Archive | October, 2009

Inside the Black Box

The Modern Firm, Corporate Governance and Investment (New Perspectives on the Modern Corporation), edited by Per-Olof Bjuggren and Dennis C. Mueller, explores developments in the theory of the firm, as well as how ownership structure and institutional frameworks impact performance. Below, I look at a small sample of the contributions contained in this stimulating reader.

As a demonstration of the book’s timeliness, the author of chapter 2, Oliver Williamson, was awarded the Nobel prize in economics while I was reading the book… always nice when that happens. In the essay included in this volume, Williamson argues that contract/governance is an instructive way of opening the black box of the firm, especially with regard to antitrust matters. He examines the application of a contractual approach to various forms, such as lateral integration, pricing, scaling, horizontal mergers, and conglomerates.

Dennis Mueller reviews the development of the firm, focusing on constraints (or their lack) on managerial discretion, finding constraints weak but developing. I a 1993 study with Elizabeth Reardon he found agency costs high. “Cumulative over the 19-year period, the 699 companies have collectively destroyed roughly $1 trillion by investing in projects with returns less than their costs of capital.” General Motors alone contributed $150 billion of the total. It would be interesting to see an update. The merger wave, growing competitive markets and the increased proportion of institutional investors increased constrains but the later weren’t as effective as some think, since institutional investors also got swept up in the euphoria of the bull market.

Kristen Foss examines managerial authority in the knowledge economy and finds changes are likely to be as dramatic as many suppose. “Although knowledge workers may have more bargaining power… they too will be subject to authority, as long as productive activities are characterized by uncertainty and measurement costs which make complete contracting prohibitively costly.”

Johan Eklund examines ownership concentration and dual-class equity structures in Scandinavia. He finds that dual-class shares drive a wedge between cash-flow rights and control rights. “Firms with only on equity class are, on average, investing efficiently, whereas firms with dual-class equity structure are over-investing… Vote-differentiation creates massive entrenchment and destroys large values.” “On average, ‘entrenched’ firms have returns on investments that are approximately 30 percent below the cost of capital.” “Separation of cash-flow rights from control appears to distort the incentive of the controlling owner by significantly reducing the incentive effect.”

Deakin and Singh look at the market for corporate control and conclude that takeovers are a very expensive way of changing management because of huge transaction costs. Lack of a market for corporate control in Japan, Germany and France avoids these costs but has not imposed hardship on their economies because of other mechanisms to discipline managers. Additionally, many acquiring firms do not impose discipline, since they are motivated by empire-building or asset-stripping.

Daniel Wiberg examines the relationship between institutional ownership and dividends. He finds that institutional ownership has a positive effect on dividend payout policies and disciplines free cash flow to management. Control instruments, such as vote-differentiated share, “induce investors to demand higher levels of dividends as compensation for increased agency costs.”

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Review: Moving Beyond Cycles of Regulation, Deregulation & Reregulation

The endless cycle of government regulation is explored in a new book, Regulation, Deregulation, Reregulation (Advances in New Institutional Analysis) by Michel Ghertman and Claude Menard. Contributors bring an international perspective, touching on a myriad of industries. While not directly focused on developing a post-subprime regulatory framework in the financial industry, the book does reflect the latest thinking by a respected group of scholars for understanding theory and practice in regulatory approaches.

For example, the research of Andres, Guasch and Azumendi develops indexes of regulatory governance from cross-country data and shows that regulatory involvement improves results in utility performance. Another study by Delmas, Russo, Montes-Sancho and Tokat finds that deregulation has a negative impact on efficiency and a positive impact on the provision of renewable energy. ne way to create willingness to pay for public goods is to bundle them with private goods. Consumers are willing to pay a premium for non-toxic cleaners because they see the likelihood of direct impacts on their own health.

More on target for those concerned with reform of the financial industry, Romano discusses how SOX’s use of a “one-size-fits-all” approach is oblivious to the microanalytic approach of firms matching governance structures and processes to specific organizational developments and requirements. Rulemaking expansions often occur after business crises galvanize public opinion and action by legislators around sometimes ill-conceived compromise solutions supported by powerful and vocal interest groups. In contrast, refinement of poorly conceived regulatory schemes generally takes many years and requires substantial research.

If nothing else, be sure to read the essay by Ghertman who outlines Stigler’s 1971 article, the “Economic Theory of Regulation,” which recognized that many rules are advocated by incumbent firms as barriers to entry. Stigler generally favored market-oriented deregulation… the road we took for decades. Ghertman goes on to discuss refinements offered by subsequent scholars that discuss variables such as group cohesion, political balance, and unintended incentives and transaction costs.

Explanations of movements away from and back toward a dominating policy paradigm (regulation or deregulation) benefit from the dynamic properties of political science for third order changes (the paradigm), the dynamic properties of transaction cost theory for second order changes (regulatory instruments), and the behavioral theory of the firm and the contractual design view for first-order changes (regulatory mechanisms).

Transaction cost economies are better grounded than a simple Stigler-based assertion that “regulation (or government) IS the problem” would warrant. Finding appropriate proxies to measure transaction attributes is problematic, especially across industries and jurisdictions, but is essential. We need to focus more on ex ante choices and less on ex post empirical tests if we are to move beyond the cycle of regulation, deregulation and reregulation.

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Does Corporate Governance Matter to Economic Development?

The editors of Corporate Governance and Development: Reform, Financial Systems and Legal Frameworks (The Crc Series on Competition, Regulation and Development), Thankom Gopinath Arun and John Turner answer with a resounding yes. As they indicate in their introduction,

If finance matters for economic development, then corporate governance must also affect economic development for at least two reasons. First, corporate governance affects how and at what cost firms finance their real investments… Secondly, the quality and nature of corporate governance can affect the structure of the financial system.

If shareowners are poorly protected, finance through bank loans will be more expensive.

This collection of essays provides a broad outline of recent scholarship around the world. Chisari and Ferro suggest that unintended consequences of reforms in Argentina could impinge on consumers. Based on experience in Botswana, Gustavson, Kimani and Ouma also argue reforms originating in Anglo-American models must tailored better when imported to other cultures. Goyer and Rocio also find that corporate governance is mediated by the larger institutional framework in their study of electricity sectors in Britain and Spain.

Other authors focus on corporate governance relative to the banking sector, finding a correlation between debt and poor performance, the need for prudent regulatory reforms for divestiture of government ownership and good governance practices, while two chapters on Bangladesh also argue for strong legal and regulatory institutions to protect minority shareholders, creditors and depositors.

Three additional chapters focus on legal frameworks in Ireland, UK and the EU, as well as more broadly. It is that broader focus of developing a “shareholder protection index,” which I found most interesting. Building on prior work by La Porta and others, Priya P. Lele and Mathias M. Siems construct a much more elaborate index of shareowner rights based on a “leximetric” (quantative measurement of law), rather than econometric approach.

They endeavored to include the variables which best reflect shareowner protections developed in the UK, US, German, France and India over the last 35 years. Aggregate scales for each of these countries trend upward. Shareowner protections have increase, especially in the last five years. On a number of scales, the US comes out at or near the bottom but that doesn’t mean the authors recommend redirecting capital from the US to France, for example. Other aspects, such as financial disclosure, the rule of law and socio-economic attitudes have not bee considered. Neither have factors such as blockholder control and other variables. They didn’t examine whether a better score leads to better governance or economic development but will be examining these questions in the future.

Overall, the volume offers a good cross-section of essays reflecting current scholarship in field of growing importance.

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Review: An Islamic Perspective on Governance

An Islamic Perspective on Governance (New Horizons in Money and Finance) by Zafar Iqbal and Mervyn K. Lewis reads like a carefully constructed dissertation setting forth a theory of justice, taxation, government finance and accountability, governance and corruption grounded in Islam. Indeed, it originated as an academic piece and is unlikely to find the wide audience it deserves in this format. Continue Reading →

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Moving Beyond Cycles of Regulation, Deregulation & Reregulation

The endless cycle of government regulation is explored in a new book, Regulation, Deregulation and Reregulation: Institutional Perspectives (Advances in New Institutional Analysis Series) by Michel Ghertman and Claude Menard. Contributors bring an international perspective, touching on a myriad of industries. While not directly focused on developing a post-subprime regulatory framework in the financial industry, the book does reflect the latest thinking by a respected group of scholars for understanding theory and practice in regulatory approaches.

For example, the research of Andres, Guasch and Azumendi develops indexes of regulatory governance from cross-country data and shows that regulatory involvement improves results in utility performance. Another study by Delmas, Russo, Montes-Sancho and Tokat finds that deregulation has a negative impact on efficiency and a positive impact on the provision of renewable energy. ne way to create willingness to pay for public goods is to bundle them with private goods. Consumers are willing to pay a premium for non-toxic cleaners because they see the likelihood of direct impacts on their own health.

More on target for those concerned with reform of the financial industry, Romano discusses how SOX’s use of a "one-size-fits-all" approach is oblivious to the microanalytic approach of firms matching governance structures and processes to specific organizational developments and requirements. Rulemaking expansions often occur after business crises galvanize public opinion and action by legislators around sometimes ill-conceived compromise solutions supported by powerful and vocal interest groups. In contrast, refinement of poorly conceived regulatory schemes generally takes many years and requires substantial research.

If nothing else, be sure to read the essay by Ghertman who outlines Stigler’s 1971 article, the "Economic Theory of Regulation," which recognized that many rules are advocated by incumbent firms as barriers to entry. Stigler generally favored market-oriented deregulation… the road we took for decades. Ghertman goes on to discuss refinements offered by subsequent scholars that discuss variables such as group cohesion, political balance, and unintended incentives and transaction costs.

Explanations of movements away from and back toward a dominating policy paradigm (regulation or deregulation) benefit from the dynamic properties of political science for third order changes (the paradigm), the dynamic properties of transaction cost theory for second order changes (regulatory instruments), and the behavioral theory of the firm and the contractual design view for first-order changes (regulatory mechanisms).

Transaction cost economies are better grounded than a simple Stigler-based assertion that "regulation (or government) IS the problem" would warrant. Finding appropriate proxies to measure transaction attributes is problematic, especially across industries and jurisdictions, but is essential. We need to focus more on ex ante choices and less on ex post empirical tests if we are to move beyond the cycle of regulation, deregulation and reregulation.

Select-A-TicketSelect-A-Ticket

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Proxy Access: The Letters Are In

The deadline was August 17th, so the comment letters on proxy access have all been filed and posted. Many are well worth reading. If you don’t see yours posted, you might want to resubmit it.

TIAA-CREF, one of the more conservative shareowner activists, calls on the Commission to raise the threshold to 5% for shareowners at all companies, regardless of size. Additionally, they want to require a two year holding period and recommend instead of the “first in” approach, nominations should go to the largest owner or and (here they get creative) to the shareowner or group that has held their shares the longest. They voiced opposition to reimbursement: “Reimbursement of expenses could be used to facilitate the election of special interest directors. Reimbursement also encourages fighting and proxy contests to achieve representation at the distraction of directors rather than dialogue and productive change.” Instead, they favored “incentives for a meeting between shareholders and the board in order to identify director candidates who are acceptable to both parties… Ultimately, the best possible outcome is to avoid a proxy contest altogether… We believe that the nominee should receive at least 20% of the vote in order to be re-nominated in subsequent years.”

Cornish Hitchcock, writing on behalf of the LongView Funds warns against a state-law carve-out, praising the merits of a uniform system. Like TIAA-CREF, the LongView Funds would like to see the required holding period extended to two years and nominations going to the largest nominator.

J. Robert Brown, of theRacetotheBottom.org, offers a spirited rebuttal to comments by the Delaware Bar Association regarding their argument in favor of private ordering. “The evidence in fact suggests that in the absence of a federal requirement, companies will opt for a categorical rule denying access.” “Evidence suggests that management’s control over the drafting process and its ability to rely on the corporate treasury eliminate any real prospect of private ordering. Instead, when matters are made discretionary, they result in a categorical rule that favors management.” “The only way to ensure meaningful access to the proxy statement is to adopt a federal rule that institutes the requirement.”

Lucian Bebchuk’s letter, signed by 80 professors, favors the rulemaking and notes, “no matter how moderate eligibility or procedural requirements may be, shareholder nominees must still meet the demanding test of getting elected before they can join the board. A shareholder nominee will join the board only if the nominee obtains more votes than the incumbents’ candidate in an election in which incumbents, but not the shareholder nominee or the nominator, may spend significant amounts of the company’s resources on campaign expenses.”

As expected, the Shareholder Communications Coalition, comprised of the Business Roundtable, the National Association of Corporate Directors, the National Investor Relations Institute, the Securities Transfer Association, and the Society of Corporate Secretaries & Governance Professionals sent a letter opposing the rulemaking “until the Commission: (1) completes its intended examination of the proxy system; and (2) promulgates new regulations to modernize and reform this cumbersome and expensive system.” “A shareholder nomination process that operates in a proxy voting system that cannot produce an accurate and verifiable vote count will do little to improve the overall
corporate governance system.” I just can’t help making a snarky comment. So we should just go with the current system that elects incumbents based on inaccurate and unverifiable voting results until we can ensure the system works properly

Broadridge submitted a letter discussing various technical issues. Great for those who want to get into the weeds.

Writing on behalf of Sodali, a global corporate governance consultancy, John Wilcox asks: “Is Rule 14a-11 is sufficiently deferential to the traditional role of the states in regulating corporate governance?; and (2) Does the proposal achieve the Commission’s goal of removing burdens that the federal proxy process currently places on the ability of shareholders to exercise their basic rights to nominate and elect directors?” His analysis answers with a resounding yes.

Eleanor Bloxham, of the Value Alliance and Corporate Governance Alliance notes that “having an orderly, ongoing process for shareholder to nominate directors may produce improvements in shareholder returns. Certainty, competition in the process for board seats could, I believe, produce better candidates.” She addresses the issue of affiliation and loyalty, Bloxham recommends each candidate be required to prepare a statement as part of the proxy process that would stipulate that the candidate understands that as a director, if chosen, their  obligations are to act in the best interests of all shareholders, including minority shareholders, and to act without preferential treatment related to who may have nominated them.”

As I have previously mentioned, I signed on to a letter from the United States Proxy Exchange (USPX), endorsed by members of the Investor Suffrage Movement, Robert Monks, John Harrington and John Chevedden. Glyn Holton did a great job of putting together sixty-nine pages of comments. I urge everyone to read our common sense approach outlining the democratic option, the need for deliberation and the reasons for our recommendations, which include:

  • Mandating a federal standard that take precedence over state laws.
  • Placing all bona fide candidates on a single management distributed proxy card.
  • Not encouraging a system where corporations are willing to
    reimburse expenses shareowners incur in conducting a proxy contest, since this will only escalate costs paid by shareowners.
  • Don’t place an overt limit the number of candidates shareowners are able to nominate. If limits are need to keep the pool manageable:
    • limit individuals to five for-profit corporate boards
    • charge a modest fee
    • require a system of endorsements
    • require all candidates to file pre and post election estimates and accounting of all campaign expenditures
  • Reduce the focus on control by establishing a system that will encourage diversity. “Corporate democracy will allow shareowners to take ‘control’ away from an entrenched board and not give it to any one faction.”
  • Eliminate the arbitrary and elitist proposed thresholds, opting instead for the time-tested $2,000 of stock held for a year. “The challenge should reside in winning the election, not in making the nomination.”
  • Increase candidate statements to 750 words and specified space for graphics that can address any issue related to the election, including short-comings of the current board.
  • Measures to ensure board members nominated by shareowners are not marginalized.
  • Implementation of a broad safe harbor for individual director
    communications with shareowners.

After we had already sent the USPX comment letter, I recalled a few additional issues and sent in my own letter as an addendum, recommending the following:

  • Amendments to Rule 14a-8 also clarify that shareowner resolutions can seek to collectively hire a proxy advisor, paid by for with company funds, that isn’t precluded from offering advice on board elections.
  • Require that companies must allow shareowner resolutions to be presented during the business portion of the annual meeting.
  • An override mechanism on Rule 14a-8(i)(5) (Relevance) and (i)(7) (Management Functions).

Dozens of studies in communications and organizational behavior find current corporate structures to be inefficient. Most decision-making structures, including those now governing corporations, are designed around status needs related to dominance and control over others. They are not designed to maximize the creation of wealth for shareowners or for society at large. In order to gain higher status, individuals seek to dominate more and more people. This dynamic moves the locus of control inappropriately upward. In order to generate more wealth, we need to take advantage of all the brains in our companies, as well those of concerned shareowners. We can do so by making corporations more democratic, top to bottom.

Now, we eagerly await the Commission’s action. If they are slow in finalizing the proposed rules, I hope it is because they carefully read our letters and are rewording them to require more, not less, democracy.


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