Corporate Governance: Promises Made, Promises Broken

Tuesday, October 7, 2008
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The 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 hodgepodge 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. The book develops three original insights about corporate governance.

Those insights can be summarized as follows:

  1. Corporate governance is about promises. I believe that it is more accurate to characterize corporate governance as being about promises than to characterize corporate governance as being about contracts. The relationship between public shareholders and corporations is so attenuated that it is misleading to characterize it 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 that corporate governance is about promises is that 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 promises, 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 the book analyzes various devices and mechanisms of corporate governance for the purpose of determining which ones work well—and which do not.
  3. Having analyzed which corporate governance devices work well, it is then possible to analyze them politically. Regulation can impede, discourage, and even ban the operation of particular 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 encouraged, and even directly or indirectly required, by regulation.

Some arguments from the book

Board capture. The reliance on boards of directors by U.S. policy makers 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, participants in corporate decision-making, 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 will 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. 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, as beliefs become ingrained in the minds of directors, the possibility of altering those beliefs decreases substantially. Thomas Gilovich argues that “beliefs are like possessions” and that, “when someone that challenges our beliefs, it is as if someone [has] criticized our possessions.”

Academic writing on corporate governance has paid virtually no attention to specific features of contract design such as the buy-sell agreement.

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 of participants in the market for corporate control.

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 on 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 its shares at a negotiated, formulaically determined price.

As board tenure lengthens, it becomes increasingly less likely that boards will remain independent of the managers they are charged with monitoring.

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 before investing probably constitutes professional negligence.

Although shareholder voting probably does not do shareholders much harm, it doesn’t do them much good either.

Although 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 policy makers, if shareholders were only given more and better voting rights, then corporate performance and accountability could 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.

The reliance on boards of directors by U.S. policy makers and academic corporate governance experts is entirely misplaced.

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. Nearly all shareholders—even in 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 sufficiently in the business operations and strategies of the companies in which they invest to make informed business decisions, it is impossible. With modern funds holding shares in thousands of companies, the costs to their clients of engaging in corporate governance would make their funds noncompetitive.

Stephen Bainbridge of the University of California, Los Angeles, has described 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 its assets. 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 pass through the board for its approval. The only exceptions to this rule are the provisions for electing directors and for amending the bylaws. 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 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.

Shareholders have almost no contractual rights and virtually no contractual rights to corporate cash flows.

Current policies on shareholder voting are too restrictive. Shareholders are only permitted to vote on major issues 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.