Corporate Governance, Promises Made, Promises Broken

My forthcoming book, Corporate Governance, Promises Made, Promises Broken, presents my views about what corporate governance is all about and what sorts of corporate governance institutions and mechanisms work best. Corporate governance consists of a farrago of legal and economic devices that induce the people in charge of companies with publicly owned and traded stock to keep the promises they make to investors. This book develops three original insights about corporate governance. These insights can be succinctly summarized:

1. Corporate Governance is about promises. I believe that it is more accurate to characterize corporate governance as being about promises than it is to characterize corporate governance as being about contracts. One reason I believe this is because the relationship between public shareholders and the corporations is so attenuated than it is misleading to characterize their relationship with the corporation as contractual in nature, rather than promissory. Shareholders have almost no contractual rights and virtually no contractual rights to corporate cash flows. Shareholders’ investments are based on trust. This trust, in turn is based on the belief that the managers who run corporations will keep the promises that they make to investors. Another reason why I believe that corporate governance is about promise is because the idea of promise captures the primordial fact that trust rather than reliance on the prospect of enforcement is the focal point of a successful system of corporate governance.

2. Since corporate governance is about promise, then it stands to reason that the various institutions and mechanisms of corporate governance can be evaluated on the basis of how well they facilitate the keeping of promises by corporate managers. The bulk of this book analyzes various devices and mechanisms of corporate governance for the purpose of determining which ones work well and which do not work so well.

3. Having analyzed which corporate governance devices work well, it is then possible to analyze these corporate governance devices politically. Regulation can impede, discourage and even ban the operation of particular corporate governance devices. Likewise, regulation also can facilitate, encourage and even require corporate governance devices to operate or to operate in a particular way. One of the principal contributions of this book is to point out that many of the most effective corporate governance devices such as certain kinds of trading and activities in the takeover market are either heavily regulated or banned outright. On the other hand, the mechanisms and institutions that I regard as the least effective, corporate boards of directors and credit rating agencies, for example, are facilitated encouraged and even directly or indirectly required by regulation. Chapter 3 develops this point and presents the results of my analysis in chart form.

Examples of some of the arguments in the book:

Board capture

In my view, perhaps the most important contributions of this book are contained in chapters 4 through 6. These chapters describe and analyze the role of corporate boards of directors. The reliance on boards of directors by U.S. policymakers and academic corporate governance experts is entirely misplaced. Public choice, social psychology, and historical observation all suggest that boards can be counted on to be only as honest and effective as the managers they are supposed to supervise. The problem with boards is their unique susceptibility to capture by the managers they are supposed to monitor. The problem of capture is so pervasive and acute that almost no board, not even those that appear highly qualified, independent, and professional, can be relied upon entirely.

Directors, participate in corporate decision-making, they take ownership of the strategies and plans that the corporation pursues. In doing so, these proximate monitors are rendered incapable of objectively evaluating these strategies and plans later on.

In particular, boards of directors have long been responsible for selecting and evaluating the performance of top management. After top managers have been selected, retained, and promoted, boards become committed to and responsible for these managers. For this reason, as board tenure lengthens, it becomes increasingly less likely that boards will remain independent of the managers they are charged with monitoring.

Research in public choice and psychology strongly supports the claim that the potential for capture is inextricably associated with proximate monitoring such as that performed by boards of directors. Boards inevitably have close proximity to management, and this makes it highly likely that they will become captured by management. For example, the theory of escalating commitments” predicts that board members identify strongly with management when they begin to agree with management’s decisions. Earlier decisions, once made and defended, affect future decisions such that later decisions comport with earlier decisions. As such, studies of the decision-making process during the Vietnam War era reveal that U.S. leaders paid more attention to new information compatible with their earlier decisions. They tended to ignore information that contradicted those earlier assumptions. These studies suggest that once ideas and beliefs become ingrained in the minds of a board of directors, the possibility of altering those beliefs decreases substantially. Thomas Gilovich argues that “beliefs are like possessions” and “[w]hen someone challenges our beliefs, it is as if someone [has] criticized our possessions.”

Furthermore, social psychologists show that people tend to internalize their vocational roles. Occupational choices, such as the choice to accept employment as a corporate director, strongly influence our attitudes and values. In the context of boards of directors, this influence means that board members tend to internalize management’s perspective, which causes them to lose their objectivity (The idea of board capture, of course, is not entirely new. Oddly, however, analysis of the problem that the independence of ostensibly independent outside directors might be compromised by board capture has been confined to the relatively narrow issue of executive compensation.). This problem does not arise with shareholders in public markets who have little or no contact with management, and thus does not generally affect the objectivity in participants in the market for corporate control.

The cognitive bias that afflicts boards of directors and other proximate monitors involves what Daniel Kahneman and Dan Lovallo have described as the “inside view.” Like parents unable to view their children objectively or in a detached manner, proximate monitors tend to reject statistical reality and view their firms as above average.

Oppression of minority shareholders in closely-held corporations

The power of contract in corporate governance is profound. In theory, contractual remedies can provide complete protection for shareholders against corporate oppression. Academic writing in corporate governance has paid virtually no attention to specific features of contract design such as the buy-sell agreement that can eliminate shareholder oppression. A buy-sell agreement commits either the corporation or certain of its shareholders to purchase the interest of a withdrawing shareholder upon the occurrence of contractually specified contingencies. These arrangements can solve virtually all of the problems that shareholders face in closely held corporations, from job stability for the minority, to liquidity, to oppression, and freeze-out. A buy-sell arrangement can be structured so as to give equity investors a put option that allows such investors to force the corporation, or a subgroup of its shareholders, to repurchase their shares at a negotiated, formulaically determined price.

These arrangements are used frequently in closely held corporations in order to provide market-mimicking protection for investors, particularly minority shareholders, in closely-held firms. Buy-sell agreements are so useful that a lawyer’s failure to advise a minority investor in a closely held company of her ability to negotiate to obtain such protection prior to investing probably constitutes professional negligence.

While buy-sell arrangements are extremely common, they are deployed only under very limited, clearly specified conditions. For example, buy-sell arrangements sometimes cannot be triggered until a certain date, often years after a shareholder has made her initial investment. It is extremely common for the triggering event for buy-sell arrangements in closely held companies to be the death or incapacity of the shareholder (or her heirs) seeking to exercise the contractual right to sell her shares. Such limitations are not surprising in light of the fact that buy-sell arrangements are very costly for companies. In particular, creditors understandably view such arrangements as a significant source of risk, since the exercise of a buy-sell agreement by a shareholder reduces the “equity cushion” available to creditors whose loans have not been repaid when the shareholder’s stock is purchased by the company. Moreover, since buy-sell agreements often are funded by insurance policies, restricting the trigger events to death or incapacity is necessary to mitigate the problem of moral hazard.

Shareholder Voting

Along with boards of directors and the market for corporate control, the ability of shareholders to vote in corporations, albeit occasionally, has oddly been heralded as a source of improved corporate governance, at least potentially. According to this view, which is the dominant view among academics and policymakers, if shareholders were only given more and better voting rights, then corporate performance and accountability would have the capacity to improve even further. But there are strong dissenters, with some claiming that shareholders probably vote too much, and others taking the position that voting rules are efficient just as they are.

This chapter begins with a brief description and analysis of the rules governing shareholder voting. I will argue that while shareholder voting probably does not do shareholders much harm, it doesn’t do them much good either. Voting serves shareholders well in takeover contests and in expressions of shareholder disapproval in salient high-profile instances of corporate governance breakdown. However, it is irrational in my view to think that expanding shareholder voting can possibly improve the daily governance and operation of a large public corporation. Shareholders simply do not have the requisite information, or the inclination, to become sufficiently knowledgeable about what is going on within a public company to be useful to management in this way. Quite significantly, nearly all shareholders, even large institutions like pension funds, mutual funds, and insurance companies, hold highly diversified portfolios of securities. It is not only illogical for such shareholders to immerse themselves in the business operations and strategies of the companies in which they invest sufficiently to make informed business decisions, it is impossible. With modern funds holding shares in thousands of companies, the costs to their clients of emerging in corporate governance would make their funds noncompetitive.

Since mutual funds and pension funds own shares in such a vast number of companies, it makes sense for them only to become well informed about very major issues, such as takeovers or other fundamental corporate changes. In order for large, sophisticated investors to take the time to become sufficiently informed about their portfolio companies, they must reduce the number of companies in their portfolios. Most hedge funds and private equity funds pursue exactly this strategy, as we will see in chapter 15. Hedge funds and private equity firms own bigger blocks of shares in fewer companies than mutual funds, and this ownership structure makes it rational for them to become involved in corporate governance. But even with hedge funds and private equity funds, formal voting is not useful. Instead, it is far more sensible and efficacious for such funds to immerse themselves in real-time decision-making. When the time comes to vote to ratify a major decision such as an acquisition or a divestiture, it’s too late for investor input to add value. As the available evidence shows, when sophisticated outside investors do become involved in corporate governance, they do not express themselves by voting; rather, they inject themselves into the corporation’s quotidian decision-making on an ongoing basis.

The argument here is that the basic infrastructure of the law of corporate voting is not in need of repair. To be sure, the system is far from perfect and some major details need fixing. For example, the ability of management to control the timing of elections and the federal rules governing proxy solicitations do not serve the interests of shareholders and should be reformed.

More important, the point that shareholders are not likely to be effective at corporate governance simply by exercising their voting rights merits two important analytical qualifications. First, it is important to clarify that the relevant policy issue is not how effective shareholders are at corporate governance in some abstract way. Rather, the question is how effective shareholders are relative to alternative corporate governance institutions such as boards of directors and management. Thus, while shareholders are ill informed and inexpert at making managerial and strategic decisions about the firms in which they have invested, they do have the virtue of having the right incentives.

Shareholders do not face the same conflict of interest problems that plague decision-making by management and what earlier chapters have shown is their systematically docile nature and captured boards of directors. On issues where the choice is between the shareholder’s lack of information and management’s self-interest, corporate law should choose the shareholders by giving them the deciding voice in corporate governance. Takeovers are perhaps the paradigmatic example of a corporate governance issue that forces us to “decide who should decide” as between shareholders and management.

Second, it is important to distinguish between “generic” and “firm specific” corporate governance issues. The argument that diversified shareholders are unlikely to find it efficient to inform themselves sufficiently to assist in the corporate governance of the firms in which they have invested applies only to “firm specific” corporate governance issues, that is, issues that are unique to the specific circumstances of a particular company or its securities. For example, issues such as whether a particular CFO or CEO should be retained, or whether a company should buy or sell a particular asset such as a subsidiary or a division, are specific to particular firms. As a general matter, voting by shareholders is not likely to be an effective corporate governance mechanism for making decisions about these sorts of issues.

In contrast, a generic corporate governance issue is an issue concerning broad policy that is likely to affect the value of all of the companies in a particular portfolio. For example, the answer to the question of whether a particular anti-takeover device such as a poison pill (discussed in chapter eight) should be adopted by a company is likely to be the same for all companies. For such generic or market-wide corporate governance issues, it will likely be efficient for diversified shareholders to become well-informed because the resources spent in learning about the relative merits of various anti-takeover devices can be distributed across all of the public companies in an investor’s portfolio.

Stephen Bainbridge of UCLA has succinctly summarized the law of shareholder voting as “so weak that they scarcely qualify as part of corporate governance.” Consistent with this analysis, the list of items about which shareholders have voting rights is remarkably short. Shareholders vote annually on director elections, amendments to the corporate charter, and fundamental corporate changes, such as mergers, dissolution of the corporation, and the sale of all or substantially all of the assets of a corporation. Confusingly, shareholders and directors both hold the power to vote on changes to corporate bylaws. This, in turn, raises difficult legal questions about whether a shareholder vote on bylaws can trump a decision on bylaws made by the company’s board of directors.

While shareholder voting is limited to just a few issues, this is not the only or perhaps even the most significant restriction on the impact of shareholder voting. An important additional constraint on the practical efficacy of shareholder voting is the problem of screening by boards of directors. Before an issue even gets to the shareholders for their approval, it must almost always first pass through the board of directors for its approval. The only exceptions to this rule are the provisions for electing directors and for amending the bylaws, which do not require board approval prior to action by the shareholders. Some avaricious managers have even tried to impose greater constraints on the election process by attempting to screen nominees of outside groups. While this practice is probably illegal, it is nevertheless accomplished by requiring that all candidates proposed as nominees for directorships must first be approved by the nominating committee of the incumbent board. Given their questionable legality, these provisions illustrate the extent to which some companies are willing to go to deter outside efforts to gain control.

The current policy consensus about shareholder voting reflected in current law, is too restrictive. Shareholders are only be permitted to vote on issues of large magnitude because it is thought that these are the only instances in which shareholders will be able to overcome the rational ignorance and voter apathy problems that plague the decision-making process and make voting uninformed and irrational. Shareholders also should be allowed to vote on generic issues, that is, on issues that come up again and again in the course of share ownership (or, in the political context, in the case of citizenship), and not just on the major issues. The costs of becoming informed on such generic issues can be amortized over every investment in the investor’s portfolio in which these issues arise.