The Appearance of Legitimacy: Board Elections

Robert A. G. Monks is asking some fundamental questions on his blog and, at least so far, is responding to comments. That’s a rare phenomenon in the blogosphere. I urge readers to get involved in this dialogue (The Appearance of Reality: Shareholders & Ownership):

The process by which directors are chosen is described as an election. And yet, virtually no one would describe the reality of how individuals accede to board membership as an election in the sense that word is generally understood by political scientists. Without pausing overlong to describe the actualities, it is at least clear that no individual appears on the company’s proxy statement for election to a vacancy except with the approval of the chief executive officer and the incumbent board members. It is equally clear that there are only as many individuals enumerated on the proxy card as there are vacancies.

All of this compels the conclusion that the election is a ritual without meaning in the corporate world. Why then do we insist on using a word that plainly does not describe what actually happens? This evokes the marvelous novels describing “double think” – 1984 and Brave New World –

“This was where “doublethink” came into play, minds were trained to hold contradictory positions simultaneously and unquestioningly- for example you had to believe at one and the same time that Democracy was impossible and that the Party was the guardian of democracy.” (Orwell, Nineteen Eighty-Four)

Here are my questions:

1. What does election mean in the context of governance and corporations?

2. Does a corporation function optimally under democratic or autocratic leadership? In other words, is it clear that centralized leadership is essential for maximizing corporate values and that “democratic” influence is distracting? Can centralization be harmonized with accountability?

3. Is there some justification for the deliberate misuse of a word that is an important part of corporate governance? (Robert A. G. Monks – The Appearance of Reality: Board Elections, 3/16/2011)

There have been several back and forths. I was, frankly, a little surprised at one of Alex Todd‘s conclusions (Todd is a contributor to the recent Corporate Governance: A Synthesis of Theory, Research, and Practice (Robert W. Kolb Series):

I believe director primacy (or director centralization) is the optimal model for mature companies and that shareholder influence is generally counterproductive. However, the operative word here is “mature” or “evolved”, a condition we must aspire to achieving. With today’s somewhat crude corporate governance methods, a valid case can be made for temporarily limiting the powers of corporate boards with regulations and shareholder empowerment.

After a brief foray to see if anyone was reading comments, I posted quite a lengthy response. I’ll add some links here:

Do corporations function better when shareholders really exercise the power to designate directors or when their power is nominal and real authority for director selection remains in the hands of others? Can centralization be harmonized with accountability? Key here is the word “better” or your original term “optimally.” Better or optimally for whom?

My educated guess is that if you work for a company, it would probably be in your best interest if you had a voice in who is nominated. There have been lots of studies showing that companies where employees are also owners and are given opportunities to participate in meaningful decision-making are significantly more productive and profitable. Such employees are also more active in their community and politics. Empowerment at work transfers to other spheres of life.

Although there is less scientific evidence regarding what happens when shareowners exercise the power to nominate board members, there are several studies, including some done by The Corporate Library and Governance Metrics International, that firms with stronger shareowner rights have higher firm value and higher profits.

It is also clear that when boards have been ineffective, external corporate takeovers are expensive. Even after much of the wealth has been destroyed, the takeover and transition back to profitability is also expensive…generally ranging between 2-4% of the value of the firm. That doesn’t count the cost of layoffs, lost wages, as well as to communities in the form of lost taxes and charitable contributions. The cost of proxy driven changeovers has run “considerably below” 1%, according to Institutional Shareholder Services.

One might ask, if democratic companies both at the shop floor and at the boardroom levels are more productive, why don’t we see more of them?

We can take an interesting lesson in power relations from professional sports. The Green Bay Packers are the only major league professional team owned by its community. The Packers will never move; their owners won’t let them. Concession stands are regularly rotated among community-based organizations.

Joan Kroc tried to donate the Padres baseball team to the city of San Diego but the rules forbid public team ownership. If communities own teams, owners can’t threaten to move unless the city ponies up a new stadium.

Just like the rules prohibit communities from owning major league sports teams (except the Packers that have been grandfathered in), the rules are also stacked against the more democratic operation of corporations.

About 70 years ago the Gilbert brothers won the right of shareowners to have their resolutions placed in corporate proxies. After decades of struggle, just when shareowners were beginning to win near majority votes, the SEC reinterpreted one of its rules to deny resolutions that would allow shareowners proxy access for their board nominees. (See AFSCME v AIG or my discussion, Proxy Access: Was Long Island Care a Deception?)

Just as behavioral and other schools of economics are finally beginning to overturn the notion that all people are calculating unemotional maximizers of their own wealth, we are now also seeing those in the field of corporate governance begin to realize corporate frameworks are social constructions.

It is no longer assumed that a structure where a single CEO/Chair dominates is in the best interest of shareowners or the larger society. Although I have every respect for Alex Todd, I think we will find an “aspirational corporate governance,” to use a term he is fond of, will result in expanding real power well beyond the board.

One of my professors in the sociology of knowledge, Peter Berger, espoused that it is “futile to try to apply normative principles to technological production, to try to run a factory as if it were a Gemeinschaft, or to try to apply participatory democracy to the bureaucratic structures of the national state.” To him, coercion is inevitable in all spheres of life. Socialization not only prepares one for this reality but also provides a self-fulfilling prophecy for later life. (see Pyramids of Sacrifice: Political Ethics and Social Change)

During the 1970s there were many experiments creating participatory workplaces. I was involved in one of these at what was the world’s largest meatpacking facility in Waterloo Iowa. Many of these experiments were wildly successful in increasing production but were shut down by management whose status was derived from dominating subordinates.

Authoritarian corporate governance, in most cases, is neither legitimate nor efficient for shareowners or societies. In a world where knowledge creation is key, cognitive respect is crucial. We are unlikely to get the diversity of brainpower we need by vesting corporate governance with a self-replicating corporate board.

Monks responded as follows:

The paramount question, in my view, is the accountability of those having the unelected power of corporate officials within a democratic society. Government authorizes the creation of corporations. It does not, thereby, contemplate creating sources of power that are independent of, and not accountable, to the public good as defined in the democratic process. Therefore, directors who are given plenary powers to direct the allocation of corporate resources should be accountable to someone and not simply part of a self perpetuating and self referential process. In most jurisdictions outside the United States, the accountability of corporate officials to public authority is straight forward – state ownership and influence in the largest companies has been common practice. In the United States, where government direct involvement – notwithstanding the recent heroics caused by the Financial Crisis – is anecdotal, some (other than government) form of accountability is necessary. Requiring that directors actually be “elected” by shareholders is a way of trying to fill that gap.

While not addressing the specific question that Monks raises, a recent post by J. Robert Brown is also instructive:

There are very different views on the appropriate composition of boards of directors.

A recent memorandum from Wachtell Lipton took issue with the contention that friends of the CEO (or other directors) should not serve as independent directors. As the memorandum stated:

friends can and should be independent directors. There is absolutely no basis for second-guessing a board’s reasonable determination that a friend of the CEO, or a friend of another director, is independent.

It may be the case that friends of the CEO bring to the board some skills or knowledge base that would be useful. It may also be the case that friends of the CEO in some instances contribute to the collegial nature of the board.

But that is not the issue. The issue is whether close friends of the CEO should be counted as independent. The answer is (as in the case with family relationships) at least sometimes, no. Depending upon the nature of the friendship (live in companion, best friends from elementary school, etc), there can be serious doubt as to whether the director can decide matters free of the relationship.

Does this mean such an individual cannot be on the board? Again, no. Boards of exchange traded companies need only have a majority of independent directors. There is plenty of room for friends, even close ones, just not in the 51% that are supposed to be independent. (Directors and FOCs (Friends of CEO), 3/19/2011)

This, of course is in response to the decision by ISS to recommend against the reelection of members of the nominating committee at H-P because the CEO participated in a screening committee that made recommendations to the nominating committee. I think Brown is over generous. Allowing 49% of directors to be close friends of the CEO while 51% are independent provides little assurance of independence, especially given how independence is defined by the exchanges.

I think one of Monks’ points is that even “independence” is no guarantee that the public good will be served. Shareowners, especially those who are long-term holders through pension funds and other vehicles that largely index investments, may be the closest our legal framework comes to a body that could act as a proxy for the public good.