Corporate Governance: Who Should Be in Charge? Corporate Governance: Who Should Be in Charge?

September 1, 1997

When CalPERS, administrator of retirement funds for California state employees and the largest public pension plan in the nation, released a draft copy of its principles for corporate governance last June, it set off a heated discussion in boardrooms and business magazines. Much of the controversy focused on whether corporate boards of directors should face term limits and mandatory retirement at age seventy. Many complained that to enforce these guidelines would sacrifice valuable board experience and be discriminatory to boot. "To criticize the effectiveness of anyone based on age is simply naive," said a spokesperson for Digital Equipment. Others defended the proposals, noting that board members with long tenures were likely to support management at the expense of shareholders. CalPERS is now reconsidering both recommendations. But its other guidelines -- including such things as how much of directors' pay should be in stock and whether a retiring CEO may serve as a director on the board -- all designed to make managers more accountable to shareholders, are already being used to evaluate the companies in which it invests.

In the smallest businesses, where one person provides both the finance and labor, such elaborate rules and procedures for running the enterprise are unnecessary. But bigger firms must coordinate a complex web of relationships among sometimes conflicting constituencies. Corporate governance is concerned with the rules and practices that determine how large corporations are controlled and how they relate to shareholders, creditors, employees, customers, suppliers, and even the communities in which they operate.

For most of the century, these were dusty topics, of concern mostly to academics. But since the 1980s, globalization, deregulation and financial innovation, downsizing, and unprecedented increases in CEO pay have brought governance questions front and center.

Large corporations account for a significant portion of our economic activity. The rules that govern their decision making are critical to wealth creation and the economic well-being of the nation. An efficient governance system places control in the hands of those with the incentive and means to create wealth. And, in the view of many, that means shareholders. So much recent corporate governance activity has aimed at making management more responsive to shareholders.

But in the rush to embrace shareholder value, it is easy to ignore the contributions of other parties. Employees, suppliers, and even communities sometimes make costly investments that increase productivity with a particular firm, but may leave them stranded if that relationship ends. Thus, we might want to provide certain safeguards for everyone undertaking such investments, and governance is one mechanism to do this. We ignore shareholder value at our peril. But it is also worth considering whether this standard is always best.


The commonly held view of the corporate governance problem has been summed up succinctly, if not elegantly, by economists Andrei Shleifer and Robert Vishny "How do investors get managers to give them back their money?" Their problem is this As businesses grow larger and more complicated, those who manage the firm do not typically provide its finance. Instead, firms go to outside markets for funds, including the sale of stock. Firms get access to funds from a variety of sources and investors gain liquidity and the ability to diversify holdings across many different companies. But stockholders often know little about the business and acquiring that knowledge would be costly. So, the firm's managers get the authority to make business decisions; it is their job to develop the expertise and intimate knowledge it takes to run the firm efficiently.

This sets up the potential problem noted above Shareholders provide funds; but managers have the inside knowledge and the decision-making authority -- and thus the opportunity to expropriate part of capital's fair return. And individual share holdings are both too small and too dispersed to effectively prevent this from happening.

Managers may use this opportunity to advance their interests above those of shareholders. They might turn down risky projects and reject opportunities for merging or selling the company because they fear losing their jobs. Or they may use the firm's extra cash to fund vanity projects and make acquisitions that enhance their own power and influence.

The conflict has an impact beyond the return to individual shareholders. For, if managers make decisions that waste resources and reduce the return to capital, shareholders may be reluctant to provide finance, and the entire economy will grow more slowly as a result.

This governance problem was identified in the United States as early as 1932, by A. A. Berle and Gardiner C. Means. In their pathbreaking book, The Modern Corporation and Private Property, they concluded that, by 1929, stock ownership had become so dispersed in half of the largest American companies that managers were effectively able to make decisions without being answerable to shareholders or anyone else. "Separation of ownership from control" was their famous phrase.

We recognize the significance of this insight to this day. The size and complexity of the modern corporation have created the need for governance mechanisms to monitor managers and restrain them from spending corporate money for their own benefit, while not unduly restricting their ability to make decisions. But modern scholars place less emphasis on "ownership" as the central issue. It is difficult to identify a single individual or group as "owners," if what one means by that term is who retains all the rights to control the firm's resources and to receive the residual income it generates. For example, it is often said that stockholders own the corporation. Yet, that does not mean they are individually free to take possession of or sell their share of the firm's assets. So, simple appeals to "ownership" are not especially useful at sorting out who should have control over what.

Thus, some argue that shareholders should be in charge because they have the incentive to maximize the value that can be wrung from the firm's resources. Shareholders get the profits -- what is left after other costs are paid. So, while workers, managers, and suppliers are insured their return via contracts that obligate the firm to pay up, shareholders bear the risk that there won't be anything left.

Shareholders have the motivation to ensure that production is efficient, that new markets are entered, that unprofitable products are abandoned, in short, to direct the firm's resources where they will be most valuable. Giving shareholders the ultimate control ensures that the firm's potential to create wealth will be realized.


Many of the governance battles of the 1980s can be understood as attempts by shareholders to discipline managers and assert control. Stock ownership had become more dispersed in the forty years since Berle and Means. Edward Herman estimated that, by 1975, 80 percent of the largest U.S. corporations were effectively under management control. And productivity growth, business investment, and the rate of return to capital had dropped, in part, some have argued, because of inefficient and complacent management.

As performance lagged, shareholders grew aggressive in their efforts to focus management's attention on the bottom line and boost capital's return. Deregulation and financial innovations, such as junk bonds, also increased shareholder discipline. Hostile takeover attempts, even unsuccessful ones, such as Revlon's bid for Gillette, forcefully reminded managers about the perils of ignoring shareholders' interests. Leveraged buyouts concentrated stock ownership in fewer hands and left firms with high debt service, effectively limiting management's chance to spend the firm's extra cash on pet projects and empire building.

Champions of shareholders' rights strongly opposed governance rules, such as "poison pills," or other devices that limited this "market for corporate control." They argued that the threat of takeover encouraged managers to concentrate on profits and shareholder value, and forced them to make the painful, but necessary, decisions to restructure and downsize in the face of global economic pressure and technological change. In their view, although the distress experienced by many dislocated workers was real, the subsequent economic recovery and high returns to capital over the past few years have vindicated these efforts.


Shareholders also began vociferously defending their interests via shareholder resolutions and other direct lobbying efforts. CEO compensation developed into a hot issue; awarding stock options and other pay schemes were viewed as a way to align managers' interests with those of shareholders. More recently, shareholder activists have focused on the board of directors. The board has a duty to monitor managers and hold them accountable to shareholders, they argue. But directors can become lazy, or unduly influenced by friendship or financial ties with management, leaving the fox guarding the henhouse.

Leading the charge for well-functioning, and independent boards have been pension funds and other institutional investors. Large investors now own about 60 percent of all the outstanding shares of stock in corporate America, and many amass significant stakes in individual companies. For example, TIAA-CREF, which administers retirement savings for college professors and teachers, buys as much as 10 percent of a firm's stock. Such large-stakes investors can have difficulty selling their shares without upsetting the market. So, many have turned to active oversight as a way to encourage independent and well-functioning boards.

Many of these groups have issued guidelines which they use to evaluate the boards of companies in which they invest. In addition to term limits and mandatory retirement age, CalPERS' principles cover a range of topics, from the percentage of independent directors to the staffing of key committees. The LENS fund, which invests in underperforming firms with the intent of using shareholder activism to improve performance, favors two more general rules Directors should have a significant portion of their net worth in company stock, and they must schedule regular meetings that include only independent members. As LENS principal Nell Minow puts it, this gives the board both "motive and opportunity" to work on shareholders' behalf. "You never saw the pocket calculators come out so fast."

Firms that do not meet guidelines are generally approached privately and asked to make changes. Between 1992 and 1996, TIAA-CREF successfully reached agreement with all but one of 43 companies it targeted; in only eight instances did the issue reach a shareholder vote.

But such interventions are not a panacea. Some firms have remained resistant to shareholder pressure and have refused to reform their boards. Others have made cosmetic efforts, but their boards are still captured by management. "In most cases, boards are a joke," grumbled one money manager to Business Week. "They do what's necessary to minimize the possibility of being sued." And response to pressure from particular investor groups may not benefit all shareholders. Clifton R. Wharton, Jr., former CEO of TIAA-CREF, notes that some money managers are, themselves, evaluated on short-run returns and thus may not have the same interests as investors in it for the long haul

The statistical evidence that model boards pay off in higher stock prices is also sketchy. The most widely reported study, by McKinsey , Company, asked institutional investors, chief executives, and directors to compare two equally well-performing companies and decide whether to pay a premium for the one with good governance rules. The conclusion Investors would pay from 11 to 16 percent more, although the hypothetical nature of this experiment is not entirely convincing. Ira Millstein and Paul MacAvoy of Yale University examined 275 companies ranked by CalPERS; those considered well governed earned an extra 1.5 to 2 percent on average in annual returns to shareholders. But the weight of the evidence is still unclear, and some investors remain unconvinced that these sorts of governance rules are as important to performance as more traditional factors.

Still, there is a good deal of faith that improving the way boards operate will light a fire under business performance. Activists cite examples of newly energized boards, where members are devoting more time to their duties and soliciting guidance from outside advisors. Campbell Soup, General Electric, Compac Computer, and IBM have all been praised for their independent and demanding directors, and good financial results have followed. By contrast, Archer Daniels Midland has turned up on several "worst board" lists and, with its well-publicized and embarrassing legal problems, has become a poster child for the perils of bad governance.

So, when the Business Roundtable endorsed yet another set of model board guidelines, Business Week noted that "once radical ideas about corporate governance are now firmly in the mainstream." Shareholder value is the accepted governance standard, and the important question is how best to achieve it. The parties are left to skirmish over details, such as mandatory retirement and term limits. But this is fighting around the edges, a relative tempest in a teapot.

The ideal board

...according to CalPERS, the largest public pension plan in the United States, is likely to be one in which

THE CEO IS THE ONLY company employee who is a director. Nonindependent directors, beyond the CEO, comprise no more than 20 percent of the board. The chair of the board is an independent director.

INDEPENDENT DIRECTORS meet at least once a year without the CEO or other nonindependent directors.

AT LEAST 50 PERCENT of the director's compensation is in stock.

IMPORTANT COMMITTEES , such as audit, director nomination and evaluation, CEO evaluation and compensation, and ethics, consist entirely of independent directors. The chairs of these committees have access to their own advisers.

THE BOARD ESTABLISHES performance criteria for itself, including standards for individual director attendance, preparedness, participation, and candor.

THE INDEPENDENT DIRECTORS establish performance criteria and compensation incentives for the CEO. The board has a CEO succession plan.

ALL DIRECTORS HAVE access to senior management. The board also has a formal program for dialogue with shareholders.

NO DIRECTOR SITS on more than two other boards. A company's retiring CEO may not continue to serve on the board.

THE BOARD HAS ADOPTED term limit guidelines. No more than 10 percent of directors are over the age of seventy. These two principles are currently under reconsideration by CalPERS' board.


Although the takeovers and restructurings of the 1980s may have prodded some firms to better performance, there is evidence that also points to other motivations. Dispersed stock ownership and managerial discretion had been features of the U.S. economy through much of the twentieth century. And during most of that period, production and earnings grew vigorously. So, profligate managers were probably not to blame for the productivity slowdown and drop in profits that preceded the governance battles of the 1980s. Many of the firms that went private in leveraged buyouts subsequently went public again, indicating that reigning in managers may not have been their original motivation. Retail department stores, among other companies, underwent a series of restructurings and ownership changes that failed to improve performance, suggesting that the market for corporate control was not infallible in its judgments.

Moreover, these restructurings exacted a toll on workers who lost their jobs and on customers, suppliers, and even the towns in which the firms operated. Legal and other consulting fees only swelled the total bill. Thus, it is worth thinking about Do efficiency considerations always give shareholder interests primacy in corporate governance decisions? Or might there be reasons to look beyond shareholder value and consider all of the other parties who have something at risk in the enterprise?

Employees, for example, may learn specialized skills or make extra efforts on behalf of the firm. They may absorb part (or all) of the cost, with the implicit understanding that they will receive a share of any added output by getting higher wages or some other consideration in the future. If these new skills are not easily transportable (that is, they are geared specifically to one firm), the employees now have an investment at risk. If demand softens unexpectedly, and they are laid off, they will receive lower wages at their new jobs, losing whatever they had been implicitly promised for making that investment.

According to estimates by University of Chicago economist Robert Topel, approximately 10 to 14 percent of employee compensation at large corporations from 1969 to 1983 was a return to such firm-specific skills. Thus, these workers are akin to financial investors, who sink funds into specialized physical assets whose value would be largely destroyed if the firm went under.

One could extend this analogy to the local town or county that makes a specialized investment in infrastructure to attract a new employer or keep a local business from leaving the area. If that firm later relocates, the community loses the value of its investment.

When an unexpected event, such as a change in technology or an increase in global competition, results in declining demand, it matters who is in charge. If shareholder interests control corporate decisions, the firm will tend to view past promises to these workers as an avoidable cost, and will cut production and employment more than is efficient. A firm may undervalue the destruction of their specialized skills and ignore the lost production and search costs in matching employees with new jobs. Since the firm faces an immediate decline in demand, it may also discount the impact on employees' long-term incentives to make future firm-specific investments. Economists Andrei Shleifer and Lawrence Summers have suggested an alternative interpretation of the corporate raids of the 1980s The raiders took over firms in declining industries, then downsized or sold off parts of the business and, in the process, extracted any remaining cash for themselves by reneging on past promises to workers.

One way to avoid such problems is by writing a contract that spells out all future obligations of the parties. But, in practice, it is impossible to imagine and write down a contract that covers all eventualities. Most employment arrangements rely a great deal on trust and implicit promises, rather than written, legally enforceable agreements.

So, Margaret Blair, a Senior Fellow at Brookings, has argued that an efficient corporate governance system should take into account the interest of all parties that make risky investments. She notes that the conventional focus on shareholder return may have worked reasonably well in earlier times. Workers employed in heavy industry and early mass production systems possessed mostly generic skills; they received a market wage and could move to a comparable job if the company failed. It was the investors who made the large-scale, firm-specific investments -- in railbeds and large factories, and in entrepreneurship -- that were critical to economic growth.

But in today's high-tech companies, where value is created through custom services and innovation, the specialized skills and efforts of employees are critical ingredients in creating new wealth. Thus, Blair argues, unless corporate governance mechanisms take account of their interests and protect their firm-specific investments, we risk slowing productivity and economic growth.

In the past, government partly assumed this role of protecting employee interests through labor law, legislation preserving private pensions, and other workplace regulations. Unions also played an important part. As globalization and technology alter the nature of work and business, new, more efficient corporate governance designs may yet emerge. Or, we may find ourselves looking again to government and organized labor.

Berle and Means would be both sympathetic and cautious. Inventors of the phrase, "the separation of ownership from control," they nonetheless viewed the corporation, in part, as a public institution with public purposes. As such, corporate governance introduced responsibilities that extended beyond the interests of shareholders. But how to build those responsibilities into a governance design in a way that augments the creation of wealth is far from clear. As Berle warned, "You cannot abandon emphasis on the view that business corporations exist for the sole purpose of making profits for their stockholders until such time as you are prepared to offer a clear and reasonably enforceable scheme of responsibilities to someone else."

The devil is in the details

It is one thing to argue that corporate governance should look beyond shareholder value. Figuring exactly how is another. Margaret Blair, of Brookings, favors broad experimentation in governance designs that take account of all stakeholders making risky investments. One of her ideas Pay workers with voting stock for skills geared specifically to their current employer. This would encourage investment in these skills, she argues, by assuring employees of their share of future returns. It would also facilitate efficient corporate reorganizations in the future. Pay would be more volatile in the short run, but possibly less so in the long run, as firms would be less likely to lay off employees with skills that were still valuable, but whose value had declined.

However, there are formidable problems. Firm-specific skills are difficult to measure and employees may object to making their pay more volatile, preferring to lay this risk elsewhere. Shareholder activist Nell Minow warns that stock ownership may do little to encourage firm-specific investments (she cites Pepsi, where employees responded by eating more snacks made by Fritos, one of its subsidiaries, not by changing their work behavior), while badly structured plans may be used to entrench management. And including employees and others in governance will likely increase decision-making costs and may, ultimately, bog down the company. Blair concedes that her proposal may be most practical in firms where the employees, at least, have relatively homogeneous interests.

Another Blair proposal Make the board of directors a neutral body with a duty to maximize wealth creation, not shareholder value. The board would mediate important conflicts, minimize fighting, and assure all parties of a fair return. But when faced with declining demand and dividing up a loss, can the board fulfill its duty to all parties? And to whom would such a board be accountable? Blair recognizes that such decisions would, ultimately, be political, and she sees a role for social norms in assuring that boards discharge these obligations honorably. But Nell Minow is dubious. "Once we start letting boards make these tradeoffs, they will be accountable to no one."

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