Is corporate governance really broken?
Professor Stephen Bainbridge of the UCLA School of Law was not impressed with my essay last week on "Who needs a board of directors, anyway?"
"It's a very good question," he wrote in his blog, ProfessorBainbridge.com. "Unfortunately, he [me, that is] offers a very bad answer." Bainbridge's main complaint appears to be that I attributed the existence of the corporate board of directors to historical factors. He's a law and economics guy, which means he's dubious of explanations like that. If corporations have boards of directors, there must be an economic reason for it.
I'm actually pretty sympathetic to such arguments. Business practices don't survive for centuries unless they help make somebody money. But the article (it's a pdf file, so I don't want to link without warning, but here it is) I cited by University of the Pacific law professor Frank Gevurtz did posit an economic reason for boards' survival: that they make the existence of large corporations, which are important engines of our economy, palatable to the citizenry.
That may not be an entirely convincing explanation, but neither is Bainbridge's. He says boards exist because groups make better decisions than individuals. That in itself is debatable--although Bainbridge marshals an array of empirical evidence to back it up. But even if it's true, Gevurtz points out, the chief decisionmaking group at most large corporations is top management, not the board.
So where does that leave us? Confused. The board of directors isn't going away, but neither does it appear capable of reliably serving the role envisioned for it in law--that of ultimate decisionmaker at a corporation.
The big question, really, is whether we need to do anything about this. Most of the commenters to my original post seemed to think we do. "Boards would be fine if they were truly elected by shareholders," wrote Dale Lamm of Canton, Ohio, expressing a sentiment shared by several others.
As it stands now, board nominees are chosen by the existing board and management and almost always run unopposed. A couple years ago, the SEC proposed changing proxy rules to enable large, long-term shareholders to place candidates on a company's director ballot--but opposition from corporate executives kept the plan from getting anywhere.
Bainbridge opposed the proposal, too. His key objection, as he put it in his comment letter to the SEC, was this:
Large-scale investor involvement in corporate decisionmaking seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decisionmaking authority in the board of directors. The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decisionmaking structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge ...My sense is that there's a continuum of shareholder involvement in corporate decisionmaking, and over the past two decades in the United States we have gone from almost none to a little. The SEC proposal would have pushed things slightly farther in that same direction, but I find it hard to believe that it would have dramatically shifted the balance.
Do we need to dramatically shift the balance? Well, it depends whether you think corporate America is a pit of self-dealing, waste, and fraud or a spectacularly successful economic endeavor marred by occasional breakdowns and more frequent blind spots. However sympathetic I am to the arguments of the Jack Bogles and Bob Monkses of the world, I invariably find myself landing in the latter camp. So I'm basically a fellow traveler of Stephen Bainbridge. (Which bums me out, because I'd been hoping to milk this into a debate that dragged on for months.)
Finally, for those of you who went to the trouble to read Bainbridge's post: He claims that a couple of my descriptions of changes in corporate governance through the years (the decline of shareholder and creditor power in the first few decades of the 20th century, and the modest rise in shareholder clout in recent years) are factually incorrect. That's a bit much. The real story is that I was repeating the standard history, while Bainbridge favors the work of a few revisionist scholars who have chipped away at the edges of it.
Hi Justin - I'll offer another reason why Bainbridge's rationale for a board seems suspicious. When there is a breakdown, the board seems able to state that it was in fact not in charge. Case in point, Patricia Hurd's recent statements in the breakdown of accountability at HP. Given the possibility choices of mendacity or incompetence when corporate wrongdoing is exposed, board members are increasingly willing to choose the latter.
Bainbridge: "In such a firm, someone must be in charge ..."
Ouch. This is a denial of the American economic experience, which is about small competing ventures and local ownership out-competing the crowned heads of europe. Ouch. how can these modern royalists deny 200 years of success of devolved power and ownership. If hierarchies work, why didn't old china, old Europe, old India, old soviet union, old fascist Germany, my my my how these royalists raise their ugly heads 200 years later I cannot fathom, don't encourage them though, eh
The main trouble I see with Boards of Directors is that they tend to be highly inbred, the same people picking the same people all the time. If they truly are to represent the interests of all the shareholders - not just a few - they need to be far more diverse. I'm afraid I don't have the foggiest idea of how to get this accomplished with our present system of doing things.
Bainbridge is wrong, and the laws of common sense prove it. His suggestion that someone must be in charge is correct, but there is absolutely no logical link to assume that the person in charge is the board or even on the board. If you think back over the corporate scandals of the last 10-15 years, in almost all cases the CEO involved was also on the board. Just look at the news of the last week involving HP and it's board. The scandal that rocked the company came from a board member spying on other board members. For a board to truly guide the ship, it must be completely independent from the executive officers of the company. A ship is truly a good example of how a company should function:
The Captain (the board) should set the direction for the company.
The Executive Officer (the CEO) should navigate the course and order the crew.
Too often though, the CEO runs the whole show and the board is handcuffed by either a few large shareholders who support the CEO or by the fact that the CEO is also Chairman of the Board. Even worse is that often the boards are not involved or consulted in major decisions made by the corporation and are told only after the fact, thus relegating them to complete helplessness.
In short, the theory of a board is good, but only if it is well-informed, active, and independent of the executive office and officers of the corporation. 99 times out of 100, that description does not apply to the current boards of publicly traded entities.
One needs to look at what role does the board of directors perform in a corporation. They perform a vital role not only of ensuring that decisions made in large corporation are for the benefit of the stakeholders but also in ensuring that the corporation complies with all the legal requirments.
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