Monday, October 30, 2006

Shareholder democracy in the U.S. brought to task

An interesting article by Kate Burgess and Andrew Grant in this past week's Financial Times ("Investors 'lack basic rights' on US boards") notes a peculiar feature of U.S. corporate governance and securities law. In particular, while the United States has been at the bleeding edge of securities law reform designed to strengthen corporate disclosure standards and come down hard on managerial malfeasance, the actual rights of shareholders of U.S. companies to "kick the bums out" (i.e., replace not just crooked but also poorly performing managers and board members) is surprisingly weak. This is even more so when the U.S. is compared with other Common Law countries such as the United Kingdom and Australia.

As Adolf Berle and Gardinar Means noted 70 years ago, the modern corporation is characterized by a "separation of ownership and control" -- in other words, the people who own the company (shareholders) do not actually run it. This is in stark contrast to most other models for organizing human economic behavior, such as partnerships, where the entrepreneurs who put in their money to create the organization actually have a close hand in running it (and face a significant personal risk should it fail). In fact, this single feature of the modern corporation is both its greatest strength and most dangerous weakness. The strength comes from the fact that modern corporations can draw on financing from millions of investors willing to accept a (comparatively) small risk for a small return, rather than the handful willing to take a major risk for a big potential return. But the weakness is that corporate managers are using "other people's money" when they run the company, and this poses an inherent conflict of interest.

This strength and weakness was recognized as long ago as 1776, when Adam Smith wrote in The Wealth of Nations:

This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. ...The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxioux vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion therefore, must always prevail, more or less, in the management of the affairs of such a company.
Corporate governance and securities laws are two tools designed to reduce this problem. Corporate governance laws are meant to provide shareholders with mechanisms by which their own interests are protected against management, while securities laws are designed to give them accurate information about how the company is performing so they can make informed decisions. In the United States, corporate governance is mostly a function of state law and, in practice, of Delaware law in particular. And Delaware didn't become the home jurisdiction of 70 percent of U.S. public companies because of its particularly pro-shareholder approach. Quite the contrary. Delaware permits a number of anti-takeover devices, such as poison pills and staggered board member terms, designed to make it very difficult for shareholders to kick poorly performing managerial teams out of their coveted positions.

This issue recently became more prominent in the United States when the Second Circuit Court of Appeals ruled last year in AFSCME Pension Plan v. AIG, Inc. that the SEC's rule on proxy voting is unclear. When that decision came out, the SEC agreed to clarify the rule to state whether companies must include in proxy materials proposals to modify how board members are elected. However, the SEC recently backed off on when it will conduct this clarification, as apparently there is no consensus among the five Commissioners about how to do this.

This is a shame, as a recent letter to SEC Chairman Christopher Cox from 16 U.S. and international investors points out. As a large number of these investors are foreign (including the Association of British Insurers and the Third Swedish National Pensions Fund), they note in the letter that:
It cannot be emphasized enough how difficult it is for investors based outside the US to come to grips with the fact that shareholders of US companies lack basic rights which they take for granted in other developed markets. Both in principle and in practice, the American board election procedure is both outdated and detrimental to the maximization of long-term shareholder value.
Normally I would say that this sounds like typical UK whining. ("It cannot be emphasized enough..."? I mean, who says that?? And anyone complaining about the lack of shareholder rights in the U.S. clearly hasn't seen the system in France or Japan.) That said, they do have a point. Under the current system, the only control investors have over board performance is by "voting with their feet" -- divesting themselves of companies with underperforming boards or management. However, for large pension funds or index-based mutual funds, such divestments may not be practical or even permitted. At the same time, given how difficult hostile takeovers are in the United States, "normal" market mechanisms that might act to discipline a corporate board just aren't there, and the only real mechanism for a shareholder to assert his or her rights is through shareholder derivative litigation -- a costly, often self-defeating process.

As a practical matter, the institutional investors' letter may tie in closely to efforts underway by the so-called "Paulson Committee" (see here), though it seems likely that Hal Scott, Glenn Hubbard and John Thornton might not see it that way. Restraining tort lawyers may go a long way to improving the competitiveness of U.S. capital markets. However, such restraint will not be likely (or helpful) if other mechanisms for disciplining corporate boards and managers are not available. Therefore, improving shareholder proxy voting processes so shareholders are given back the right to appoint their own boards of directors, is important. It will make corporate managers more accountable for long-term performance, and better align the interests of those who control modern companies with those who own them.

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