The very expression “corporate governance” – as the defense of the corporate governance solution to which it was inextricably linked from the outset – first surfaced in the 1970s. Although the New York Times featured the phrase as early as 1972, it was not until 1976 that the concept acquired theoretical backing. That year marked both the publication of Ralph Nader et al.’s “Taming the Modern Corporation,” as well as the initial appearance of the term in the Federal Register. The first problem which corporate governance purported to address was the perception of unbridled “corporate power” and the ensuing need for “corporate accountability.” Two central events in the 1970s contributed to this diagnosis. The first was the unexpected debacle of the Penn Central Railroad, then regarded as “the bluest of blue chips” of the time. The second was the illegal campaign contributions and foreign corruption incidents associated with the Watergate scandal. To be sure, suspicion of corporate power runs deep in U.S. history, not least due to the early association between the corporate form and monopoly power. From a historical perspective, the initial policy reaction was to restrict, and then later to liberalize, access to corporate charters in an era in which incorporations required prior governmental approval. Curiously, some of the early responses to corporate (market) power took the form of governance arrangements, such as voting caps and corporate purpose restrictions. Nevertheless, as time went by, corporate law became increasingly narrow and specialized in the rights of shareholders, managers, and creditors. Concerns about corporate and market power became the object of distinct areas of law, such as antitrust and industry regulation. By the mid-1970s, however, the emerging view once again was that limitations on corporate power should come from within the corporate form. Rather than receiving further constraints by the government, the corporation could and should look more like government itself – and hence cure its apparent failings through internal checks on misconduct. From the left, reforming the corporation from within seemed to be the only feasible solution given the government’s frailty in the face of ever increasing corporate power and the accompanying degree of political influence, which rendered futile other forms of regulation. From the right, internal governance reform appeared as a reasonable concession to deflect the specter of government intervention. Indeed, resort to the metaphor of the corporation qua government – and the related defense of mechanisms typical of government control – was pervasive across the political spectrum. At one extreme, in their progressive opus “Taming the Giant Corporation,” Ralph Nader, Mark Green, and Joel Seligman claimed that “[t]he modern corporation is akin to a political state in which all powers are held by a single clique” – and suggested, after quoting James Madison in the Federalist No. 47, that “[t]hese are precisely the circumstances that, in a democratic political state, require a separation of powers into different branches of authority.” The same analogy between the corporation and government also permeated the discourse of conservative business associations. The Statement of the Business Roundtable of 1977 likewise relied on the Federalist papers and the “tripartite organization of the Federal Government” to address the “corporate governance triad of shareowners, directors, operating management.” The document expressly conceded that “the public and its elected representatives should be concerned that private business organizations like government itself be subject to checks and balances, to constraints on excessive power.” The essence of the corporate governance obsession – then as now – resides in the transposition to the corporate context of two time-honored mechanisms for constraining and legitimizing state power: “checks and balances” through separation of powers and democracy. In the corporate arena, the main actors in the tripartite separation of powers are shareholders, boards of directors, and managers. Yet managerial power, the perception went, had gone unchecked. An adequate system of checks and balances required strengthening the role of the board of directors and affording a meaningful role to shareholders – a recipe that would prove to be remarkably resilient to cope with a variety of economic problems for decades to come. (i) Strengthening the board: independent directors and the monitoring function Revitalizing the role of the board of directors was from the outset the most popular and least controversial of the two goals. There was growing recognition that actual boardroom practice had failed to live up to the central role conferred on the board of directors by corporate law. Although the “law on the books” assigned to the board the job of “managing the business affairs of the business corporations,” real-world directors fell far short of this ideal. Therefore, it was argued, directors ought to transition from their historical roles as mere “pawns” of management to become effective monitors of corporate officers. In the terminology coined by Melvin Eisenberg, the imperative makeover was one from an advisory board to a “monitoring board.” It was evident that such a transformation in the actual functioning of the board nonetheless required a corresponding change in board composition. Specifically, effective monitoring necessitated a certain level of distance and differentiation from management. The key, it seemed, was to replace corporate insiders with outside – and later, more forcefully, also independent – directors. Another companion policy to the rise of independent directors did not take long to surface: namely, the implementation of independent board leadership through a split in the positions of board chair and chief executive officer (CEO). The intuitive idea was that it did not make sense for the monitoring board in charge of overseeing the company’s management to be led (and have its agenda controlled) by the person who was the main target of the monitoring efforts. These proposals shared a common spirit: as the state retreated, the promise of independent directors – as arbiters of adequate corporate performance of the private sector, by the private sector, and for the private sector – progressively gained ground. The call for greater board independence gathered broad support, in part because of its political ambiguity. Social activists viewed independent directors as a suitable – if not ideal – mechanism to render corporate management more sensitive to the public interest. Other commentators, by contrast, regarded the rise of independent directors as perfectly consistent with the goal of maximizing shareholder wealth. In 1977, urged by the Securities and Exchange Commission (SEC), the New York Stock Exchange adopted a listing rule requiring audit committees to be composed of a majority of outside directors. The new rule came in the aftermath of the corruption scandals of the Nixon administration. The link between the corruption scandals and the policy response is revealing. Instead of relying solely (or primarily) on public law and government action, 68 the promise of independent directors ran in the opposite direction. It was premised on the assumption that private sector checks and balances are the best cure for private sector ills. Interestingly, even corporate managers – the constituency whose power independent directors were designed to curb – came to support the measure as a sensible private sector reform that crowded out more intrusive forms of government action. In the same statement in which the Business Roundtable warned that “both human liberty and economic efficiency depend heavily on limiting the power of the state,” it supported the “tendency of U.S. corporations to move to a board structure based on a majority of outside directors” to further the board’s role in carrying out “the effective performance of the economic functions of an enterprise and for meeting other responsibilities.” The rise of outside directors likely looked so palatable to business interests in view of the far more radical character of the alternative policy prescriptions floating around at that juncture. Proposals for federal corporate chartering proliferated rapidly, as did calls for revamping the board’s role through the inclusion of constituency directors, with representatives of workers, consumers, or general representatives of the public interest. In this environment, the voluntary embrace of independent directors – whose precise practical import was, and continues to be, dubious – was an attractive compromise. Indeed, as the political climate cooled in subsequent years, the Business Roundtable abandoned its prior moderate position, and vigorously opposed the attempt by the American Law Institute (ALI) to endorse a majority of independent directors. The Business Roundtable’s change of heart was clearly driven by the different political environment of the Reagan era, which eliminated existing threats of federal regulation and, therefore, the need to make corporate governance concessions. In fact, in 1982 the Chairman of the Business Roundtable Task Force on Corporate Responsibility urged the Roundtable’s members to oppose the ALI project by underscoring “its roots in the ‘70s as part of the effort to meet federal incorporation and similar proposals” and pointing out that “[i]f the effort to adopt that kind of legislation was unsuccessful in the halcyon days of the activists, it is difficult to regard that concern as having much validity now or, for that matter, in the foreseeable future.” Nevertheless, the obsession with independent directors was there to stay, and was in an important sense also aided by courts. In controversies ranging from derivative suits to takeover battles, Delaware jurisprudence increasingly blessed decisions made by independent directors (or special committees thereof) in situations that would otherwise entail a conflict of interest. This is yet another instance of devolution of decision-making power from the public to the private sector, with independent directors serving as the relevant arbiters of fairness. (ii) The promise of shareholder democracy Checks and balances through a monitoring board composed of independent directors was not the only politically inspired remedy to the perceived corporate crisis. Though far less agreeable to business interests, the application of democracy to the corporate form – especially by increasing shareholder voice and power – was a popular concept among reformists. The corporate governance movement envisioned “a new role” for shareholders in monitoring and disciplining the board. By the 1980s, the SEC Staff Report on Corporate Accountability acknowledged that “the emerging consensus concerning the proper role of corporate boards of directors, while extremely important, is only one part of the larger effort to enhance corporate accountability in America,” drawing specific attention to the role of shareholders in corporate governance. This was so even though the link between the problems of the time – illegal payments and corporate failures – and the proposed solution of greater shareholder involvement in corporate affairs was tenuous at best. As underlined by the contemporary critique of Daniel Fischel, illegal payments to foreign officials were in fact consistent with the pursuit of shareholders’ financial interests. Likewise, attributing financial collapses to a “‘breakdown’ in corporate accountability” was, in his view, a “colossal nonsequitur” – akin to blaming such corporate failures on the concomitant rise of independent directors during the period. Yet the view that the lack of shareholder monitoring was at the root of economic underperformance in the United States would only gain force through the growing interest in comparative corporate governance in the 1980s. Besides the United Kingdom, a sister jurisdiction, the main focus of comparative investigations were Germany and Japan, the great exemplars of economic success at the time. And, it turned out, Germany and Japan had systems of corporate governance that were markedly different from that of the United States. Monitoring by large institutional investors – especially financial institutions – was a hallmark of German and Japanese corporate governance. The comparative experience underscored that the U.S. system of shareholder apathy was not inevitable, and might not necessarily be desirable. Combined with the growing awareness about the expansion of institutional ownership in the United States in the 1980s, the German and Japanese experience played a part in inspiring the movement for greater institutional investor activism in the United States. The corporate governance movement expanded in the 1980s as the product of the particular economic conditions and political context then prevailing in the United States. But it was in the 1990s – described, perhaps prematurely, as the “decade of corporate governance” – that the movement went global. In blending a reformist project with a private sector focus, corporate governance would provide an attractive agenda both for international development agencies in charge of promoting economic growth in developing and transitional countries and for think tanks seeking to revitalize the economies of the Wealthy West. A number of factors help explain the increasingly global grip of the corporate governance agenda. First and foremost – and consistent with its U.S. origin – corporate governance reform arose as a substitute for government action in the international context as well. In the 1990s, governments worldwide were in retreat as the fall of the Berlin Wall and the neoliberal ideological sway of the Washington consensus impelled a wave of privatizations and deregulation. In this context, a new system of corporate governance was needed to replace the old one based on state ownership of enterprise. As the early experience with privatizations made painfully clear, the shift to private ownership alone was unlikely to bolster economic performance in the absence of accompanying institutions. The idea that governance was a substitute for government was explicit in the global embrace of the movement. The influential Principles of Corporate Governance of the Organisation for Economic Co-operation and Development (OECD), first published in 1999, bring home the point. Their preface is structured around three pillars: (i) it highlights the economic transformation leading to greater reliance on the private sector and market forces in the previous decade; (ii) it links the rising prominence of corporate governance to the growing “awareness of the importance of private corporations;” and (iii) it implies that corporate governance – defined as the “internal means by which corporations are operated and controlled” – is not only a product of greater emphasis in the private sector, but also a contributing force to continued private sector dominance. That is, at the same time as the document acknowledges that “governments play a central role in shaping the legal, institutional and regulatory climate within which individual corporate governance systems are developed,” it stresses that “the main responsibility lies with the private sector.” Second, and relatedly, the reformist ambitions of the corporate governance movement meant that it would gain traction in periods of economic failures or crises. While the initial establishment in 1991 of a U.K. Committee on the Financial Aspects of Corporate Governance, chaired by Sir Adrian Cadbury, drew only limited attention, the “harsh economic climate” and subsequent corporate scandals afflicting British companies Maxwell and BCII soon brought the Committee’s efforts into the spotlight. The work products of the Committee, embodied in the celebrated Cadbury Report and its influential Code of Best Practices, benefited from the attention and sense of urgency spurred by a corporate crisis – a “climate of opinion which accepts that changes are needed,” in the words of Sir Adrian Cadbury himself. But even if the corporate scandals in question were reasonably confined, the ambitions of the corporate governance movement as it expanded in the U.K. were far more grandiose. As was the case in the United States, reform proponents underscored the fundamental role played by corporate governance practices in the economy. The Cadbury Report opens by stating that “[t]he country’s economy depends on the drive and efficiency of its companies.” It then immediately posits a strong causal relation between the board of directors and the general economic performance of the country (“[t]hus, the effectiveness with which their boards discharge their responsibilities determines Britain’s competitive position”). Even though it was a relative latecomer, Britain’s approach to corporate governance, which relied on the promotion of a “Code of Best Practices,” would become a particularly successful export in years to come. To that effect, it was assisted by the progressive reversal of economic fortunes in the 1990s, which prompted a reassessment of the lessons drawn from comparative corporate governance in the prior decade. As the U.S. and U.K. economies took off during this period, the prevailing conceptions about the efficiency of different systems of corporate governance changed accordingly. While in the 1980s the systems of Germany and Japan served as a source of inspiration, in the 1990s the conventional wisdom came to regard the U.S. and U.K. systems as the ultimate models of good corporate governance for both European and developing countries. A new wave of academic research would soon reinforce this trend. Inaugurated in the 1990s, the booming economic literature on “law and finance,” contributed to the increasing prominence of corporate governance reform as an integral part of the recipe for economic development. A growing number of works pointed to the existence of a causal relationship between financial development and economic development. And a related, though more controversial, literature came to suggest that the level of legal investor protection in a given jurisdiction – as determined by its legal origin (whether common law, or French, German or Scandinavian civil law) – influenced both the degree of ownership dispersion and the observed levels of capital market development. Taken at face value, one could be tempted to conclude that a logical policy corollary of the law-and-finance literature would be the prescription of sweeping regulatory reforms and a greater role for state intervention. Dispelling such doubts, however, subsequent work suggested that disclosure mandates and private enforcement were superior to public enforcement. And although development agencies formally embraced legislative reform, a combination of free market ideology and political resistance to legal change by incumbents redirected the reform efforts to voluntary programs through the private sector. International development agencies not only supported the creation of stock exchange listing segments requiring greater investor protection – as in Brazil’s successful experiment with the Novo Mercado – but also backed a number of firm-level corporate governance initiatives. The World Bank has also sponsored a number of country-specific Corporate Governance Reports on the Observance of Standards and Codes (ROSCs), so as to not only “strengthen regulators,” but also to “develop CG codes, and create institutes of directors.” International development agencies have thus been instrumental in propagating the view that good corporate governance – as primarily implemented by the private sector – plays a fundamental role in economic development. Finally, the use of corporate governance to deflect more intrusive modes of state regulation carried forward to the international arena as well. The Cadbury Report was unequivocal in this regard, taking pride in “striking the right balance between meeting the standards of corporate governance now expected of them and retaining the essential spirit of enterprise.” It also explicitly warned that “if companies do not back our recommendations, it is probable that legislation and external regulation will be sought All in all, the internationalization of corporate governance also served as a substitute for government action in two mutually reinforcing ways. The increasing retreat of the state propelled the decision-making processes of private corporations further into the spotlight. At the same time, the advancement of the corporate governance agenda reinforced this trend by crowding out attempts at greater governmental intervention. As the “corporate governance decade” drew to a close with the successful export of the Anglo-Saxon blueprint, the emergence of high-profile corporate scandals in the early 2000s in the United States reignited the debate. The unveiling of massive financial fraud at U.S. giant energy firm Enron was followed by similar problems at WorldCom, Tyco, and Adelphia. These failures were striking for at least three reasons. First, they took place at the United States, which at the time enjoyed the status of international paragon of good corporate governance. Second, Enron itself had formally exemplary corporate governance practices: its highly independent board was composed of directors with stellar credentials, boasted a sophisticated committee structure, and met frequently. Third, prior progress in the corporate governance movement in encouraging managers to maximize share prices might have, inadvertently, created the very incentives for doing so at any cost – even if by fraudulent means. The sheer magnitude of the Enron debacle – which, among other things, wiped out US$ 60 billion in market capitalization and US$ 2 billion in pension plans – triggered public calls for reform. This was so even though the fraudulent conduct in question was already considered criminal under existing law. Indeed, Enron’s executives endured extraordinarily long jail sentences as a result of their actions. Enron CEO Jeffrey Skilling was sentenced for 24 years (subsequently reduced to 14), CFO Andrew Fastow received a six-year sentence after cooperating with the prosecution, and former board chair and CEO Kenneth Lay faced dozens of years in prison when he died prior to his sentence in 2006. The legislative response to the Enron scandal came in the form of the Sarbanes-Oxley Act of 2002 (“SOX”), described by then President George W. Bush as “the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” In SOX, the compromise character of the corporate governance solution offered an attractive blueprint for policymakers. If SOX innovated in imposing federal corporate governance mandates for the first time in U.S. history, it followed the new tradition of treating internal checks and balances within the corporation (and other private sector gatekeepers as well) as a universal remedy. Although SOX contained its fair share of traditional regulatory mandates (ranging from new financial disclosures to insider trading prohibitions and criminal sanctions), it also reflected and reinforced the growing corporate governance obsession. Instead of solely compelling or proscribing specific conducts or increasing existing sanctions, it also placed greater weight on the ability of private sector actors to act as monitors and arbiters. Two of the most salient statutory additions – the requirement of wholly independent audit committees and the mandate of executive certification of financial statements – fall squarely within the concept of a corporate governance solution. In the same spirit, a number of other rules relied on other types of private gatekeepers, such as auditors, attorneys, analysts, and whistleblowers. The apparent contradiction in imposing further corporate governance prescriptions in response to Enron did not escape observers – but did little to derail the initiative. Particularly striking was the disjunction between the causes of the collapse and the new statutory requirements. As noted by Jonathan Macey, it is ironic that “Enron itself already met or exceeded the standards ostensibly promulgated to prevent future ‘Enrons.’” Roberta Romano advanced an influential critique of the substantive mandates embraced by SOX. She described the reform as a set of “recycled ideas advocated for quite some time by corporate governance entrepreneurs” whose effectiveness was either unconfirmed or positively denied by the existing empirical evidence. Romano attributes what she regarded as the flawed legislative outcomes in SOX to the “frantic political environment.” Even if puzzling at first sight, the lack of empirical support to the efficacy of the corporate governance practices mandated by SOX is perfectly consistent with the compromise character of the corporate governance obsession. For one, empirical ambiguity facilitates bipartisan support. Moreover, even reforms that are ultimately ineffectual can be useful in fending off more intrusive modes of government intervention. This is a plausible reason why SOX was initially able to garner support even from conservative associations, such as the Business Roundtable, which later reversed its stance on the statute once the threat of regulation was gone. Moreover, to the extent that SOX also encompassed new regulatory requirements, it would soon come under attack based on the argument that the associated compliance costs decreased the competitiveness of U.S. capital markets. Interestingly, the reaction against regulation once again took the form of a corporate governance solution – this time through an emphasis on shareholder empowerment. The influential report of the Committee on Capital Markets Regulation advocated for stronger shareholder rights which, in its view, “go hand in hand with reduced regulation or litigation.” Pargendler
Posted on: Mon, 13 Oct 2014 08:24:03 +0000