Contemporary corporate governance reform has been a mixed bag: reforms that increase a company’s exposure to competition through the control market have been helpful, while reforms that empower special interest shareholders are a cause for concern. First part of a two-part series.
Corporate governance has emerged as a central issue concerning corporations in the 21st century. A powerful and organized network of reformers has succeeded in changing a variety of corporate practices and influenced two major pieces of federal legislation (Sarbanes-Oxley and Dodd-Frank) as well as rulemaking by key regulatory agencies such as the SEC. This post and a companion piece argue that contemporary corporate governance reform has been a mixed bag: those reforms that increase a company’s exposure to competition through the control market have been helpful, while those that empower special interest shareholders are a cause for concern. This blog focuses on the role of governance in increasing exposure to competition.
Competition is the central force in pushing corporations toward value-creating activities and away from monopolization and rent-seeking. Competition comes through several channels: product market competition disciplines firms that fail to produce good products at low prices; the corporate control market allows outside investors to take over companies that are being run inefficiently and replace their managers; and managerial labor markets reward executives who perform well.
Public policy in the United States has long sought to create a competitive environment across these various channels, most notably through antitrust policy, which seeks to maintain competitive product markets, and takeover laws, which promote an active market for corporate control. But more recently, some observers have begun to doubt the efficacy of market competition in controlling firm behavior and have turned their attention to the corporate governance channel instead.
To get a sense of the evolution of public discourse, Figure 1 reports a Google Ngram plot of “antitrust” (enhancing product market competition), “takeovers” (competition over control of corporate assets), and “corporate governance.” Antitrust has been mentioned most often, but its prevalence peaked in the 1980s. Interest in takeovers grew rapidly beginning in the 1960s and peaked in about 1990. Corporate governance is the new entrant on the scene, with interest accelerating in the 1990s and continuing to rise to the present, with nearly as many mentions for corporate governance as for antitrust and more than for takeovers.
Corporate governance encompasses a wide array of practices but at heart is about who has the right to make corporate decisions (what is called a “control right” in the theoretical literature). Corporate law in the United States assigns most decision rights to the board of directors. The business judgment rule, which presumes that the board is acting in the interest of shareholders, gives the board a free hand, absent strong evidence that it is acting in bad faith. Corporate governance reform in practice then typically involves chipping away power from the board of directors and transferring it to other actors. One type of governance reform reduces the power of the board in order to make the company more susceptible to competitive pressures, and less inclined to use corporate resources to advance their private interests at the expense of shareholders.
Key governance reforms that enhance the company’s exposure to competition are:
- Removal of staggered terms for directors. With staggered terms (so-called “classified” boards), typically one-third of the board is elected each year. Switching to a system in which all directors stand for election each year allows an outside investor to gain control of the company in a matter of months.
- Removal of supermajority voting requirements. Many companies require a supermajority of shareholders (say, two-thirds) to approve a control transaction such as sale of the company, absent support of the board. A switch to majority voting makes it easier for an outsider to acquire a company.
- Allowing shareholders to call special meetings and to act by written consent. A takeover can be concluded more quickly if shareholders are allowed to call special meetings or to act by written consent, rather than having to wait for the next scheduled annual meeting.
- Enhanced proxy access to nominate directors. Normally, a company’s nominating committee controls the identity of the candidates for the board. Enhanced proxy access makes it easier for investors to wage a proxy fight by allowing them to nominate their own slate of director candidates.
- Boards with a majority of independent directors. A board dominated by “inside” (management) directors, although charged to look after shareholder interests, may find it difficult to ignore their private interests as managers. A board dominated by “outside” (independent) directors will be less inclined to protect the managers.
All of these reforms, on the face of it, have the desirable effect of making the company more subject to pressure from the corporate control market. If managers squander corporate resources, the stock price will be low and attract the attention of outsiders who can earn a return by improving efficiency. Corporate reformers have been highly successful in pressing companies to adopt these corporate governance practices. For example, the number of S&P 500 companies with staggered boards declined from 300 in the year 2000 to 60 in 2013, and Sarbanes-Oxley and new exchange regulations have forced most companies to have a majority of independent directors.
While all of this seems for the better, there is a puzzling tension between common expectations and the scholarly literature, which has struggled to find convincing evidence of benefits from these governance reforms. Part of the reason might be the inherent difficulty in inferring causal effects from endogenous practices, but even studies with reasonable identification are inconclusive. For example, Duchin, Matsusaka, and Ozbas (JFE 2010) examine how changes in board independence required by SOX affected firm performance; they find that some firms benefit but others were hurt. Cremers, Litov, and Sepe (JFE forthcoming) control for endogeneity of the decision to adopt a staggered board, and exploit a Massachusetts law that forced some firms to adopt a staggered board, and find no value gain from a staggered board.
Another puzzling finding, from a working paper by Laura Field and Michelle Lowry, is that the percentage of firms going public with staggered boards has increased from 40 percent in 1990 to 80 percent today; if staggered boards are really so bad, IPO firms are increasingly leaving money on the table. Several studies have also failed to find that firm value is higher with enhanced proxy access.
(Note: this is the first installment of a two-part series. The second part will appear next week.)