How to avoid implementing today's wrong policies to solve yesterday's corporate governance problems.

AuthorMayer, Colin
PositionResponse to articles in this issue, p. 1773 and 1907

In response to Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. PA. L. REV. 1773 (2013), and Edward B. Rock, Adapting to the New Shareholder-Centric Reality, 161 U. PA. L. REV. 1907 (2013).

INTRODUCTION I. THE PRINCIPAL-AGENT DEBATE II. THE SHAREHOLDER-SHAREHOLDER CONFLICT III. THE CREDITOR-SHAREHOLDER CONFLICT IV. THE STAKEHOLDER-SHAREHOLDER CONFLICT V. SEEKING LEGAL REDRESS FOR WEALTH TRANSFERS VI. REMEDYING CONTRACTUAL FAILURES VII. REESTABLISHING CORPORATE COMMITMENT CONCLUSION INTRODUCTION

According to Edward Rock, the issue that has concerned scholars and practitioners of corporate governance and corporate law for decades, namely, the principal-agent problem between shareholders and managers, has been solved. (1) It is yesterday's problem and has already been addressed through a combination of increased shareholder activism and intensified executive remuneration. We should recognize this and move on to confront today's problem. Rock asserts that today's problem is the reemergence of an issue that used to be center stage in corporate law, namely, the conflict between shareholders and creditors. It is this conflict, rather than the shareholder-manager debate, that should be the focus of our attention going forward. (2)

Barry Adler and Marcel Kahan take Rock's thesis as a starting point for proposals to address the shareholder-creditor conflict. (3) They argue that the problem is creditors' inability to recover losses sustained as a consequence of firm misconduct in, for example, incurring excessive risks or additional debt liabilities that undermine the claims of earlier creditors. (4) They believe that liability for such actions should rest with shareholders and subsequent creditors, rather than management, since these were the parties that encouraged and incentivized management to undertake them. They therefore argue that creditors should have the right to seek recovery from shareholders and later generations of creditors in compensation for their losses. In effect, they are proposing that creditors should be able to pierce the corporate veil and impose liability through direct claims against shareholders and subsequent creditors. (5) This will, according to Adler and Kahan, discourage shareholders and creditors from promoting these damaging actions in the first place. (6)

These thought-provoking and important Articles raise several fundamental questions about the nature of the corporation and the design of corporate governance and corporate law. The first question is whether Rock's assertion that the traditional principal-agent problem has been solved and can be laid aside is correct. The second question, if he is right, is whether the creditor-shareholder conflict is the next issue that should be addressed. Finally, are Adler and Kahan then correct in suggesting that the problem's resolution lies with shareholders and new creditors instead of with management, and should the problem then be addressed by allowing the affected parties to recover from shareholders and later creditors?

This Response argues that Rock is fundamentally right in recognizing that we are using today's policy tools to address yesterday's corporate governance problems and that the traditional principal-agent issue is no longer the primary concern. Furthermore, an excessive preoccupation with this one issue has aggravated and caused, rather than rectified or extinguished, existing deficiencies of the corporation. Rock is therefore making an important contribution to the corporate governance debate by alerting us to this deficiency in the corporate governance literature.

Adler and Kahan are also right to seek a resolution of the distortions through realigning incentives. Their suggestion of allowing creditors, under certain circumstances, to recover damages sustained from shareholders and other creditors is interesting and could play an important role in enabling corporations to expand the set of contractual relations that they can establish with their creditors and shareholders.

This Response suggests that Rock should go further in recognizing the consequential nature of the problem that he identifies. It is but the tip of the iceberg, and in focusing on the tip Rock could cause us to crash into the mass that lies hidden below the surface. The problems created by an excessive preoccupation with principal-agent matters are an illustration of this, but so too are Adler and Kahan's proposals, which in turn risk creating new distortions.

To properly address the problem that both Articles have correctly identified, we need an approach that recognizes the corporation's full complexity and its potential to resolve its own failings without resorting to further private litigation or public regulation. To understand the strengths and weaknesses in Rock's and Adler and Kahan's proposals, we first need to put their important contributions in the context of the existing debate.

  1. THE PRINCIPAL-AGENT DEBATE

    Since Berle and Means, (7) increasing attention has been devoted to the consequences of the separation of ownership and control in dispersed shareholder corporations caused by the divergence of the shareholders' and managers' interests. (8) Corporate governance in this traditional context has most recently been associated with the failures of institutions during the financial crisis. (9) Egregious managerial conduct resulted in excessive risk-taking that undermined the solvency of financial institutions to the detriment of shareholders as well as creditors and governments. The solutions required to address this included better stewardship by shareholders; more accountability of management to the owners; a closer alignment of executive remuneration with corporate performance; and stronger oversight by auditors, risk management committees, and risk officers. The common theory was that by bringing managerial interests closer in line with those of shareholders, the management's reckless conduct could have been avoided.

    In fact, in all likelihood the corporate governance failure was a result of exactly the opposite--an excessively close alignment of managerial interests with those of shareholders led management not to act in an uncontrolled fashion, but to respond recklessly to the incentives provided by shareholders. In holding "put options" on a firm, shareholders are the beneficiaries of excessive risk-taking because they derive benefits from the upside gains from risk-taking but impose the costs of failure on creditors. In highly leveraged institutions such as banks, shareholders benefit from the increased risk-taking, which augments the value of their call options on the firm. Banks that engage in high-risk investments benefit their shareholders by transferring wealth from their creditors to their shareholders. (10)

    This is a specific example of the general conflict between shareholders and creditors that Rock describes, namely, the misalignment of interests between the two parties. Creditors with fixed claims on firms wish them to maintain conservative, low-risk investment policies; as residual claimants, shareholders prefer high-risk investments, particularly when equity markets allow them to diversify their firm-specific risks across a large number of shareholdings. This conflict becomes more acute as leverage and the value of shareholders' put options increase.

    In this context, as corporate governance--in its traditional manifestation of aligning shareholder and managerial interests--is strengthened, the problem becomes more--not less--acute. The stronger the alignment of managerial remuneration with shareholder earnings, the greater the incentive on management to make...

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