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E-MailMartin Lipton’s speech last week in Miami, Shareholder Activism and the ‘Eclipse of the Public Corporation’, noted yesterday, got a strong reaction from the NYT‘s Gretchen Morgenson on Sunday – she called it a “rant,” as I discussed on my blog. But while Lipton is clearly angry, his speech is no mere rant, and I’m going to give it the attention it deserves.
Briefly, Lipton identifies alien forces that have besieged the modern corporation and are threatening the functionality of its key institution–the board of directors. Among other things, Lipton indicts:
–Activist investors who pressure the board to “manage for the short-term”;
–Experts who “reduce boardroom collegiality”;
–Powerful committees that function as “distinct fiefdoms”;
–Disruptive special investigation committees;
–Public pension funds that demand meetings with independent directors;
–Withhold-the-vote campaigns used to “embarrass compensation committee members”;
–The use of shareholder litigation as “a type of extortion”;
–“Media critics and governance watchdogs [who] simplify scandals and assume that all directors are at fault when something goes wrong”;
–Burdensome director screening that that discourages service by qualified candidates; and
–Governance watchdogs who “justify their existence and satisfy political motivations by finding new governance practices to propose each year”.
Lipton concludes by “embracing Professor (Michael) Jensen’s 1989 article [The Eclipse of the Public Corporation] less for the reasons he espoused in 1989 and more as the solution to the problems created by rampant, unrestrained and unregulated shareholder activism.”
I sympathize with Lipton’s litany of woe. I’ve discussed and criticized a lot of what bothers him on my blog over the years. Moreover, I think he’s correctly identified where all this is headed–the end of the publicly held corporation. Indeed, this was my topic at the AALS Agency, Partnership, LLCs and Unincorporated Associations Section of the AALS last month, where I presented a paper on the same topic, also drawing inspiration from Jensen’s “eclipse” paper.
However, I disagree with Lipton about what’s fueling the disruptive influences on corporate governance. To condemn all “shareholder activism” is to imply the irrelevance of accountability. Surely no organizational form is sustainable if it doesn’t deal successfully with agency costs. And this somehow has to involve the residual claimants.
The problem is that Lipton’s Goths who are storming the boardroom, while surely “activists,” are not quite so clearly “shareholders” in the sense that they are acting on behalf of the residual claimants. There’s at least an argument that the diversified shareholders care more about identifying successful new business strategies than they do about who sits on the compensation committee.
Yet all these groups Lipton attacks are clearly speaking to somebody. Why does anyone listen?
Let me put that question aside for a moment to agree with Lipton about his prediction of the eclipse of the publicly held corporation.
At the AALS I put these developments in the perspective of the rise of what I call the “uncorporation.” This is what is Jensen said was producing the “eclipse” of the public corporation sun. I refer not just to publicly held uncorporations like master limited partnerships, but also to the limited partnership private equity firms that are the descendants of the LBO associations Michael Jensen discussed in 1989, and to the limited partnership hedge funds that have intervened aggressively in corporate management (and are among the activist shareholders Lipton condemns).
These firms’ portfolios may be populated by corporations, but the uncorporations provide the critical managerial discipline. In other words, as I’ve said, this boom isn’t just about the restructuring and the leveraging of the portfolio firms, but about the structure of the “uncorporate” firms that are provoking and supervising these changes. This structure includes strong financial incentives for managers and real capital market discipline (because owners’ capital contributions are not permanent).
The rise of public equity is also fueled by the internal governance gaps of the public corporation form. Effective agency cost control requires more than just independent directors and shareholder proposals, but also more high-powered managerial incentives and owner discipline than the corporate form is able to provide. I discuss these problems in more detail in my articles Why Corporations? and Accountability and Responsibility in Corporate Governance.
Moreover, the rise of financial and supply markets is making the large publicly held firm less necessary. Outsourcing and derivatives are combining with regulation and shareholder activism to drive the standard public corporation form increasingly to the margin.
One indication of these developments is that one of the biggest financial events of the last week or so was the IPO of Fortress–an LLC that manages limited partnerships.
Finally I return to the mystery of what empowers the “activists” Lipton criticizes. I think part of the blame can be laid at the feet of Lipton himself. Lipton, after all, helped derail the takeover movement of the 80’s that Jensen wrote about, with his poison pill and high-tech arsenal of takeover defenses. The decline of takeovers created an accountability vacuum, which lent credence to arguments that public corporations needed some other form of “activism.”
But I don’t want to put too much stress on takeovers. I doubt that in the long run a continuation of the 80’s takeover boom would have saved the public corporation, any more than I think private equity will do the same today. The more fundamental forces that are marginalizing the public corporation form would still be present.
Which leads me to my final point. As I discussed in my Why Corporations? article, the corporation has stayed dominant through modern business history in part because it has had political support. In other words, perhaps we should be asking not why the public corporation is threatened, but why, despite everything, it continues to survive. The answer, I think, is that without the pseudo-democracy of the public corporation form, the activists that Lipton condemns would have no access to the levers of capitalism. Indeed, this explains at least some of the political hostility to private equity and hedge funds. These organizations, which truly serve the residual claimants, are a bit too much “shareholder activism” for the so-called “shareholder activists.”
In short, the activists that Lipton scorns are less a threat to the public corporation than its raison d’etre. The question is how much longer these groups will be able to stop the rise of the new business forms that are threatening to eclipse the public corporation.
One Comment
My law practice is focused in part on defending shareholder class and derivative actions, but here I am speaking for myself as a lawyer involved in securities litigation matters since 1973.
I believe that Martin Lipton’s recent speech in Miami was unfortunate in many ways. It appears to me that his remarks were an attempt to protect directors from organized attempts to hold them (or their D&O insurers) responsible even in those rare occasions when directors can be found to have engaged in egregious failure to execute their oversight duties. His hyperbole is particularly inappropriate given the prominence of his position and his vast experience. A more focused approach would have been far more interesting and useful.
I wish to comment in particular on his statement concerning “shareholder litigation” in his speech in Miami:
Although the number of cases brought each year seems to have leveled off after dramatic increases in the post-Enron period, shareholder litigation against directors has grown to be a big business and a type of extortion. While courts, commentators and legislators have long recognized the potential for abusive shareholder class actions, reforms aimed at reducing that potential have not had their intended effect. The recent Hubbard Committee report calls for further efforts to curb this type of litigation. Shareholder litigation continues to be hugely profitable for plaintiffs’ firms, without conferring any real benefits on shareholders generally.
The statement that “reforms aimed at reducing [the potential for abusive shareholder class actions] have not had their intended effect” is patently incorrect. Federal courts have aggressively enforced the requirements of Securities Exchange Act Section 21D(b)(1) and (2) (enacted as part of the Securities Litigation Reform Act of 1995) that plaintiffs in securities class actions plead extensive facts to justify their allegations that the defendants made material misrepresentations or omissions with scienter.
The recent Eleventh Circuit decision, Garfield v. NDC Health Corp., 466 F.3d 1255 (11th Cir. 2006), is a good example. There, the court affirmed the dismissal of a putative class action complaint alleging “channel stuffing” because of failure to comply with the specificity requirements of the PSLRA. The complaint alleged that “NDC understated expenses in violation of GAAP in three ways: ‘(1) it began to capitalize costs well before its development projects reached “technological feasibility;” (2) it amortized costs over periods much greater than the economic life of its software assets; and (3) it applied an excessive burden factor to its capitalized costs, thereby expensing less than necessary in the present term.” The Eleventh Circuit affirmed the dismissal, finding that the plaintiff’s “allegations regarding amortization and capitalization are vague and difficult to evaluate. For example, the Second Amended Complaint does not specify when the improper accounting occurred. It also fails to allege how and what products were improperly capitalized or amortized.” With respect to scienter, the court held that “it is possible to surmise that the Individual Defendants might have been aware of improper revenue recognition in the VAR channel and also knew that they needed to increase actual sales rather than ‘promot[e] discount buying[,]”that conclusion is based on multiple inferences and drawn from somewhat baffling language. [Plaintiff] failed to allege what was actually discussed at the meeting. Accordingly, the allegation regarding the meeting of March 1, 2004, does not give rise to a strong inference of scienter.” Finally, the court held that a certification of financial statements filed with the SEC in accordance with Sarbanes-Oxley is not per se indicative of scienter.
The Garfield decision has been aggressively followed in the district courts in the Eleventh Circuit. The October 2006 decision in Spectrum and the February 2007 decisions in Coca-Cola are good examples. It is only a matter of time before this important decision is cited in other circuits. And, of course, the law is not significant different in the other circuits.
Moreover, the Supreme Court has granted certiorari in a Seventh Circuit case in which the issue before the Court will be whether, in determining whether sufficient facts have been alleged to give rise to the required “strong inference” of scienter, courts are to weigh competing inferences from the allegations. The Sixth Circuit, for example, ruled six years ago that “plaintiffs are entitled only to the most plausible of competing inferences.”
Add to the 10b-5 case law the Delaware Supreme Court’s decision last year in Disney. I quote Professor Ribstein’s description of that decision: “It follows that the only way a board is going to be held liable for breach of fiduciary duty when it it isn’t self-dealing is to (1) really not have any idea what it is doing; and (2) not have a 102(b)(7) clause in the charter; or (3) have such a clause but proceed in conscious disregard of the board’s responsibility, which would be truly puzzling in the absence of self-dealing. In other words, the board will be liable for non-self-dealing conduct on a cold day in August in Miami under a blue moon.” It will be most interesting to see how the Delaware Supreme Court handles the recent decisions of Chancellor Chandler in the options backdating cases.
In short, the reforms are working. Any suggestion that they are not working would appear to be asking for blanket immunity for director decisions, no matter how egregious.
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[…] finally, see Why is the Public Corporation in “Eclipse”? by Larry Ribstein, where he discusses the rise of private equity, the decline of the public […]