Speech by SEC Staff:
Remarks on UK and US Approaches to Corporate Governance and on the Market for Corporate Control1
Director, Office of International Affairs
U.S. Securities and Exchange Commission
Madrid, Spain, and London, England
February 8–9, 2007
Buenos días. Me da much gusto estar aquí con Ustedes para cambiar ideas sobre el tema de buen gobierno de las sociedades cotizadas. Y con eso he agotado todo el español lo que se, y con su indulgencia, continuaré en inglés.
But before I continue in English, I must give the standard disclaimer required by my employer. "The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission."
During the height of the Cold War, journalists used to play a game in which they would take a headline from the Wall Street Journal and try to predict the headline for the same story in Pravda, then the leading newspaper of the Soviet Union and an official organ of the Communist Party. For example, if the Journal reported that "Soviet Armies Invade Yugoslavia," then it was a fairly safe bet that that morning's headline in Pravda would read something like "Yugoslav People Liquidate Puppets of Capitalist Powers."
Continuing along these lines, the English philosopher Bertrand Russell jokingly noted that embedded in the very structure of language and thought itself was this tendency to perspectivism, particularly notable in the "declension of irregular adjectives." He pointed out that the specific form of some adjectives depends on whether it is being used in the first, second, or third person. For example, you may well say about yourself, "I am firm." But when you talk to someone else, this becomes "you are obstinate." And when you speak about someone who is not in the room, the third-person declension is, of course, "he is a pig-headed fool."
In the discussion of corporate governance, we have seen a bit of the same dynamic at work. In the wake of Sarbanes-Oxley, it has become commonplace to characterize the approach to corporate governance in the United States as "regulator-led" and that of the United Kingdom (which is not unlike the approach in continental Europe) as "shareholder-led." Just as journalists were able to predict the content of the stories in Pravda from the headlines in the Journal or the New York Times, so to are we able to discern where the discussion is headed when someone describes an approach to corporate governance as "shareholder-led" and "principles-based" or "regulator-led" and "rules-based." If an approach is "shareholder-led," then it follows, as a matter of course, that it is flexible and can be tailored to meet particular needs. And if an approach is "regulator-led," then it follows that it must be a "one-size-fits-all" approach that squelches innovation and adaptability.
A similar dynamic is at work when you hear someone talk about "corporate democracy." The assumption is that if something is "democratic," it must of course be a good thing. After all, who can be against democracy? And thus it follows that any approach to corporate governance in which shareholders are not viewed as citizens of a corporate republic is necessarily anti-democratic.
But to really understand approaches to corporate governance, it is necessary to look beyond the labels and the adjectives, and to consider the history and current context underlying alternative approaches to corporate governance.
Rules of the Road: The "Regulator-Led" and the "Shareholder-Led" Approaches to Corporate Governance
The US corporate governance system is commonly held out as the exemplar of the "regulator-led" approach to corporate governance, in which the SEC and the exchanges are responsible for implementing and enforcing good corporate governance standards. By contrast, in the UK shareholders are given the autonomy and the authority to decide what corporate governance measures are necessary and appropriate to protect their interests.
What drives these different approaches may be the simple fact that we have very different markets. I was struck by a remark Hector Sants made during a meeting we recently had with the FSA. He noted that the UK regime was designed for sophisticated, institutional, mobile capital, whereas the US market has historically included an important local retail component that one would not necessarily characterize as sophisticated. As such, the US market may be more akin to a system of public roadways and the UK market more comparable to a Formula 1 circuit.
Interestingly, there are historical reasons for the relatively strong presence of institutional investors in the UK compared to the United States. In the UK, for example, high personal income tax rates during the post-war period suppressed individual retail shareholding. At the same time, tax exemptions for pensions led to a rapid increase in the assets managed by institutional investors and mutual fund managers. By the 1960s, large institutional shareholders in the UK began to press for greater corporate governance controls and norms by which they could protect their interests. It has been this strength of institutional investors in the UK that has made feasible the "comply or explain" corporate governance provisions that are the hallmark of what is referred to as "shareholder-led" regulation.
By contrast, in the United States, federal and state regulation in the first half of the 20th century limited the equity that banks and insurance companies could hold. As a result, equities markets in the US today have a much higher degree of retail investor participation and at least until the 1980s a relatively lesser participation by institutional investors. The relative weakness of institutional investors in the US and the comparatively large size of the retail investor market have led to far greater federal corporate disclosure requirements and more aggressive securities law enforcement designed to protect retail investors.
Given differences in our markets, and the different roles that institutional and retail investors play in these markets, it should not be at all surprising that we have different approaches to regulation. In the US market, there are traffic laws that are administered and enforced by the authorities. In the UK, they rely on the skills of sophisticated institutional investors to navigate the F1 circuit.
That means that in the United States, when you travel our corporate roadways, whether you are an investor that resembles Michael Schumacher or Fernando Alonso, or an investor more like the proverbial little old lady from Pasadena, the speed limit is 55 miles per hour, regardless of whether it is 3:00 in the morning and the streets are empty or whether it is 3:00 in the afternoon and the streets are clogged with rush hour traffic. We wouldn't expect to strap the average US motorist into a Formula 1 car and expect him to hold his own against experienced race car drivers on a challenging course. Similarly, it would not be surprising to find that a race car driver accustomed to speeds of 190 miles an hour probably finds that plodding along on city streets does not exhaust his or her talents. While we cannot hope to make the Grand Prix Circuit safe for the average motorist or every-day driving exciting for the F1 racer, we can adopt regulations appropriate to each arena and to the skills of its participants.
You might argue that the US approach is unduly costly, forcing each one of us to drive more slowly than he or she is otherwise capable of and causing all of us to waste resources that would otherwise redound to the benefit of society. But in countries that have a large retail presence in their markets, it is difficult to abandon government-enforced speed limits altogether for a driver-led "comply or explain" approach for several reasons.
First, the speed limit is painfully clear to corporate motorists. Investors large and small alike issuers, and regulatory authorities all know exactly what is expected on corporate roadways. As corporate motorists, investors and issuers know that a stop sign is intended to signal prohibited behavior, and it is to be complied with, without variation or explanation.
Second, the speed limit is a pretty good proxy for solving the problem of speeding. Regulators try to set speed limits to avoid accidents before they happen. The same is true of corporate governance requirements. It is for this reason that I think that the complaint we so frequently hear that "regulator-led governance" is geared more towards enforcement rather than prevention is fundamentally misplaced. The rules are designed to prevent problems before they arise.
But whatever our approach to corporate governance, our touchstone must remain shareholder protection. Indeed, regulator- versus shareholder-led governance is not an either-or proposition. We need both. And we should not fall prey to a false dichotomous question much like the debate over "rules-based" and "principles-based" regulation. To paraphrase an American legal scholar, "Rules without principles are a menace. But principles without rules are likely a mess."
The "Corporate Republic" Who Governs?
Which brings me to the second topic that gets much attention in discussions about corporate governance: the "market for corporate control." In a nutshell, the issue boils down to this: in the context of a takeover bid for the corporation, who should decide whether to accept the bid management or shareholders? Within this debate, there are two schools of thought the managerialist school and the shareholder choice school.
Under the managerialist view, the board should have extensive discretion to respond, including the right to "just say no." Managerialists believe that for the same reasons the board is delegated the authority to manage the business in the first place, the board is in the best position to respond to a bid for the company. It is part of ordinary business decision making. The board has better information than shareholders about both the target's business and the bidder's prospects for the company. And whether or not the long-run prospects of the target company improve as a result of the takeover is fundamentally a business decision. In addition, managerialists believe that depriving boards of the ability to reject hostile takeover attempts encourages management to focus on short-run performance rather than potentially more profitable long-term strategies.
In the shareholder choice view, the decision whether to accept a takeover bid is not an ordinary business decision. Instead, takeover offers affect core shareholder rights the right of ownership and the right of voting one's shares. Although the board may have a comparative advantage in making ordinary business decisions, the board has no advantage over the shareholders when it comes to deciding whether or not to sell the company to a bidder. That decision is simply a variation of the decision whether to buy or sell shares in the first place. In addition, the right to tender shares to a bidder permits shareholders to displace under-performing management. Thus, in the shareholder choice view, an active market for corporate control ensures that managers are accountable to shareholders. The shareholder choice view recognizes that in the takeover context, managers face a material conflict of interest, given that in deciding whether to accept or reject a takeover, managers are also deciding their own fates. While a corporate takeover may be a bloodless revolution, it is a revolution nonetheless, and we should not be surprised that a manager might be a bit less than willing to hasten up the steps of the guillotine.
The debate about the market for corporate control is, at its heart, a debate that cuts to the very heart of corporate governance, and it is a debate that is as old as the corporate form itself. More than two hundred years ago, Adam Smith wrote that managers "cannot well be expected" to watch over a corporation's assets "with the same anxious vigilance with which the partners" in a private partnership "frequently watch over their own." In 1932, Adolf Berle and Gardiner Means suggested in their seminal work on the corporate form that the conflicts of interest between shareholders and managers were so great that the corporation might be an untenable form of organization.
Reading the dire predictions of these great thinkers separated by more than two centuries, I am reminded of the old saying that an economist is someone who sees that something works in practice and then asks whether it could also work in theory. The corporate firm not only works, it works well. Thanks to the innovation made possible by the corporate form, economies have flourished. To pick just one development, it is thanks to the corporation that we today enjoy the benefits of things such as commercialized transistor technology, the integrated circuit, semiconductors, and the personal computer.
The current approach in the United States to corporate governance and the current approach to markets for corporate control is firmly grounded in a highly traditional view of what makes corporations successful. It is a view that Leo Strine the Vice Chancellor of the Delaware Court of Chancery has called the view of the "corporate law traditionalist," which is closely aligned with the managerialist school. As Vice Chancellor Strine describes it, the corporate law traditionalist believes there is great value to the American that is, the Delaware approach to corporation law. This approach invests corporate managers with the nearly unfettered authority to pursue business strategies through diverse means, subject to a few important constraints, such as the requirements that shareholders approve certain transactions such as mergers, vote for directors annually, and have access to books and records.
To the corporate law traditionalist, the core element of the American approach to corporate law is the belief that what ultimately produces corporate wealth is the ingenuity and skill of talented managers, and that corporate law works best when it facilitates the ability of managers to react adroitly to emerging developments and opportunities. To the corporate law traditionalist, the law must enable managers to make good-faith business decisions with the speed and efficiency that modern commerce demands, and it should minimize distractions from value-creating tasks so that managers can spend more time improving the company's products and services to increase profits.
And it is this perspective that informs the takeover debate in the US. Over the years, Delaware takeover law has been described as "equivocal," "confusing," "unprincipled," "muddied," "murky," and "inconsistent." At various times and to varying degrees, the Delaware courts have emphasized the duty of loyalty, the duty of care, the interests of non-shareholder constituencies, the type of consideration in the tender offer, the size of the companies, the governance structure of the new combined entity, the extent to which target shareholders are subject to coercion, the extent to which the target board has superior information and bargaining power, the existence of a control premium, whether the bid price is too low, and whether the bidder has a controlling shareholder.
But believe it or not, there is a method to this madness. Without canvassing Delaware takeover jurisprudence case-by-case, it seems to me that these cases turn on whether the takeover offer infringes on the prerogatives of the board to manage the corporation as an ongoing concern or whether the takeover offer implicate the rights of shareholders to sell or vote their shares. Thus, under the Unocal and Paramount line of cases, the target board is granted broad discretion to adopt defensive tactics when the hostile bid threatens the enterprise as an on-going concern. On the other hand, under the Revlon and QVC line of cases, the board's authority to adopt defensive tactics is limited when the company is up for sale or there is a change of control. In these circumstances, there is no tomorrow for the target board. The target board will inevitably cease to be the corporation's steward and protector, and will inevitably cease to be responsible for the future business and strategy of the corporation. In cases like these, the board is obliged to obtain the best possible detail for the target's shareholders.
You can see that the Delaware approach to takeovers cleaves closely to the notion that in the modern corporation, there is an efficient, wealth-maximizing split between ownership and control. If the takeover bid implicates ownership rights, then the interests of the shareholders are front and center, and the board's power to adopt anti-takeover measures is quite limited. However, if the takeover bid implicates the right to manage a corporation and determine its business strategy as a going concern, then the interests of management predominate and the board decides whether the corporation may resist the takeover.
To some, all this may seen unnecessarily complicated a Gordian knot in need of a good axe, and shareholder choice seems to be the sharpest axe we have. After all, the shareholders own the corporation, and the managers work for the shareholders. Shouldn't the shareholders get to decide? And what's worse, all this may seem unnecessarily inefficient. Shouldn't shareholders get the benefit of whatever premium the acquirer is willing to offer as part of the takeover?
But in the United States, shareholder choice is not the only prism through which the relevant policymakers view corporate law. Elected officials are likely to embrace some form of the corporate traditionalist perspective in which managers are charged with managing and shareholder authority is limited. According to Strine, these policy makers
and most individual investors embrace this perspective in part because they do not see corporations as having solely the social purpose of benefiting investors as investors. Rather, they understand and embrace the historical reality that the corporate form was authorized as an instrumental means of enhancing the well-being of our society as a whole and not simply as a means to make investors rich and immune from liability for corporate acts. Although many traditionalist policymakers would concede that making managers more directly accountable to stockholders is a useful means to achieve the larger objective of increasing societal wealth, they do not conflate the goal of a durably wealthier society with the short-term interests of investors in higher stock prices. Indeed, they are concerned that tilting the direction of corporate policy toward short-term thinking is counterproductive, not simply for investors but for other important constituencies such as employees and communities.
When viewed through this prism, it is not surprising, that Delaware refuses to view the takeover issue purely from the perspective of shareholders seeking a premium in the context of a takeover battle or looking to discipline management for perceived incompetence.
To conclude, there is an extraordinary power in the ability to name things.2 And it is only when we begin to name things that we can start to think about them and discuss them. But there is always the danger that our discussions will be cut short by our mistaken belief that simply by naming a thing, we have understood it fully. These are important and challenging issues, to which there are different approaches informed by different assumptions, contexts, and histories. Not until we look behind the labels will we fully benefit from a discussion about alternative approaches to the problems of corporate governance.