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Decreasing Marginal Returns to Corporate Democracy?

Jason Wong

Robert Barro, in his book Determinants of Economic Growth: A Cross-Country Empirical Study, observed that the relationship between the economic growth of countries and their level of democracy was non-linear. Barro theorized that at a low initial level of political openness, democracy served to boost economic progress. However, beyond a certain point, overly high levels of democracy may create chaos and instability in the decision-making process, resulting in sharp cutbacks in growth. In this essay, I apply this model of decreasing marginal returns to democracy to corporations. In the SECs push for increased shareholder control over the board of corporations in America, I argue that we need to be careful in finding the right balance point in order to maximize the efficiency of US companies. In the current process of board appointment, companies create nominating committees that pick nominees for board positions. They then distribute packets of information along with ballots to all shareholders to allow them to vote for the candidates. Shareholders may nominate their own candidates. However, their nominees would not be on the standard corporate ballot, and they would have to go through the expensive process of campaigning and distributing another set of ballots to other shareholders out of their own pockets. The ideal scenario is one where shareholders exercise voting rights in order to keep corporate management accountable through electing a strong, independent board. The problem is that the nominating committee usually consists of board members and the CEO, and they often select compliant board members. Furthermore, companies often present only as many

nominees as board positions, providing shareholders with no real voting options. These factors present large barriers for shareholders to elect board members that may provide a dissenting voice to an underperforming or wayward management team. The overall effect is that actual control over the board of directors is very tightly held by the senior management of the company, rather than individual shareholders, with little recourse for shareholders to challenge this allocation of control besides selling their stock. Given the corporate scandals that have happened in the past few years, I think that it is clear that the model is not working for many companies. In many ways, this is through the principalagent problem, when company executives are not the owners of the company, and act in their own interests rather than of the shareholders. The monopoly of senior management on power in the corporation exacerbates the problem, providing few checks and balances to what they can do, and creates large inefficiencies. As recent cases show, when executives are not held properly accountable, they engage in actions such as paying themselves large pay checks even when the companies are performing poorly, and making decisions that boost short-term stock price but not increasing long-term value. In such situations, reallocating control over the board to shareholders would provide large marginal returns by providing transparency and accountability. After reading several commentators, I think that most critics of the proxy access rule dont deny that there is currently a problem. What they seem afraid of is going too far to the point of paralysis. At such a point, marginal returns to democracy would be negative. I illustrate what I mean by diminishing marginal returns to corporate democracy in the Appendix.

The SEC sought to redistribute power over the board to shareholders through the proxy access rule, the latest incarnation of which allowed shareholders that held at least 3% of a companys stock for three years to have proxy access. While the SECs intentions are in the right place, these new rules go too far and open themselves to abuse. For example, institutional investors like hedge funds and unions may use their voting rights to engage in manipulative practices in order to benefit their constituents, while compromising long-term shareholder value. One example is California pension fund Calpers pressurizing Safeway Inc. to give in to union interests, likely at the cost of long-term share price. Some commentators have come up with good proposals for a system that allows for greater accountability, yet keep shareholder power at an appropriate level. Gale (2002) proposes a mandate that more candidates than vacancies must be chosen, say 1.5 times, in order to provide shareholders a real choice. Also, he suggests that the selection process is removed from the purview of corporate management. Pozen (2010) recommends reducing the control of management over boards by choosing independent directors that have industry experience, and increasing their scope of responsibility within the company. It seems as though we are on the upward sloping part of the curve, and work needs to be done to increase corporate governance and effectiveness to an optimal point in terms of allocation of control over the board of directors. But where is this optimal point? I dont think we have found it yet, given all the hand-wringing and dramatic turns in policy. But I do believe that in order to find it, we have to do the necessary groundwork in order to establish where net benefits are maximized with the appropriate amount and type of regulation.

Appendix Efficiency against corporate democracy


(2) (1)




Level of corporate democracy

Marginal Benefits/Costs of increasing corporate democracy through shareholder access to the board of directors.

Ranking of marginal benefits or costs is purely based on my own judgment, but this is helpful in illustrating what I intend to talk about. 1. Provides checks-and-balances on management, to prevent them from abusing their power. This reduces conflicts of interest e.g. large executive pay checks, foul play in terms of accounting fraud. 2. Puts pressure on the CEO and rest of management to perform better since they will be held to greater accountability by shareholders. 3. Management will become distracted from running day-to-day operations well, and instead spend time trying to defend their decisions and protect themselves. 4. Special interests will hijack the board with their own agendas e.g. unions or hedge funds will use proxy access to obtain concessions that have nothing to do with long-term shareholder value.