In a WSJ op-ed today, Martin Lipton, Jay Lorsch, and Theodore Mirvis opine that:
This week New York Sen. Chuck Schumer is expected to introduce the Shareholder Bill of Rights Act of 2009. The stated goal of the legislation -- "to prioritize the long-term health of firms and their shareholders" -- is commendable.
The trouble is that its provisions actually encourage the opposite. In its current form, the bill would require annual votes by stockholders on executive compensation. It would grant stockholders a new right to include their own director nominees in the corporation's proxy statement. The bill would put an end to staggered boards at all companies (the traditional option of electing one-third of the board each year). And it would require that all directors receive a majority of votes cast to be elected. Public companies would be forced to split the CEO and board chair positions.
Excessive stockholder power is precisely what caused the short-term fixation that led to the current financial crisis. As stockholder power increased over the last 20 years, our stock markets also became increasingly institutionalized. The real investors are mostly professional money managers who are focused on the short term.
Let's continue breaking this collection of really bad ideas down into its component parts, picking up with (a prior post tackled the say on pay aspect):
A Federal Solution?
We live in an era of creeping federalization of corporate law. Indeed, some among Delaware’s elite finally seem to be waking up to the threat. A News Journal article reports that:
The most significant intrusion into Delaware territory came in 2002, following Enron and other corporate scandals. Congress passed the Sarbanes-Oxley Act, which created accounting and governance standards for public companies. It was seen by some as a turning point because it marked the first time Congress explicitly intruded into corporate governance.
[Mark] Roe, of Harvard, said: "If I was a Delaware lawyer, Sarbanes-Oxley would make me wary that there's a renewed chance the things I do for a living could move to Washington," Roe said.
Say on pay long has a particularly likely target for federalization. Not only did Barney Frank's say on pay bill (HR 1257) pass the House in 2008, but then-Senator Barack Obama sponsored the essentially similar Shareholder Vote on Executive Compensation Act in the Senate. And now we have the Schumer bill that would federalize say on pay and a host of other core corporate governance issues.
I believe that federalizing corporate governance is a task that should be approached with extreme caution. The state-based system of regulating corporate governance is one of the main strengths of the U.S. capital markets. Indeed, as Professor Roberta Romano famously claimed, state regulation and the resulting regulatory competition between jurisdictions it is the “genius of American corporate law.”
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. As the clear winner in this state competition, Delaware is usually the poster-child for bad corporate governance. Interestingly, the two main poster-children for reform, Enron and WorldCom, were not Delaware corporations. (They were incorporated in Oregon and Georgia, respectively.)
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.
Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns.[1]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.[2]
The event study findings are buttressed by a well-known study by Robert Daines in which he compared the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981-1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth.[3]Although subsequent research suggests that this effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data.
Additional support for the event study findings is provided by 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 John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder.[4]Given the clear evidence that hostile takeovers increase shareholder wealth,[5]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.
Arguments in favor of federal preemption, moreover, betray a complete lack of sympathy for—and perhaps even awareness of—the vital relationship between federalism and liberty. In other words, even if state competition is a race to the bottom, basic federalism principles would still counsel against federal preemption of corporate law. The corporation is a creature of the state, “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.”[6]In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.
According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area, as well. As Justice Powell explained in that case, 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.”[7]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 federal law 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.
The point is not merely to restate the race to the top argument. Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. if one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, such that exit by the regulated is no longer an option, an essential check on excessive regulation is lost.
--------------------------------------------------------------------------------
[1]Roberta Romano, Law as a Product: Some Pieces of the Incorporation Puzzle, 1 J. L. Econ. & Org. 225 (1985).
[2]See generally Roberta Romano, The Advantage of Competitive Federalism for Securities Regulation 64-73 (2002) (discussing the relevant studies and criticisms thereof).
[3]Robert Daines, Does Delaware Law Improve Firm Value?, 62 J. Fin. Econ. 525 (2001).
[4]John C. Coates IV, An Index of the Contestability of Corporate Control: Studying Variation in Takeover Vulnerability (June 30, 1999).
[5]See generally Stephen M. Bainbridge, Corporation Law and Economics 612-14 (2002).
[6]CTS Corp. v. Dynamics Corp., 481 U.S. 69, 91 (1987).
[7]New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).
It will be interesting to see what role VP Biden would play in confronting Shumer's proposal. As the former Senator from Delaware, I would expect Biden to be a vigorous opponent of further federalization of corporate law.
Posted by: Cornellian | 05/12/2009 at 02:11 PM
A further risk to U.S. markets resulting from the federalization of corporate law is that managers will seek to incorporate and capitalize their business interests outside of the U.S. - a trend that clearly followed Sarbanes-Oxley - and further reduce the U.S. share of the global market for corporate finance activity.
Posted by: Paul J. DesHotels | 05/12/2009 at 02:17 PM