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E-MailJames C. Spindler is Hart Chair in Corporate and Securities Law at the University of Texas Law School, and Professor at McCombs School of Business; and Jeffrey Meli is Head of Research at Barclays. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here).
In a recent trend, “governance inclusion mandates” intercede directly in internal corporate governance by requiring specific changes to board membership. Some are “constituency mandates,” which add representatives of a specific constituency to the board; an example is the Accountable Capitalism Act, a plank of Senator Elizabeth Warren’s recent presidential bid, which would require 40% of the directors of large firms to be selected by the firm’s employees. Others are “diversity mandates,” which require minimum levels of board membership of females or members of underrepresented communities; examples include California’s A.B. 979 and NASDAQ’s recent proposal for listed companies. Underlying these proposals is the conjecture that inclusive boards will, somehow, make better decisions—and, in particular, more socially responsible decisions—than laissez-faire, market-constituted boards.
In a forthcoming paper, we develop a framework to assess if, and how, board inclusion mandates can lead to more pro-social corporate decisions. Underlying our framework are two principal assumptions about what it means to be included in corporate governance and, in particular, in the corporate board room. First, the board room represents a sort of Coasian bubble, in which its participants are able to bargain efficiently (or, at least, more efficiently than those outside it). Second, the director’s privilege is a sort of property right, in that those possessing it will garner a greater fraction of corporate surplus, ceteris paribus, than those without. Overall, then, inclusion in the board room is valuable, and those so included will use it to maximize their objectives, whatever those may be. With such tools at hand, it is possible to say something about the channels through which inclusion mandates work, and how to engineer them to have socially beneficial effects.
The appeal of inclusion mandates over other approaches to improving the balance between social concerns and profit maximization is that they allow firms to make their own decisions, based on their own information, and without relying upon the government to regulate optimally. The sheer size and scope of today’s largest corporate entities presents a challenge to the effectiveness of the traditional regulatory mechanisms of ex post adjudication (such as the tort system or anti-fraud liability) and various degrees of command-and-control regulation (particularly prominent in industries like banking and energy production), which are intended to prevent or deter corporations from externalizing costs onto others. Recent history shows that the potential harms caused by large corporations can far exceed their attachable assets, and problems of judgement-proofness and limited liability dampen or eliminate the deterrent effects of ex post liability. Further, regulators have been outpaced by innovative and sophisticated business entities, and much new command-and-control regulation is developed only after crises—that is, once the horses are already out of the barn. Such concerns are especially pressing given growing dissatisfaction with corporate shareholder primacy, which is increasingly considered at odds with social ends such as economic and social stability, environmental protection, and even the preservation of American democracy.
However, inclusion mandates do not necessarily change corporate behavior. In most circumstances, those awarded a share of corporate surplus by an inclusion mandate will wish to maximize the value of this share, and will engage in the same profit-maximizing activity, regardless of social desirability. The situation is essentially that of swapping out one set of business owners for another.
There are two important exceptions to this “same activity” result. First, inclusion may allow inefficient contracts to be replaced with efficient ones (for example, allowing investment in firm-specific human capital of workers). That said, countervailing inefficiencies could arise if the share of corporate surplus obtained is not tradeable, as there is the potential to introduce risk-aversion into the boardroom, distorting corporate incentives.
Second, and more importantly from a societal standpoint, is that inclusion will lead to socially beneficial changes where the included group would expect to bear what would otherwise be externalized harm. Representation of such a group changes the joint-welfare maximization calculus to take into account such harms. If the firm dumps its trash on constituency A, for example, putting constituency A’s representative on the board might lead to discontinuing such practices.
In order to realize these improvements, the board representative must actually be accountable to the constituency she represents; if not, then her preferences do not fully internalize those of her constituency for purposes of the joint-welfare maximization calculus. An individual, atomistic director could be co-opted or bought off, as her preferences are relatively small in intensity compared with that of the whole group from which she is drawn. This is a principal difference between constituency mandates and diversity mandates. While a more diverse board may arguably enable a corporation to better achieve its stated purpose (as NASDAQ and California have opined), diversity mandates simply require that the board nominate, and the shareholders elect, a member of that group; accountability to shareholders-at-large remains unchanged, and, as a result, so will corporate purpose. In contrast, by placing the board seat under the control of the represented constituency, constituency mandates can change corporate purpose by integrating the preferences of that full group into the joint-welfare maximization calculus.
These improvements also depend on how the constituency’s claims on the firm are structured; poor design can actually lead to worse incentives. A constituency with much to lose from a corporate meltdown may help steer the corporate ship away from such meltdowns. In contrast, if an included constituency obtains benefits that are not sensitive to corporate performance or social outcomes, the firm is effectively less well capitalized, and the constituency may drive corporate behavior in less desirable directions. For example, under the Accountable Capitalism Act as proposed, labor would retain its board representation even in the event of a corporate meltdown and restructuring, along with other benefits such as funded pensions; therefore, labor would not be a “residual claimant” and would not have the proper incentives to maximize either corporate or social outcomes. Yet a fix is at hand: subjecting the constituency to punishment for corporate malfeasance improves incentives, since the value at risk serves as a useful lever to push incentives in a pro-social direction. Ex post liability for corporate wrongs makes the constituency a residual claimant, and the constituency will use its control over corporate activity to improve corporate behavior. This has implications for policy issues such as bailouts (namely, represented constituents should not be bailed out) as well as the reach of corporate liabilities (liability should attach to included constituencies). In other words, inclusion mandates can provide a potential deep pockets defendant, overcoming problems of limited liability and judgment-proofness that often accompany and precipitate corporate malfeasance.
Accordingly, constituency mandates have significant potential to improve corporate behavior. However, proper design is crucial. The extant proposals lack adequate “skin in the game,” which limits their likely benefits, and may even lead to worse corporate behavior. Diversity mandates, at least as currently conceived, do not appear likely to change corporate purpose, but could make corporations more efficient at maximizing shareholder value. Of course, this would (ironically) only worsen any social ills that are linked to such a motive.
The complete paper is available for download here.
