Dent, George

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Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 55 | Issue 32005Comment: The Case for Real ShareholderDemocracyGeorge DentFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationGeorge Dent, Comment: The Case for Real Shareholder Democracy, 55 Case W. Res. L. Rev. 581 (2005)Available at: https://scholarlycommons.law.case.edu/caselrev/vol55/iss3/10COMMENT: THE CASE FOR REALSHAREHOLDER DEMOCRACYGeorge DenttWe have now had two excellent presentations of opposing views.'In order to continue to build on this success, I will try to give a pro-vocative idea here. Craig White did an able job of taking on LucianBebchuk from one side of the continuum. What I will do-and, Pro-fessor Bebchuk, if you think this is unfair, well, that's just tough-Iam going to take you on from the other side.I agree with Professor Bebchuk that our corporate governance sys-tem now is flawed, that many boards of directors are heavily influ-enced or dominated by the CEO so that the company is not managedwith the goal of maximizing shareholder wealth. I also agree withhim that more shareholder input into the election of directors wouldimprove things, but that the reforms recently enacted or proposed donot go far enough in this direction.We have heard statements from a couple of speakers today to theeffect that most boards are doing a good job. Most boards have im-proved, and are trying to do the right thing; I am not going to questionthat. But that seems to me like saying, "Most people don't engage inarmed robbery, so why do we need laws against armed robbery?" Ina minority of companies, boards are still not doing a good job. Inseveral recent cases catastrophes struck corporations, and boards werenot there to prevent this from happening. It is unrealistic to think thatconditions have changed so that the same thing could not possiblyhappen again today. I am confident that there are some boards wherethe same thing could happen. But I am not sure Rule 14a-1 12 wouldt Schott-Van den Eynden Professor of Law, Case Western Reserve University School ofLaw., See Lucian Arye Bebchuk, The Casefor Shareholder Access: A Response to the Busi-ness Roundtable, 55 CASE W. RES. L. REV. 557 (2005); Craig Owen White, Corporate Govern-ance: Directors v. Shareholders?, 55 CASE W. RES. L. REV. 569 (2005).2 Security Holder Director Nominations, 68 Fed. Reg. 60784-01 (proposed Oct. 23,CASE WESTERN RESERVE LAW REVIEWeven help prevent such incidents. Professor Bebchuk admits that anybenefits from the rule would be small.We have heard references to some of the rule's detriments thismorning: disruption and diversion of company personnel to deal withmore frequent election contests, deterrence of the best candidatesfrom serving as directors because life is going to be unpleasant onboards, and balkanization of boards into hostile factions. I think thosesupposed detriments have been exaggerated by the critics. But if therule has even small detriments, they still outweigh its benefits becausethose benefits will be paltry. Professor Bebchuk has said in defenseof Rule 14a- 11 that even if it does not bring much improvement, itslack of success could justify consideration of more expansive reformsof corporate elections; people will come back and say we need to gofarther down that road.I am not sure that would happen. First of all, pro-managementforces will be saying-and we have already had a hint of this in somecomments this morning-that we should take more time to see ifthese reforms work. Of course, "more time" turns out to be basicallyforever. Second, the failure of Rule 14a- 11 could weaken the enthu-siasm of investors for more shareholder involvement in elections. Inother words, if 14a- 11 produces no benefits, the reaction may not bethat we need to go farther in the same direction. Rather, investorsmay lose hope for efforts to strengthen shareholder democracy.Furthermore, as I mentioned before, the enthusiasm for reformebbs and flows. At most times there is little impetus for reform. Wehave now a window of opportunity. If we let that window shut with-out doing anything substantial, it may be a long time before it opensagain.I am not suggesting, though, that we abandon efforts for moreshareholder input. Quite the contrary, I offer what will be to Profes-sor Bebchuk, I hope, a friendly challenge, and to Mr. White what willbe more of a provocation, and that is to consider an alternative that isbolder and yet quite simple.I propose that the nomination of the corporation's official slate ofdirectors be removed from the incumbent board, which is often pas-sive and dominated by the CEO, and be given instead to a committeeconsisting of the ten to twenty largest shareholders. These sharehold-ers should seek directors who strive to maximize shareholder wealth.Choosing different directors is not, however, the primary objec-tive. As Professor Bebchuk and others have suggested, independence2003) (to be codified at 17 C.F.R. 240.14a-1 1).[Vol. 55:3THE CASE FOR REAL SHAREHOLDER DEMOCRACYin the sense of a lack of conflicts of interest is no guarantee of effec-tive board performance. The more important goal is to change theincentives of directors. As a behavioral psychologist would say: Thequestion is not so much who sits on the board, but what is theirschedule of reinforcement? There was mention earlier today of aconference directed by Jay Lorsch at Harvard. He has said that toomany directors feel that they serve at the pleasure of the CEO.3 Di-rectors who were selected by the shareholders would strive to servethe shareholders, even if they were the same people who are servingon the board now.Right now there is a lot of pressure on directors to go along withthe CEO. If you do not feel like doing that, what do you do? You donot fight. You either do not take the position to begin with, or yousay, "This is not fun, I don't want to serve on this board any more."If the same people were really chosen by the shareholders, their in-centive would be to serve the interests of shareholders. It is not reallyagain a question of whether they are independent, or unaffiliated. It isa question of where the incentives are.But would directors so chosen serve special interests of the largershareholders? This is a criticism we always get of shareholder pri-macy, but it is highly improbable. Professor Bebchuk touched on thisin connection with 14a- 11, and I think the same thing is true of myproposal. Any special interest would have to be shared by a majorityof the largest shareholders. It is hard to imagine such a situation aris-ing. Besides, the committee I envision would only nominate direc-tors. If the nominees seem committed to special interests, if by someunimaginable scenario all the official nominees were beholden to thecompany's labor union, other shareholders would have an incentive torun and elect an opposing slate.Would directors chosen by shareholders overemphasize short-termperformance? It is a common criticism that investors are only con-cerned about short-term performance. It is hard for me to imaginethat the largest shareholders would communicate to directors that theywant the board to focus on next quarter's earnings.Even if the largest shareholders did that, the directors would havean incentive to ignore them so as not to offend shareholders who areconcerned about shareholder wealth. Lots of directors serve on manyboards. How do you get a reputation for being a good director so thatyou will be invited to serve and remain on other boards? Today, youat least have to get along with the CEO because the selection process3 JAY W. LORSCH & ELIZABETH MACIVER, PAWNS OR POTENTATES 17 (1989).20051CASE WESTERN RESERVE LAW REVIEWis heavily influenced by the CEO. The CEO typically has a veto over,or actually dominates, the selection of directors.Now imagine a world in which the selection of directors wasdominated by shareholders. Even if you came under pressure fromsome of your own shareholders in a particular company to focus onthe short-term, you would have to think, "Wait a second. If I do thatand the company's fortunes briefly flare and then fizzle, is that goingto enhance my reputation as a director?"If instead you enhance share value, lots of investors will be im-pressed and want you to sit on the boards of their companies. So it isunlikely that directors chosen by shareholders would focus on theshort-term at the expense of prudent, patient capital.Would directors chosen to serve shareholders mistreat other con-stituencies? That too is unlikely.First, what are the interests of the other constituencies? True, foran employee of an unprofitable plant it is better that the companykeeps running that plant, even if it means the company may go bank-rupt in a few years, rather than shut it down today.But, in general, employees, customers, suppliers, and the commu-nities in which companies operate tend to benefit themselves from theefficient operation of the corporation. Generally, the companies thatare the most profitable grow the most rapidly, and the companies thatgrow the most rapidly are likely to increase employment, wages, andbenefits. So in the long run, employees' interests are very little dif-ferent from, if not identical to, the shareholders' goal of maximizingshareholder wealth.The criticisms of shareholder primacy seem to me to be weak.One possible response is to ask if one can guarantee that this or thatparade of horrors will not occur under my proposal. Of course, theanswer to that is no; one never can. Human institutions are alwaysimperfect. Recall Churchill's comment about democracy: It is theworst form of government except for all the others that have everbeen tried.Just as democracy is imperfect, shareholder primacy will be imper-fect because directors, investors, and executives are human beings.The proper question is not, "Is it perfect?" The proper question is,"Compared to what?" We should compare shareholder primacy withthe current system in which most boards are heavily influenced, if notdominated, by the CEO.I noted the objection that shareholder primacy leads to dominationby special interests. Well, managers have their own special interests,and there is plenty of evidence that they use their influence now to[Vol. 55:32005] THE CASE FOR REAL SHAREHOLDER DEMOCRACY 585advance those interests. Professor Bebchuk has done studies aboutexcessive compensation. We have seen in the last ten or twelve yearsthat executive compensation exploded without any justification inmanagers' performance that I am aware of.Another current problem is empire building, as when CEOs devotecorporate resources to unprofitable acquisitions or to other unpromis-ing projects. As for concern for other constituencies, CEOs have noreason to treat them better than shareholders would, and there is noevidence that they do so now.As for short-term focus, we have already seen plenty of that withpump and dump schemes by executives who exaggerate earnings andthen sell their stock at artificially inflated prices. It would be a lotharder for the ten to twenty larger shareholders to pull a stunt likethat. So even if you are less sanguine than I am about the idea ofshareholder control, it is hard to argue that it would be worse thanCEO domination is now.You all know the story of the economist who is walking with astudent. The student says, "Professor, that looks like a $20 bill on thestreet. Shall I pick it up?" The economist says, "Don't be silly. If itreally were a $20 bill, somebody would have already picked it up."Well, if this idea I am putting forth is so great, why didn't some-body else already think of it? Why hasn't some state tried to chal-lenge Delaware by adopting this law? Why don't investor groupspush it? As for the states, occasional efforts by other states to takefranchise business away from Delaware have invariably failed.First of all, Delaware has a big advantage to start with just in hav-ing a fully fleshed out, well known statute. For any state to competeit would have to offer a law that was not just marginally but dramati-cally better than Delaware's. And if some state did that, Delawarewould just move its law in the same direction and regain its initialadvantage from superior judicial competence and familiarity. So,whatever benefits there might be in what I am suggesting, it is highlyunlikely that North Dakota could attract a huge number of franchisefees by adopting it.As for investors, they have the same collective action problemwith respect to legislation that they have now in voting. SupposeTIAA-CREF or some other institutional investor waged a big cam-paign to improve corporate governance. TIAA-CREF is a big outfit,but it still owns just a tiny fraction of all American stock. So its shareof any benefit from better corporate governance would also be small,and proportionately no greater than any other investor's gain. ThereCASE WESTERN RESERVE LA W REVIEWreally is not much incentive for any particular investor to knock itselfout to change the system.That does not mean, though, that shareholders are taking abuseslying down. Bob Monks claims that excessive executive compensa-tion alone exacts a tax of ten percent on investors, and that, to escapethis mistreatment, investors are fleeing to private equity.4 Why?Well, venture capitalist and leveraged buyout firms do participateactively in choosing directors, and this participation does not seem toresult in mistreatment of other constituencies, subjection of the port-folio company to special interests or excessive focus on short-termperformance, or any of the other horrors conjured up by critics ofshareholder primacy.In general, these firms are well managed and do not waste re-sources on unprofitable undertakings. I realize that shareholder con-trol is not politically viable right away, but I am an academic-I thinkideas have consequences-and people who care about corporate per-formance as a key element of the success of the American economycan get behind good ideas. I hope that eventually this proposal willbe adopted.4 Lucian Arye Bebchuk, Symposium on Corporate Elections, Harvard Law and Econom-ics Discussion Paper No. 448, *17, at http://ssm.comlabstract-471640 (November 2003)(Comment of Robert Monks).[Vol. 55:3

Comment: The Case for Real Shareholder Democracy

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