A Revised Monitoring Model Confronts Today’s Movement Toward Managerialism

James D. Cox is the Brainerd Currie Professor of Law of Duke Law School and Randall S. Thomas is John S. Beasley II Chair in Law and Business at Vanderbilt Law School. This post is based on their recent paper, forthcoming in the Texas Law Review. Related research from the Program on Corporate Governance includes The Case for Increasing Shareholder Power, by Lucian Bebchuk; and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

This paper is motivated by our belief that the shareholder vote is important as a source of validating the power held by the board, but most importantly as an “error correction/protection” device. We therefore find it odd that with the ever-growing concentration of ownership of public companies among various financial institutions (and not retail customers) there are at the same time numerous legal developments reviewed in the paper that have the effect, and likely intended effect, of quieting the shareholders’ voice. These developments are occurring at a time when the prevailing governance structure for public firms is the monitoring model, whereby boards are independent of management so that they can best reflect the concerns of the shareholders. We thus find recent developments in corporate law incongruous with the monitoring model’s initial aspirations. To make this point we review the multiple social, financial and regulatory forces that ushered the monitoring model into broad adoption. Foremost among these is the dramatic failure of managerialism, the philosophy pursued by American corporations post-WWII.

In the decades immediately following WWII American companies were largely run by unfettered CEOs purportedly for the benefit of their stakeholders. Stockholders were dispersed, weak, and with few exceptions, universally ignored. Corporate directors were underlings, or friends of the CEO, and often rubberstamped whatever the CEO told them to approve. This continued throughout the ‘50s and ‘60s, with corporate boards dominated by inside directors, friends of the CEO, and outsiders with deep commercial relationships with the company, such as its investment bankers or lawyers, and thus not truly independent of management. And, under the stakeholder model boards were not focused exclusively on increasing shareholder value, seeing this as just one of many objectives managers were to pursue within the broader mission of balancing the sometimes competing interests of the firm’s many stakeholders. Thus, the stakeholder model required and got what it needed: a dominant CEO and a docile board of directors. Directors were weak.

The weaknesses of the managerialist governance model for the public firm became manifest beginning in the 1970s with the poor performance by American companies in the face of the rising global competition from industrial powers in the once war-torn countries, the inherent inefficiencies of the conglomerate form of business organization that pervaded many sectors of American industry, and the high-profile bribery scandals uncovered in the wake of Watergate. At the time these operational problems arose, the composition of investors changed as did the focus of this new owner base. Increasingly management’s stewardship was evaluated from the owner perspective with an acute focus on wealth maximization.

With the benefit of history, we observe that the monitoring model as adopted was incomplete. It did embrace the importance of a board being independent so that it could evaluate management’s stewardship. But that independence required anchoring the board into their electors. In an era lacking activist shareholders, the monitoring model, though not optimal, was nonetheless better than the governance structure it replaced. In this paper, we argue that in a world of institutional investors, as exist today, the monitoring model can better achieve its potential by facilitating shareholder-board interactions. Hence our concern for numerous recent developments that quiet, not facilitate, the shareholder voice.

We review the empirical evidence bearing on the effects of hedge fund activism. We find the evidence supports our belief that the monitoring model is strengthened by shareholder activism so that the agenda for corporate governance should be based on accommodating shareholder input not obstructing it in ways that we review in the paper.

The paper also reviews two contemporary developments in corporate governance: the New Paradigm and the stakeholder model. The New Paradigm encourages both corporations and their institutional investors to pursue long-term objectives and to engage one another. Even though we do not disagree with either of these prescriptions, we find the New Paradigm is a call not for patient capital but neutered capital as it fails to support mechanisms for concerned shareholders to act when consulation with management has failed. Furthermore, we reject the stakeholder model, recently endorsed by the Business Roundtable, believing this returns American corporations to the era of managerialism, which, as discussed in the paper had earlier proved its failings.

The complete paper is available for download here.

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