Corporate Law and the Longterm Shareholder Model of Corporate Governance
80 Pages Posted: 9 Jul 2011 Last revised: 30 Jul 2011
Date Written: January 1, 1992
The key to effective corporate accountability today appears to be the existence of a class of "permanent" owners, holding approximately one-quarter of the outstanding equity, who have an incentive to monitor the operations of the corporation. This is essentially the system in Germany, Britain, and Japan. . . . In the United States, encouraging a pattern of domestic institutional ownership will be a way of ensuring the continuance of effective governance. The challenge, then, for the United States is to identify its "permanent" shareholder institutions and to ensure that they have the incentive and ability to perform the monitoring function.
As recently as a few years ago, the ability and desire of corporate shareholders to mount a challenge over corporate governance seemed suspect. After all, shareholders were considered to be passive, impotent, and unconcerned. A shareholder revolution, however, is occurring, highlighted by the ascendancy of the institutional investor. This development, combined with the current anti-shareholder corporate governance trend, renders obsolete much of contemporary corporate law doctrine and practice. As a result, corporate law is in flux and turmoil.
"[A]n extraordinary ferment of activity in the field of corporate governance" has resulted, including the proliferation of state-adopted and corporation-imposed antitakeover mechanisms such as the poison pill,increased involvement by the Securities and Exchange Commission (SEC), and intense criticism by institutional investors of current corporate governance structures and mechanisms. Such intense controversy surrounding corporate governance issues appears inevitable given the far-reaching economic and social impact of the modern corporation The stakes are enormous.
The current corporate governance framework does not adequately address the evolution of the nature and role of modern institutional investors. Accompanying institutional investors' growth and concentration of share ownership is their desire and ability to participate meaningfully in governance issues Moreover, at no time has the need for shareholder activism been more acute; the marked downturn in takeovers this decade eliminates the potential disciplinary force that the threat of takeovers can have upon management. Although commentators have struggled to keep pace with institutional shareholder activism amid this changing corporate landscape, none have proffered a model procedural governance framework as proposed in this Article.
Corporate law has developed dialectically in four stages. In the current "insulated managerialism" stage of corporate law, institutional shareholders lack an incentive to invest in a corporation for the long term. They currently lack the opportunity to offer meaningful guidance on fundamental corporate affairs and major longterm financial strategies. Piecemeal reform efforts cannot address the core weakness in the current framework of corporate governance – that modern institutional shareholders lack both the incentives and legal base to invest in a corporation for the long term.
This Article proposes to harness fundamental principles of corporate governance to develop an innovative governance framework responsive to the evolving nature of modern institutional shareholders and boards of directors. The focus of this model framework is the process by which corporate governance powers are allocated. Rather than setting out substantive rules fixing the respective duties and powers of shareholders and nonshareholders, the proposed model establishes a process by which governance issues are resolved.
Such a "process approach" offers many advantages. First, a procedural framework can remain viable amid a dynamic corporate law landscape. Second, although most institutional investors cannot monitor the hundreds of companies within their portfolio, they can monitor particularly important events and issues in those companies. Indeed, focusing upon significant issues common to all corporations obviates the need for longterm shareholders to engage in firm-specific monitoring. The increased economies of scale afforded by this procedural focus will fuel longterm shareholders' incentives to improve underlying corporate performance and profitability. The proposed procedural governance framework ensures that the directors will seek input from longterm shareholders whenever fundamental changes in the corporation's governance regime are proposed. Third, a procedural corporate law regime may be the inevitable result of the forces currently shaping corporate law. In particular, such a structure is the logical result of the "nexus of contracts" perspective of corporate law.
Process-oriented reform should squarely address the circumstances under which shareholders should or must be allowed to guide directors' or managers' business judgment. Longterm shareholders must be allowed to do so when either or both of two factors exist: when conflicts of interest between shareholders and nonshareholders substantially blur a board's ability to determine an appropriate course of action objectively and efficiently, or when the decision facing a director will have such an impact upon the shareholders' financial investment that shareholders possess significant incentives to determine the course that will maximize longterm shareholder/corporate value.
Shareholders' procedural involvement may appear through several mechanisms, including shareholder voting and shareholder advisory committees. Fully implemented, this proposal would enable the board to perform the function it is best suited to perform: to be an effective central mediator between longterm shareholders and longterm stakeholders. Under the proposal, the board would also seek the advice of major longterm shareholders on significant financial matters, in addition to seeking the counsel already provided by management and longterm stakeholders.
The longterm economic efficiency that this model generates should be self-propagating. Sophisticated shareholders will invest only in those corporations with responsive management. This fosters cooperation. Corporate management will be forced to consider the desires of major longterm shareholders. Corporations that acknowledge major longterm shareholders' governance desires will have share prices that reflect greater shareholder satisfaction, and ultimately will be able to attract the patient capital essential for longterm success.
This Article suggests a process by which longterm shareholders may meaningfully influence corporate governance. Part I describes the development of the current governance regime as framed by practices, legislation, and case law. Corporate law has evolved in four stages, from shareholder primacy to managerial capitalism, and then from management monitoring to the current situation, flourishing insulated managerialism. Consequently, the current governance framework is inconsistent with the ascendancy of the institutional investor. Part II describes the potency of the escalating conflict between shareholders and nonshareholders and examines current reform proposals. This Part argues that institutional investors lack an effective means of involvement in governance issues and thereby lack the incentive to view their holdings as longterm investments.
Accordingly, Part III of this Article sets out a model framework of corporate governance based on the assimilation of the institutional investor as the quintessential longterm shareholder. This part proposes recognizing the role and right of the "longterm shareholder" as a means toward reducing this shareholder/nonshareholder tension. The purpose is to promote cooperation, thereby easing the conflicts between shareholders and nonshareholders that have escalated with the rise of the institutional investor, and to provide a process by which shareholder interests are represented effectively. Moreover, since meaningful reform must ultimately be ground in specific statutory language, this Article proposes model statutory provisions that are consistent with the role of the longterm shareholder in corporate governance. Part IV of the Article explores the nature and destiny of the "longterm shareholder" governance regime.
Suggested Citation: Suggested Citation