In this book Stephen Bainbridge addresses the changes introduced into corporate governance law by both Sarbanes Oxley (the Public Company Accounting Reform and Investor Protection Act of 2002 – SOX) and Dodd Frank (the Wall Street Reform and Consumer Protection Act of 2010). These two public policies serve as temporal bookends to the contemporary era of financial crisis. Sarbanes Oxley was a response to the Enron accounting scandal as well as corporate malfeasance at World Com, Global Crossing, etc.; while Dodd-Frank was a response to the financial crisis created by the securitization of mortgages.
With regard to these two public policies, Bainbridge raises two questions: (1) did they improve corporate governance and (2) how did they affect the relationship between state and federal regulation of corporate governance. It is with regard to the second issue that liberty issues are raised.
This book can be read at three different levels: First, it addresses the two questions noted above raised directly by the author; second, it alludes to a fundamental debate about the nature and role of corporations; and second it calls attention to an even more fundamental philosophical debate about the relationship between the market economy and the role of government. The last debate we shall refer to later as the democratization debate.
Turning first to the direct issues of corporate governance, Professor Bainbridge takes a director-centric position as opposed to a shareholder-centric position on corporate governance. From Bainbridge’s point of view, the role of the Board of Directors is to help manage the corporation. What he objects to in the shareholder-centric view is the notion that the role of the Board is to monitor management’s performance. He objects to the latter on the grounds that it undermines director discretion and promotes shareholder activism. He objects to shareholder activism because it is counter-productive to corporate success. Worse than the lack of any benefit, the costs of the new regulation “are disproportionately borne by smaller public firms” (p. 265). As a further cost, Bainbridge cites the fact that Sarbanes-Oxley’s gutting of Arthur Andersen reduced competition among major accounting firms.
Bainbridge examines specific provisions of both public policies and concludes in every case that both reflect what he calls “Quack” corporate governance regulation. Bainbridge cites the work of Roberta Romano (“The Sarbanes-Oxley Act and the Making of Quack Corporate Governance; 114 Yale Law Review, 1521/2005). Quack corporate governance has the following main features: it is a response to financial crisis usually in the form of a bubble, it is a political response at the federal level to populist backlash, and inevitably transfers power from the states to the federal government. Moreover, the federal response is dictated neither by logic nor experience nor does it have empirical support but reflects, instead, a long-standing preconceived political agenda of specific special interest groups. Bainbridge identifies these groups, quoting former SEC Commissioner Paul Atkins as “politically powerful trade-union activists, self-nominated shareholder rights advocates [and] trial lawyers” (p. 227) as well as their academic allies. Public employee pension funds, in particular, are “vulnerable to being used as a vehicle for advancing political/social goals unrelated to shareholder interests” (p. 247). Two immediate consequences of this analysis are (a) that the crises themselves were not the result of previous poor corporate governance (“systemic flaws in the corporate governance of Main Street Corporations were not a causal factor in the housing bubble, the bursting of that bubble, or the subsequent credit crunch” p. 10) and (b) that the reforms contributed to precipitating the next crisis. For example, post Sarbanes-Oxley, “directors distracted by the emphasis on internal controls and disclosure may have let slide tasks like risk management oversight” (p. 67).
Bainbridge gives a very enlightening and concise account of how the early scandals were the result of greed on the part of individuals confounded by the failure of key gatekeepers (p.6). He attributes the problem ultimately to imperfections in human beings rather than to institutional structural problems. Activists, on the other hand, attribute the scandals to systemic problems requiring government regulation.
In Chapter Six, Bainbridge discusses at length the failure of gatekeepers such as accountants, auditors, rating agencies, securities analysts, investment bankers, and lawyers. Lawyers, in particular, “have both economic incentives and cognitive biases that systemically incline them” (p. 196) to support management, and “often lack the mathematical skills and accounting knowledge to tell the difference between earnings management allowed by GAPP and illegal financial chicanery” (p. 198). Bainbridge favors up-the-ladder reporting, but he is concerned that “the new post-Sox legal ethics rules will make the lawyer-client relationship more adversarial and less productive” (p. 199).
Bainbridge’s discussion of proxy access to nominating Board members, something very much in the news, is especially insightful. The SEC justifies this policy on the grounds that it will produce director accountability – modeling a corporate Board to a legislative body. The likely result, according to Bainbridge, is an increase in interpersonal conflict among the different constituencies that ultimately undermines “the trust-based relationships that are the foundation of effective board decision making” (p. 230). In fact, “early research suggests that proxy access reduces shareholder wealth” (ibid.).
Having concluded that quack corporate governance is counterproductive, Bainbridge cites Robert Higgs “ratchet effect,” namely that wars and financial crises “trigger a dramatic growth in the size of government, accompanied by higher taxes, greater regulation, and loss of civil liberties” (p. 269).
Turning now to the second level of discussion, we raise the question of how we are to understand corporations. The typical discussion in the economics and the business ethics literature centers on the now canonical debate between Friedman (shareholder primacy) and Freeman (stakeholder primacy). Friedman presupposes that the shareholders are a kind of owners of the corporation. Bainbridge is much-more insightful. Citing Coase, a firm is nothing more than a nexus of contracts. As such, no one actually owns a corporation. A corporation is a legal device for pursuing economic activity on a scale hitherto undreamt of. The managers make the major decisions, the directors help management by providing additional expertise and networking advice, and investors of all kinds are invited to participate in the risk and the rewards. There is no “agency problem.” Managers and Directors are not agents of investors. Investors, including but not limited to shareholders, like this system because it satisfies their appetite for risk-reward and frees them from the day to day responsibility of managing the corporation. “Most shareholders prefer to be passive investors” (p. 3). Does this system work? On the whole, it has produced the most successful economies to date.
Although not cited by Bainbridge, his position is very close to that of Jonathan Macey’s work, Corporate Governance: Promises Kept; Promises Broken (2010). A further consequence is that Ed Freeman’s well known suggestions that the Board of Directors represent a wide-range of stakeholders places Freeman in the activist camp. Freeman becomes the academic ally of the activists. In fact, Freeman’s position is even more radical since it goes way beyond shareholders. I suspect, as well, that Friedman would have been very sympathetic to Bainbridge’s recasting of the debate.
“Activist” shareholders (previously identified above) disapprove of Bainbridge’s conception of the corporation. According to the activists: the shareholders own the corporation; and the shareholders elect the Board to monitor management. In this conception, the corporation is likened to a democratic political structure: shareholders are like citizens of a community or state, directors are like members of the legislature, management is likened to the executive branch, and the SEC is likened to the Supreme Court [reviewer’s analogy]. The analogy is not exact (yet) because is it one-share one vote, in general, not one-person one-vote. Whenever there is management malfeasance, such as Enron, the solution is to have the Directors remove management. To prevent future misconduct, the Board of Directors should be composed of individuals who are “independent” of management and should reflect the various shareholder interests. Those interests can be other than increased share prices and dividends.
Bainbridge’s contention is that the political model (“democratization”) is not applicable to corporations according to corporate law and it is not what the vast majority of shareholders want. This model is being foisted onto the corporate world by the SEC under pressure from activists. Moreover, it is dishonest or disguised in that the ultimate aim is not to increase share value but to achieve a variety of private political and social agendas. Part of the strategy of the activists, is to circumvent (competitive) state control of corporate governance (“erodes the system of competitive federalism” p. 15) and to concentrate control in the federal government. There is definitely a political agenda at work.
Bainbridge does not go further than identifying the problem. At this point I would like to suggest the background philosophical debate between director-centric and shareholder-centric partisans. The debate is between two different narratives. Since the seventeenth century, there have been two conflicting narratives about modernity. Narratives appeal to facts and arguments, but they also reflect fundamental commitments about how one chooses to engage the world. No public policy debate can be resolved simply by appeal to objective facts.
What are the two narratives? The originalist narrative is the Lockean Liberty narrative. Lockeans endorse the technological project (transformation of nature for human betterment); understand that the project is best executed in a free market economy wherein (à la Adam Smith) private property releases the imaginative ability of as many people as possible; assert that a free market economy requires limited government (providing the legal machinery to protect negative rights, enforce contracts, and dispute resolution), and wherein liberty is understood as restraining the government on behalf of individuals private interests; recognize that the rule of law must be focused on restraining government power by its emphasis on due process and with the recognition that economic planning is incompatible with the rule of law (Hayek). Finally, Lockeans favor a culture of personal autonomy within which individuals pursue happiness and are not overruled by a collectivist good. Equality for Lockeans means equality of opportunity and equality before the law; economic inequality is inevitable but unproblematic in a growth economy made possible by the technological project and the market economy and wherein “a rising tide raises all boats.”
The second and adversarial narrative is the Rousseau/Marx equality narrative. Rousseaueans reject the technological project (extreme environmentalists), but Marxists and socialists eventually accepted it. Both Rousseaueans and Marxists attribute all social problems to the market economy. The entire Lockean worldview is illegitimate because it institutionalized inequality by letting everyone keep his/her original possessions in the first social contract. Hence, we must start over with a new dispensation in which the original position (Rawls) is a radical egalitarianism. Rousseaueans cannot negotiate with Lockeans in good faith because they truly believe that the present context is illegitimate. As a consequence, the economy must be heavily regulated to promote equality of outcome even in a global context. The Fortune 500 (management in general and highly paid CEOs in particular) are likened to the rich and powerful who imposed the original agreement on the weak. The present (unequal) order is always illegitimate. Instead of limited government Rousseaueans advocate a collectivist, all-encompassing good—a general will to which individuals are subordinated. Everyone shall have positive rights, which means that you have liberty only when the government provides you with the resources, through the redistribution of wealth, to achieve your goal. The legal system does not restrain government, but is the faithful servant of the democratically determined general will. Finally, each and every citizen gives up individual identity in return for the achievement of happiness by serving the greater collective good instead of individually pursuing happiness. There will be equality of outcome. Although there will be inequalities of function or status, somehow this will not cause resentment.
“Democracy’ means something different in each narrative. For Lockeans, following Madison in Federalist No. 10, democracy is a negative or blocking device. There will always be a plurality of competing interests in a market economy; in order to prevent one economic interest from dominating, a majority of the other interests can restrict or block the hegemony of that interest. What the majority wants is not necessarily good; what the majority opposes is probably bad. As John Stuart Mill pointed out (following Tocqueville—both are obviously Lockeans) the term “democracy” in the eighteenth century context meant protection from government tyranny; in the nineteenth century, following Rousseau, “democracy” acquired a positive function—namely, a consensus on the common good understood as the collectivist general will. Lockeans worry about the tyranny of the majority and try to protect the rights of all individuals through constitutional guarantees; Rousseaueans have no need for such a constitution.
It should now be obvious that activists are Rousseaueans; that they advocate ‘democracy’ in its positive sense; that they see democracy as a way of redistributing wealth and power away from management and what they consider obscenely overpaid CEOs; that they welcome the centralization of power in the federal government and the SEC, and that they hope through their conception of the democratic process to gain political control over corporate America.
Bainbridge has written a remarkably clear and concise account of the major controversies in the corporate governance literature. This book will be of great value to legal scholars, economists, and business ethicists for a long time to come.