Legislation of the Year . . . If the Year Is 1950

Senator Charles Schumer recently announced plans to introduce the “Shareholder Bill of Rights Act of 2009.”  This bill is a compendium of corporate governance reforms that shareholder activists have been advocating for many years.  Among other things, the bill would require companies to elect the entire board of directors each year, rather than putting only a portion of the board up for a vote.  It would also require that directors receive a majority of the votes cast before being allowed to serve, and the bill would make it easier for shareholders to nominate their own director candidates to run in opposition to the candidates nominated by management.

Senator Schumer’s bill is best understood as embodying the principle that, when it comes to corporate governance, more democracy is always better.  The assumption is that corporate governance will improve in tandem with increased shareholder voting power.  I question that assumption.

First, more democracy might actually lead to worse directors. 

The transformation of director elections into real voting battles, with the attendant risk that a management-backed candidate might face serious opposition and possible defeat, could very well deter desirable candidates from subjecting themselves to the process.  A director position already entails a risk of legal liability, and the days of “figure-head” directors who have modest demands placed on their time are long gone.  The risk of an embarrassing election defeat only adds to the long list of reasons that well qualified candidates already have for declining a nomination to the board.

Second, contested board elections assume that shareholders can cast an informed vote.  In the past, the cost of gathering and disseminating information to the voters deterred all but the largest shareholder activists from mounting a challenge to board nominees put forth by management.  This ensured that the voters heard only the pro-management side of the story prior to an election, unless activist shareholders succeeded in a time-consuming and expensive effort to include their views in the company’s proxy materials.  The Internet has changed this equation by making information-gathering and communication on behalf of opposition candidates more cost-effective.  But it is not clear that an explosion of information both in favor and against a particular board candidate will result in a better-informed shareholder electorate.  Our experience under the political model suggests that multiple sources of contradictory information can lead to voter confusion or even apathy.

Finally, and most significantly, the time when reforms to the shareholder voting process could make a meaningful difference to corporate governance has already passed.  The direct ownership of stock by American households has declined from 91 percent in 1950 to just 32 percent in 2007.  In contrast, in 1950, financial institutions such as mutual funds and retirement plans owned only nine percent of all stock, while in 2007 that figure was 68 percent.

Today, the majority of votes in a corporate election are cast not by millions of individual shareholders, but rather by a small class of professional money mangers.  These managers of large financial institutions do not behave like the prototypical private individual shareholders.  In particular, the short investment horizon of these money managers makes them less motivated than private individuals to use their voting rights to demand improved corporate governance. 

My colleague Nadelle Grossman has recently written about the problem of “short-termism” among institutional investors and its impact on the structure of corporate governance.  I recommend her piece, which can be found here.  I merely would add a couple of points.

As mutual fund pioneer John Bogle has pointed out, money managers have little or no incentive to support board candidates put forth by activist shareholders against candidates backed by management.  From 1950 until 1965 the average portfolio turnover rate at a mutual fund was 17 percent per year.  From 1990 through 2005, the turnover rate averaged 91 percent per year.  When you replace virtually your entire investment portfolio each year, aggressive participation in proxy contests and director elections concerning the individual companies in your portfolio is a pointless exercise.  What good does it do to improve the machinery of shareholder democracy if fewer shareholders see any connection between their own long-term interest and the outcome of a particular board election?

Moreover, so long as they generate acceptable investment returns for the beneficiaries of their pension funds and mutual funds, the managers of these financial institutions are free to ignore the interests of the broader universe of shareholders.  Financial institutions can and often do contact management directly when they have concerns about the governance of a particular company in their portfolio, bypassing other shareholders, and they may negotiate side deals with management that address the financial institution’s interests without considering the interests of other shareholders. The law leaves largely undefined the legal duties that mangers of financial institutions might owe to their fellow shareholders.         

Given the dominance of institutional investors among today’s electorate, and the ability of institutional investors to bypass the electoral process in favor of other means of influencing corporate policy, Senator Schumer’s bill may be arriving about six decades too late.

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