Why Shareholder Democracy is Essential
John Carney, the CNBC.com business journalist, doesn't like shareholder democracy. He argues that reforms, such as say on pay rules, which give shareholders a non-binding vote on executive compensation, won't improve corporate governance anymore than electoral reforms have improved our government.
But his views are based on antiquated notions about shareholders, and a distorted view of democracy and capitalism. Here is some of what he overlooks:
1. Shareholders can make informed decisions. Carney makes the paternalistic and management-centric "shareholders are stupid" argument, sometimes referred to by economists as "rational apathy." In a blog post for CNBC.com, he wrote:
At the corporate governance level, the problem is that things like say-on-pay introduce complicated elements into proxy elections. These complexities make it difficult for ordinary shareholders, typically equipped with only a passing interest and knowledge of the issues at hand, to form preferences, much less vote their preferences.Carney seems to envision the family in Leave It To Beaver sitting around the kitchen table scratching their heads over how to vote their two shares of AT&T. But due in part to the complexity of investments, the high stakes involved, and the shameless misconduct of unsupervised corporate managers, numerous companies have now entered the market to help manage those "complexities." Most individuals invest through intermediaries, full-time professionals who administer mutual funds and pension funds. The overwhelming majority of stock, up to 70 percent in some large companies, is held by institutional investors who can compute compound interest in their heads and get paid to make very complex asset allocation decisions all the time. They can handle the "complexities" of figuring out the link between pay and performance. The largest single category is the corporations themselves, through their ERISA funds.
Carney would benefit from speaking to institutional investors, or attending an event like the upcoming annual meeting of the Council of Institutional Investors. Or, he could read the newspapers to discover that shareholders have already demonstrated their ability to parse the complexities of executive pay plans with majority votes against the excessive pay plans at Occidental Petroleum (OXY), Beazer Homes USA (BZH) and Jacobs Engineering Group Inc. (JEC). Demonstrating how sophisticated and nuanced these votes are, when Monsanto made some improvements to its awful pay plan it got a positive response from shareholders -- the old plan would not have managed a 65 percent vote in favor. And I predict that they will need to make additional improvements to get even that level of support next year.
That's the kind of shareholder oversight that keeps markets efficient. But unless Carney is willing to review the complexities of those plans himself and demonstrate why reasonable shareholders could not vote against them, he will have a hard time persuading shareholders they are too dumb to know what's in their best interest.
2. Shareholder democracy is an essential element of capitalist risk management. Adam Smith and Karl Marx did not agree on much, but both wrote that what we now call agency costs were the irreducible problem of capitalism. The only way to make sure that executives do not misappropriate the money provided by investors for their own benefit is to set up a system of accountability to shareholders. That system, an indispensable element of a robust and sustainable economy, includes the ability of shareholders to vote on critical areas of potential conflicts of interest, including the election of directors and executive compensation. The weakening of this kind of accountability was one important cause of the financial meltdown because compensation that was all upside and no downside, based on the quantity of transactions and not the quality of transactions, externalized the costs and the risks.
Mr. Carney remains unconvinced, at least when it comes to the agency cost of inadequate shareholder oversight. The rest of the world has learned the hard way over the last few decades that the only way to make sure executives do not misappropriate or misuse the capital provided by investors is to safeguard the system of accountability to shareholders. That indispensable element of a robust and sustainable capitalist economy, must include the ability of shareholders to vote on critical areas of potential conflicts of interest, including the election of directors and executive compensation. The weakening of this kind of accountability was one important cause of the financial meltdown. When compensation was all upside and no downside, based on the quantity of transactions and not the quality of transactions, it externalized the costs and the risks and the result was catastrophic.
Carney begins by setting a test for the reforms -- will they make the system better or worse? But his answer ignores the role of agency costs in creating the recent catastrophe as well as the benefits of reducing those costs to prevent future ones. And he further skews his analysis with a misguided analogy to political elections. Among the many differences between public and private elections is the alignment of economic interests based on one share, one vote rather than one person one vote.
3. Directors cannot represent shareholders unless it is the shareholders who select them. Carney argues that giving shareholders more say somehow makes their views more poorly represented. Under current law, directors who get only a single vote may serve and more than 80 directors failed to get a majority of votes cast but continued to serve. How can this be characterized as "representative?" Carney alleges without any evidence whatsoever that activists like union pension funds will hijack elections from the rationally apathetic. In the first place, the few union pension funds that have been active have, like other activist shareholders, pursued priorities related to their obligation as fiduciaries of the pension funds to maximize shareholder returns, not only appropriate and required by law but also a critical element for capital markets. Second, even assuming that some rogue activist agenda was promoted by a small group of investors, whether a hedge fund manager or a union pension fund, they cannot succeed without the support of other institutions. The very conservative funds managed by financial services firms and corporate pension funds would stop them from getting very far.
Carney's test is the right one; he just skews the results by ignoring the considerable costs of a management-centric system that has resulted in the greatest wealth transfer and the most unstable economic events of the century. Would the reforms make things better? Bet on it.
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