TCS Daily

Proxy Fright

By Stephen Bainbridge - December 2, 2005 12:00 AM

In the Wall Street Journal, Robert Pozen recently proposed that the Securities and Exchange Commission should adopt two new rules to empower shareholders:

"First, the SEC should allow shareholders of a public company to propose in its proxy statement a bylaw disqualifying any director nominee who receives less than a majority of the votes cast from being renominated at the company's next election. If approved, the bylaw would permit such a director to be seated after an uncontested election because there are no competing candidates. In the next election, however, such a director could not be nominated again for a seat on that company's board. ...

"Second, instead of risking investor confusion by combining company and shareholder candidates in the same proxy statement, the SEC should help reduce the costs of making a separate solicitation of proxies for a minority of directors running for office: a "short list" rather than a full slate of nominees. Under current SEC rules, proponents of a short list must incur enormous expense by mailing proxy statements to every company shareholder. To reduce these costs, the proponents of a short list should be allowed to publish their proxy statements on the Internet, according to a task force of the American Bar Association. Internet publication would reach most company shareholders, small and large, especially if the company's Web site included a Web address for the materials of the short list proponents.

Pozen is a very serious and influential fellow -- chairman of MFS Investment Management, former member of the President's Commission to Strengthen Social Security, former associate general counsel of the SEC, and so on -- so anything he recommends is likely to get a serious hearing in Washington. Unfortunately, these are both very bad ideas.

If adopted, the short list proposal would significantly increase the prospect of a divided board of directors. As with all minority representation schemes, such as cumulative voting or codetermination, the resulting divisions within the board of directors will significantly reduce the board's effectiveness.

Granted, some firms might benefit from the presence of skeptical outsider viewpoints. It is well-accepted, however, that cumulative voting tends to promote adversarial relations between the majority and the minority representative. The likelihood that cumulative voting will results in affectional conflict rather than cognitive conflict thus leaves one doubtful as to whether firms actually benefit from minority board blocks.

The likelihood of disruption in effective board processes is confirmed by the experience of German firms with codetermination. German managers sometimes deprive the supervisory board of information, because they do not want the supervisory board's employee members to learn it. Alternatively, the board's real work is done in committees or de facto rump caucuses from which employee representatives are excluded. As a result, while codetermination raises the costs of decision making, it seemingly does not have a positive effect on substantive decision making.

The likely effects of electing a short list therefore will not be better governance. It will be an increase in affectional conflict (as opposed to the more useful cognitive conflict). It will be a reduction in the trust-based relationships that causes horizontal monitoring within the board to provide effective constraints on agency costs. It will be the use of pre-meeting caucuses and a reduction in information flows to the board. In sum, it will be less effective governance.

Expanding the Federal Role

Both of Pozen's proposals are also problematic because they would represent a significant and unwarranted expansion of the federal role in corporate governance. In particular, variants on his first proposal, relating to a requirement that directors be elected by majority vote, are currently being actively debated in state legislatures around the country and among the drafters of the American Bar Association's influential Model Business Corporations Act.

For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states.

As the US Supreme Court explained in CTS Corp. v. Dynamics Corp., 481 U.S. 69 (1987):

"It ... is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares."

Indeed, the Court opined that "[n]o principle of corporation law and practice is more firmly established than a State's authority to regulate domestic corporations." It thus is state law that determines the rights of shareholders, "including ... the voting rights of shareholders."

The basic case for federalizing corporate law rests on the so-called "race to the bottom" hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

The problem is that the race to the bottom theory makes no economic sense and is unsupported by the empirical evidence.

Basic economic common sense tells us that investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not lend to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes.

The empirical research bears out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time. A study by Yale law professor Roberta Romano of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive stock price gains. In other words, reincorporating in Delaware increased shareholder wealth.

This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. (For a good summary of the research, see Roberta Romano, The Advantage of Competitive Federalism for Securities Regulation.)

Additional support for this conclusion is provided by state takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware's single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by Harvard law professor John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly.

According to the Supreme Court's CTS decision, the country as a whole benefits from the fact that this area is regulated by the states rather than the federal government. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law.

As Justice Brandeis pointed out many years ago, "It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country." So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by rules like those proposed by Pozen will preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed -- no "laboratory" of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete.

In conclusion, the SEC should promptly toss Pozen's proposals into the circular file. This is an area best left to the states.


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