Corporate Governance

Jon Macey on Corporate Governance (Part 6)

By J Robert Brown Jr et al.

Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recenlty published a book titled Corporate Governance, Promises Kept, Promises Broken.

Macey forcefully shows that boards of directors are "captured" by management.  As such, they cannot adequately protect the interests of shareholders.  His solution to the problem, as any good proponent of the nexus of contracts theory must argue, is to let the market resolve matters.  The best way to ensure the protection of shareholders is to ensure an active and robust market for corporate control.

The market penalizes inefficiency.  "Because running a firm below its firm potential would make it more likely that the company's incumbent management would be replaced in a hostile acquisition, a robust market for corporate control is vitally important as a corporate mechanism for monitoring and disciplining managers."  He notes that the "scientific evidence" on the importance of these markets is "so overwhelming as to be incontrovertible" (he does note, in his footnote, that some notable scholars disagree with the overwhelming and incontrovertible evidence).  The evidence?  That there are "significant positive abnormal returns on the investments of shareholders in companies that receive takeover bids." 

It is a theoretical argument in today's market.  As he notes, "the poison pill has effectively destroyed the hostile takeover market."  He places the blame on the Delaware courts, where they have "by judicial fiat . . . removed from the marketplace the hostile tender offer, which is the most powerful corporate governance device in the shareholders' corporate governance arsenal."

The observation is quite accurate.  The explanation? 

• The shareholders who would benefit from the high premiums and more rigorous scrutiny of management associated with a robust market for corporate control from more intense monitoring and are widely disbursed and disorganized.  On the other hand, the managers who want to be free of the intense market discipline associated with a robust market are a small, discrete, well-organized group that constitutes an effective political coalition.  This coalition, aided by management lawyers and investment bankers who benefit from a sclerotic market for corporate control that is run by lawyers and bankers rather than entrepreneur, can be credited for the regulations we observe. 

It is a powerful observation but one that entirely undercuts the entire nexus of contracts analysis.  It suggests that contracts are not a product of bargaining, but the result of self serving behavior by management, aided by key advisors.  In other words, with this dynamic in place, all contracts are better explained by self serving behavior than by efficiency.  It is the point that we make in Opting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom.

It is also not enough to emphasize the wide dispersion and disorganization of shareholders.  They are also subject to substantial legal limitations, whether the lack of the authority to initiate amendments to the articles or to adopt shareholder proposals that provide for mandatory repayment of expenses in proxy contests. 

In addition, the criticism of lawyers and investment bankers leaves entirely unmentioned the role of the Delaware courts.  It is the Delaware courts that resolutely refuse to impose meaningful duties on directors that would otherwise result in increased protections for shareholders. 

The irony in all of this is that those in the law and economics movement generally and those favoring the nexus of contracts approach specifically typically approve of the role of the Delaware courts.  The courts have resolutely removed categorical protections of shareholders in favor of broader discretion for the board.  Thus, directors can discriminate against shareholders of the same class of stock or buy votes, so long as consistent with fiduciary duties.  It is an approach that theoretically favors private ordering. 

But of course the Delaware courts are motivated not by efficiency but by pro-management outcomes.  Any overlap of the two approaches is entirely accidental.  Thus, one of the reforms not really addressed in the book is a mechanism that would seek to reduce the pro-management bias of the courts.

We address the issue of hostile takeovers and the market for corporate control in the next post.

Full post as published by The Race to the Bottom on December 05, 2008 (boomark / email).