Review: Corporation Nation

Corporation Nation (Haney Foundation Series) by Robert E. Wright  delves into the history of the corporation, particularly in pre-Civil War United States (the antebellum period). Like the earlier reviewed Shareholder Democracies?: Corporate Governance in Britain and Ireland before 1850, Corporation Nation addresses central issues such as agency theory, democracy and public interest through the lens of history.

Despite protests that corporations were potentially corrupting, U.S. state governments early on combined to charter more corporations per capita than any other nation—including Britain—effectively making the United States a “corporation nation.” Robert E. Wright traces the shift in corporate governance from relatively self-governing business republics to the much more regulated entities we are familiar with today.

In the nineteenth century, checks and balances, primarily enforced by shareowners, kept managerial interests aligned with both shareowners and the larger society. As the ownership of typical corporations became more widely dispersed, owners had less and less incentive to monitor. That led to increased managerial malfeasance, more repeated economic crises and increased intervention by government in the way of required disclosures and regulations. Based on historical evidence, Corporation Nation makes a compelling argument for improved internal corporate governance.

Most early U.S. corporations sold shares via direct public offering (DPO), similar to IPOs but without the involvement of an investment bank or intermediary, other than a subscription agent. Businesses often relied on prominent backers, “smart money,” to assure small investors. Although Wright doesn’t mention it, the JOBS Act appears to have some potential to bypass expensive intermediaries. See video clip prepared by/for Cutting Edge Capital (this is not an endorsement of their services).

Corporations, like governments, operate best when designed with rogues and knaves in mind, rather than virtuous citizens. Before the Civil War, stockholders were much more involved in major policy decisions and corporate governance facilitated that involvement.

Stockholders ultimately ruled most early American corporations just as voters ultimately ruled early American governments… With fewer investment options to choose from and somewhat higher transaction costs, early Americans, like early Scottish investors, often stood their ground rather than sell out. (p. 121, 133)

Corporations aren’t democracies (which Wright equates to one person, one vote);

The correct analogy is that of a republic. The members/citizens of corporations and nations need to protect their interests through the use of various institutional checks and balances. The right to vote, in other words, is but one of numerous checks against tyranny and expropriation. (p. 135)

Often corporations capped the number of votes any one shareholder could cast to balance the power of large and small shareholders. But such “prudent mean” rules faded out because they were early circumvented.

Good governance, even before the Civil War, required stockholders with ample incentives to monitor their investments carefully. Wright argues that “early securities markets were fairly efficient, in part because they allowed insider trading.” (my emphasis, p. 165) Yes, securities prices were certainly subject to manipulation attempts, but their calculations were generally founded upon exact knowledge of the business. (I’m not sure I buy Wright’s argument here, which might be less problematic if such trades were immediately known. That seems less likely in a pre-computer and mandatory filing age.)

Directors typically had a lot of their net worth invested in the companies they governed, so they didn’t need additional pay to incentivize them, although contracts with both potential and real conflicts of interest were not uncommon. Wright discusses a host of problems, many of which ring true today — unannounced or inconvenient meetings, abuse of proxy votes, and fraudulent accounting, to name a few.

It is interesting to read how state’s began to regulate corporations, especially banks, after the Panic of 1819. In 1829, for example, New York enacted the first banknote-insurance scheme, the Safety Fund. Wright points out that several of the Fund’s provisions worked well by aligning the incentives of stockholders and their corporations. However, the insurance aspects increased moral hazard, required more careful supervision by the state and attracted the interest of rogues who set up “rag institutions” that quickly went bust.

“The best reforms were those that sought to provide stockholders with the powers and incentives they needed to monitor their own property for themselves,” Wright argues. However, with more widely disbursed shareowners, coordination was difficult and by 1910 Woodrow Wilson would write that the “position of the minority stockholder is… extremely unsatisfactory. I do no(t) wonder that he sometimes doubts whether corporate stocks are property at all.” (p. 197)

Wright argues that well-meaning laws like the Clayton Act and Glass-Steagall actually decreased the balance banks were able to provide as intermediaries and actually increased the weight of managerial dominance at the biggest companies. He provides good analysis of the issues surrounding stock options (only upside, fluctuation not necessarily company specific, short-term, and backdating removed any incentive alignment). (p. 214)

What lessons should be drawn from history for application to current issues? Wright is not shy or moderate in his recommendations, which are well aimed at restoring rights to shareholders. Given the right tools, shareholders can protect their own interests and those interests are broader, more closely aligned with those of society, than are the interests of dominant managers.

Much of the recent debate about corporations centers on whether they should maximize profits (shareholder value) or act in presumably more socially conscious ways… That very ideologically based debate largely misses a more important point: most corporations today are run in the best interests of executives, not stockholders, let alone God’s critters. Executives… encourage the debate because if helps deflect attention from the real problem: their complete control of most large, publicly traded corporations…

Gatekeepers turned out to be mere agents with incentives that were not entirely, or even especially closely, aligned with those of investors…

It’s an old canard that if executives and directors are made personally responsible for their actions, they will decline to serve. That simply is not true, as the history of Anglo-American corporations shows…

What investors and policymakers do not realize is that the emasculation of U.S. Stockholder was not inevitable and was not the product of a Darwinian struggle…

Once the history of corporate governance has been laid bare, discerning the path to take is relatively easy: policies should be implemented that will allow stockholders to protect their investment, both directly and through institutional investors…

Independent directors are the latest flawed fad… What are needed… are ‘dissident’ directors beholden to institutional investors, not executives….

Wright ends with a list of reforms, highly abbreviated below, “to make corporations more like republics by giving their citizens (stockholders) the ability to prevent their legislatures (directors) and their managers (executives) from acting like tyrants by engaging in excessive self-dealing (my comments in parentheses):”

• Directors should be shareholders, nominated by shareholders, and should only get reasonable expenses for attending meetings. Their ownership stake should be all the incentive to work needed. (I like this idea but think it might limit diversity on the board too much.) Directors hired by funds should disclose the terms of compensation to both the fund’s investors and the other stockholders in the general corporation.
• Say on pay should be binding, not advisory.
• Executive pay should be in the form of long-term deferred cash compensation tied to empirical measures of performance (not share price). Bonuses should be both positive and negative.
• Companies should not provide directors and officers liability insurance and should prohibit such individual purchases. (I would be satisfied with much more restricted insurance. One of the reasons the corporate form is so successful is limited liability. Perhaps D&O insurance should only kick in once payments from the company have been exhausted.)
• To minimize incentives for stock manipulation, executives should not own shares or options. Failing that, they should be required to hold stakes (almost all their familial assets) for a year or more after retirement or departure. (I have introduced several proxy proposals to require holding until after retirement.)
• Executives should be hired from within whenever possible.
• One vote per share is preferred to super voting rights but experimentation to improve long-term performance should be encouraged, such as one vote per share per year held. (Although I’m willing to see experiments to encourage long-term holding, I think one vote per share held per year held would lead to entrenchment and stagnation.
• Voting by proxy should be banned. Corporate meetings should be held over several days so stockholders can “attend” and vote. (Many investors oppose virtual-only meetings but we all favor hybrid meetings.) All measures should require an absolute majority vote. (This sounds good in the ideal but you can’t force retail shareholders to vote, so this provision would leave companies with a high proportion of retail investors frozen, unable to make critical changes.) Cumulative voting should be allowed. (Agreed; this becomes even more important and effective with proxy access.)

I’ve seen no better examination of antebellum corporate governance in the U.S. than Corporation Nation and agree with the thrust of Wright’s recommendations. One more minor area of disagreement is that Wright places too much faith in institutional investors and not enough in retail investors as when he calls for more “‘dissident’ directors beholden to institutional investors, not executives.” See The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, Ronald J. Gilson and Jeffrey N. Gordon (January 1, 2013 discussed here). Gilson and Gordon are correct in arguing the value of activist hedge funds, since large primarily indexed funds have little incentive to monitor the corporate governance of companies in their portfolios and take an active role in challenging management and boards. Any benefit these large funds could obtain through such actions would equally benefit competitors, while the initiating fund would bear all the costs (free rider problem).

While Gilson and Gordon primarily point to the need for active hedge funds with disproportionate ownership in targeted firms to take monitoring roles, I think there is or could be room for more active monitoring by retail owners as well. A retail shareowner with $300,000 invested in a company may be more highly motivated to monitor than a mutual fund with $10 million invested. Finance professors, retired executives and industry specialists may find activism more interesting and rewarding than golf or another trip to Europe. Anyone with the right subscriptions can mine ‘big data.’ Social media tools like Linkedin, Twitter and more specialized sites like The Motley Fool, Stockr.com, and Sharegate.com have potential to be useful tools for announcing and, to the extent allowable by law, coordinating campaigns. With today’s tools, shareholders don’t have to be Carl Ichan to be heard and to make a difference.