Securities and Exchange Commission Chairman Chris Cox holds the swing vote in one of the most important questions of corporate control currently being considered by the government. Sometime soon he’ll have to decide whether to support the proxy access proposals put forward by the Democratic commissioners or cast his lot with Republican proposals to maintain the status quo.
As is so often the case, at the heart of the matter is a confused concept. In particular, the concept of shareholder democracy seems to have broken out of its academic box and run rampant through the minds of some otherwise sensible people. Fortunately, the proxy access proposals are the subject of two of the most important articles published today—one from law professor Lynn Stout in today’s Wall Street Journal and the other from Larry Ribstein on Ideoblog.
Stout takes the argument for shareholder democracy head on, arguing that the “proposed proxy access rule is driven by the emotional claim, unsupported by evidence, that American corporations benefit from ‘shareholder democracy.’" Current shareholders, who are only temporary owners with easy entrance and exit strategies, have incentives to exploit and loot a company for immediate gains—which is exactly what some well-known activist shareholders have been urging on public companies. A stronger shareholder franchise will only acerbate the problem, Stout says.
What makes US companies function so well is the fact that they are managed by strong central boards and run by powerful managers. “Successful corporations are not, and never have been, democratic institutions. Since the public corporation first evolved over a century ago, U.S law has discouraged shareholders from taking an active role in corporate governance, and this ‘hands off’ approach has proven a recipe for tremendous success,” Stout writes.
Ribstein is less enthusiastic about traditional models of corporate governance. In fact, he thinks that the traditional public corporation may be on its way out—or at least in for some real evolution. But he agrees with Stout that attempts to force change on corporations through a new national regulation on proxy access are a very bad idea. “[T]he reason why the SEC should keep its hands-off here has more to do with the appropriate limits of SEC power than with the substance of the proposal. This is a matter of internal corporate governance which should be for the states,” Ribstein writes. “There is no justification for making this a federal matter unless you buy in to the shareholder democracy myth.”
What neither Ribstein nor Stout touch on today is the actual mechanism for the disfunction of shareholder democracy. Both understand that it won’t work as promised but they don’t spell out the reasons why. But fortunately you read DealBreaker, so you are about to learn why.
Clearing up the puzzle of shareholder democracy after the jump.
The Problematics of Political Analogy
Proxy access in publicly held corporations is commonly viewed through a paradigm based on democratic political theory. The legitimacy of governments, according to a famous American declaration, is based upon the consent of the governed. Similarly, the legitimacy of corporate governance is said to rest on shareholder consent.
You can find plenty of politicians—Barney Frank, we’re talking about you—announcing exactly this parallel. But even the Delaware Chancery court has made this connection explicit: “The shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests.” This analogy of political governance to corporate governance has led to a theory of shareholder democracy that dominates most talk about it.
One indication, however, that something is wrong with this analogy is the lack of shareholder demand for an extended franchise. If shareholders placed as high of a value on an extended franchise as, say, citizens do on their voting rights, we would expect to see public companies fleeing to jurisdictions which grant shareholders greater franchise rights. We do not. Similarly, we would see companies changing their corporate charters to grant these rights in order to attract investors. That’s not happening. If shareholders desired a greater franchise, they would not so often reject proxy proposals that would grant these. But shareholder majorities often do reject these proposals. For the theory of shareholder democracy, the lack of shareholder enthusiasm for an extended franchise is a puzzle.
The deeper problem is that the theory of shareholder democracy rests on naïve version of democratic theory which fails to appreciate the role of public ignorance in limiting democratic competence and the implications this has for capture of the mechanisms of governance by interest groups. Looked at in the light of a more sophisticated version of democratic theory, limitations on the shareholder franchise appear to be rational responses to ignorance and the threat of interest group exploitation. The puzzle of shareholder support for franchise limitations melts away under this light. Shareholder majorities reject so many shareholder empowering proposals because they would have the effect of opening up the company to being preyed upon by interest groups.
This has surprising implications for supporters of shareholder democracy. Instead of overcoming limitations on shareholder franchise in an attempt to empower shareholders, supporters of shareholder democracy should see those limitations as an exercise of shareholder empowerment. Efforts to erode those limitations do not promote the interests of shareholders as a whole or in general, they advance the power of interest groups. They are, in short, the bulwarks of shareholder democracy against exploitation and alienation by predatory interest groups seeking to capture corporate governance.
The Rational Ignorance and Diversity of Shareholders
The first thing to understand is that most shareholders are largely rationally ignorant of corporate governance and strategy. Most have diversified portfolios that would render a deep understanding of the operations of any one corporation impossible. Certainly the effort would not be worth it. Warren Buffett might not buy companies he doesn’t understand but he’s an exception to the rule. Instead of actually getting to know the inner workings of a company, we tend to rely on reports from analysts or fund managers to tell us where to invest.
The second important part of the puzzle is to observe that not all shareholder are created equal. That is, there is a great diversity in types of shareholders. Some—the kind the SEC was allegedly formed to protect—are individuals attempting to invest for the future. Others are fund managers, who themselves have diverse strategies and goals. Still others are interested parties such as pension funds dominated by labor unions. These various players will have different, sometimes conflicting goals. And, importantly, they will have different informational costs. Some will find strategies that will incentivize them to become more informed and more active in corporate governance, creating the potential for manipulation of less informed shareholders.
Stout brings up the example of Carl Icahn.
Consider Carl Icahn's demand this past spring that Motorola undertake a massive stock buyback program, at a time when the company desperately needed to invest in research and development to produce a successor product to its RAZR cellphone. By giving activists even greater leverage over boards, the SEC's proposed proxy access rule will undermine American corporations' ability to do exactly what investors, and the larger society, want them to do: pursue big, long-term, innovative business projects.
But even grimmer scenarios are imaginable. Take the possibility of a labor union negotiating its members’ pay with a companies management. Now imagine if that the pension fund dominated by the union invested heavily in the company and could easily and cheaply vote against, say, the pay packages of the executives they are negotiating with. In this case, Say on Pay—another proposal being considered by lawmakers—would quickly develop into a way for workers to force management into a bargain to exploit the resources of the company—basically expropriating the gains from the disinterested shareholders.
We know from contemporary social science that electorates tend to be characterized by mass ignorance leavened only by ideologically committed and self-interested elites. Deliberation is characterized by manipulation and franchise exercise by apathy. There is plenty of reason to conclude that these problems will be even worse for shareholder democracy than it is for political democracy.
Corporations Shouldn't Be Democracies [Wall Street Journal]
The real problem with the SEC's proxy access proposal [Ideoblog]
Posted by Oh the horror, Sep 27, 2007 4:33PM
"But even grimmer scenarios are imaginable"
You mean like rapacious managers voting themselves huge compensation packages and their friends on the board giving the rubber stamp?
Somewhat easier to imagine than horror stories of union-dominated pension funds forcing uneconomic decisions.