02.25.12
Both the Right and the Left are Confused about Governance
UCLA Professor Stephen Bainbridge, in his new book, Corporate Governance After the Financial Crisis, attempts to trace an historical lineage of what he calls “quack corporate governance,” through a series of regulatory responses to business scandals and market crises, especially since the Enron scandal in 2001. Indeed, much of the regulation which has been adopted (and more which has been proposed) may justly be characterized as burdensome over-reactions by Congress and foreign legislatures, which raise the costs of doing business and are potentially a drag upon an already struggling economy. This layer upon layer of new regulation may be described as well-intentioned but often ill thought-out efforts with significant unforeseen consequences; much of the lobbying for it has been carried on by special interest groups which may fairly be described as having something other than the economic recovery of the world’s free markets at heart. However, Prof. Bainbridge’s otherwise interesting and thorough analysis unfortunately obfuscates as much as it reveals.
The problem, as Professor Bainbridge should know, is that we are dealing with two very different kinds of legislation here, with different intent. One is intended to substitute government agencies’ control for the decisions of independent actors (managements and the free market.) The other is intended to ensure that the free market, i.e., the shareholders, have the power to do something regarding their own investment—other than sell it—when they feel that it is being mismanaged. The dichotomy is important: regulatory decision-making by government agencies, vs. the actions of independent economic actors who have invested their own money with the company.
“Corporate governance” is frequently used as a synonym for some sort of reform. This is misleading. Every corporation must be governed. The questions are How? By whom? and, Well or badly? The question for legislators and the markets is to what extent the corporation (which is, let us not forget, an artificial creation of the State) is allowed to run itself without external interference, and to what extent outsiders are allowed to intervene. Clearly, when the company violates some other laws pertaining to the public good (i.e., pollution, sale of defective merchandise, abuse of its labor force and/or of public safety, fraud) the State is entitled to intervene, just as it would be if the actor were a private individual. But that is not the issue here. The issue is the internal governance of the corporation.
If the managers of the company are the principal owners, there is no agency problem: it is their money, and they are allowed to do with it what they want, (providing they do not violate any of the laws regulating external behavior, as above.) Normally, they will be very careful with their own property, and ‘monitoring’ is seldom a problem. The issues instead involve fair treatment of minority investors, who own less than enough to control the company, even if they were to vote unanimously. Their protection necessarily involves market regulations, listing rules, and laws to make sure that they receive their fair share of any distributions (dividends or asset sales), and are not victimized by self-dealing among the dominant shareholders for their own benefit, looting of the assets, etc., because market responses would have no effect upon the situation. The potential for such issues becoming problematic frequently arises among smaller corporations, and more often among some larger ones in other countries, particularly those with less-highly developed capital markets. But the more commonly-expressed concerns regarding corporate governance do not apply. Most entrepreneurial enterprises also fall in this category: the founder has his or her own wealth at risk, and any significant investors they have usually know management personally and are frequently represented on the board.
The problem arises—and it is particularly acute in the most developed markets, the U.S. and the U.K. most notably—where the company is mature, ownership is widely dispersed, and management has only a relatively small stake in the capital. The company is essentially ‘ownerless’ (as one prominent authority has described it) and it is run by whomever has control of the executive suite. Absent some sort of check on the part of the shareholders, the managers can do whatever they want, for the good or ill of the corporation, and no outsider has any effective say in how the assets are being used. Particularly if management is entrenched through the use of anti-takeover devices, even the extreme case of relying upon the discipline of the market is of no avail, because the market for corporate control does not function. There have been repeated cases where such managements have been able to loot the company, leaving only a shell for their shareholders, without violating any laws. Enron was a prime example, but there have been many others.
Fortunately, only a small percentage of managements have any such larcenous intentions. However, it is much easier for managers and directors to confuse their own interests with those of the company: this is a nearly universal human tendency. Lavish payouts to the CEO and other senior executives, who may have done their jobs well—but can be morale-crushing in times of distress and economic contraction of the company, dubious strategies which benefit certain insiders at the expense of the rest of the corporation, radically raising the risk profile of a company when it is, after all, someone else’s money at risk, and not their own—these are all problems which are dealt with only imprecisely and clumsily through regulation, with frequent unintended consequences, but which can and should be subject to review by those whose money is actually involved: the shareholders of the corporation.
All that is required to allow this mechanism to function is that the laws and regulations involving the existence and functioning of corporations be properly written so that those with the capital—most of them institutions representing small savers who are relying upon their investments to make a comfortable retirement possible—be allowed to express their concern and possible disapproval by removing some or all of the directors if necessary. In most ways, this is the ANTITHESIS OF REGULATION. It does not involve a government agency telling a company what it should do, what strategies and practices it may or may not follow. It is simply guaranteeing that the free market can function properly, without insiders managing to tilt the playing field so that they have an insuperable advantage. It is ensuring that those with capital at risk potentially have some say in how that capital is employed. Of course, the investors can decline to do anything with this power. Most of the time, they will do nothing, and probably should do nothing. But it prevents egregious abuses, and more importantly, it encourages the managements of companies with dispersed ownership to communicate more clearly with those whose money is at risk, to make sure that they are content with what management is doing in their behalf.
Opponents of this sort of governance reform deliberately confuse matters by conflating it with hyper-regulation and micro-management by government agencies. Lobbyists on behalf of managers and boards who wish to do whatever they want (especially to extract oversized compensation packages from companies essentially for functioning as bureaucrats overseeing well-established companies) have successfully confused the issue so that their clients may continue to exercise control over assets which are not their own. This is not entrepreneurialism, it is the modern version of the same game of monopoly which has been played since the days of the first exclusive royal charters in the seventeenth century.
Similarly, “activists” are not all cut from the same cloth. Some are busybodies who labor under the mistaken belief that the corporation should function like a popular democracy, with all significant decisions of the board subject to micro-management through mandatory shareholder approval. These are actually rather rare. Some are single-issue advocates, who attempt to impose their special views upon a corporation resistant to their ideas. Some are attempting to hijack the corporation to shift its balance of decision-making in favor of some specific constituency. One thing all these have in common is that they are unlikely to find support among even a significant minority of shareholders of any reasonably well-run corporation. Another group of activists are those attempting to force a transaction—sale of the company, a merger, an acquisition—to their own advantage. Such activity will only succeed in attaining support of a majority of shareholders if it is in all their interests, and management cannot make a case why they shouldn’t do it, in which case, it probably should succeed.
Finally, there are those activists—frequently the most reviled by managements, because they are the most difficult to buy off with token measures or compromises—in favor of good governance in general. These attempt to foster adoption of those mechanisms which can ensure that the company listen to its shareholders when it is important for them to do so, and to abolish those measures which tend to entrench a management, or allow abuses to proliferate to the detriment of the majority of shareholders. This last group of activists, which includes most of the governance activity engaged in by the better-known pension funds and other institutional investors (including some hedge funds and certain private equity funds) is wrongly lumped together with the others. Unlike them, it is neither event-driven nor directed myopically at some single-issue cause, nor is it dedicated to promoting some self-interested subgroup at the expense of the other shareholders. Almost all of these are geared toward improving the rules by which the company is run, making the corporation a better long-term investment for its shareholders, and keeping it functioning in conformity with the objectives and risk profile the investors assumed when they bought shares in the company, until and unless there is a consensus that these should change. And let us not forget, the measures these activists advocate will succeed only to the extent they are perceived by the majority of shareholders as being in their own interests, and voted upon accordingly.
Confusing this investor-friendly approach to corporate governance involvement with increased governmental regulation is unjustified. In fact, most of the proponents of better governance advocate decreased regulation, provided that the shareholders, and therefore the market, get to pass on major departures from good governance. This is at the core of the ‘comply or explain’ approach taken by so many corporate governance codes of best practice around the world, and by the most influential advocates for improved governance. Yet this conflation of two different causes has successfully hijacked much of the Republican Party’s thinking, on the grounds that it violates their ideology that ‘less regulation is needed in order to free up the entrepreneurial energies of our free market system,’ when what is being protected here is neither entrepreneurial nor the exercise of free markets. Normally, Republicans would be counted upon to defend the interests of private property, but here most oppose it, as if it were the managers whose property the company was, rather than the shareholders.
Conflation of the two opposing approaches has also had the perverse effect of benefiting special corporate interests at the expense of the small investor and saver/would-be pensioner by confusing the Democratic Party on ideological grounds as well: the party which ostensibly believes that government must intervene directly wherever there are abuses of power by entrenched interests, ends up forever adding on further layers of regulation which are always to be administered by the same incumbent management. Most of these are enacted in lieu of any reform of the fundamental method by which companies are controlled and managements are chosen in the first place.
The two must be separated, once and for all, or we will end up with the worst of both worlds: a private sector hopelessly encumbered by regulations, most of which do not accomplish their intended purpose but which add immeasurably to the uncompetitiveness of the economy, while the free market continues not to function at what it is supposed to do, allocating capital to those enterprises which can use it best, and away from those which are wasting and destroying it.