system is broken beyond repair. It's truly a failed state, in the classic political science sense of the term. If it were its own country, the US would be consulting with the UN and NATO about establishing a presence and supervising elections. So the state needs radical help, and a bailout will only make things worse. But theoretically the state is salvageable, argues Breakingviews, if only because the state could both afford higher taxes and reduce state spending. Spending is far from bare-bones levels, and state employees are extremely well paid.

But Breakingviews actually proposes a much more radical solution, which is breaking California up into 4 distinct states (seriously). Think of it like good bank/bad bank, but for states. Actually it's a little different. The idea is not that this will solve the state's financial problems, but that it will split it into four coherent political units, which would be:

• San Diego/Orange County/Inland Empire (socially conservative, Hispanic, heavily military)


• Greater LA (Hollywood and Hispanics, very liberal)


• San Francisco/Silicon Valley (Liberal, but very dynamic and market oriented)


• Central (Conservative, Kansas-like)

This is a political scientist's late night fantasy and doing this might actually solve some political problems, but in the end it wouldn't work. The first state to go would be Greater LA. You see, the Hollywood liberal types may love to support government spending and immigration, but the moment the entire burden fell on them to support the rest of the population they'd scream bloody murder. You know they would. And it's probably a gloss-over to just say that the San Diego state would be solidly "conservative" just because there's a lot of military and socially conservative Hispanics there. There'd be huge public support tensions over spending and government safety nets.

Beyond that, national Republicans would never go for this, since you'd essentially be creating three new Democratic states (it sounds like Central would probably be Republican), giving Democrats permanent dominance in the US Senate.

As for his second point, what if we broke Texas up into the 5 states contemplated by its annexation agreement? Most of them would be GOP states, which would balance out the new democratic states formed by breaking up California.

The more serious objection would be the near impossibility of allocating water rights.

Even so, it's at least as plausible an idea as the laughable hypothesis that the legislature can actually fix out budget problems.

GM's Problems: Too Much CSR?

I recently ran across an old post by Dale Oesterle on the form of corporate social responsibility waged by GM:

There is a sizable group of academics that favor empowering boards of directors to favor constituencies other than shareholders (employees, suppliers, local citizens) in corporate decision making.  GM overpaid labor, buying peace for managers, at the expense of shareholder profit (and share price) for years.  Now GM's survivability is at stake; employees themselves would be better off it the GM board had been more careful of shareholder profits.  Railroads situation is similar to GM (they have special legislation that protects their unions). Compare GM's (or the railroad's) situation to that of Caterpillar's.  Caterpillar went through some tough strikes to hold the line on labor costs;  Caterpillar is now doing very well and is an international success story. The theory of shareholder primacy, rejected by many academics, is that in 9 cases out of 10, sustained shareholder profits are a surrogate for long-term gains for other constituencies -- when shareholders make money over-time, employees have good, stable jobs.  If we hold boards accountable for profits, all constituencies, over-time, also benefit.

Still timely today. And it makes you wonder about the merits of giving the UAW 55% of Chrysler.

The Most Conservative Law Faculties

Brian Leiter:

Among the top law schools, Northwestern University and University of Virginia are clearly both the farthest to the right and with the most prominent scholars, but Harvard University isn't far behind (with Goldsmith, Manning & Vermeule, among others). University of Notre Dame is right up there, and so too George Washington University, University of San Diego, and George Mason University. Chapman University and Brigham Young University would also have to be mentioned as centers of conservative legal scholarship, though probably not as prominent as the preceding. Most, but not all, of the top law schools have at least a couple of prominent legal scholars "on the right"--e.g., Epstein & E. Posner at Chicago, Baker & Rodriguez at Texas, Bainbridge & Volokh at UCLA, Barnett & Rosenkranz at Georgetown, Benjamin & Young at Duke, Bobbitt (on some issues) & Monaghan at Columbia, among others--and certainly the American right is better-represented on U.S. law faculties than the social democratic left, but that just speaks, again, to the indexical character of the terms "left" and "right," or "liberal" and "conservative."

You'd have to have a very narrow definition of the 'social democratc left" and a very broad definition of the right to say the former is less well represented on law faculties than the latter.

Anyway, Brian continues:

Of course, it is probably worth remembering that in most areas of scholarship and legal study, political ideology sheds almost no light on the substantive, analytical issues serious scholars and students must grapple with.

Right.

What the Future of American Motoring Will Look Like

Yesterday, Megan McArdle observed of the Obama Administration's new automobile gas mileage standards that:

• It will raise the prices of cars, and make them less safe
• It will reduce our carbon emissions, but not by as much as advertised, because more fuel efficient cars make driving cheaper, so people will do more of it. This "rebound" effect robs about 25% of gains, and also means more congestion, and more wear-and-tear on roads
• This will either help the Big Three compete, or seal their doom as the Japanese manufacturers continue to eat into their market share. If I had to bet, I'd wager this means big ongoing subsidies for our favorite three public charities.
• If you want to cut down on the pollution from driving, this is about the worst possible way to do it. On the other hand, it may be the only politically feasible way to do it. If you take global warming seriously, as I do, it may be the best of a bad set of policy choices.

I couldn't agree more. (Patrick Appel gathers additional commentary.)

What I bring to the table is not additional commentary. Instead, by virtue of being an Anglophile gearhead, I have seen the future of motoring. (Actually, it's more a back to the future sort of thing.) It's a mixed bag, at best:

As a bonus, you also get a brilliant send up of diversity training.

SEC Proxy Access Proposal

SEC Chairman Mary Shapiro announced that the SEC is, as expected, revisiting the question of shareholder access to the proxy statement. Here speech is available here. Money quote:

The nation and the markets have recently experienced, and remain in the midst of, one of the most serious economic crises of the past century. This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors, to the interests of shareholders. These concerns have included questions about whether Boards are exercising appropriate oversight of management, whether Boards are appropriately focused on shareholder interests and whether Boards need to be more accountable for their decisions regarding such issues as compensation structures and risk management.

The trouble, of course, is that Board accountability is not a primary concern of the SEC. It is a concern of state corporate law.

Back in 2004, when the SEC last considered proxy access I published A Comment on the SEC Shareholder Access Proposal, to which I would refer those interested in a detailed legal analysis of shareholder access. For the benefit of readers to whom foonotes are abhorent, this seems an opportune moment to reprint my op-eds on shareholder access from the last go round:

Does the SEC Know When Enough Is Enough?

The Securities and Exchange Commission is now considering proposed regulations designed to allow shareholders to nominate directors and, moreover, to require the incumbent directors to place the shareholder's nominee on the company's own proxy statement and ballot, albeit under relatively limited circumstances. At first blush, the regulation strike many people as perfectly reasonable. After all, directors are elected by shareholders, so why shouldn't the shareholders be allowed to nominate directors?

This argument, however, fails to put the SEC proposal in context. The SEC's proposed regulations are just the latest in a continuing string of new corporate governance rules. Taken together, these new rules have significantly increased the regulatory burden on Corporate America. So let's step back and look at the SEC proposal in its proper context: the recent corporate scandals and the government's response.

Good for Government

History teaches that market bubbles are fertile ground for fraud. Cheats abounded during the Dutch tulip bulb mania of the 1630s. The South Sea Company, which was at the center of the English stock market bubble in the early 1700s, itself was a pyramid scheme. No one should have been surprised that fraudsters and cheats were to be found when we started turning over the rocks in the rubble left behind when the stock market bubble burst in 2000.

We all know the litany, of course: accounting scandals at Enron and WorldCom, to cite but two; insider trading at ImClone; alleged looting at Adelphia and Tyco; and so on. New York's attorney general, Elliott Spitzer has brought to light high profile problems calling into question the integrity of both stock market analysts and mutual fund managers.

Corporate scandals are always good news for big government types. After every bubble bursts, going all the way back to the South Sea Bubble, a slew of new laws have been enacted. Why? There is nothing a politician or regulator wants more than to persuade angry investors that he or she is "doing something" and being "aggressive" in rooting out corporate fraud. Look, for example, at how vigorously the SEC is trying to keep up with attorney general Spitzer.

Hence, it was entirely predictable that the shenanigans at Enron, WorldCom et al., coming after several years of steady decline in the stock market, would lead to regulation. Yet, how quickly we forget. Remember what Ronald Reagan said: "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"

Costs Beginning to Mount

Like a cook who throws spaghetti at the wall to see if it's done, legislators and regulators have been throwing a lot of new rules at corporations to see what sticks: Sarbanes-Oxley, numerous SEC regulations, California's onerous corporate disclosure act, Spitzer's settlement with the analyst community, and countless law suits and indictments. Unlike the cook, who stops when the spaghetti is done, the lawmakers just keep throwing stuff at corporations without stopping to ask whether enough is enough.

The costs of all this regulatory activity are beginning to mount. Some companies, for example, will incur 20,000 staff hours to comply with just one SEC new rule -- a rule the SEC estimated would require only 383 staff hours per firm. According to a study by Foley Lardner, "Senior management of public middle market companies expect costs directly associated with being public to increase by almost 100% as a result of corporate governance compliance and increased disclosure as a result of the Sarbanes-Oxley Act of 2002 (SOX), new SEC regulations and changes to [stock] exchange listing requirements."

If adopted, the SEC's shareholder access proposal would significantly add to that regulatory burden. A review of contests in the late 1980s found that insurgents spent an average of $1.8 million and incumbents an average of $4.4 million. Those costs are almost certainly much higher today, but let's use them as a baseline. Assume that a company faces a shareholder nominee every three years. Assume further that a shareholder nomination contest costs one-third what a full proxy contest costs. On those assumptions, each public corporation would face annualized costs of about $500,000. Using the 10,000 actively traded U.S. companies in the Compustat database as a proxy for the number of companies potentially subject to the rule, we can estimate an aggregate annual cost of $5 billion. Of course, I may be overestimating the number of contests and the cost of each contest. Remember two things, however: (1) I'm using 1980s era cost estimates and (2) the SEC grossly underestimated the cost of complying with Sarbanes-Oxley.

A more conservative estimate might use data about shareholder proposals under current SEC regulations. According to the SEC's own figures, the cost per company of including a shareholder proposal in the proxy statement is $87,000. ISS tracked 1,042 shareholder proposals at public corporations during the 2003 proxy season, which gives us total corporate expenditures on shareholder proposals of $90,654,000.

Either way, there can be no doubt that giving shareholders access to the proxy statement to nominate directors is going to be expensive. Plus there are all the indirect costs. Companies are already having a hard time attracting independent directors. The shareholder access proposal likely will make that search even harder. Why would somebody be willing to serve on the board if he or she might be the one singled out to be ousted?

Disrupting Successful Boards

The election of a shareholder representative also will disrupt the delicate internal dynamics that make boards successful. Its effect will be analogous to that of cumulative voting, which allows minority shareholders representation on the board. Experience with cumulative voting suggests that it often leads to pre-meeting caucuses by the majority and a reduction in information flows to the board as a whole. In turn, this results in adversarial relations between the majority and minority board members, which interferes with effective board governance.

Is it clear that the benefits of shareholder access will exceed these costs? Why, for example, should you and I have to subsidize some activist or gadfly who wants some free publicity?

If the SEC could figure out a way to limit the proposal to situations in which the board is clearly dysfunctional, these concerns might less important. The problem is that the SEC rules apply to all public corporations, whether their internal governance is good, bad, or just indifferent. As currently drafted, a shareholder would be allowed to put its nominee on the corporation's proxy if one of two triggering events occurred:

· A shareholder puts forward a proposal to authorize shareholder nominations, which is then approved by the holders of a majority of the outstanding shares; or

· Shareholders representing at least 35% of the votes withhold authority on their proxy cards for their shares to be voted in favor of any director nominated by the incumbent board of directors.

Nothing in either trigger limits the rule to the Enrons of the world. If enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of all these reforms, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest?

Just as a good cook eventually stops throwing spaghetti at the wall, it is time for the regulators to stop, take a deep breath, and stop throwing new reforms at Corporate America. Let's wait and see how the first couple of rounds of reform play out before imposing yet more burdens on corporations in our still precarious economic environment.

The SEC: From Bad to Worse?

In October of last year, the SEC proposed a new rule that would permit shareholders to directly nominate directors of the corporations in which they have invested. As I detailed in my TCS column, Does the SEC Know When Enough Is Enough?, the proposal was seriously flawed. It was likely to impose significant indirect costs on corporations, without much in the way of countervailing benefits. (For more details, see my blog's archive of posts on the rule.)

As bad as the original proposal was, however, things may be about to take a turn for the worse.

The WSJ ($) reports that a "compromise" is in the works, under which:

"While details of the proposal are still being worked out, it would essentially allow shareholders to sit down with a company and agree on a person to replace a director who has been targeted by investors for removal. If an agreement couldn't be reached, shareholders would likely gain the right to nominate their own director the following year. The proposal may allow companies to bypass negotiating with investors if they agree to include shareholder-backed nominees on the ballot the following year."

Problems:

(1) Which shareholders get to sit down with management? All of them, which can be in the millions, or just a select few? If a select few, how do we ensure that the interests of the few coincide with those of the many? How, for example, do we ensure that unions don't use the shareholder access rule for leverage in collective bargaining (as they often use the current shareholder proposal rule)? Or that social activists don't use it to promote a social agenda at odds with the profit-maximization interests of most shareholders?

(2) If adopted, the proposal may deter qualified individuals from being willing to serve as a member of the board. There will be a significant risk that activist investors will use the rule frequently and at numerous companies. Unlike the current system, under the rule, the activists will be targeting individual investors. Who would want to serve as a director if there is a significant risk one might be singled out for a smear campaign by unhappy investors? (Granted, the effect may only be at the margins, but many companies report that in light of the director liabilities created by Sarbanes-Oxley they are already having a hard time attracting independent directors.)

(3) The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the board's decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes. A chief indirect cost of the proposed compromise therefore will be less effective governance.

(4) Finally, and perhaps most disturbingly, there is still nothing in the reported compromise that would limit the rule to situations in which the targeted board is clearly dysfunctional. Instead, it apparently still applies to all public corporations, whether their internal governance is good, bad, or just indifferent. Hence, if enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of the rule, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest?

Several recent major SEC rules were adopted by a 3-2 vote, with SEC Chairman Donaldson (a Republican) siding with the Commission's two Democrats against his two fellow Republicans. It's been reported that Chairman Donaldson doesn't want to see that happen to this particularly controversial rule. Potential dissenters Glassman and Atkins thus may have significant leverage. If they can't use it to kill the proposal, they should use at the very least use it to emasculate the rule so that it does as little damage to corporate governance as possible.

Proxy Fright

In the Wall Street Journal, Robert Pozen recently proposed that the Securities and Exchange Commission should adopt two new rules to empower shareholders:

"First, the SEC should allow shareholders of a public company to propose in its proxy statement a bylaw disqualifying any director nominee who receives less than a majority of the votes cast from being renominated at the company's next election. If approved, the bylaw would permit such a director to be seated after an uncontested election because there are no competing candidates. In the next election, however, such a director could not be nominated again for a seat on that company's board. ...

"Second, instead of risking investor confusion by combining company and shareholder candidates in the same proxy statement, the SEC should help reduce the costs of making a separate solicitation of proxies for a minority of directors running for office: a "short list" rather than a full slate of nominees. Under current SEC rules, proponents of a short list must incur enormous expense by mailing proxy statements to every company shareholder. To reduce these costs, the proponents of a short list should be allowed to publish their proxy statements on the Internet, according to a task force of the American Bar Association. Internet publication would reach most company shareholders, small and large, especially if the company's Web site included a Web address for the materials of the short list proponents.

Pozen is a very serious and influential fellow -- chairman of MFS Investment Management, former member of the President's Commission to Strengthen Social Security, former associate general counsel of the SEC, and so on -- so anything he recommends is likely to get a serious hearing in Washington. Unfortunately, these are both very bad ideas.

If adopted, the short list proposal would significantly increase the prospect of a divided board of directors. As with all minority representation schemes, such as cumulative voting or codetermination, the resulting divisions within the board of directors will significantly reduce the board's effectiveness.

Granted, some firms might benefit from the presence of skeptical outsider viewpoints. It is well-accepted, however, that cumulative voting tends to promote adversarial relations between the majority and the minority representative. The likelihood that cumulative voting will results in affectional conflict rather than cognitive conflict thus leaves one doubtful as to whether firms actually benefit from minority board blocks.

The likelihood of disruption in effective board processes is confirmed by the experience of German firms with codetermination. German managers sometimes deprive the supervisory board of information, because they do not want the supervisory board's employee members to learn it. Alternatively, the board's real work is done in committees or de facto rump caucuses from which employee representatives are excluded. As a result, while codetermination raises the costs of decision making, it seemingly does not have a positive effect on substantive decision making.

The likely effects of electing a short list therefore will not be better governance. It will be an increase in affectional conflict (as opposed to the more useful cognitive conflict). It will be a reduction in the trust-based relationships that causes horizontal monitoring within the board to provide effective constraints on agency costs. It will be the use of pre-meeting caucuses and a reduction in information flows to the board. In sum, it will be less effective governance.

Expanding the Federal Role

Both of Pozen's proposals are also problematic because they would represent a significant and unwarranted expansion of the federal role in corporate governance. In particular, variants on his first proposal, relating to a requirement that directors be elected by majority vote, are currently being actively debated in state legislatures around the country and among the drafters of the American Bar Association's influential Model Business Corporations Act.

For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states.

As the US Supreme Court explained in CTS Corp. v. Dynamics Corp., 481 U.S. 69 (1987):

"It ... is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares."

Indeed, the Court opined that "[n]o principle of corporation law and practice is more firmly established than a State's authority to regulate domestic corporations." It thus is state law that determines the rights of shareholders, "including ... the voting rights of shareholders."

The basic case for federalizing corporate law rests on the so-called "race to the bottom" hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

The problem is that the race to the bottom theory makes no economic sense and is unsupported by the empirical evidence.

Basic economic common sense tells us that investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not lend to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes.

The empirical research bears out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time. A study by Yale law professor Roberta Romano of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive stock price gains. In other words, reincorporating in Delaware increased shareholder wealth.

This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. (For a good summary of the research, see Roberta Romano, The Advantage of Competitive Federalism for Securities Regulation.)

Additional support for this conclusion is provided by state takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware's single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by Harvard law professor John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly.

According to the Supreme Court's CTS decision, the country as a whole benefits from the fact that this area is regulated by the states rather than the federal government. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law.

As Justice Brandeis pointed out many years ago, "It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country." So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by rules like those proposed by Pozen will preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed -- no "laboratory" of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete.

In conclusion, the SEC should promptly toss Pozen's proposals into the circular file. This is an area best left to the states.

Football and Baseball as Metaphors for the Governance of Organizations

Perhaps Michael Novak's observation about the difference between football and baseball explains why a corporate governance guy like me prefers the former:

In football, on each play eleven men act in unison, and in each action not the individual but the corporate unit acts. When Bart Starr completed a pass for the Green Bay Packers, all the Packers could be said to share the deed; one man alone is quite helpless. When Joe DiMaggio stepped to the plate in Yankee Stadium with his unforgettable stance and fluid swing, DiMaggio stood in spotlighted solitude, and none of his teammates could act in his behalf. Football is corporate, baseball an association of individuals.