7 of 13 people found the following review helpful
Stephen M. Bainbridge
- Published on Amazon.com
"Power & Accountability" contends that institutional investors are changing U.S. corporate governance for the better, and that the law should encourage those changes. In my view, the thesis is both positively and normatively flawed.
The empirical evidence on institutional investor activism is mixed, at best. There is some anecdotal evidence that institutions are becoming more active, using the proxy system to defend their interests. Less visibly, institutions supposedly influence business policy and board composition through negotiations with management. Yet, there is little concrete evidence that shareholder activism matters. Even the most active institutions spend trifling amounts on corporate governance. Institutions devote little effort to monitoring management. They rarely conduct proxy solicitations or put forward shareholder proposals. They do not to try to elect representatives to boards of directors.
Even if institutional investor activism matters, it is not clear that it should be encouraged. U.S. public corporations are characterized by a separation of ownership and control: the firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares. This separation is carved into stone by U.S. corporate law-under all corporation statutes, the key players in the formal decision making structure are the members of the board of directors. The separation of ownership and control has costs, the most significant of which are referred to as agency costs, incurred to prevent shirking by managers. The agency cost model forces one to confront the question: who will monitor the monitors? In any team organization, one must have some ultimate monitor who has sufficient incentives to ensure firm productivity without himself having to be monitored. Otherwise, one ends up with a never ending series of monitors monitoring lower level monitors. Institutional investors, at least potentially, may behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, they could play a far more active role in corporate governance than dispersed shareholders. Institutional investors holding large blocks have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, will enable them to more actively monitor the firm's performance and to make changes in the board's composition when performance lagged. As a result, concentrated ownership in the hands of institutional investors might lead to a reduction in agency costs.
The benefits of institutional control, however, may come at too high a cost. There is good evidence that bank control of the securities markets has harmed that Japanese and German economies by impeding the development of new businesses. More importantly, there is a risk that institutional investors will abuse their control by self-dealing and other forms of over-reaching. If management becomes more beholden to the interests of large shareholders, it may become less concerned with the welfare of smaller investors. The U.S. experience with social investing by public pension funds, moreover, suggests that politicization of stockownership will be an economic drag. In general, the greater the extent to which a public pension fund is subject to direct political control, the worse its investment returns.
In my view, moreover, the separation of ownership and control is a highly efficient solution to the decisionmaking problems faced by large corporations. Separating ownership and control by vesting decisionmaking authority in a centralized entity distinct from the shareholders is what makes the large public corporation feasible. To be sure, this separation results in the agency cost problem described above. A narrow focus on agency costs, however, easily can distort one's understanding. Corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. Important constraints are provided by a variety of market forces. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. In addition, the legal system evolved various adaptive responses to the ineffectiveness of shareholder monitoring, establishing alternative accountability structures to punish and deter wrongdoing by firm agents, such as the board of directors.
An even more important consideration, however, is that agency costs are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly. Neither discretion nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, they are ultimately antithetical: one cannot have more of one without also having less of the other. The power to hold to account is ultimately the power to decide. Managers cannot be made more accountable without undermining their discretionary authority.
The root economic argument against shareholder activism thus becomes apparent. Large-scale institutional involvement in corporate decisionmaking seems likely to disrupt the very mechanism that makes the modern public corporation practicable; namely, the centralization of essentially nonreviewable decisionmaking authority in the board of directors. Given the significant virtues of discretion, one ought not lightly interfere with management or the board's decisionmaking authority in the name of accountability. Preservation of managerial discretion should always be the null hypothesis. The separation of ownership and control mandated by U.S. corporate law has precisely that effect.