The Aardvark in the Boardroom

Editor’s Note: This post is from Joseph Hinsey of Harvard Business School.

Okay–that was a shameless play on the classic elephant metaphor.  But perhaps it’s a worthwhile way to remind us (once again?) of a fundamental issue long embedded in the corporate governance dialogue about shareholder rights and “shareholder democracy.”  That issue is called to mind by the introductory sentence of Professor Lucian Bebchuk‘s paper, The Myth of the Shareholder Franchise: “The power of shareholders to replace the board is a central element in the accepted theory of the modern public corporation with dispersed ownership.”

Who are the shareholders possessing this power “to replace the board”?  That question is, of course, not new.  Whenever it is posed in the course of the corporate governance discourse, however, the typical response is a simple assertion that the identity of the shareholders is irrelevant to the debate.  But we do need to acknowledge that–notwithstanding the time-honored debates about the influence of day-trading market speculators, managers of fixed-portfolio mutual funds, and other long term investors–the conventional wisdom that there is some monolithic shareholder able to control the board is inconsistent with dispersed public ownership that characterizes most major public companies.

It is quite true, of course, that dispersed shareholders can occasionally act to defeat management proposals–for example, removing an incumbent director or voting down a proposed transaction.  Proxy advisory firms like ISS and Proxy Governance, Inc. can substantially influence shareholder activism.  However, in most instances dispersed shareholders suffer from a leadership vacuum and are thus incapable of initiating action on their own.  On occasion, a mutual fund executive or corporate governance activist will step forward to provide leadership–but that leadership can be tainted by a private agenda.  In most cases, a leadership vacuum is an unfortunate hallmark of dispersed share ownership.

The baseline legal tradition–the fundamental principle that underlies the “shareholder franchise” with which Professor Bebchuk deals–posits that the board is to be subservient to the shareholders.  Today, such textbook legality must yield to practicality: dispersed shareholders can and should look to a properly functioning board for leadership on company decisionmaking.  The key to having a board capable of providing leadership for a dispersed group of shareholders is an independent board chair (“IBC”) who possesses not only the requisite skills to balance the board’s role with that of management but also an awareness of the Chair’s responsibility to provide leadership for dispersed stockholders.

It is quite true that the pool of qualified candidates for IBC positions is comparatively limited.  But an effective IBC need not have a career background geared to the enterprise’s business activities.  In reality, the most important qualification is a talent for leadership.  A useful way to describe a successful relationship between an independent board (i.e., a board providing effective management oversight) and management might be the phrase “constructive tension.”  Shareholders might ask themselves: does a candidate for the IBC position have the talent to lead such a board?  If so that director, in all likelihood, will be a quick study with respect to the enterprise’s business activities.

Rather than flogging away at general notions of shareholder democracy, activists would better serve the noble interests of corporate governance reform by articulating reasonable expectations with respect to the performance of independent boards and independent board chairs–i.e., feasible ways for the directors to serve the legitimate interests of shareholders.  Wouldn’t the “shareholder franchise” be better described as an entitlement to a responsive board exercising independent judgment rather than the pursuit of shareholder “dominance” over boards, a notion that ignores the impracticality of dispersed shareholders exercising leadership over corporate affairs?  Identifying the shareholder franchise as a theory of shareholder “dominance”–and recognizing that stockholder “dominance” would require supervision of corporate affairs–reveals the flaw of that approach, because dispersed shareholders are fundamentally incapable of providing ongoing supervision of the work of the board.

The legal traditions that conceived shareholders as “principals” and directors as “agents” have long since been overtaken in light of dispersed share ownership.  But the “aardvark” in the boardroom–the lack of leadership on behalf of dispersed shareholders–can best be resolved by an independent board that, in the words of section 2.01 of the ALI Principles of Corporate Governance, has “as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain.”

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