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. In Corporate Governance, Jonathan Macey argues that less government regulationnot moreis 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 Governance reveals why the market is the best guardian of shareholder interests.
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About the Author
Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School. He is the author of a number of books, including Macey on Corporation Laws.
Read an Excerpt
CORPORATE GOVERNANCEPROMISES KEPT, PROMISES BROKEN
By JONATHAN R. MACEY
PRINCETON UNIVERSITY PRESSCopyright © 2008 Princeton University Press
All right reserved.
Chapter OneTHE GOALS OF CORPORATE GOVERNANCE
The Dominant Role of Equity
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 as the Articles of Incorporation). This charter, supplemented by more detailed bylaws, contains the baseline rules that govern the corporation and constitute the fundamental corporate governance rules for the corporation. The charter and bylaws describe the contours of the relationship between the shareholders and the company. Consistent with the contracting paradigm, corporate charters and bylaws vary widely from corporation to corporation.
Consistent with the idea that the relationship between shareholders and the corporation is characterized by promise rather than contract, the typical corporate charter is extremely cursory. The document will contain a statement of the purposes and powers of the corporation. (Typically, corporate charters permit corporations to pursue any lawful act or activity for which corporations may be organized and to exercise powers granted under the Business Corporation Law of the state in which they are incorporated.) The charter will specify how much stock the corporation can issue, and it may provide that the company's board of directors can issue different classes of stock. The charter may specify the respective rights of the holders of various classes of stock with respect to such matters as dividends, voting, and order of priority in liquidation and other distributions, but often the charter will delegate this power to the corporation's board of directors. The charter will provide that other things, such as the number of directors of the corporation, are to be specified in the company's bylaws. For example, the corporate charter for IBM requires that the number of directors of the corporation shall be provided in its bylaws, but shall not be less than nine or more than twenty-five. These sorts of provisions, of course, give corporations a lot of freedom to operate within the constraints of the "contracts" they have with shareholders.
State law does not require that corporate charters contain very much. The only mandatory requirements are for provisions that specify the name of the corporation, the number of shares of stock that the corporation is authorized to issue, the names and addresses of the people organizing the company, and the name and address of an agent in the jurisdiction where the company is organized who can accept service of process if the corporation is sued.
Since the mid-1980s, most corporations in the litigious United States have amended their charters to reduce the risk of personal liability of directors in shareholder lawsuits. These charter amendments have come in the wake of state legislation that permits corporations to insert in their corporate charters provisions that eliminate the liability of a corporation's directors to the corporation or its stockholders for damages for negligence and breach of the duty of care. However, state statutes specifically provide that corporate charters may not eliminate directors' liability for receiving financial benefits for which they are not entitled, intentional harm done to the corporation or its shareholders, criminal acts, and payment of dividends to shareholders while the company is insolvent.
The bylaws govern the details of the internal management of the corporation. Unlike corporate charters, bylaws can be amended either by the shareholders or by the corporation's directors. The corporation is, to a large extent, a political entity. It has a chief executive who is appointed by a democratically elected group of directors. The rules governing these elections and appointments, and indeed the officials elected and appointed, are subject to the controlling law contained in the corporate bylaws and charter. The articles of incorporation are analogous to the corporation's constitution, while the bylaws are like the entity's statutes.
The primacy of contract theory in corporate governance cannot be overemphasized. Corporate governance is about the constraints on the behavior of corporate actors, and these actors, whether they are officers, directors, or controlling shareholders, are governed in the first instance by contract. The role of contract in corporate governance, and, indeed, in corporate law generally, is so pervasive that it is often not clear where contract law ends and where corporate law begins. Some prominent law and economics scholars take the entirely defensible view that corporate law is simply a specialty within the larger field of contract law.
Scholars who take this view, most prominently Frank Easterbrook and Daniel Fischel, generally place little emphasis on corporate charters and bylaws, despite the fact that these are the actual contracts that exist between investors and their companies. Instead, the corporation is viewed as a hypothetical bargain between shareholders and managers. Under this approach, judges are directed to decide cases by determining what the parties to the disputes would have agreed to had they negotiated the question being litigated ex ante, that is, at the time of their original investments.
The hypothetical bargaining approach is central to the contractual approach to corporate law. But this is not because corporate charters and bylaws and other real contracts are unimportant. Rather, the opposite is true: where corporate charters and bylaws control a particular dispute among the various claimants to a corporation's cash flows, disputes do not arise among these claimants because the actual corporate contracts clearly control. Only where an intracorporate dispute arises that is not specifically covered in the actual corporate contract does hypothetical bargaining have a role to play in corporate governance. But that happens a lot.
From an economic perspective, corporations are not only organized around the idea of contract, they are most accurately described as contracts. As Ronald Coase has suggested in his seminal article "The Nature of the Firm," the corporation is best conceptualized not as an entity but as a complex web or nexus of contractual relationships. It is undeniable that every corporate constituency, including shareholders, directors, managers, workers, suppliers, customers, and even local communities, has a relationship with the corporation or other constituencies that is contractual in nature. Once these contractual relationships are unbundled from the corporation, there is nothing left. For this reason, to the extent that corporate governance is effective in controlling corporate conduct, it must control the people who actually act for the corporation and for themselves.
Contract plays such an important role in corporate governance that one must ask why there needs to be anything else. Contracts inevitably generate outcomes that are ex ante efficient. Participation in the corporate enterprise is voluntary and inevitably precipitated by a voluntary exchange. Unless we can identify with some precision a flaw or deficiency in the contracting process, we should conclude that corporations and corporate actors should be governed by contract rather than by statute.
At various times, three distinct (though often conflated) objections to the claim that contracts provide a sufficient infrastructure for corporate governance have surfaced. First, it is argued that contracts are necessarily incomplete and therefore something is needed to deal with the pervasive incompleteness of the corporate contract. A second, but related, reason why the contractual (or, as it is sometimes called, a "contractarian") paradigm may be considered insufficient is because contractual provisions are not sufficient to the task of protecting the claims of shareholders. Shareholders, as residual claimants, have financial interests in the firm that simply cannot be protected ex ante by contract. Third, and from a completely different perspective, comes the assertion that corporations simply are too important to society to be relegated to the contractual sphere of private ordering.
Each of these claims is unpersuasive. As for the first, all contracts are incomplete and many are unclear in their drafting. Most of the subject of contract law is concerned with how to deal either with the problem that contingencies arise that were never considered by the parties or with the problem that even the contingencies that were foreseen were ignored or dealt with in an ambiguous fashion.
The second claim, that contracts are insufficient, ignores the fact that all solutions to the contracting problems that face shareholders have costs as well as benefits. The relevant question, then, is not whether contracts are sufficient to the task of protecting shareholders but whether contracting is the best device for maximizing wealth. It may very well be the case that adding other sorts of legal "remedies" to the baseline solutions provided by contract will make investors worse-off, not better-off.
The third claim, that corporations simply are too important to society to be relegated to the contractual sphere of private ordering, fails to address the fundamental question of whose interests are at stake in the formulation of corporate governance rules. Where the issue involves the narrow question of whose interests the corporation should serve, the contracting, promissory approach taken in this book seems clearly superior to any alternatives. Of course, nobody asserts that contract is sufficient to deal with all problems, particularly the problems associated with externalities or third-party effects. Environmental law, criminal law, tort law, and so forth deal with these sorts of problems, but this fact, of course, is by no means limited to corporations or even to business organizations. Contract is not sufficient to regulate private ordering among individuals where there are clear negative effects on third parties from the agreements made by the private individuals.
The claim that corporate governance should be analyzed entirely through a contractarian paradigm can be easily dispensed with. It clearly is the case that contracts of all kinds, including corporate contracts, are incomplete. Much of contract law concerns itself with dealing with this problem. For example, commercial contracts contain "implied covenants of good faith" that require the parties to act in good faith when carrying out their contractual obligations. Courts long have allowed people to discharge their contractual obligations where they can claim fraud, unconscionability, or impossibility of performance because of the pervasive failure of contracting parties to deal with these issues satisfactorily.
Another way to approach the gap-filling function served by law is from the perspective of efficiency. To a large extent, corporate contracts are incomplete because it is efficient for them to be incomplete. State actors in the form of judges simply do a better job than private parties in ordering the arrangements among participants in the corporate enterprise. While this seems odd in light of the overwhelming evidence that government is inefficient in general and particularly inept at running businesses, it appears true nevertheless. Apparently, the fact that government has demonstrated that it cannot efficiently run businesses does not necessarily mean that the state is ineffective at assisting the private-ordering process when the entrepreneurial decisions are made by others. The state has a clear role to play in enforcing the contracts that are made in the private sector. Unbiased, professional interpretation and enforcement of contracts is a significant undertaking that adds incalculable value to business.
In fact, the role of the state goes even beyond the mere enforcement function. The state applies "off-the-rack" rules that actually serve as substitutes for the rules that investors might develop. It has long been recognized, particularly by those in the "law and economics" movement, that the corporation, along with other forms of business organization, including such modern forms as the limited liability company (LLC) and the limited liability partnership (LLP), should be viewed as a "nexus of contracts" or set of implicit and explicit contracts. The term "nexus of contracts" describes corporations and other forms of business organizations as complex webs of contractual relationships among the various participants in the enterprise: investors, managers, suppliers, workers, customers, and so forth. Under this view, business law, including corporate law, exists to economize on transaction costs by supplying sensible "off-the-rack" rules that participants in a business can use to economize on the cost of contracting.
Critically, this analysis also applies to fiduciary duties. Fiduciary duties are part of the contractual nature of the corporation and exist to fill in the blanks and inevitable oversights in the actual contracts used by business organizations. The purpose of fiduciary duties is to provide people with the results that they would have bargained for if they had been able to anticipate the problem at hand and had contracted for its resolution in advance. Thus the law of business organizations in general and corporations in particular is highly contractual in nature. The purpose of the various laws of business organizations is to facilitate the contracting process, not to displace the actual contracts reached by the parties. Business organizations need law, including fiduciary duties, because it simply is not possible for those who organize businesses to identify all of the potential problems and conflicts that inevitably will arise in a business. Specific issues and transactions invariably will present themselves that could not have been identified ex ante. Fiduciary duties exist to provide a framework for dealing with those issues.
Consistent with this analysis, the modern trend is inexorably toward more contractual freedom in corporate law. For example, in Delaware, the law that applies to limited liability companies explicitly permits members and managers of LLCs to expand, restrict, or eliminate fiduciary duties and other duties, other than the implied contractual covenants of good faith and fair dealing. However, it is clear that the default rule for all other forms of business organization in Delaware, and elsewhere, is that fiduciary duties are owed to investors. Fiduciary duties exist unless the parties have explicitly and unambiguously contracted them away.
Investors can opt out of these rules in at least three ways. First, they can draft their own rules to cover a particular contingency. Where this is done properly, the agreement reached by the parties will be respected, so long as there has been no fraud or unfair dealing in the contract negotiation. Second, promoters and entrepreneurs who organize corporations can choose from among many U.S. and offshore jurisdictions when they decide where to incorporate, and thus where to "locate" their businesses for legal purposes. Simply by incorporating their businesses in a jurisdiction that contains statutory provisions that are to their liking, people organizing new business (or reorganizing existing businesses) can select or "opt into" the set of "off-the-rack" legal rules that best fit their needs. Third, even within a single jurisdiction, people organizing a business can select among a variety of different forms of business organization, such as the traditional corporate form, as well as the limited partnership, the limited liability company, and the limited liability partnership.
Excerpted from CORPORATE GOVERNANCE by JONATHAN R. MACEY Copyright © 2008 by Princeton University Press. Excerpted by permission.
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Table of Contents
INTRODUCTION: Corporate Governance as Promise 1
CHAPTER 1: The Goals of Corporate Governance: The Dominant Role of Equity 18
CHAPTER 2: Corporate Law and Corporate Governance 28
CHAPTER 3: Institutions and Mechanisms of Corporate Governance: A Taxonomy 46
CHAPTER 4: Boards of Directors 51
CHAPTER 5: Case Studies on Boards of Directors in Corporate Governance 69
CHAPTER 6: Dissident Directors 90
CHAPTER 7: Formal External Institutions of Corporate Governance: The Role of the Securities and Exchange Commission,
the Stock Exchanges, and the Credit-Rating Agencies 105
CHAPTER 8: The Market for Corporate Control 118
CHAPTER 9: Initial Public Offerings and Private Placements 127
CHAPTER 10: Governance by Litigation: Derivative Lawsuits 130
CHAPTER 11: Accounting, Accounting Rules, and the Accounting Industry 155
CHAPTER 12: Quirky Governance: Insider Trading, Short Selling, and Whistle-blowing 165
CHAPTER 13: Shareholder Voting 199
CHAPTER 14: The Role of Banks and Other Lenders in Corporate Governance 223
CHAPTER 15: Hedge Funds and Private Equity 241
What People are Saying About This
This book is important, interesting, and argumentative. It is wonderfully useful for bringing us up to date with how theory applies to an important set of issues and what those issues say about theory. Corporate Governance will be valuable to many readers, from faculty to students, from journalists to directors, from those who like the system we have to those who are critical of it, and from those who agree with the author and those who don't!
Peter A. Gourevitch, coauthor of "Political Power and Corporate Control"
The ambition and achievement of this work is dazzling. Macey leaves no stone unturned in his penetrating examination of the system of American corporate governance. The book will doubtless be an important contribution to the longstanding debate over how best to support the bedrock role that the public corporation plays in the American economy.
Ronald J. Daniels, University of Pennsylvania
A refreshing look at corporate governance that resonates in the real world. For example, Macey argues that so-called 'independent' directors are not really as independent as they appear and explains why the handpicked members of the boards of directors of publicly held companies often are more attentive to managers' interests than to shareholders' interests. Macey points out that there is something wrong with a corporate-governance system that regularly allows ostensibly independent corporate directors to refuse to permit shareholders to decide for themselves when to sell their own companies. Macey does an excellent job of explaining the legal and political problems that give too much power to incumbent managers and not enough to shareholders and free markets.
Macey's book is must reading for any serious student of corporate governance. He brings his usual keen analyses and fresh insights to a field where unexamined received wisdom and advocacy of me-too 'best practices' have too often been the norm.
John F. Olson, senior partner at Gibson, Dunn & Crutcher LLP
Intriguing, provocative, and readable. One comes away from this book with a good sense of why the institutions of corporate governance are not always what they seem, and why politics plays too large a role in the choice of what to embrace and what to shun. The existing literature on corporate governance is enriched by this book.
Donald C. Langevoort, Georgetown University