Corporate Governance

Corporate Governance: Promises Kept, Promises Broken

Copyright Date: 2008
Pages: 344
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  • Book Info
    Corporate Governance
    Book Description:

    Even in the wake of the biggest financial crash of the postwar era, the United States continues to rely on Securities and Exchange Commission oversight and the Sarbanes-Oxley Act, which set tougher rules for boards, management, and public accounting firms to protect the interests of shareholders. Such reliance is badly misplaced. InCorporate Governance, Jonathan Macey argues that less government regulation--not more--is what's needed to ensure that managers of public companies keep their promises to investors.

    Macey tells how heightened government oversight has put a stranglehold on what is the best protection against malfeasance by self-serving management: the market itself. Corporate governance, he shows, is about keeping promises to shareholders; failure to do so results in diminished investor confidence, which leads to capital flight and other dire economic consequences. Macey explains the relationship between corporate governance and the various market and nonmarket institutions and mechanisms used to control public corporations; he discusses how nonmarket corporate governance devices such as boards and whistle-blowers are highly susceptible to being co-opted by management and are generally guided more by self-interest and personal greed than by investor interests. In contrast, market-driven mechanisms such as trading and takeovers represent more reliable solutions to the problem of corporate governance. Inefficient regulations are increasingly hampering these important and truly effective corporate controls. Macey examines a variety of possible means of corporate governance, including shareholder voting, hedge funds, and private equity funds.

    Corporate Governancereveals why the market is the best guardian of shareholder interests.

    eISBN: 978-1-4008-2978-1
    Subjects: Law, Management & Organizational Behavior

Table of Contents

  1. (pp. 1-17)

    The purpose of corporate governance is to persuade, induce, compel, and otherwise motivate corporate managers to keep the promises they make to investors. Another way to say this is that corporate governance is about reducing deviance by corporations where deviance is defined as any actions by management or directors that are at odds with the legitimate, investment-backed expectations of investors. Good corporate governance, then, is simply about keeping promises.¹ Bad governance (corporate deviance) is defined as promise-breaking behavior.

    The theory that underlies the way that this book treats corporate governance is that all investors have certain reasonable expectations about what...

  2. (pp. 18-27)

    Corporate governance is generally about promises, while corporations themselves are about contracts. Every facet of a corporation’s existence from beginning to end is organized around contracts, although the “contract” that the corporation has with its shareholders is little more than a promise.

    Employment agreements (sometimes, but increasingly rarely these are collective bargaining agreements with unionized workers) specify the terms of the contract between workers and the corporations. Suppliers have contracts. Customers’ purchases are contracts according to commercial law. Executives have contracts. Even directors have contracts.

    The contract that the corporation has with its shareholders is the corporation’s charter (sometimes known...

  3. (pp. 28-45)

    The importance of corporate law for corporate governance is far from clear. Bernard Black, for example, argues that non-contractual corporate law is “trivial” because its provisions do not depart significantly from the rules that would be chosen voluntarily in corporate charters if the law did not intervene.¹ This observation tracks the standard account in law and economics that the role of corporate law is to economize on transaction costs by supplying the corporate governance rules that investors would have formulated for themselves if they had allocated the time, effort, and expense of doing so when they made their initial investments.²...

  4. (pp. 46-50)

    In the previous chapter, contracts, law, and social norms were identified as the three components of corporate governance. The one thing that these three components of corporate governance have in common is that they are not self-enforcing. For this reason institutions and mechanisms are required as enforcement tools.

    The major corporate governance institutions include the accounting firms that audit public companies, the credit-rating agencies that determine whether their debt is “investment grade” or not, the market for corporate control that disciplines management of poorly run companies, the organized stock exchanges that promulgate corporate governance rules, the market for IPOs of...

  5. (pp. 51-68)

    Perhaps the most basic principle of corporate law in the United States is that corporations are controlled by boards of directors, rather than shareholders. The board of directors is at the epicenter of U.S. corporate governance. Specifically, under U.S. law, corporations are managed by or under the direction of boards of directors, making the directors literally the governors of the corporation. The intuition that directors add value is strong and deeply held. That intuition is not challenged here. What is challenged is the deeply held assumption that traditional directors add value by serving shareholders as independent monitors of managers. It...

  6. (pp. 69-89)

    Operating at a fairly high level of abstraction, we have considered the fundamental question of whether corporate boards of directors are effective mechanisms of corporate governance, or whether the problem of capture compromises the efficacy of corporate boards. Summarizing, the argument to this point has touched on four themes.

    (a) the existence of cognitive biases and information asymmetries that make boards susceptible to capture by management and constrain the capacity and effectiveness of boards to monitor and control managerial conduct;

    (b) the inability of outside investors to distinguish objective boards from captured boards;

    (c) the nature and limitations of the...

  7. (pp. 90-104)

    The problem of director capture stems from director participation in managerial decision-making, including strategic planning and decisions about the recruitment, retention, and promotion of senior executives. The argument to this point maintains that although involvement by directors in these affairs does notguaranteecapture, it does make capture highly likely. The social norms of collegiality and cooperation that apply to directors’ behavior increase the probability of capture. These norms are reinforced by the fact that directors often socialize among themselves and with management during meetings. Management, of course, has strong private incentives to develop close bonds of trust and friendship...

  8. (pp. 105-117)

    This chapter considers the extent to which we can reasonably rely on formal governmental and quasi-governmental institutions to provide truly useful corporate governance rules. The major institutions of corporate governance are the Securities and Exchange Commission (SEC), the stock exchanges, and the credit-rating agencies. All three have been a major disappointment. Unfortunately, the reasons for this disappointment appear to be structural, and thus hard to fix now that they are broken. In particular, none of these institutions faces meaningful market incentives to promulgate corporate governance rules that would tend to maximize value for shareholders. As bureaucracies, they have incentives to...

  9. (pp. 118-126)

    The most important market-inspired component of the U.S. corporate governance infrastructure is the market for corporate control.¹ An efficient, vibrant market for corporate control deters managers from shirking by running the firm below its full performance potential. Because running a firm below its firm potential would make it more likely that the company’s incumbent management would be replaced in a hostile acquisition, a robust market for corporate control is vitally important as a corporate mechanism for monitoring and disciplining managers.²

    Ironically, however, as the scientific evidence about the importance of the market for corporate control became so overwhelming as to...

  10. (pp. 127-129)

    Capital markets are another poorly understood institution of corporate governance. Capital markets operate in three contexts: initial public offerings (IPOs), private placements, and ordinary secondary trading. Well-functioning secondary markets provide investors and other corporate constituencies with a succinct, accurate, unbiased real-time measure of a company’s performance and competitive position. This measure comes in the form of the company’s share price, which is set on an ongoing basis in the trading markets.

    Thus, the value from a corporate governance perspective of robust secondary trading markets for a company’s corporate governance is incalculable. From the corporate-governance-as-promise perspective taken in this book, a...

  11. (pp. 130-154)

    With the possible exception of corporate boards of directors, litigation in the form of class actions and shareholder derivative actions is conventionally believed to be the most important corporate governance mechanism available to U.S. investors. This belief is both inconsistent with the corporation-as-promise approach taken in this book and wrong.

    It is highly unlikely that shareholders would voluntarily agree to opt into an expensive private litigation system such as the one that exists in the United States that allows plaintiffs’ class action attorneys to extort billions of dollars from companies, and requires that shareholders acquiesce in lawsuits in which massive...

  12. (pp. 155-164)

    Because corporate governance is about promises, it is critical that we have some metric for gauging whether companies are living up to the promises they make about their financial performance. The metric is share prices. Accounting is, in my view, not particularly important to investors,except to the extent that accounting information is useful in the formation of share prices and in the allocation of economic resourcesthat share prices facilitate.

    For public companies in places like the United States that have well-developed capital markets, share prices provide the best lens with which to evaluate corporate performance. Share prices are...

  13. (pp. 165-198)

    This chapter considers the sorts of promises companies should make about their policies regarding insider trading, short selling of company stock, and whistle-blowing. The common theme among all of these apparently disparate topics is that they all deal with the thorny topic of how to uncover negative information about corporations. Insiders who dump their shares, short sellers who sell shares they don’t yet own, and whistle-blowers are all people who engage in ways of bringing information—especially negative information—about corporate performance and corporate conduct to light.

    It is more than passing strange, in my view, that these various sources...

  14. (pp. 199-222)

    Along with boards of directors and the market for corporate control, the ability of shareholders to vote in corporations, albeit occasionally, has oddly been heralded as a source of improved corporate governance, at least potentially. According to this view, which is the dominant view among academics and policymakers, if shareholders were only given more and better voting rights, then corporate performance and accountability would have the capacity to improve even further.¹ But there are strong dissenters, with some claiming that shareholders probably vote too much,² and others taking the position that voting rules are efficient just as they are.³


  15. (pp. 223-240)

    In 2002, the president of French bank Société Générale, Daniel Bouton, announced that European corporate giant Vivendi Universal would have to sell off assets to reduce some of its ballooning $18.5 billion debt. The bank declared that the media giant’s “president will have to quickly change (the financial picture) and begin to sell assets.”¹ When subsequently announcing the sale of a stake in one of its largest units to General Electric, the chairman and CEO of Vivendi touted the sale as “a very good agreement for Vivendi Universal’s shareholders, both in terms of value creation and the reduction of our...

  16. (pp. 241-273)

    Hedge funds and private equity funds are the newest big thing in corporate governance and are likely to remain an important and controversial feature of the financial and legal landscape for some time to come. And they are for real. Indeed, a primary argument of this book is that traditional corporate governance mechanisms and devices, including boards of directors, shareholder voting, and derivative and securities class action lawsuits, are not the panaceas for corporate governance problems that they often are touted as being.

    The market for corporate control, by contrast, as discussed in chapter 8, is a powerful tool, but...

  17. (pp. 274-278)

    This book develops the idea that corporate governance is about keeping promises to investors. Such promises are made to induce investment and participation in business ventures. These promises, in turn, create expectations on the part of investors. Unless investors have confidence that their reasonable expectations, which stem from these promises, will be met, they will decline to invest. This, in turn, will have the predicable, dire economic consequences: stunted economic growth, high unemployment, and, of course, capital flight.

    There are a wide variety of mechanisms and institutions, most notably contract, law, and norms, by which shareholders and other outside investors...