My colleague Lynn Stout and I are co-panelists today on a program here at the UCLA School of Law on Onward and Upward or Over the Cliff? The Future of Financial Reform and the U.S. Economy. My remarks will be based on my recent paper Dodd-Frank: Quack Federal Corporate Governance Round II. A written version of my remarks follows. Supporting citations can be found in the main paper.
Our economy suffered through two major asset bubbles during the first decade of this century: Dot.com at the start and housing at the end. Both were followed by what we might call “bubble laws.”
During a bubble people are lulled into inaction by the seemingly ever-rising value of their portfolios.
At the same time, however, the stage is being set for a post-bubble burst of regulation.
In the euphoria associated with a bubble, regulators and private gatekeepers tend to let their guard down, so potential fraudsters see an explosion of opportunities, and investors become both more greedy and trusting.
The net effect is a boom in fraud during bubbles, especially towards the end, when everybody is trying to keep the music going.
When the bubble inevitably bursts, investigators reviewing the rubble begin to turn up evidence of speculative excess and even outright rampant fraud. Investors burnt by losses from the breaking of the bubble and outraged by evidence of misconduct by corporate insiders and financial bigwigs create populist pressure for new regulation.
Given the upswing in populist anger and accompanying intense public pressure for action that follows the bursting of a major asset bubble, these periods offer “windows of opportunity to well-positioned policy entrepreneurs to market their preferred, ready-made solutions when there is little time for reflective deliberation.”
Our UCLA colleague Stuart Banner contends that deep-seated popular suspicion of speculation comes in bad financial times to dominate otherwise popular support for markets, resulting in the expansion of regulation. Financial exigencies embolden critics of markets to push their regulatory agenda. They are able to play on the strand of popular opinion that is hostile to speculation and markets because the general public is more amenable to regulation after experiencing financial losses.
As a result, bubble laws often “impose regulation that penalizes or outlaws potentially useful devices and practices and more generally discourages risk-taking by punishing negative results and reducing the rewards for success.”
We saw this in 2002 when Congress passed Sarbanes-Oxley. It contained a number of provisions that Yale law professor Roberta Romano apty called “quack corporate governance.”
SOX’s provisions created significant new costs that have had a deleterious effect on the economy and the capital markets. Several studies report that the increased costs associated with SOX are one reason for an increase in the number of public corporations deciding to go private. Other studies found that the costs associated with SOX negatively impacted foreign firms and encouraged them to delist from U.S. capital markets. High profile reports from groups like the Paulson Commission and the US Chamber of Commerce find that SOX has contributed significantly to a decline in the competitiveness of US Capital markets.
In a recent paper, which you can get at my blog ProfessorBainbridge.com, I identify 8 characteristics of “quack” corporate governance rules:
1. It is a bubble law, enacted in response to a major negative economic event.
2. It is enacted in a crisis environment.
3. It was a response to a populist backlash against corporations and/or markets.
4. It is adopted at the federal rather than state level.
5. It transfers power from the states to the federal government.
6. Interest groups that are strong at the federal level but weak at the Delaware level support it.
7. Typically, it is not a novel proposal, but rather a longstanding agenda item of some powerful interest group.
8. The empirical evidence cited in support of the proposal is, at best, mixed and often shows the proposal to be unwise.
All of Dodd-Frank meets the first four criteria. As I argue in the paper, the corporate governance provisions each satisfy all or substantially all of the remaining criteria.
I focus in the paper on 6 key provisions of Dodd-Frank:
1. Section 951’s so-called “say on pay” mandate, requiring periodic shareholder advisory votes on executive compensation.
2. Section 952’s mandate that the compensation committees of reporting companies must be fully independent and that those committees be given certain specified oversight responsibilities.
3. Section 953’s direction that the SEC require companies to provide additional disclosures with respect to executive compensation.
4. Section 954’s expansion of SOX’s rules regarding clawbacks of executive compensation.
5. Section 971’s affirmation that the SEC has authority to promulgate a so-called “shareholder access” rule pursuant to which shareholders would be allowed to use the company’s proxy statement to nominate candidates to the board of directors.
6. Section 972’s requirement that companies disclose whether the same person holds both the CEO and Chairman of the Board positions and why they either do or do not do so.
Each of these meets the criteria for “quack” corporate governance. Each displaces state corporate law with new federal one-size-fits-all mandates. Each was a longstanding goal of some interest group that is powerful at the federal level but weak in Delaware. In particular, the most important of these provisions—say on pay, compensation committees, and proxy access—are key parts of the institutional investor agenda.
Time does not permit me to go into the merits of each of the six proposals.
Instead, let me use this opportunity to emphasize that that systemic flaws in the corporate governance of Main Street corporations were not a causal factor in the housing bubble, the bursting of that bubble, or the subsequent credit crunch. To the contrary, “[a] striking aspect of the stock market meltdown of 2008 is that it occurred despite the strengthening of U.S. corporate governance over the past few decades and a reorientation toward the promotion of shareholder value.” The problem necessitating remedial action was the need to address the moral hazard inherent in the idea that some firms were too big to fail.
Even if flaws in the corporate governance of banks and financial institutions were a causal factor in the crisis that would not explain the form Dodd-Frank took. Banks have a number of characteristics that make their corporate governance problems radically different than those of nonfinancial firms. Yet, the provisions of Dodd-Frank addressed herein regulate the corporate governance of all public corporations, whether they are in the financial industry or not.
Instead, Dodd-Frank’s corporate governance provisions were included in the legislation because key policy entrepreneurs were able to hijack the legislative process to advance a longstanding political agenda. Specifically, as I already noted, all the major governance provisions were strongly supported by activists in the institutional investor community, especially union and state and local pension funds, for whom such items as proxy access and say on pay were high priority agenda items.
It seems reasonable to assume that these same activist investors will be the shareholders most likely to make use of their new powers. The interests of these activists, however, are likely to differ significantly from those of retail investors or even other institutions. Indeed, union and state and local pension funds are precisely the shareholders most likely to use their position to self-deal—i.e., to take a non-pro rata share of the firms assets and earnings—or to otherwise reap private benefits not shared with other investors.
SEC Commissioner Casey echoed these concerns in her dissent from the SEC’s adoption of proxy access:
I believe many [investor] activists will concede that their interests in proxy access do not lie solely in the ability to successfully place a nominee on a company’s board of directors; instead, the proxy access right is also an important means of obtaining leverage to seek outcomes outside of the boardroom that may otherwise not be achievable — outcomes that are often unrelated to shareholder value maximization.
The proposition that Dodd-Frank’s corporate governance provisions were a sop to special interests is further confirmed by the odd disconnect between the internal logic of those provisions and the back story of the financial crisis. Consider, for example, the question of executive compensation. Regulators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a contributing factor almost from the outset of the financial crisis. As was the case with almost all public U.S. corporations, banks and other financial institutions shifted in the 1990s to a much greater reliance on equity-based pay for performance compensation schemes. The rationale for such schemes is that they align the risk preferences of managers and shareholders. Because managers typically hold less well-diversified portfolios than shareholders, having significant investments of both human and financial capital in their employers, they tend to be much more averse to firm specific risk than diversified investors would prefer. Pay for performance compensation schemes that link managerial compensation to shareholder returns are designed to counteract that inherent bias against risk and thus align managerial risk preferences with those of shareholders.
As already noted, shareholder activists long have complained that these schemes provide pay without performance. This was one of the corporate governance flaws Dodd-Frank was intended to address, most notably via say on pay. The trouble, of course, is that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse, for the reasons just discussed. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders. Accordingly, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”
In sum, the shareholder empowerment measures adopted before the crisis did nothing to prevent it and may well have contributed to it. The new provisions included in Dodd-Frank thus are unlikely to prevent another such crisis and may even increase the odds of some similar crisis induced by excessive risk taking.
What we have in Dodd-Frank thus is a bubble law designed to promote rent seeking by a powerful interest group, which in my book makes it a classic example of quack corporate governance.
