Do stockholders own the company? To most board members, and probably most Americans, the idea is so axiomatic that the question hardly seems worth asking. Yet a long-simmering debate on the age-old argument over the board’s responsibilities to shareholders versus the arguably inherent rights of all company stakeholders recently burst out in the open, shedding new light on that central question.
The battle pits two leading corporate governance experts against each other: Lucian Bebchuk, a Harvard Law School professor and ardent shareholder-rights proponent, and Martin Lipton, a Wachtell, Lipton, Rosen & Katz founding partner who has been a stalwart defender of the viewpoint that it is management’s prerogative to do what is in the best interest of the corporation since he dreamed up the poison pill to help companies fend off corporate raiders more than two decades ago.
How their increasingly acrimonious duel plays out is likely to influence many of the corporate governance debates now going on in boardrooms, the Securities and Exchange Commission (SEC), and Congress. The central issue is whether directors of a public company owe their primary fiduciary duty to its shareholders, as Bebchuk insists, or have to consider the prerogatives of all the stakeholders, as Lipton maintains.
In 2005 lectures at Cardozo and Yale Law Schools called “The Myth of the Shareholder Franchise,” Bebchuk argued that the governance structure of most U.S. companies disenfranchises their true owners, the shareholders. His sharp critiques have put powerful intellectual firepower behind rising shareholder demands for more control over corporate boards, from the proxy access proposal on director elections currently under consideration at the SEC, to Say on Pay, which would give shareholders input into executive compensation. (Editors’ note: Say on Pay, sponsored by Rep. Barney Frank (D-Mass.) passed in the House by a 2 to 1 margin in April. Barack Obama sponsored similar legislation in the Senate, but the Senate Committee on Banking, Housing, and Urban Affairs has yet to take action on the proposal.)
“The fear of replacement is supposed to make directors accountable and provide them with incentives to serve shareholder interests.” –Lucian Bebchuk, Harvard Law
Lipton did not sit idly by. He rebutted Bebchuk’s world view with a pointed essay in the May issue of the Virginia Law Review called “The Many Myths of Lucian Bebchuk.” The article, co-authored by Wachtell colleague William Savitt, strikes at the heart of the widely accepted argument that a company’s primary goal is to maximize shareholder value. In addition to calling out Bebchuk in the title, Lipton challenges the very notion that corporations are the private property of stockholders, and does so in language so forceful that it might sound like heresy coming from almost anyone else in Corporate America. “Shareholders do not ‘own’ corporations,” he says. “They own securities—shares of stock—which entitle them to very limited electoral rights and the right to share in the financial returns produced by the corporation’s business operations.”
Directors, Lipton and Savitt argue, are not merely representatives of stockholders who have a legal responsibility to put investor interests first. Instead, they assert, the role of a director is simply and dutifully to seek what’s best for the company itself, which means balancing the interests of shareholders as well as other stakeholders such as management and employees, creditors, regulators, suppliers, and consumers. They conclude that Bebchuk’s postulate that the shareholder enjoys the position as the board’s primary client is a myth of corporate law, and should be understood as such.
Careful What You Wish For
Lipton vs. Bebchuk is one of those topsy-turvy clashes that has caused corporate governance experts to line up on either side of the debate, and has led to the presence of some strange bedfellows. Lipton first began articulating his director-centric position in a 1979 article published in The Business Lawyer called “Takeover Bids in the Target’s Boardroom,” years before the stakeholder view gained prominence in the late 1990s. But he has since gained backing from several of the most articulate stakeholder theorists, including University of California at Los Angeles corporate law professor Lynn Stout. Two years ago, she penned a piece called “Takeovers in the Ivory Tower: How Academics are Learning Martin Lipton May be Right.”
The problem for Lipton is that while Stout and others such as Vanderbilt University law professor Margaret Blair have fleshed out his views with impressive scholarship, their work may lead to conclusions that run counter to his pro-company perspective. For example, if the directors’ duty is to balance the interests of all corporate stakeholders, should they be given explicit guidance on how to go about doing that? And should they be held liable if they fail to do so in some egregious manner? What happens when a company, even unintentionally, rips off creditors, employees, or the community in a way that enriches its shareholders?
Similarly, Bebchuk’s many admirers may rue where they wind up. Governance reformers in the United States have been led by public and labor pension funds that have invoked shareholder rights to demand more accountability from directors, allowing them to score victories such as Sarbanes-Oxley and majority voting agreements at hundreds of companies. But many have waved the shareholder banner largely out of expediency: After all, the argument for more board accountability to stockholders fits snugly into the reigning ethos that a company’s purpose is to maximize value for its owners.
Yet their true beliefs, certainly prevalent among most union leaders, who ultimately hire and fire the union pension fund managers, lie much closer to the stakeholder view, which was widespread among business antagonists such as the anti-globalism forces of the 1990s. Warns Blair: “The labor and public funds are making a tactical mistake using the shareholder-ownership argument. It’s easy to sell, but they’re not going to like the outcome, which will put more power in the hands of private-equity firms and others who have a short-term interest in a company.”
“Shareholders do not ‘own’ corporations. They own securities – shares of stock – which entitle them to very limited electoral rights and the right to share in financial returns.” –Martin Lipton, Wachtell Lipton
While Lipton’s stakeholder view has been gaining some support in the academic and corporate world, it’s unclear whether it will upend the conventional wisdom that a company is the property of stockowners. Indeed, Bebchuk starts his attack by citing a widely quoted 1988 ruling by the Delaware courts that “the shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests.” He points out that corporate law gives boards the authority to hire and fire management and set the company’s overall direction. But there is a parallel relationship, says Bebchuk, in that directors “are expected to serve as the shareholders’ guardians,” so stockholders in turn must have the power to replace them. “The fear of replacement is supposed to make directors accountable and provide them with incentives to serve shareholder interests,” he says.
Bebchuk’s “Myth of the Shareholder Franchise” article goes on to demonstrate just how infrequently U.S. directors are actually challenged, much less unseated. His conclusion: The franchise that shareholders putatively hold under corporate law is in practice, a myth. The remedy he proposes is more expansive than the proxy- access proposal now before the SEC. To turn shareowner power into a reality, he recommends directors be elected by a secret ballot open to rival candidates nominated by shareholders. To put them on an equal footing with the management slate, challengers should be reimbursed from corporate coffers if they receive a threshold number of votes, perhaps a third of those cast.
While Bebchuk hasn’t fully addressed the stakeholder theory directly, he discusses how his proposals would benefit shareholders in his “Myth” article, which appeared in the May Virginia Law Review issue featuring Lipton’s attack as well as articles by Stout; former Chief Justice of the Delaware Supreme Court, E. Norman Veasey, who is now a senior partner at Weil, Gotshal & Manges; and others. While Bebchuk’s focus on shareholders is certainly the mainstream perspective, Lipton and company advance an alternative view.
A “Team Production”
The stakeholder proponents advance their position by rebutting the notion that shareholders have “ownership” of a public company. They point out that a stock purchase conveys none of the traditional rights that come with conventional property ownership. To support this, they cite the following: Shareowners can’t take possession of the company’s assets, nor can they exclude anyone from company property. They do not even fully control the company’s ultimate fate, since directors have the right to decide whether or not to put a possible sale up for a shareholder vote. In this corporate world view, assets are owned not by investors, but by the corporation itself, a legal entity that stands apart from its many, often shifting stockholders. Further, in the event of a default, it is the creditors who own and decide a corporation’s fate, whereas shareholders are left owning valueless shares.
Lipton even contradicts the long-established idea that directors act as agents on behalf of shareholder “principals.” Rather, he says, Delaware corporate law requires directors to oversee the company “in accordance with their independent business judgment,” he writes.
Stout, Blair, and other stakeholder theorists have backed up his analysis with an elaborate critique of the conventional view of corporations. The standard theory of the firm that underlies Bebchuk’s position views companies as enterprises owned by investors who put up the cash, and use contracts of various sorts to engage everyone needed to make them a success, from executives and employees to creditors and suppliers. Contract law, in this view, is back-stopped by government regulation, and protects the interests of everyone except the investors. In exchange for shouldering all the risk, investors get the “residual” value, i.e., whatever’s left over after all other parties get their contractual dues. The board is appointed to look after the interests of the firm on behalf of these “residual claimants,” its owner-shareholders.
The stakeholder critics say this model doesn’t capture what really happens in a public corporation. In their view, a company is actually a “team production.” They mean not a workplace team but one comprised of everyone—and every social institution—that makes it possible for a company to function: not just investors, executives, employees, suppliers, and creditors, but also customers, communities, taxpayers, lawmakers, and the society whose rules and norms govern economic activity.
All of these participants, Lipton would argue, are residual claimants to varying degrees, because all have invested something in the company that can’t be fully protected by law or contract. For example, Microsoft customers invest what economists sometimes call “sunk costs,” which extend beyond the purchase price, when they spend time and effort to learn Excel and other programs that they then depend upon for personal or business tasks. Sure, they can sue if the company favors shareholder interests over theirs, or they can choose to simply stop being a customer. But Microsoft’s goal is to balance all claimants’ interests so the company will succeed. And it’s the board’s job to make sure that the company does. “Directors need to maximize the total economic benefit that a company provides for society as a whole, not just for shareholders but for everyone else with a sunk cost in it, including employees, executives, customers, and creditors,” says Stout.
Lipton deploys the stakeholder philosophy to denigrate proxy-access proposals by Bebchuk and others. Giving shareholders too much direct control over the board, he argues, opens the door for some or all investors to exploit the company’s assets for themselves, to the detriment of other participants. If that happens, the company’s other residual claimants may refuse to participate, damaging the enterprise. The board’s role is to be the neutral, independent mediator of all those with a stake in the company’s activities, he argues, to make sure all parties are treated in a fashion that will ensure their continued participation in the company’s success. As Lipton put it in his law review attack on Bebchuk, “Case after leading case confirms that directors—not shareholders—are vested with the right and independent obligation to direct the management of corporate affairs.”
Common Ground?
Bebchuk offers a few pragmatic objections that shed light on the further elaboration needed to apply the stakeholder theory in the boardroom. For example, he points out that corporate law in Delaware and most other states allows directors to take stakeholder interests into account, but generally doesn’t require them to do so. So Lipton and others who resist proxy-access proposals are really relying on nothing more than mere wishful thinking that directors will balance stakeholder interests if they’re insulated from direct exposure to stockholder voting. Protecting boards from ouster by unhappy shareowners, says Bebchuk, leaves them accountable not to all stakeholders, but to no one. “Stakeholder theory is interesting, but the bottom line is that it uses stakeholders to justify insulating boards from shareholders,” he says.
Lipton’s response is that a board has a direct duty not to stakeholders per se, but to the corporation. “The board can and should take into account the interests of stakeholders to promote the interests of the corporation, but it doesn’t have a fiduciary duty to customers, suppliers, or employees,” he says.
Still, it may not be enough to say that directors can balance stakeholder interests and therefore should be left free to do so. For more than two decades now, Bebchuk and other critics have been demanding more shareholder input to counterbalance what they perceive as boards that have been captive to management. Lipton and his followers just as ardently believe that there is an equal and opposite danger in boards becoming beholden to a share-holder view that may be colored by short-term thinking or hidden agendas. If shareholders and stakeholders could begin the task of spelling out formal guidelines that ensure that boards put the interests of the corporation before all else, including those of the CEO, and in such a manner that both shareholder and appropriate stakeholder rights are considered, then the two camps might find they have more in common than they’re now willing to concede.
From “The Myth of the Shareholder Franchise”
By Lucian Bebchuk, Virginia Law Review, May 2007
A WELL-KNOWN…Delaware opinion states that “[t]he shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests.” Similarly viewing the shareholder franchise as a key mechanism for making boards accountable, another landmark Delaware opinion states: “If the stockholders are displeased with the action of their elected representatives, the powers of corporate democracy are at their disposal to turn the board out.” I…argue …however, that shareholders do not in fact have at their disposal those “powers of corporate democracy.” As a result, the shareholder franchise does not provide the solid foundation for the legitimacy of directorial power that it is supposed to supply.
The shareholder franchise is largely a myth. Shareholders commonly do not have a viable power to replace the directors of public companies. Electoral challenges are rare, and the risk of replacement via a proxy contest is extremely low. To restore accountability and place our corporate governance system on solid foundations, the shareholder franchise should be transformed from a myth into a reality. The reforms put forward … would provide shareholders with a viable power to replace directors. They would thereby improve the accountability and performance of corporate boards. Such reforms, which would benefit investors and the economy, are long overdue.
From “The Many Myths of Lucian Bebchuk”
By Martin Lipton, Virginia Law Review, May 2007
IGNORING DECADES of salutary historical development and the overwhelming lessons of observed boardroom behavior, Bebchuk advocates the abandonment of the traditional process for selecting and retaining directors of U.S. public corporations. In its stead, Bebchuk offers a novel electoral system of his own recent invention—a regime specifically designed to encourage costly proxy contests and frankly founded on the premise that corporate directors will not do their jobs absent the constant fear of imminent replacement.
Bebchuk’s prescription is policy revolution masquerading as reform. Indeed, it is increasingly clear…that Bebchuk has become a deconstructionist who seeks to overthrow the fundamental framework of existing corporate law. The Bebchuk approach would discard the management concepts of U.S. corporate law that have nurtured the most successful economy in the world. It would transfer the basic responsibility of corporate management from directors to shareholders. And it would thus leave management and directors subservient to the whims of shareholders (or, perhaps more accurately, to the demands of the most vocal of them), no matter how self-serving they may be, no matter how parochial their interest, no matter how inconsistent with long-term corporate performance, and no matter how destructive to the economy as a whole.