"There are only two ways of telling the complete truth—anonymously and posthumously."Thomas Sowell

Wednesday, August 10, 2005

Holding Corporate Boards Accountable

The limited-liability status of corporations allows them greater latitude in decision-making, by taking away the risk that corporate owners and decision makers will be held personally responsible for their actions. It also makes corporations less likely to respond wisely and decently to concerns raised by people outside the main circle of decision makers. As a result, it invites government to step in and regulate corporate behavior directly.

Recent corporate scandals have place increased pressure on management and boards to institute more effective ethical self-policing. Without the incentives of real liability, however, such actions are not likely to have much effect.

Hence the recent court decision regarding Disney's $140 million payoff to former Disney president Michael Ovitz, who served in that capacity for all of 14 months, has greater implications than just the relief it brings the Disney board, whose actions in hiring, firing, and paying off Ovitz "did not violate duties to shareholders," according to the judge's ruling.

The judge, however, was highly critical of the Disney board's behavior, writing in his opinion, "Many lessons of what not to do can be learned from defendants' conduct here." Today's New York Times story on the matter noted that even though Disney won the case, scrutiny over corporate boards and management will increase:

[B]oard members have good reason to adopt a more conservative stance in compensation matters and avoid second-guessing, said Charles M. Elson, head of the John L. Weinberg Center for Corporate Governance at the University of Delaware's Lerner College of Business and Economics.

Although the judge ultimately found that the Disney board did not breach its duties, he discussed a tough standard for the diligence required of board members, Mr. Elson said. The standard has been clarified, and directors at other times and at other companies could be held accountable under it.

"It means that you can't just make a decision with a devil-may-care attitude," Mr. Elson said, adding, "it has altered director behavior forever."


Hunter Baker said...

I'm not a freak about executive compensation, particularly if a guy is in the job and performing. However, the giant golden handshakes have got to stop. Shareholders should be all over that.

S. T. Karnick said...

Yes, and it shows how little able or willing shareholders have been in forcing corporate managers to act both rationally and ethically.

Tom Van Dyke said...

Professor Bainbridge has been on this for awhile.

As someone who's involved in the legal industry (headhunter), I can say private lawyers are almost always smarter than laws and bylaws.

John said...

I don't think I agree that the Disney decision implies a need to more aggressively regulate. First,I don't really see the relevance of limited liability here since this is an issue of sound management of the corporation's assets rather than an issue of the corporation causing harm (that is, it is an internal issue -- the harm is to the shareholder owners of the corporation rather than to some third party as would be the case if the corporation was dumping toxic waste in your backyard). When the issue is sound management of the corporation's assets the potential loss is the total value of the corporation and the amount of money actually at risk is the total value of the corporation. There's no disconnect.

More importantly, the board, corporate charters and other corporate governance structures are all well and good, but the are *not* the primary method (or even a particularly important method) by which shareholder interests are protected in a publicly held corporation like Disney. However crappy the board is there is one very important and sure fire way for a shareholder to ensure that he isn't harmed by corporate mismanagement -- invest elsewhere. Disney stock is traded on what is unquestionably one of the most efficient markets in existence ("efficient" in the sense that it rapidly and effectively conveys information about the management of the company and potential effects of that management on price to potential shareholders). No market is perfect, so it will always be possible, with hindsight, to point to instances where the market failed to accurately convey the quality of a company and its management. But there's a big gulf between saying "there will be failures" and saying "it is possible to identify problematic situations through rules and litigation." This is particularly so since decisions that look dumb at time t may look masterful at time t+1 and vice versa. Moreover, a decision made at time t that looks dumb at time t+1 may be vindicated at time t+2. Given that we live in a world where hundreds of large, sophisticated plaintiffs law firms like Millberg Weiss are always prepared to bring a shareholders derivative suit at time t+1 and are very effective at making any decision, however good, look like the most reckless act since the order to send in the Light Brigade we should always be reluctant to look for new legal resolutions to corporate governance issues.

Finally, markets play another important role. Corporations are largely free to create their own governance structures because there is actually a market for corporate law. The law applied to corporate governance is the law of the state in which the corporation chooses to incorporate. Thus corporations are free to choose any of 50 different sets of corporate law. The quality of the shareholder protections offered by that law, then, is subject to the judgments of the market. Other things equal, if very strong shareholder protection is, on the whole, beneficial, corporations from states with strong shareholder protections will be worth more than corporations from states with weak shareholder protections and management can raise more capital by incorporating in a strong protection state. In practice, the overwhelming winner in this market for corporate law is Delaware -- a state that has historically given enormous freedom to corporations to set up their own governance structures unencumbered by state dictates.

Kathy Hutchins said...

Excellent, very informative comment, John. We need more commenters like you on this blog.