ProfessorBainbridge.com

Directors Cut?

My latest TCS Daily column

After the Enron fiasco, reformers identified director independence as the miracle cure for everything that ails corporate governance. In Sarbanes-Oxley, Congress mandated new stock exchange listing standards requiring the corporations have a majority of independent directors and audit committees comprised solely of independent directors. The NYSE and NASDAQ have gone even further in mandating strict new director independence rules.

Shareholder activists are now taking the campaign for director independence to even greater lengths than anyone anticipated. ISS, the leading proxy voting advisory service, recently astonished observers by urging its clients to oppose reelecting Warren Buffett as a director of Coca-Cola because Buffett didn't satisfy ISS' strict definition of director independence. Then CalPers - the big California public employee pension fund -announced that it too opposed Buffett's reelection.

Not to put too fine a point on it, but this is insane. Warren Buffett is probably the most respected investor of all time. Not only is he tremendously successful as an investor, but his integrity is remarkable for a businessman of his stature. Buffett owns almost 10% of Coke's stock, moreover, which means that his personal financial interests are closely aligned with those of other shareholders (albeit not perfectly). Finally, Buffett qualifies as an independent director under the NYSE's listing standards. If Warren Buffett doesn't qualify as independent under the ISS' and CalPers' standards, the problem is with the standards not Mr. Buffett.

Yet, it just gets worse. CalPers recently announced that it will oppose the reelection of some or all of the directors at over 2,700 companies. In other words, CalPers thinks most big public corporations are being managed by the wrong people.

All of which raises a large question: Do corporations really need any independent directors, let alone a board majority of such directors? They are such an ingrained part of the corporate landscape that it seems odd even to ask the question. Yet, it is still worth asking.

In theory, independent directors oversee management and discipline managers whose performance is sub-par. If true, there should be an identifiable correlation between the presence of outsiders on the board and firm performance. In fact, however, the empirical data on this issue is decidedly mixed.

A meta-analysis of numerous studies in this area concluded that there was no convincing evidence that firms with a majority of independent directors outperform other firms. To the contrary, it found some evidence that a "moderate number" of insiders correlates with higher performance.

Interestingly, while another meta-review by Dan Dalton in the Strategic Management Journal found that, on average, increasing the number of outsiders on the board is positively associated with higher firm performance, it also found that increasing the number of insiders on the board had the same effect. In other words -- as confirmed by a second meta-analysis by John Wagner in the Journal of Management Studies - the review found that greater board homogeneity was positively associated with higher firm performance. (I reviewed the empirical studies in depth in my article A Critique of the NYSE's Director Independence Listing Standards.)

The clearest take-home lesson to be gleaned from the available evidence is that one size does not fit all. This result should not be surprising. On one side of the equation, firms do not have uniform needs for managerial accountability mechanisms. We all know managers whose preferences include a penchant for hard, faithful work. Firms where that sort of manager dominates the corporate culture have less need for outside accountability mechanisms.

On the other side of the equation, firms have a wide range of accountability mechanisms from which to choose. Independent directors are not the sole mechanism by which management's performance is monitored. Rather, a variety of forces work together to constrain management's incentive to shirk: the capital and product markets within which the firm functions; the internal and external markets for managerial services; the market for corporate control; incentive compensation systems; auditing by outside accountants; and many others. The importance of the independent directors' monitoring role in a given firm depends in large measure on the extent to which these other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does.

The critical mass of independent directors needed to provide optimal levels of accountability also will vary depending upon the types of outsiders chosen. Strong, active independent directors with little tolerance for negligence or culpable conduct do exist. A board having a few such directors is more likely to act as a faithful monitor than is a board having many nominally independent directors who shirk their monitoring obligations.

CalPers and ISS, along with Congress and the exchanges, are trying to strap all listed companies into a single model of corporate governance. By establishing a highly restrictive definition of director independence and mandating that such directors dominate both the board and its required committees, they fail to take into account the diversity and variance among firms.

Investors would be better served by an approach that allows each firm to develop the particular mix of monitoring and management that best suits its individual needs. Assuming that markets have any power to affect market actors, this approach would have resulted in optimal levels of accountability. Rational investors will not purchase, or at least not pay as much for, securities of firms lacking management accountability mechanisms. Nor will lenders lend to such firms without compensation for the risks posed by management's lack of accountability. Those firms' cost of capital will rise and their earnings will fall. Corporate managers have many strong incentives to prevent this from happening, not the least of which is that management compensation and wealth are often closely tied to firm earnings and performance.

Because monitoring by independent directors is an important source of accountability, market forces will lead management voluntarily to support the election of independent directors and to implement firm specific mechanisms designed to ensure that their directors are able to carry out their monitoring function. Nobody at CalPers or ISS has stronger incentives than that.

Directors Cut?

After the Enron fiasco, reformers identified director independence as the miracle cure for everything that ails corporate governance. In Sarbanes-Oxley, Congress mandated new stock exchange listing standards requiring the corporations have a majority of independent directors and audit committees comprised solely of independent directors. The NYSE and NASDAQ have gone even further in mandating strict new director independence rules.

Shareholder activists are now taking the campaign for director independence to even greater lengths than anyone anticipated. ISS, the leading proxy voting advisory service, recently astonished observers by urging its clients to oppose reelecting Warren Buffett as a director of Coca-Cola because Buffett didn't satisfy ISS' strict definition of director independence. Then CalPers - the big California public employee pension fund -announced that it too opposed Buffett's reelection.

Not to put too fine a point on it, but this is insane. Warren Buffett is probably the most respected investor of all time. Not only is he tremendously successful as an investor, but his integrity is remarkable for a businessman of his stature. Buffett owns almost 10% of Coke's stock, moreover, which means that his personal financial interests are closely aligned with those of other shareholders (albeit not perfectly). Finally, Buffett qualifies as an independent director under the NYSE's listing standards. If Warren Buffett doesn't qualify as independent under the ISS' and CalPers' standards, the problem is with the standards not Mr. Buffett.

Yet, it just gets worse. CalPers recently announced that it will oppose the reelection of some or all of the directors at over 2,700 companies. In other words, CalPers thinks most big public corporations are being managed by the wrong people.

All of which raises a large question: Do corporations really need any independent directors, let alone a board majority of such directors? They are such an ingrained part of the corporate landscape that it seems odd even to ask the question. Yet, it is still worth asking.

In theory, independent directors oversee management and discipline managers whose performance is sub-par. If true, there should be an identifiable correlation between the presence of outsiders on the board and firm performance. In fact, however, the empirical data on this issue is decidedly mixed.

A meta-analysis of numerous studies in this area concluded that there was no convincing evidence that firms with a majority of independent directors outperform other firms. To the contrary, it found some evidence that a "moderate number" of insiders correlates with higher performance.

Interestingly, while another meta-review by Dan Dalton in the Strategic Management Journal found that, on average, increasing the number of outsiders on the board is positively associated with higher firm performance, it also found that increasing the number of insiders on the board had the same effect. In other words -- as confirmed by a second meta-analysis by John Wagner in the Journal of Management Studies - the review found that greater board homogeneity was positively associated with higher firm performance. (I reviewed the empirical studies in depth in my article A Critique of the NYSE's Director Independence Listing Standards.)

The clearest take-home lesson to be gleaned from the available evidence is that one size does not fit all. This result should not be surprising. On one side of the equation, firms do not have uniform needs for managerial accountability mechanisms. We all know managers whose preferences include a penchant for hard, faithful work. Firms where that sort of manager dominates the corporate culture have less need for outside accountability mechanisms.

On the other side of the equation, firms have a wide range of accountability mechanisms from which to choose. Independent directors are not the sole mechanism by which management's performance is monitored. Rather, a variety of forces work together to constrain management's incentive to shirk: the capital and product markets within which the firm functions; the internal and external markets for managerial services; the market for corporate control; incentive compensation systems; auditing by outside accountants; and many others. The importance of the independent directors' monitoring role in a given firm depends in large measure on the extent to which these other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does.

The critical mass of independent directors needed to provide optimal levels of accountability also will vary depending upon the types of outsiders chosen. Strong, active independent directors with little tolerance for negligence or culpable conduct do exist. A board having a few such directors is more likely to act as a faithful monitor than is a board having many nominally independent directors who shirk their monitoring obligations.

CalPers and ISS, along with Congress and the exchanges, are trying to strap all listed companies into a single model of corporate governance. By establishing a highly restrictive definition of director independence and mandating that such directors dominate both the board and its required committees, they fail to take into account the diversity and variance among firms.

Investors would be better served by an approach that allows each firm to develop the particular mix of monitoring and management that best suits its individual needs. Assuming that markets have any power to affect market actors, this approach would have resulted in optimal levels of accountability. Rational investors will not purchase, or at least not pay as much for, securities of firms lacking management accountability mechanisms. Nor will lenders lend to such firms without compensation for the risks posed by management's lack of accountability. Those firms' cost of capital will rise and their earnings will fall. Corporate managers have many strong incentives to prevent this from happening, not the least of which is that management compensation and wealth are often closely tied to firm earnings and performance.

Because monitoring by independent directors is an important source of accountability, market forces will lead management voluntarily to support the election of independent directors and to implement firm specific mechanisms designed to ensure that their directors are able to carry out their monitoring function. Nobody at CalPers or ISS has stronger incentives than that.

Martha and Sam Must be Kicking Themselves

ImClone stock hit $79.75 today after announcing a first quarter profit based on sales of its newly approved cancer drug Erbitux. You'll recall, of course, that Sam Waksal (former ImClone CEO) is in jail because he dumped his ImClone stock after the FDA initially turned down Erbitux's application. You'll also recall that Martha Stewart likely will go to jail for lying about her ImClone sales. What you may not remember is that Martha sold her 3,928 ImClone shares at an average price of $58.43. if she had held on, she'd be a free woman and about $8000 richer. Heh.

Martha and Sam Must be Kicking Themselves

ImClone stock hit $79.75 today after announcing a first quarter profit based on sales of its newly approved cancer drug Erbitux. You'll recall, of course, that Sam Waksal (former ImClone CEO) is in jail because he dumped his ImClone stock after the FDA initially turned down Erbitux's application. You'll also recall that Martha Stewart likely will go to jail for lying about her ImClone sales. What you may not remember is that Martha sold her 3,928 ImClone shares at an average price of $58.43. if she had held on, she'd be a free woman and about $8000 richer.

IMF Protests: Private Property and Freedom

The rights to private property and freedom of contract are important not just in their own right, but also because they provide essential limitations on the power of the state. As Russell Kirk observed, "freedom and property are closely linked: separate property from private possession, and Leviathan becomes master of all." Which leads us to this LA Times (R) report on protests at the IMF meeting:

Although Saturday's events lacked the intensity of some past IMF and World Bank protests, police estimated more than 100 vehicles — mostly SUVs and luxury cars — were spray-painted with anarchist symbols or scratched with keys. Two protesters were arrested for property destruction along the march route; one also allegedly assaulted an officer with a slingshot and thumbtacks.

So much for freedom under the anti-globalization movement.

IMF Protests: Freedom, Capitalism, and Abortion

From the LA Times (R) report on protests at the IMF meeting:

The IMF and World Bank protesters received support from women who said they planned to march in today's rally for women's reproductive rights. Some combined the themes, wearing shirts declaring their "pro-choice and anti-capitalist" sentiments. "It's all related," said Edith Wilson of Pittsburg, who came to Washington with her daughter for today's women's rights protest and joined in Saturday's march against the World Bank and IMF. "It's about freedom. People should have economic freedom, and women should have a right to choose."

Wilson has an odd concept of freedom. On the one hand, no economic system has ever done more to promote individual liberty than capitalism. As a societal decisionmaking norm, the economic freedom to pursue wealth does more than just expand the economic pie. A legal system that pursues wealth maximization necessarily must allow individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, is a necessary concomitant of personal liberty—the two have almost always marched hand in hand. The pursuit of wealth has been a major factor in destroying arbitrary class distinctions, moreover, by enhancing personal and social mobility. At the same time, the manifest failure of socialist systems to deliver reasonable standards of living has undermined their viability as an alternative to democratic capitalist societies in which wealth maximization is a paramount societal goal. Accordingly, it seems fair to argue that the economic liberty to pursue wealth is an effective means for achieving a variety of moral ends.

On the other hand, no "right" has ever done more damage to human freedom than the right to abortion on demand. Since the Supreme Court decided Roe v. Wade, more than 40 million babies have been killed by their own mothers. As John Paul has observed, this holocaust has had a terrible impact that goes beyond the vast number of lives lost:

However serious and disturbing the phenomenon of the widespread destruction of so many human lives, either in the womb or in old age, no less serious and disturbing is the blunting of the moral sensitivity of people's consciences. Laws and civil ordinances not only reflect this confusion but they also contribute to it. When legislative bodies enact laws that authorize putting innocent people to death and states allow their resources and structures to be used for these crimes, individual consciences, often poorly formed, are all the more easily led into error.

Personally, I would not wish to live in a country where people like Ms. Wilson get to define the scope of our freedoms.

IMF Protests: Sudan's Comments

From a LA Times (R) report on the IMF meeting and related protests:

"We share the increased optimism regarding the global recovery," said Sudan Finance Minister Elzubier Ahmed Elhassan, briefing reporters inside the heavily guarded IMF headquarters. "But we need to remain vigilant…. Poverty is a major contributor to global instability."

So is ethnic cleansing and religious violence:

A United Nations human rights fact-finding mission has arrived in the Sudanese capital, Khartoum, to look into allegations of ethnic cleansing of black Sudanese refugees who say Arab Sudanese militias committed atrocities and forced them to flee from their western Darfur homelands to neighbouring Chad. ...

Conflict erupted early last year in Darfur between the Sudanese Government and allied militias, on the one hand, and local rebel groups, on the other. In addition to refugees, as many as one million people are now internally displaced, sometimes out of the reach of humanitarian aid.

More on the Hunley

W. Thomas Smith, whose NRO piece on the Hunley I criticized, wrote Jeff Quinton (but not me) as follows:

This is great stuff... even if Bainbridge DOES refuse to read my piece in its entirety in order to grasp my premise. I'm talking about the honor and courage of the individual soldier for pete's sake. It's NOT about the POLITICS of the Confederacy. It's about the NOBILITY in the willing, obedient response to the call to arms.

If we were to follow the logic of the good professor, everyone who believes Bush was wrong for going into Iraq would also have to condemn every single soldier, sailor, airman, and Marine operating under Central Command.

This is so specious that it is difficult to know where to begin, but here goes. I did understand Smith's premise. Unlike him, however, I see no nobility - zero, zilch, nada - in a willing and obedient response to a call to arms when that call is issued by traitors and rebels. (What about the American revolutionaries, you ask? Setting aside the merits of the respective causes, the American revolutionaries did have this going for them: Treason never prospers, for if treason prospers none dare call it treason. And, moreover, I don't think you can set aside the merits of the cause. After all, by Smith's logic, Rommel was noble for responding willingly to Hitler's call to arms.) Hence, my logic does not extend to criticizing the soldiers in Iraq. Whatever the merits of the Iraq war, nobody except a few loonies thinks that Bush committed treason when he issued that call to arms. If Smith can't see that difference, he is beyond my ability to educate him.

Abolishing LLC Veil Piercing

Several years ago I wrote an article entitled Abolishing Veil Piercing, whose titular thesis called on courts to scrap the doctrine known as piercing the corporate veil. The standard justification for veil piercing argues it serves as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. As such, veil piercing is called upon to achieve such lofty goals as leading shareholders to optimally internalize risk, while not deterring capital formation and economic growth, but while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Such a doctrine is highly unlikely to consistently effect socially beneficial policy outcomes. Instead, veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability, increasing transaction costs for small businesses.

I therefore argued for abolishing veil piercing so as to refocus judicial analysis on the appropriate question, which I posited to be: Did the defendant-shareholder do anything for which he or she should be held directly liable? Did the shareholder commit fraud, which led a creditor to forego contractual protections? Did the shareholder use fraudulent transfers or insider preferences to siphon funds out of the corporation?

In this article, I extend the argument to LLCs.

At the outset, a distinction must be drawn between veil piercing and enterprise liability. Allocating liability within a business enterprise comprised of multiple corporations and/or LLCs involves far different policy considerations than does holding liable the natural persons who own a limited liability company. These tasks should be unbundled.

Intra-corporate group liability issues should be treated as a species of enterprise liability, with veil piercing being limited to determining the of the ultimate owners of the enterprise.

In the leading Kaycee decision, the Wyoming supreme court concluded: “We can discern no reason, in either law or policy, to treat LLCs differently than we treat corporations.” Admittedly, there is a certain intuitive logic to treating LLCs the same way we do corporations. Yet, why privilege the assumption that corporations and LLCs are to be treated the same?

Granted, there is little direct evidence that legislatures intended to treat LLCs and corporations differently. Yet, if legislatures had intended to incorporate the corporate law doctrines, they easily could have done so explicitly. Indeed, some states did exactly that. Given the ready availability of such models, one could infer that subsequently adopted statutes were not intended to incorporate corporate law rules in the absence of an explicit command so to do.

It is surprisingly difficult to find coherent explanations of the policy justifications for piercing the LLC veil, as opposed to mere assertions by fiat that such reasons exist. Two tend to crop up most frequently. One depends on a notion of corporate personhood and thus can be dismissed out of hand. The other views limited liability as creating a negative externalities-based market failure, which is true, but proves too much.

First, the externalities argument makes a better justification for repealing the general rule of limited liability than it does for carving out a veil piercing-based exception to the general rule. Hansmann and Kraakman, of course, invoked the externalities argument to justify their proposal the limited liability should be eliminated with respect to tort claims.

In lieu of rehashing those arguments, suffice it to note that their proposal has not been embraced by either legislatures or courts. To the contrary, “states have been busily expanding the scope of limited liability through the creation of such new enterprise forms as limited liability companies and limited liability partnerships.”

Second, there is no reason to believe that veil piercing causes equity claimants to internalize the risks associated with their business’ operations. Both in rhetoric and application, the doctrine focuses on such irrelevancies as observation of organizational formalities, not on whether the equity claimants used their control to externalize risk.

It seems unlikely that veil piercing even inadvertently addresses concerns over negative externalities. As we all know, the law of veil piercing is remarkably vague. Indeed, the doctrine is nothing more than analysis by epithet. As a result, application of the doctrine is rare, unprincipled, and arbitrary. The members of a LLC have a far greater chance of being struck by lightning than being held personally liable for their firm’s debts and other obligations.

Equity claimants of a limited liability entity, moreover, can very effectively insulate themselves from veil piercing-based personal liability by complying with minimal organizational formalities and providing modest levels of capital and/or insurance. How can such a dysfunctional doctrine possibly create appropriate incentives for the equity claimants of either a corporation or LLC to optimally internalize the social costs of their business activities?

Would abolishing veil piercing give businesses a license to externalize risk willy-nilly? I think not. First, market forces significantly constrain their ability so to do.

Second, the important category of cases in which a LLC’s members externalize business risks through personal misconduct remains subject to sanction under a number of legal regimes. In many nominally piercing cases, the plaintiff in fact could have brought a direct action against the shareholder under such theories as fraudulent conveyance or what have you.

Finally, in evaluating the externalities-based justification for veil piercing, context is critical. Modern industrial enterprises can do harm on a vast scale. In evaluating my competing proposal to abolish veil piercing with respect to LLCs, however, it is necessary to banish this specter from your mind. The appropriate mental image is not Union Carbide’s Bhopal disaster, to which so many critics of limited liability point, but rather Walkovszky’s injury at the hands of Carlton’s driver.

So framing the issue facilitates cost-benefit analysis. As we have seen, veil piercing has real costs. Ex ante, investors are denied certainty and predictability. Some investors will over-invest in expensive precautions, while others will under-invest in insurance and risk reduction. Ex post, the vague veil piercing standards lead to expensive litigation and, not infrequently, erroneous results.

Abolishing veil piercing would have significant affirmative benefits. George Priest has noted "that the expansion of enterprise liability since the 1970s in tort law has imposed differentially burdensome costs on small business."

Truly limited liability free of the risk of veil piercing could be viewed as one of the alternative government subsidies that offsets the differential burden of the tort system on small business. Interestingly, Larry Ribstein suggests that the spread of unincorporated limited liability entities, such as the LLC, was a backdoor mechanism for achieving tort reform. One thus may plausibly infer that the legislative expansion of the availability of limited liability reflects a shift in legislative intent “from merely encouraging and protecting passive investors to actively promoting business.”

The benefit of such a subsidy goes beyond the standard rationale of promoting capital formation. The 19th century legislators who first adopted limited liability as a central feature of corporate law did so, Stephen Presser contends, to encourage small and impecunious entrepreneurs to start and grow new businesses.

Entrepreneurs and other small business owners who tie up the bulk of their financial and human capital in their business have limited ability to protect that investment through diversification. Without the shield of limited liability, accordingly, only very wealthy persons would incorporate new businesses. Only persons of pre-existing wealth could afford to start a new business while maintaining a diversified portfolio of investments. This situation was precisely what limited liability was intended to remedy.

The shield of limited liability was created so as to encourage "the small-scale entrepreneur" and keep "entry into business markets competitive and democratic." Presser demonstrated that "the policy of limited liability, and its policy of encouraging incorporation by persons of modest means facilitated the growth of a viable urban democracy by allowing a wide participation in businesses that could most advantageously be organized as corporations.” In other words, limited liability “helped equalize the opportunities to get rich."

In turn, as Michael Novak has observed, the pursuit of wealth by entrepreneurs has been a major factor in destroying arbitrary class distinctions, by enhancing personal and social mobility.

With the LLC having displaced the close corporation as the vehicle of choice for smaller firms, Presser’s argument from democratic theory now applies to LLCs even more forcefully than it does to corporations.

Pro-piercing commentators typically argue that it would be “unfair to allow LLC is to possess the positive aspects of limited liability ... without also carrying the negative possibility of piercing.” This argument assumes a fact not in evidence, of course; namely, that veil piercing is sound public policy. In this article, I have demonstrated that the emerging doctrines for piercing the LLC veil are hopelessly dysfunctional. They encourage inefficient investment in irrelevant precautions, while encouraging expensive and complex litigation. They may discourage capital formation in small businesses by exposing those businesses to a disproportionate share of the burden from the tort liability system, which in turn undermines the valuable democratic contribution—at the risk of being too corny, the American dream—of small business ownership and entrepreneurship.

The Guantanamo Hearing

Reading the accounts of the Supreme Court's oral argument yesterday on the Guantanamo prisoner appeal, I am struck yet again by the unweening arrogance of the US judiciary. Set aside the substantive merits of the case, of which I believe Justice Jackson's aphorism "the Constitution is not a suicide pact" more than adequately disposes (see also my friend and colleague Eugene Volokh's more substantive critique). Instead, consider how offended some members of the Court seemed to be by the notion that any aspect of American life might lie outside their reach. Breyer, for example, complained: "It seems rather contrary to an idea of a Constitution with three branches that the executive would be free to do whatever they want, whatever they want without a check."

Apparently only the Supreme Court is "free to do whatever they want ... without a check." If five of the nine unelected old men and women on that court agree, they can strike down any law or executive action. And our elected representatives have essentially no power to constrain them other than the impractical route of amending the Constitution. We have allowed the Supreme Court to tell our elected representatives that they cannot pass morals legislation, for example, while a Supreme Court majority is free to impose its moral judgments on all of us. It is nothing short of judicial tyrrany.

My bet, by the way, is that the Court will rule that US courts have jurisdiction. And then we'll get some left-liberal judge (probably on the 9th Circuit) deciding to let the terrorists go.

Pension Funds Play Politics

My latest TCS Daily column

In the wake of the shareholder revolt at Disney, some of the big institutional investors are feeling their oats. American Federation of State, County and Municipal Employees (AFSCME) and other union pension funds sponsored almost half the shareholder proposals on proxy statements during this annual meeting cycle. They're also among the leading advocates of the SEC's pending shareholder access proposal (which I criticized in an earlier TCS column). It was CalPers -- the big California public employee pension fund -- that made perhaps the biggest splash by recently announcing that it will oppose reelection of some or all of the directors of over 2700 companies.

The "perfect storm" metaphor has been overused to the point of becoming a cliché, but how else can one describe the Disney vote? We saw a combination of long-term performance woes, a widely disliked and autocratic CEO, a hostile takeover bid in the offing, and a crew of dissident ex-directors -- including a member of the founding family -- leading a shareholder revolt. The big question left open is whether activist shareholders can catch the same lightning in a more routine bottle.

A 1998 survey by Stanford law professor Bernard Black found relatively little evidence that shareholder activism matters in corporate governance except perhaps at the very margins. Most institutional investors historically spent only trifling amounts on corporate governance activism. Most devote little effort to monitoring management; to the contrary, they typically disclaim the ability or desire to decide company-specific policy questions. They rarely conduct proxy solicitations or put forward shareholder proposals. They tend not to try to elect representatives to boards of directors. They rarely coordinate their activities.

Does the recent spurt of activism on the part of pension funds like CalPers suggest a major shift in the behavior of institutional investors generally? It seems unlikely. The vast majority of institutional investors -- like banks, insurers, mutual funds, and private pension funds -- show little interest in corporate governance. At most, they may bring pressure on managers resisting a takeover.

Instead, activism is principally the province of a very limited group of institutions. Almost exclusively, the activists are union and state employee pension funds. They are the ones using shareholder proposals to pressure management. They are the ones most likely to seek board representation. As AFSCME chairman Gerald McEntee recently told LA Times columnist James Flanigan: "We're not looking to take over the corporation, but to have a voice through one or two or three seats on the board."

One might reasonably wonder what a public employee union knows about running business corporations. Might they have another agenda for board representation?

The interests of large and small investors often differ. As management becomes more beholden to the interests of large shareholders, it may become less concerned with the welfare of smaller investors. If the large shareholders with the most influence are unions or state pensions, however, the problem is exacerbated.

The interests of unions as investors differ radically from those of ordinary investors. The pension fund of the union representing Safeway workers, for example, is trying to oust directors who stood up to the union in collective bargaining negotiations. Union pension funds have used shareholder proposals to obtain employee benefits they couldn't get through bargaining (although the SEC usually doesn't allow these proposals onto the proxy statement). AFSCME's involvement especially worries me; the public sector employee union is highly politicized and seems especially likely to use its pension funds as a vehicle for advancing political/social goals unrelated to shareholder interests generally.

Public pension funds are even more likely to do so. Indeed, the LA Times recently reported that CalPers' renewed activism is being "fueled partly by the political ambitions of Phil Angelides, California's state treasurer and a Calpers board member, who is considering running for governor of California in 2006." In other words, Angelides is using the retirement savings of California's public employees to further his own political ends.

Such abuse of public pension funds by incumbent politicians is unfair to their political opponents, other investors, and especially the retirees who depend on those funds. Studies have consistently shown that the greater the extent to which a public pension fund is subject to direct political control, the worse its investment returns.

More than half of Americans are now stock investors. Yet, only a select self-appointed few have become activists. All too often, their activism is directed at selfish interests inconsistent with those of investors at large. It's long past time for the SEC and Congress to recognize that empowering these shareholders with expanded access to the proxy statement and the boardroom is the worst sort of special interest legislation. (Then again, maybe they already know that.)

Pension Funds Play Politics

In the wake of the shareholder revolt at Disney, some of the big institutional investors are feeling their oats. American Federation of State, County and Municipal Employees (AFSCME) and other union pension funds sponsored almost half the shareholder proposals on proxy statements during this annual meeting cycle. They're also among the leading advocates of the SEC's pending shareholder access proposal. It was CalPers -- the big California public employee pension fund -- that made perhaps the biggest splash by recently announcing that it will oppose reelection of some or all of the directors of over 2700 companies.

The "perfect storm" metaphor has been overused to the point of becoming a cliché, but how else can one describe the Disney vote? We saw a combination of long-term performance woes, a widely disliked and autocratic CEO, a hostile takeover bid in the offing, and a crew of dissident ex-directors -- including a member of the founding family -- leading a shareholder revolt. The big question left open is whether activist shareholders can catch the same lightning in a more routine bottle.

A 1998 survey by Stanford law professor Bernard Black found relatively little evidence that shareholder activism matters in corporate governance except perhaps at the very margins. Most institutional investors historically spent only trifling amounts on corporate governance activism. Most devote little effort to monitoring management; to the contrary, they typically disclaim the ability or desire to decide company-specific policy questions. They rarely conduct proxy solicitations or put forward shareholder proposals. They tend not to try to elect representatives to boards of directors. They rarely coordinate their activities.

Does the recent spurt of activism on the part of pension funds like CalPers suggest a major shift in the behavior of institutional investors generally? It seems unlikely. The vast majority of institutional investors -- like banks, insurers, mutual funds, and private pension funds -- show little interest in corporate governance. At most, they may bring pressure on managers resisting a takeover.

Instead, activism is principally the province of a very limited group of institutions. Almost exclusively, the activists are union and state employee pension funds. They are the ones using shareholder proposals to pressure management. They are the ones most likely to seek board representation. As AFSCME chairman Gerald McEntee recently told LA Times columnist James Flanigan: "We're not looking to take over the corporation, but to have a voice through one or two or three seats on the board."

One might reasonably wonder what a public employee union knows about running business corporations. Might they have another agenda for board representation?

The interests of large and small investors often differ. As management becomes more beholden to the interests of large shareholders, it may become less concerned with the welfare of smaller investors. If the large shareholders with the most influence are unions or state pensions, however, the problem is exacerbated.

The interests of unions as investors differ radically from those of ordinary investors. The pension fund of the union representing Safeway workers, for example, is trying to oust directors who stood up to the union in collective bargaining negotiations. Union pension funds have used shareholder proposals to obtain employee benefits they couldn't get through bargaining (although the SEC usually doesn't allow these proposals onto the proxy statement). AFSCME's involvement especially worries me; the public sector employee union is highly politicized and seems especially likely to use its pension funds as a vehicle for advancing political/social goals unrelated to shareholder interests generally.

Public pension funds are even more likely to do so. Indeed, the LA Times recently reported that CalPers' renewed activism is being "fueled partly by the political ambitions of Phil Angelides, California's state treasurer and a Calpers board member, who is considering running for governor of California in 2006." In other words, Angelides is using the retirement savings of California's public employees to further his own political ends.

Such abuse of public pension funds by incumbent politicians is unfair to their political opponents, other investors, and especially the retirees who depend on those funds. Studies have consistently shown that the greater the extent to which a public pension fund is subject to direct political control, the worse its investment returns.

More than half of Americans are now stock investors. Yet, only a select self-appointed few have become activists. All too often, their activism is directed at selfish interests inconsistent with those of investors at large. It's long past time for the SEC and Congress to recognize that empowering these shareholders with expanded access to the proxy statement and the boardroom is the worst sort of special interest legislation. (Then again, maybe they already know that.)

Bainbridge on CSR

<p>I got an email from a reader today who asked whether I thought a &quot;proactive stance&quot; on corporate social responsibility would have prevented the Martha Stewart situation. I don't see how, but that may be because I don't really believe in CSR. I've got several articles that explain why in more detail:</p>

 

<ol><li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=303780">In Defense of the Shareholder Wealth Maximization Norm</a>: This essay was written as a reply to an article in the same symposium by Professor Ronald M. Green - &quot;Shareholders as Stakeholders: Changing Metaphors of Corporate Governance,&quot; 50 Wash. &amp; Lee. L. Rev. 1409 (1993) - in which Professor Green criticized the dominant view of corporate governance, according to which directors have a fiduciary duty to maximize shareholder wealth. In sharp contrast, this essay argues that the principle of shareholder wealth maximization is both a valid positive account of corporate law and also a legitimate normative proposition.</li>

<li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=461100">Catholic Social Thought and the Corporation</a>: Human dignity and freedom are central principles of Catholic social thought. This essay argues that preserving the economic freedom of corporations to pursue wealth is an essential part of effective means for achieving human freedom. To the extent prudential judgments about corporate regulation are required, the Church and civil society should strive towards a nuanced balancing of freedom and virtue.</li>

 

<li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10335">Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship</a>: The bulk of this essay is devoted to exploring the emerging communitarian theory of the firm. In the course of doing so, however, I also begin developing an explicitly conservative version of the law &amp; economics account of corporate law. The essay looks to the intellectual tradition that runs from Edmund Burke to Russell Kirk to articulate an alternative to both the left communitarianism of progressive corporate law scholars and the classical liberalism embraced by many practitioners of law and economics.</li></ol><p>I got an email from a reader today who asked whether I thought a &quot;proactive stance&quot; on corporate social responsibility would have prevented the Martha Stewart situation. I don't see how, but that may be because I don't really believe in CSR. I've got several articles that explain why in more detail:</p>

<ol><li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=303780">In Defense of the Shareholder Wealth Maximization Norm</a>: This essay was written as a reply to an article in the same symposium by Professor Ronald M. Green - &quot;Shareholders as Stakeholders: Changing Metaphors of Corporate Governance,&quot; 50 Wash. &amp; Lee. L. Rev. 1409 (1993) - in which Professor Green criticized the dominant view of corporate governance, according to which directors have a fiduciary duty to maximize shareholder wealth. In sharp contrast, this essay argues that the principle of shareholder wealth maximization is both a valid positive account of corporate law and also a legitimate normative proposition.</li>

<li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=461100">Catholic Social Thought and the Corporation</a>: Human dignity and freedom are central principles of Catholic social thought. This essay argues that preserving the economic freedom of corporations to pursue wealth is an essential part of effective means for achieving human freedom. To the extent prudential judgments about corporate regulation are required, the Church and civil society should strive towards a nuanced balancing of freedom and virtue.</li>

<li><a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10335">Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship</a>: The bulk of this essay is devoted to exploring the emerging communitarian theory of the firm. In the course of doing so, however, I also begin developing an explicitly conservative version of the law &amp; economics account of corporate law. The essay looks to the intellectual tradition that runs from Edmund Burke to Russell Kirk to articulate an alternative to both the left communitarianism of progressive corporate law scholars and the classical liberalism embraced by many practitioners of law and economics.</li></ol>

Economics as a Predictive Science

A provocative op-ed in today's WSJ ($) offers up a number of data points for the proposition that "inflation indices are not capturing fundamental structural changes under way in the economy," which leads to the following observation:

Economists try to position themselves as hard scientists, similar to physicists or chemists. They have derived laws of economics, on which they base their advice to businesses and politicians. Physical scientists, however, derive their laws from studying controlled environments, isolating their experiments and repeating them under the same conditions.

Economists don't have that luxury. Each economic cycle is unique, and has no obvious starting or ending point. Moreover, society is constantly changing in ways that are hard to understand while those changes are taking place. It's as if Galileo's famous experiment with metal balls were conducted by dropping them not from a stationary tower but from a wild ride at Disney World.

Economics is an important science, but it has allowed the political and business establishment to misuse it. Economists are asked to forecast future economic developments. They should be more forthright in saying that it can't be done.

I must confess that I have a lot more faith in the predictive power of microeconomics than macroeconomics, but I wonder what the guys at Marginal Revolution make of this? Or Arnold Kling? Or even Brad DeLong?

The Hunley

The section of US 29 near my family's home in Virginia is named the "29th Infantry Division Highway." Virginia National Guard troops from that famous "Blue and Grey" division helped lead the assault on Omaha Beach. I got to thinking about that when I read W. Thomas Smith's ode to the crew of the CSS Hunley, whose bodies were recovered from that early submarine and recently buried after a heroes' funeral:

Politics aside, those Confederate submariners who perished in the cramped hold of their submarine will always be part of America's military history. They were indeed American heroes, every bit as much as the courageous federal sailors and Marines they attacked.

Sorry, but I don't buy it. If the crew of the Hunley and their fellow Confederate soldiers and sailors had prevailed, would the Blue and Gray division have been on Omaha beach when the world needed them?

In my book, the Hunley's crew were traitors and rebels who tried very hard to rend asunder the nation Lincoln called "the last best, hope of earth," and all to defend the incredibly cruel and unjust system of chattel slavery. When I think of the dire consequences a Confederate victory would have had not just for Americans but for the whole world, I cannot regard those who perished on the Hunley as heroes.

Update: It gets worse. It turns out that some Confederate diehards actually wanted to ban the US flag from the Hunley funeral:

A Texas activist has posted a petition on the Internet asking the Hunley Commission to bar the U.S. flag from all ceremonies relating to the interment of the sub's final crew. So far, more than 1,600 people have signed the petition, which calls the Stars and Stripes the "eternal enemy" of the Hunley crewmen.

The chairman of the Hunley funeral project quite properly rejected that petition, although he did permit use of Confederate flags, apparently including the particularly noxious battle flag:

"Let me be absolutely clear. The Hunley submarine is a national treasure. As such, the flag of the United States of America and the "Star Spangled Banner" as well as the Confederate flags and "Dixie" will all be together at this funeral. We will celebrate in the spirit of the veterans of both sides as they did at their post-war reunions on the former battlefields. As far as I am concerned, the issue is closed."

I come from a military family with southern connections, but I really don't understand the enduring sentimental attachment of so many southerners to treason and rebellion. Confederate flags belong in history museums where people are educated about slavery and treason.

Update: W. Thomas Smith, whose NRO piece on the Hunley I criticized, wrote Jeff Quinton (but not me) as follows:

This is great stuff... even if Bainbridge DOES refuse to read my piece in its entirety in order to grasp my premise. I'm talking about the honor and courage of the individual soldier for pete's sake. It's NOT about the POLITICS of the Confederacy. It's about the NOBILITY in the willing, obedient response to the call to arms.

If we were to follow the logic of the good professor, everyone who believes Bush was wrong for going into Iraq would also have to condemn every single soldier, sailor, airman, and Marine operating under Central Command.

This is so specious that it is difficult to know where to begin, but here goes. I did understand Smith's premise. Unlike him, however, I see no nobility - zero, zilch, nada - in a willing and obedient response to a call to arms when that call is issued by traitors and rebels. (What about the American revolutionaries, you ask? Setting aside the merits of the respective causes, the American revolutionaries did have this going for them: Treason never prospers, for if treason prospers none dare call it treason. And, moreover, I don't think you can set aside the merits of the cause. After all, by Smith's logic, Rommel was noble for responding willingly to Hitler's call to arms.) Hence, my logic does not extend to criticizing the soldiers in Iraq. Whatever the merits of the Iraq war, nobody except a few loonies thinks that Bush committed treason when he issued that call to arms. If Smith can't see that difference, he is beyond my ability to educate him.