The “Corporate Governance Misalignment” Problem

On March 9, 2017, the SEC’s Investor Advisory Committee (“IAC”) held an open meeting to discuss, among other things, unequal voting rights of common stock. I was one of four presenters to the IAC, and my presentation focused on how what I call the “corporate governance misalignment” has led many successful companies, especially technology companies, to adopt dual-class (or multi-class) stock in recent years.

The presentation asked an important—but unspoken—question in corporate governance today: if corporate governance is fundamental to good corporate performance (as I believe it is) why are many of today’s most innovative and successful companies considered to have bad (or at least below average) corporate governance? More broadly, why is the most dynamic sector of this country’s economy—the technology sector, best represented by Silicon Valley—also generally viewed to have poor corporate governance?

To answer this question one must understand what I call the “Corporate Governance Misalignment” that exists in today’s public markets. This misalignment is the result of two factors: first, the legal rules requiring directors to favor public equity holders over other constituencies in today’s corporation; and second, the changed nature of the equity holder in public companies, and in particular the growth of the institutional investor (as well as hedge funds and other activist investors).

The control of public equity investors in public corporations has been well documented. As I (and many others) have previously written, Delaware law today is based upon the concept of stockholder primacy. Put simply, Delaware law requires that directors make decisions based upon how their decisions will ultimately affect and create stockholder value. This means that while directors under Delaware law have substantial discretion to take actions that benefit other corporate constituencies, ultimately a director must give top priority to stockholder value when considering the different alternatives before her.

At the same time Delaware law gives directors substantial discretion to take actions that are in the best long-term interests of the corporation and its stockholders. However the changing nature of the public equity markets, and in particular the rising ownership and control of institutional investors in public equities, including both passive and activist investors, has led corporate boards to take actions that favor short-term profits at the expense of long-term growth or risk-taking.

The growth of the institutional investors has been well documented. According to SEC Commissioner Stein, institutional investors today own approximately 70% of the shares of all public companies, while just three institutional investors held the largest stock position in 88% of the companies in the S&P 500.  Because the money managers who select the stocks (or index funds) that these institutions invest in are incentivized to outperform their peers on a short-term basis, these fund managers are generally looking at short-term results.

This short-term focus has had a particularly large impact on technology companies. As discussed in my remarks to the IAC, technology companies have become the prime targets of activist investors. Activist investors often favor technology companies because of their strong balance sheets and cost structures, which include high investments in employees and R&D. Such investments are often easy to cut to improve short-term results.

Yet technology companies, particularly many of our most innovative companies, often want to take a longer-term view. This includes focusing on such issues as building great products, investing in R&D (even with the recognition that such investment may ultimately not be successful), paying extra to train and retain great talent and taking other actions that may require a longer-term focus than the current market environment allows for boards. As a result, and following Google’s (now Alphabet’s) successful IPO in 2004, a number of leading technology companies have adopted a dual-class (or multi-class) share structure as part of a successful IPO, at least in part to avoid the pressure to maximize short-term returns.

This does not mean, of course, that all dual-class structures (or technology companies) will be successful. Rather, it simply means that as long as this “corporate governance misalignment” continues to exist, we are likely to continue to see companies try and adopt governance structures that give them greater flexibility to respond to the misalignment.

A full copy of my remarks can be found here.