Jonathan Macey is Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School. He is the author most recently of Corporate Governance: Promises Made, Promises Broken (Princeton University Press, 2008) available at http://www.amazon.com.
My second post is on the general problem with shareholder democracy caused by defects in the shareholder voting process.
In “Corporate Governance: Promises Made: Promises Broken,” I discuss the need for additional shareholder voting rights. With an improved process, corporate performance and accountability would have the capacity to advance even further. Some dissenters claim that shareholders probably vote too much, and others take the position that voting rules are efficient as they are.
In my view, as currently practiced, shareholder voting probably does not do shareholders much harm, but it doesn’t do them much good either. And the annual votes that shareholders make for boards of directors certainly do not legitimize all of the decisions of boards of directors to routinely support and highly compensate incumbent management.
Voting could serve shareholders well in takeover contests and in expressions of shareholder disapproval in high-profile instances of corporate governance breakdown, such as when poison pills have been proposed by management or outside lawyers. It is, however, irrational to think that expanding shareholder voting can improve the daily governance and operation of a large public corporation. Shareholders simply do not have the requisite information, or the inclination, to become sufficiently knowledgeable about what is going on within a public company to be useful to management in this way. Nearly all shareholders, even large institutions like pension funds, mutual funds, and insurance companies, hold highly diversified portfolios. It is not only illogical for such shareholders to immerse themselves in the business operations and strategies of the companies in which they invest, it is impossible. With modern funds holding shares in thousands of companies, the costs to their clients of emerging in corporate governance would make their funds noncompetitive.
Since mutual funds and pension funds own shares in such a vast number of companies, it makes sense for them only to become well informed about very major issues, such as takeovers or other fundamental corporate changes. In order for large, sophisticated investors to take the time to become sufficiently informed about their portfolio companies, they must reduce the number of companies in their portfolios. Most hedge funds and private equity funds pursue exactly this strategy. But even with hedge funds and private equity funds, formal voting is not useful. Instead, it is far more sensible and efficacious for such funds to immerse themselves in real-time decision-making. When the time comes to vote to ratify a major decision such as an acquisition or a divestiture, it’s too late for investor input to add value. As the available evidence shows, when sophisticated outside investors do become involved in corporate governance, they do not express themselves by voting; rather, they inject themselves into the corporation’s quotidian decision-making on an ongoing basis.
The argument here is that the basic infrastructure of the law of corporate voting is in need of repair. For example, the ability of management to control the timing of elections and the federal rules governing proxy solicitations do not serve the interests of shareholders and should be reformed.
Shareholders do not face the same conflict of interest problems that plague decision-making by management and their captured boards of directors. On issues where the choice is between the shareholder’s lack of information and management’s self-interest, corporate law should choose the shareholders by giving them the deciding voice in corporate governance. Takeovers are perhaps the paradigmatic example of a corporate governance issue that forces us to “decide who should decide” as between shareholders and management.
It is also important to distinguish between “generic” and “firm specific” corporate governance issues. The argument that diversified shareholders are unlikely to inform themselves sufficiently to assist in the corporate governance applies only to “firm specific” corporate governance issues. For example, issues such as whether a particular CFO or CEO should be retained, or whether a company should buy or sell a particular asset such as a subsidiary or a division, are specific to particular firms. As a general matter, voting by shareholders is not likely to be an effective corporate governance mechanism for making decisions about these sorts of issues.
In contrast, a generic corporate governance issue is an issue concerning broad policy that is likely to affect the value of all of the companies in a particular portfolio. One example is whether a particular anti-takeover device such as a poison pill should be adopted by a company. For such generic or market-wide corporate governance issues, it will likely be efficient for diversified shareholders to become well-informed because the resources spent in learning about the relative merits of various anti-takeover devices can be distributed across all of the public companies in an investor’s portfolio.
Stephen Bainbridge of UCLA has succinctly summarized the law of shareholder voting as “so weak that they scarcely qualify as part of corporate governance.” Consistent with this analysis, the list of items about which shareholders have voting rights is remarkably short. Shareholders vote annually on director elections, amendments to the corporate charter, and fundamental corporate changes, such as mergers, dissolution of the corporation, and the sale of all or substantially all of the assets of a corporation. Confusingly, shareholders and directors both hold the power to vote on changes to corporate bylaws. This, in turn, raises difficult legal questions about whether a shareholder vote on bylaws can trump a decision on bylaws made by the company’s board of directors.
While shareholder voting is limited to just a few issues, this is not the only or perhaps even the most significant restriction on the impact of shareholder voting. An important additional constraint on shareholder voting is the problem of screening by boards of directors. Before an issue even gets to the shareholders for their approval, it must almost always first pass through the board of directors for its approval. The only exceptions to this rule are the provisions for electing directors and for amending the bylaws, which do not require board approval prior to action by the shareholders. Some avaricious managers have even tried to impose greater constraints on the election process by attempting to screen nominees of outside groups. While this practice is probably illegal, it is accomplished by requiring that all candidates proposed as nominees for directorships must first be approved by the nominating committee of the incumbent board. Given their questionable legality, these provisions illustrate the extent to which some companies are willing to go to deter outside efforts to gain control.
The current law and regulation of the shareholder voting is too restrictive. Shareholders are only be permitted to vote on issues of large magnitude because it is thought that these are the only instances in which shareholders will be able to overcome the rational ignorance and voter apathy problems that plague the decision-making process and make voting uninformed and irrational. Shareholders also should be allowed to vote on generic issues, that is, on issues that come up again and again in the course of share ownership (or, in the political context, in the case of citizenship.). The costs of becoming informed on such generic issues can be amortized over every investment in the investor’s portfolio in which these issues arise.