Federalizing corporate governance is not the answer

Federalizing corporate governance is not the answer
© Anna Moneymaker

A new bill introduced by Sen. Elizabeth WarrenElizabeth Ann WarrenCarbon tax could give liberals vast power to grow federal government Democrats opposed to Pelosi lack challenger to topple her More Massachusetts Voters Prefer Deval Patrick for President than Elizabeth Warren MORE (D-Mass.) aims to make all corporations with $1 billion in annual revenue subject to Federal corporate governance by requiring them to be chartered as a United States corporation. The Accountable Capitalism Act, in effect, rejects shareholder primacy and advocates stakeholder governance. While Warren’s proposal is well-intentioned in its attempt to consider all stakeholder groups, the economics underlying it are flawed in several ways. 

First, the proposal may hinder the ability of some businesses to attract capital. It is one thing to take into consideration the interests of stakeholders in decision-making as good business practice, but quite another to hand over control of the business to the detriment of its owners. We are not sure how private sector capital would ever be attracted to such a system unless there were no alternatives. Under the proposed system, stock prices would likely fall as the benefits from the bill may not accrue to shareholders.

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Second, the bill assumes that employee representation is an effective governance tool, which is not necessarily true. It prescribes that no less than 40 percent of directors be elected by the employees. If we take Germany as an example, their corporate governance system requires employee representation on corporate boards. This configuration did not stop one of the biggest governance lapses in recent history, which occurred at Volkswagen. They had a board makeup similar to what Warren proposes. In the U.S., employee co-ops like Etsy have also underperformed.

 

Third, legislating the interests of stakeholders can be counterproductive and comes at the expense of the board’s ability to weigh competing priorities. As proposed, the Federal charter would provide that directors consider the interests of all corporate stakeholders—employees, customers, suppliers, shareholders, and the communities in which the corporation operates. General governance practice already takes into consideration the interests of all stakeholders to the extent necessary to manage a stable and viable organization. Ignoring one (or more) of these interests is neither in the interest of a corporation nor its owners, and introduces elements of risk and instability. However, a corporation's mandate is to optimize longer risk-adjusted returns to the shareholder – and not returns to any of these other groups. Asking a manager to maximize the value of multiple stakeholders can be contradictory and impractical. For instance, paying employees more than their marginal contribution to a firm’s value is shareholder value decreasing.

Fourth, the bill requires executives to hold equity received as managerial compensation for a period of five years. Many companies already have mandatory equity holding requirements. These voluntary adopters typically report higher stock return and future operating performance. However, it is unclear whether forcing all managers to hold equity for five years is value-added for shareholders. Such a constraint will lead managers to demand a compensation for the illiquidity associated with their inability to diversify their holdings in the firm. Whether the benefits of encouraging a long-term view exceed the cost of an illiquidity premium is unclear, and requires further research.

Fifth, the bill advocates facilitating the rejection of takeover bids, modeled on constituency statutes in some 30 states. This is precisely the wrong way to go. Decades of research suggest that takeover bids, on average, promote more efficient use of scarce corporate resources. Otherwise, entrenched management tends to linger on and waste shareholder funds. Better governance could be accomplished by making it easier for activists to intervene and removing barriers to corporate takeovers.

Finally, the bill contains a director business judgment provision, promoting long-term investment. We are unclear about the purpose of this provision as "business judgment" should already be taken care of under the fiduciary standards that directors are required to uphold. Getting into the territory of defining what is good business judgment and what it not is difficult and counterproductive. It should not be legislated, partly because it is heavily dependent on the context surrounding the business decision.

Sen. Warren’s proposal is a well-intentioned effort to address the short-term pressures imposed by the stock market and activists versus the goal of productive, long-term investment. But the conversation needs to be re-directed to deeper economic questions, such as what is short-termism and what are the pressures that cause it to occur, and what are the most effective methods to address these pressures? We believe federalizing corporate governance is not the answer.

Katherine Hensel is an executive in residence at Columbia Business School. Shiva Rajgopal is the Kester and Byrnes Professor at Columbia Business School, and a Chazen Senior Scholar at the Jerome A. Chazen Institute for Global Business.