Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law

Leo Strine, Chief Justice of the Delaware Supreme Court Review and a Senior Fellow of the Harvard Law School Program on Corporate Governance, recently published in the Columbia Law Review a response essay to an essay by Professor Lucian Bebchuk published in the Columbia Law Review several months earlier. Professor Bebchuk’s essay, The Myth that Insulating Boards Serves Long-Term Value, is available here and was featured on the Forum here. Chief Justice Strine’s essay, titled Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law, is available here.

The abstract of Chief Justice Strine’s essay summarizes it briefly as follows:

In his essay, The Myth That Insulating Boards Serves Long-Term Value, Professor Lucian Bebchuk draws a stark dichotomy between so-called “insulation advocates” and proponents of shareholder-driven direct democracy. This Essay begins by rejecting this crude divide between “good” and “evil,” and focuses instead on the practical realities surrounding increases in stockholder power in an era where there is a “separation of ownership from ownership.” That separation arises because the direct stockholders of private companies are typically not end-user investors, but instead money managers, such as mutual funds or hedge funds, whose interests as agents are not necessarily aligned with the interests of long-term investors. These practical realities suggest that Bebchuk’s crusade for ever more stockholder power may not actually be beneficial to ordinary investors, and that his contention—that further empowering stockholders with short-term investment horizons will not compromise long-term corporate value—is far from proven. This Essay concludes with some thoughts on improvements that could be made in the system that we have. These suggestions are not radical in either direction and they do not involve rolling back the rights of stockholders. Rather, these suggestions recognize that the fiduciaries who wield direct voting power over corporations should do so in a manner faithful to the best interests of those whose money they control, include proposals to require activist investors to bear some of the costs they impose and to disclose more information about their own incentives so that the electorate can evaluate their motives, and provide incentives that better align the interests of money managers and ordinary investors toward sustainable, sound long-term corporate growth. Taken as a whole, these suggestions would create a more rational accountability system by making all of the fiduciaries for ordinary investors focus more on what really matters for investors, citizens, and our society as a whole—the creation of durable wealth through fundamentally sound economic activity.

Chief Justice Strine provides a more detailed account of the analysis of his Essay in the introduction:

“According to my dear friend and colleague, the distinguished Professor Lucian Bebchuk, everyone who has at any time questioned the extent to which public corporations should be direct democracies whose board of directors and managers must follow the immediate whim of a momentary majority of stockholders can be labeled and lumped together as an “insulation advocate,” in order to create an intellectual straw man for him to burn down easily. Bebchuk is the sincere champion of one group of “agents” wielding power and authority over others’ money—the money managers who control most of the investments belonging ultimately to ordinary Americans who are saving to pay for their retirements and for their children’s education—against another group of “agents” that he believes is somehow more conflicted—the agents who actually manage corporations that make real products and deliver useful services (i.e. “productive corporations”). The fact that he is an advocate for the power of one group of privileged “haves” against another might lead a dispassionate observer to expect that Bebchuk would be cautious in drawing stark lines, on one side of which are the good and faithful agents—the money managers—and on the other side are the suspect and presumptively faithless agents—the managers of productive corporations. In fact, such an unwitting observer might infer that someone passionate about constraining the agency costs of those who directly manage productive corporations would also be passionate about constraining the agency costs of the money managers who directly hold other people’s money.

But Bebchuk is not an Adolf Berle who is concerned that all who wield economic and political power in a republican democracy are accountable for their responsible use of that power. That is not how Bebchuk approaches things. For him, there is only one set of agents who must be constrained—corporate managers—and the world will be made a better place when corporations become direct democracies subject to immediate influence on many levels from a stockholder majority comprised not of those whose money is ultimately at stake, but of the money manager agents who wield the end-users’ money to buy and sell stocks for their benefit.

In this crude divide between good and evil, Professor Bebchuk is not alone. Arrayed against him and his fellow “money manager advocates” are scholars, corporate lawyers, and businesspersons who view stockholders as having little to no utility in helping corporations generate wealth and who seem to wish stockholders would simply go away. As with Bebchuk’s fellow money manager advocates, there are differences among those who wish to constrain stockholder influence. In some cases, these skeptics go so far as to deny that boards of directors must, within the constraints of the law, make the best interests of stockholders the end goal of the governance of a for-profit corporation. Instead of accepting that a prerequisite to the application of the business judgment rule is that the directors have the same interest as the stockholders—i.e., in making the decision that will make the corporation the most profitable—these skeptics argue that the business judgment rule is really just a beard to give boards the cover they need to treat the stockholders’ best interest as only one of many permissible ends, including the best interests of the communities in which the corporation operates, the corporation’s consumers and workers, the environment, and society as a whole. In their minds, iconic cases like Dodge v. Ford and Revlon, which hold the opposite, are mere aberrations; really, the law is that boards can treat all constituencies equally in terms of the ends of management.

Inconvenient to this notion on two levels is an indisputable reality of American corporate law. That is the reality that if American corporate law makes all constituencies an end of corporate governance, American corporate lawmakers chose a decidedly unusual way to enable that equality. In American corporate law, only stockholders get to elect directors, vote on corporate transactions and charter amendments, and sue to enforce the corporation’s compliance with the corporate law and the directors’ compliance with their fiduciary duties. An unsubtle mind might believe that this statutory choice to give only stockholders these powers might have some bearing on the end those governing a for-profit corporation must pursue. But regardless of whether that is so as a matter of law, this allocation of power has a profound effect as a matter of fact on how directors govern for-profit corporations. When only one constituency has the power to displace the board, it is likely that the interests of that constituency will be given primacy.

More nuanced participants in the debate do not quibble with the notion that the end goal of for-profit corporations is the best interests of stockholders. But these participants argue that the best way to ensure that corporations generate wealth for diversified stockholders is to give the managers of corporations a strong hand to take risks and implement business strategies without constant disruption by shifting stock market sentiment. Those in this more measured place are troubled by the fact that traditional rights granted to stockholders may have a less desirable impact on the ability of corporations to generate wealth given important market developments, such as the realities that: Money manager intermediaries constitute a supermajority of those wielding actual stockholder rights rather than the long-term investors whose money is actually invested; activist investors are able to engage in hedging strategies that limit their exposure if their preferred strategies for the corporation do not turn out to be sound; putting together a momentary majority is easier today because of more concentrated ownership patterns and the Internet; and institutional investors have emerged who seem to be motivated by a desire for engagement for reasons unrelated to investment value. Even when the debate is narrowed to focus on the best interests of equity investors, these commentators worry that the demands of money managers and their advocates for additional rights will compromise the ability of corporations to pursue the most profitable courses of action for those whose money is ultimately at stake—the end-user investors saving to pay for college and retirement—because managers will be distracted and disrupted by constant mini-referendums and continual election seasons initiated by activist investors.

As may fit their shared experiences as Dungeons & Dragons aficionados, Bebchuk and his sparring partners share an affinity for exploring “myths” and engaging in rhetorical jousts where no real world blood is shed. One area of sharp disagreement between his money manager advocate team and the stronger insulation advocate team members is whether more wealth will be created for end-user investors by corporations if corporate managers are given more or less room to pursue strategies without fearing displacement of themselves or those strategies by stockholders. In this new essay, Bebchuk claims that there is no rational basis to believe that operating corporations under a direct democracy model will result in any reduction in the ability of corporations to generate profits in a durable manner. Even if the money managers who directly act as stockholders do not hold stock for more than the blink of an eye in real business terms, giving them more power for constant intervention is not worrisome because there is no empirical evidence that making corporate managers accountable to direct stockholder influence at all times, rather than periodically, reduces corporate value. In other words, Bebchuk argues that even if the activists proposing corporate action hold their shares for a few years at most and the electorate considering their proposals holds for months at a time, that does not necessarily mean that their incentives are distorted in any sense that might lead them to favor strategies that are inconsistent with the corporation’s ability to create the most long-term, sustainable economic value for stockholders and to honor its obligations to creditors and society as a whole.

By contrast, Bebchuk’s intellectual adversaries are skeptical that money managers, who buy and sell stocks rapidly in defiance of the core insight of the efficient capital market hypothesis (ECMH), are focused on whether strategies proposed by hedge funds are well-thought-out in terms of their effect on the corporation’s capacity to comply with its legal duties and generate strong profits on a long-term basis. Many of them view it as likely that money managers—who do not intend to be around when the consequences of corporate policies proposed by activist hedge funds come to fruition—will give great weight to the short-term effect of policies, without adequately considering whether those policies create too little long-term investment or too much leverage and externality risk. For end-user investors who depend on their portfolio’s ability to generate sustainable long-term growth, bubbles in equity prices that come at the expense of more durable and higher long-term growth are counterproductive. For society as a whole, further empowering money managers with short-term holding periods subjects Americans to lower long-term growth and job creation, wreckage from corporate failures due to excessive risk taking and debt, and the collateral harm caused when corporations face strong incentives to cut regulatory corners to maximize short-term profits.

As I understand the primary purpose of Bebchuk’s essay, it is to impose on the so-called insulation advocates the burden of proving that any limitation on the direct democracy model that money manager advocates favor is justified. Absent empirical proof that stockholder activism directed at corporations reduces stockholders’ returns, insulation advocates should be mute and accept Bebchuk’s view that corporations should be governed as direct democracies subject to the will of whatever majority happens to own their stocks at any particular time. Bebchuk marshals various empirical studies to support his contention that insulation advocates cannot meet the burden he puts before them. Although his essay is lengthy, his empirical claims are essentially two in nature and related. First, as to corporate governance rules of the road affecting how easy it is to replace a corporate board or effect a takeover—such as whether a corporation has a classified board—there is evidence that corporations without strong antitakeover defenses have higher values than similarly situated corporations with such defenses. In other words, Bebchuk contends that corporate managers who are more vulnerable to displacement by the market for corporate control deliver better returns. Second, and relatedly, Bebchuk argues that it has not been shown that long-term returns have been harmed because of the greater influence that reduced takeover defenses and increased electoral vulnerability for directors gives to activist investors such as hedge funds proposing that corporations change their business strategies. Because Bebchuk reductively focuses on equity returns, he blinds himself to any consideration of externality effects or the larger economic outcomes of the American economy for its citizens. Although he does not say so explicitly, one would suppose that he would argue, as others have, that what is good for equity holders as the so-called residual claimants is good for everyone else, and that if corporations can produce higher returns to equity, they will be better able to pay their other bills and honor their obligations to society.

I will not pretend to have had sufficient time nor training in statistical “social science” to evaluate whether Bebchuk’s review of the empirical evidence is convincing. I must admit to having a healthy skepticism whenever the “law AMPERSAND” movement cranks up its machinery and tries to prove empirically a contestable proposition about a complicated question involving the governance of a human community of any kind. I am particularly skeptical about claims that actions have no, this, or that effect in the long-term by reference to short-term period effects, justified by the argument that long-term effects cannot be measured because they are drowned out by “noise.” I cannot and will not claim that my respected friend Professor Bebchuk misstates the results of the studies he cites or that the one he himself conducted was done with anything but the greatest accuracy and rigor. I leave to others whose full-time job is writing academic articles to engage with the cited studies on those terms.

I do note that Bebchuk’s view—that there is no empirical reason to doubt that further moves toward the direct democracy model he favors will be good for long-term stockholder interests and those of society as a whole—is not universally shared. Respected scholars who are not fans of unconstrained corporate management believe that there are substantial reasons why a move to direct democracy might harm long-term corporate value. As they note, it is a solar system from the central claim of the ECMH—that it is unlikely that any person pursuing an active trading strategy is likely to outperform the market as a whole—to presuming that the stock market price of a particular company on a particular day represents a reliable estimate of the company’s future expected cash flows. They point to real world evidence that the companies most heavily engaged in and exposed to the risks of the financial practices that led to the financial crisis had received a premium in the stock market for doing so, despite the existence of public information suggesting that these practices were unsustainable in the long run and posed substantial risk. Bubble run-ups in the value of these companies’ stock might have provided value to stockholders engaged in rapid trading, but the companies’ stuck-in stockholders (such as those who were indexed) took the whole ride, which in some cases ended in a ravine. Furthermore, these scholars note that it is difficult to measure the system-wide costs of making corporate managers more directly accountable to changing market sentiments, but point out that such accountability could be dangerous to our economy’s long-term prospects for growth when a survey of corporate managers revealed that many of them would fail to pursue net present value positive capital investments if they feared that those projects would result in an inability to meet near-term earnings estimates. Some of Bebchuk’s debating adversaries even venture a more macro-level critique, wondering why proponents of direct democracy believe that the strong directional inertia in their favor should not be braked when a forest-level look at outcomes reveals: (i) much higher executive compensation and a growing disparity between CEO and average worker pay; (ii) unimpressive returns to stockholders; (iii) stagnant economic growth; (iv) the need for huge government subsidies for corporations and industries that engaged in speculative and excessively risky conduct in pursuit of stockholder profit; and (v) sharp declines in the number of American public corporations. Put simply, they wonder what big-picture results for stockholders, or Americans more generally, have come from the sharp move in the last quarter century toward making corporations more responsive to stockholder pressure that might justify the efforts of Bebchuk and his allies to continue to push corporations even closer to the direct democracy model.

Interestingly, Bebchuk’s debating adversaries have overlooked what might be seen as an admission on his part that increasing demands on corporations to manage to immediate stock market pressures might not be good for stockholders or society generally. Consistent with his distrust of agents who run actual corporations, Bebchuk has expressed concern about rewarding corporate managers for increasing the stock price without contractual protections requiring them to hold on to their equity for a long-term period. The reason: Bebchuk fears that if managers can benefit from short-term stock price increases without bearing the long-term risks that the policies causing those increases entail, they may propose and implement measures that sacrifice long-term, sustainable growth for short-term gain. In his own words: “Executives who are free to unload shares or options may have incentives to jack up short-term stock prices by running the firm in a way that improves short-term results at the expense of long-term value.”

Likewise, although Bebchuk’s career-long obsession has been advocating that corporate managers should be directly responsive to the immediate demands of the current stockholder majority, in recent writings he has expressed concern that paying corporate managers equity-based compensation could lead managers to implement excessively risky strategies that create a potential for bankruptcy and cause harm to creditors, employees, and society as a whole. The long-term stockholders who hold the stock when such risks come to fruition would, of course, suffer too.

It is likely that corporate managers, in contrast with activist investors such as hedge funds, are actually far more dependent on their employer firm’s sustainable value and would thus be more, not less, immune to the temptation of forsaking long-term value for a short-term stock pop coming from an unduly risky business strategy. But the logic that drives Bebchuk to worry about these temptations does not seem to trouble him when he is dealing with anyone claiming the title “stockholder,” regardless of whether their investment horizons and portfolio likely make them far less invested in the corporation’s long-term fate than a typical corporate manager. A dispassionate observer, however, might note that the analytical force of Bebchuk’s analysis of the dangers of paying corporate managers in a way that breaks the link between short-term reward and accompanying long-term risk cannot be confined to that specific context. Ideology can be blinding, even apparently when one’s secular faith involves the simple creed that those who own stocks are presumptively selfless while those who manage corporations are presumptively selfish and untrustworthy.

There is another oddment to Bebchuk’s continuing push for direct democracy. For years, he and his allies pushed to make corporate directors more accountable directly to stockholders and to shift power within the boardroom to independent directors meeting stricter definitional standards. They were successful in this effort. Most boards are comprised not simply of a majority of independent directors, but almost exclusively of independent directors, with the CEO often being the only nonindependent director. Key board committees like compensation, audit, and nominating must be comprised solely of independent directors. But, rather than the increasing power of independent directors providing a relaxation of the need to move further toward a direct democracy model, Bebchuk and his fellow money manager advocates have instead proposed that these newly empowered independent directors be subject to the specific direction of stockholders on virtually every important aspect of management, including compensation, charter and bylaw changes, and change of control transactions. They also propose that these independent directors be removable from office not just when beaten at the polls by an actual human candidate, but also through a de facto recall vote in the form of a withhold campaign.

As, or more, important than the composition of boards, easy financing and the sharp reduction in the prevalence of antitakeover defenses have made the market for corporate control more vibrant as a disciplinary tool. Although Bebchuk will likely not admit the extent to which his world view helped to form a more open market for corporate control, that does not mean it is not a reality. With managers regularly subject to the type of discipline that Bebchuk and others thought would keep managers on their toes, the need for further ballot initiatives is not evident. Of course, Bebchuk might note the decline in hostile takeovers. But the reason is telling: Serious bidders have no need to go hostile; they can get a fair opportunity to buy just by making an offer. The more expensive and risky route of hostility is not necessary, as most boards are happy to consider selling at a genuinely attractive price.

To the extent that Bebchuk claims that the empirical evidence regarding average increases in value at firms targeted by hedge fund activism supports deviating from board insulation at current levels, he must confront the possibility that increasing the leverage that hedge funds have against boards will generate less positive results. If, as Bebchuk and others posit, the market is now working well because hedge funds and the board each have clout and can debate their respective positions, leaving the solid center of the stockholder electorate to decide which is right and to encourage both hedge funds and boards to move toward policies that increase stockholder profitability in a durable way good for most investors, his contention that this relationship should be further tilted in favor of the insurgents itself requires more support. As a respected scholar notes, “[S]ince the mid-2000s . . . management has responded to shareholder demands as never before.”

The need for fuller and more timely disclosure about the interests of activist investors who propose changes in the business plans of corporations but are not prepared to make a fully funded, all-shares offer to buy the corporation is arguably made more advisable because of these market developments. At the beginning of the takeover and merger boom that began in the early 1980s, scholars sharing Bebchuk’s viewpoint that stockholders should get the final say on whether to accept a takeover bid argued that the optimal blend for stockholders was one where the traditional values of the business judgment rule gave managers room to innovate and take risks, with the takeover market acting as a protective check to ensure that stockholders could exit through a premium if a buyer believed it could do better in managing the assets than incumbent management. With easy access to financing available for buyers and the decline in structural takeover defenses, it has never been easier to make a full company offer and get it accepted. When a buyer purchases the entire company, it signals that it and its financing partners are willing to fully absorb the future risk of its business strategy. By contrast, when an activist argues that a corporation would be more valuable if it changed its business strategy, but is not prepared to buy the company or to even commit to hold its stock for any particular period of time, there is good reason to make sure that the other stockholders have full information about the precise economic interests of that activist. With the sharp decline in structural takeover defenses, the plush access to deal financing, the prevalence of boards with supermajorities of independent directors, the increasing ease of running proxy contests and withhold campaigns due to increased institutional ownership, and the inexpensive nature of internet communication, the barriers to takeover bids, corporate governance and business strategy proposals, and changes to the board itself are lower than ever. Put simply, it is not clear that Bebchuk’s findings do not support the conclusion that the current status quo, with all of its real world human blemishes, strikes, as a general matter, a reasonable balance between stockholder and management power. And Bebchuk’s own articulation of the dynamic, which is shared by other distinguished scholars who may not agree with him on other particulars, suggests that modest policy moves that better enable the solid center of the investor community to more effectively evaluate activist proposals so that sound ones are more likely to become corporate policy and excessively risky ones are more likely to be rejected might even appeal to him.

I do not presume that there is any way to bridge the great divide between Bebchuk, on the one extreme, and those like Lynn Stout, on the other, as their positions are so starkly divergent. A far more modest goal might be in reach, though, suggested by the preceding discussion of disclosure regarding hedge fund activists’ economic interests. That is, it may be possible to find some common ground between these dueling camps that might allow us to improve the corporate governance system we actually have, given the allocation of legal and market power that in fact exists. For example, it might be possible for all participants in the debate to acknowledge three things. First, stockholders have formidable power under our system of corporate governance. Second, the direct stockholders of productive corporations primarily consist of institutional investors who are themselves susceptible to conflicts of interests and other incentives that may lead them to act in ways that diverge from those whose capital they are controlling. Third, all fiduciaries within the accountability system for productive corporations should themselves be accountable for acting with fidelity to the best interests of the end-user investors whose money is ultimately at stake. If there is agreement on these mundane grounds, it might be possible to improve the system as it actually exists so that it works better for both investors and society more generally.

To the extent that Bebchuk accepts his sparring partners’ contention that it is important that corporations be governed in a manner likely to create the most sustainable wealth for their investors and society, this means that both he and they should want a process of corporate accountability where there is adequate and effective representation of the interests of investors who have entrusted their capital to the market for the long term. To the extent that Bebchuk believes that stockholder input on key corporate issues is valuable, one would assume he believes that stockholder input should be based on a genuinely thoughtful deliberative process that involves careful consideration of what is in the interests of the ultimate investors for whom the stockholder is acting. In particular, if Bebchuk believes that any dangers posed by certain stockholders who have short-term investment horizons are checked because institutional investors representing long-term investors cast most of the votes, he should support ensuring that the representatives of long-term investors in fact think and vote in the manner faithful to their investors’ unique interest in sustainable, durable wealth creation. Likewise, if Bebchuk believes that facilitating a reasoned debate between management and activist stockholders about important issues where the argument is settled by mainstream elements of the institutional investor community will produce good results for investors, one would also assume that he would not want those mainstream investors deluged with thousands of annual votes that are impossible to consider in a careful, cost-effective way.

Although it would be difficult to find much acknowledgement in his work, Bebchuk is likely to agree that innovative and competent management remains the key driver of returns for stockholders. Certainly his sparring partners would. Therefore, it might be that Bebchuk would recognize that it is counterproductive for investors to turn the corporate governance process into a constant Model U.N. where managers are repeatedly distracted by referenda on a variety of topics proposed by investors with trifling stakes. Giving managers some breathing space to do their primary job of developing and implementing profitable business plans would seem to be of great value to most ordinary investors. Likewise, Bebchuk and his sparring partners might agree that business strategies do not tend to be proven successful or not within the space of a year and that an effective system of accountability would be one where stockholders periodically have an enhanced opportunity to displace the board or change corporate policies such as compensation plans based on their assessment of several years of data regarding the company’s performance and the consequences of the board’s policies. In other words, if it was wise of our Founders to put in place a system where Abraham Lincoln would be subject to removal based on his performance in 1864, rather than every year, perhaps that sensible notion of holding vibrant elections after a rational time frame that takes into account the incumbent’s performance over a period more relevant to the governance of a sophisticated entity is one that ought to be considered in determining how often to hold stockholder votes on issues like executive compensation and how often to enhance the chances of a proxy contest through subsidies like proxy access or reimbursement.

In the pages that follow, I will venture some thoughts on improvements that could be made in the system that we have. As befits someone who embraces the incrementalist, pragmatic, liberal tradition of addressing the world as it actually is, these suggestions are not radical in either direction. They do not involve rolling back the rights of the stockholders of productive corporations. Rather, they involve accepting the reality that stockholders have strong rights and trying to create a system for use of those rights that is more beneficial to the creation of durable wealth for them and for society as a whole. Consistent with Bebchuk’s concern that humans controlling others’ money should be accountable for faithfully using that power, they do involve some modest requirements: that the fiduciaries who wield direct voting power over productive corporations do so in a manner faithful to the best interests of those whose money they control, and that stockholders who propose corporate actions that cost other stockholders money have a sufficient economic stake to justify the substantial costs imposed by ballot measures. Likewise, they recognize that activist stockholders who seek to act on the corporation and cause it to change its business strategy are taking action that affects all stockholders, and that the electorate should therefore have information about the activists’ economic incentives in considering whether their proposals are in the best interests of the corporation.

With that framework in mind, I hazard some specific thoughts about what a more sensible system of corporate accountability might involve.”

Chief Justice Strine’s response essay is available here.