The "shareholder democracy" scam

The reformers who brought you SOX have been gearing up for the next battle, what they euphemistically call "shareholder democracy."

Here's the state of play:  In AFSCME v. AIG the Second Circuit permitted a shareholder proposal for shareholder access to board nominations. The current SEC shareholder proposal rule doesn't allow proposals on director nominations. The SEC had dropped a proposed amendment to allow direct shareholder nominations, indicating that the prior prohibition was intact. This court ruling now permits proposals for general corporate voting rules. Thanks to this judicial spanner in the works, the SEC has clarify what the rule is. The political forces will soon be facing off at an SEC hearing, and the WSJ and the NYT are publishing their samizdats in preparation for battle. I'm here to tell you what this is really all about.

Today Levitt says:

Counting every vote is not only integral to our political life; it is central to our economic life as well. Shareholder capitalism enables our markets to thrive, our companies to grow and our economy to remain strong.* * *[The SEC's review of the AFSCME issue] is critical to the future of shareholder capitalism. * * * Support of the AIG decision will make it clear that the reforms of the past few years were not ephemeral, and that even though the markets are once again delivering high returns, the commitment to good governance will not falter.

I've been reporting on these appeals to "shareholder democracy" for awhile now. The argument sounds irrefutable:  the shareholders are the owners of the corporation. They should hold the real power, right?  Well, it's not so simple.

Last month Harvey Goldschmid and Ira Millstein said that the SEC should “strive for a solution that gives shareholders a voice in the director election process.”

I responded that

whatever the SEC does in this area, it should make it clear that it is subject to state law. In other words, even if a shareholder nomination proposal is not barred under the director-election exclusion of Rule 14a-8, Delaware should still be able to clarify whether shareholders can initiate bylaw amendments. * * *

As for the Millstein/Goldschmid/Morgenson argument that director elections without shareholder nominations are Soviet-style – this is backwards. American corporate governance is fundamentally ruled by the capital markets, which discount information into stock prices and give firms and their managers incentives to respond to market demand. “Soviet-style” is when this process is circumvented by one-size-fits-all federal rules or, possibly even worse, by the chaotic system that exists in the absence of SEC clarification.

Gretchen Morgenson got in on the act, quoting one of her troupe of performing commentators as saying that "a good libertarian would seek an easier way for the market’s participants to order their affairs and provide an oversight mechanism for owners that would help eliminate the call for greater regulation and criminal prosecution.”

I had this response to Morgenson's newfound libertarianism:

The market approach would be to let state law and corporate charters control this issue and take the SEC out of it.

Two years ago, when the SEC was considering its direct nomination rule I said that "direct shareholder nomination of directors brings the securities laws in conflict with state business association law."

And last year I said

This isn’t about shareholder “democracy,” but about shifting power from powerful managers to powerful shareholders [i.e., unions] who are even less likely to champion the interests of shareholders generally.

While Goldschmid, Millstein, Levitt and Morgenson want you to think that this is about some fundamental American principle of "shareholder democracy," it's really about two other issues. The first is whether we are going to abandon what Roberta Romano has called the "genius" of American corporate law – that is, the creative dynamism of state law on internal corporate governance -- and install in its place control by the Congress, the SEC and federal courts. SOX was a major start in that direction, and the "reformers" would like to finish the job.

Despite all the complaints about state law, there is scant evidence that federal control of corporate governance would be any better. Delaware must compete actively and continue to innovate to maintain its dominance against all the other states. Within that system firms themselves can experiment, as they have, for example, with majority voting for directors. The reformers would replace that system with a one-size-fits-all federal system in which interest groups, particularly including unions, contend and corporate policy shifts with the political winds.

For those who think uniformity when they see federal, consider how, in the AFSCME decision, one federal court has thrown the SEC's shareholder proposal rule into chaos while the political forces line up in Washington. This sort of thing doesn't happen in Delaware.

The second principle is about who controls our modern corporations. The reformers like to shout about "shareholder democracy" as if it meant anything. But the question is which shareholders. It's no accident that the AFSCME case was brought by a union. Corporate elections are unions' last opportunity to shore up their declining clout.

Unions already have secured an extensive executive compensation disclosure rule to whip up populist resentment about executive pay. The next step is to create a mechanism to bring that resentment to bear in corporate elections. It should be obvious to anybody who cares to look past the rhetoric that the unions are seeking bargaining leverage on behalf of their members, and to ensure their own survival. They are not seeking to represent the interests of investors generally. Their ideal is the sclerotic European firm, with its labor representatives on the board.

None of this is to say that current corporate governance is perfect and that there are no agency costs. More shareholder power is indeed an answer to unresponsive entrenched managers. But there are viable alternatives to union dominance, including hedge funds and private equity. We don't see reformers, unions (or for that matter incumbent managers) lining up to defend these shareholders because they might actually want to make more money for the rest of us. Instead we see calls for more federal regulation of these shareholders.

So peek behind the "shareholder democracy" rhetoric and we see what Levitt and the rest of his "reformer" mob have on their minds: federal control of corporate law, turning corporate governance into a political battle between unions and managers, and a rich market for consultants on "good governance."

Comments

[save_the_rustbelt]

The officers and board members have abused their positions so long and so thoroughly, what do you expect but a backlash?

Will the backlash create bad law?

Probably.

Both Wall Street and corporations have been abusing shareholders, and especially small investors, and now it is payback time.

As one of my business law professors told me years ago "free markets only work when the markets are honest."

The markets are not honest.

[M. Hodak]

"The markets are not honest." !?!

If honesty was the relevant distinction, here, I would pit the markets against the only real alternative--politics--any day of the week.

Fact is, market honesty is not even close to the relevant distinction in an argument about "shareholder democracy." The relevant question is whether we want the Federal government to dictate contracts between parties, or do we continue to allow individuals the right to contract as they wish?

"Shareholder democracy" is just a code for using federal power to trump existing, voluntarily-entered relationships. As Larry laid bare, the unions, which have continually lost in the marketplace, are using the cover of rhetoric to circumvent market-evolved relationships. You can call those relationships Soviet-style, if you wish, but the dictatorships of Rockefeller, Watson, and Gates didn't prevail with the threat of state sanction. They prevailed because their ways worked in the market--the only arena where honesty has a chance. If you didn't like their undemocratic ways, if you didn't like the power they had over their boards or fellow shareholders, you didn't have to invest with them. If you want shareholder democracy, set up your own company using your preferred governance mechanisms, and go at it.

"Free market only work when markets are honest"? You had the wrong law prof.

[Jake]

What a rich vein.

Prof. Ribstein decries, among other things, "federal control of corporate law." The heavens did not decree corporations as a natural state. Having generously provided limited liability for investors in corporations, the states may regulate corporations as they please. And the Congress may do likewise -- unless one is mired in a view of the Commerce Clause resembling Lochner-era jurisprudence.

Save_the_rustbelt speaks realism.

M. Hodak states: "If you want shareholder democracy, set up your own company using your preferred governance mechanisms, and go at it." Fine, so far as it goes. But one also might observe that companies that fear shareholder democracy can always go private (as many now are).

Face facts. As a practical matter, companies cannot have access to large, organized capital markets protected by the rule of law if they wish to engage in immoral behavior (meaning, for immediate purposes, behavior that a majority of the electorate will not tolerate). Companies can opt out, however.