Reflections on a visit to Leo Strine's Peaceable Kingdom.

• Author: Olson, John F.
• Position: Response to article by Leo E. Strine Jr. in this issue, p. 1

Management and activist shareholders have engaged in a tug-of-war for leverage over corporate decisions for the last decade or more. Most recently, each contestant seeks to strengthen its position by advocating for changes in the way directors are chosen. With the Securities Exchange Commission (SEC) currently vetting two competing proposals concerning shareholder board nominations and elections, and an active debate on how much "say" shareholders should have on CEO pay, Vice Chancellor Strine's contribution to the debate is timely.

Vice Chancellor Strine is one of the most insightful judges writing today. For example, he pithily describes short-term investors, such as activist hedge funds, as "transients on short-term visas" in contrast to "long-term citizen" investors. (1) He argues that, based on their relative commitments to the corporate enterprise, the current governance structure inappropriately allocates control, giving short-termers undeserved influence.

In the key theme of his Article, recognizing that labor union pension funds and their public pension fund allies have played a major role in struggles for greater "investor" influence over corporate governance, Vice Chancellor Strine identifies the unheralded commonalities between labor and management in this arena. Vice Chancellor Strine argues that an alliance between management and labor will serve both parties by focusing on long-term financial success to the benefit of employees and retirees, as well as shareholders. In today's environment of defined-contribution rather than defined-benefit plans, many employees and retirees depend on company stock based retirement investments and company funded post retirement benefits.

Vice Chancellor Strine is right. Management and labor do have mutual interests that short-term investors may threaten with their emphasis on nimble profits and the pressure for immediate value realization through sales of parts of the enterprise, super dividends, and other immediate gratification strategies.

In effect, Vice Chancellor Strine invites American corporate management and those who represent workers to enter into a new world of enlightened cooperation driven by mutual recognition that governance instability, and bending to short-term pressures, is in the interest of neither. He paints a lyrical picture of the benefits of such cooperation that is reminiscent of the Utopian vision and optimism about human nature that animated so much of early nineteenth century American thought and art. Edward Hicks, the Pennsylvania Quaker lay minister and artist, exemplified this optimism by painting no less than 62 versions of "The Peaceable Kingdom," based on the verse in chapter 11 of the Book of Isaiah, which reads, "The wolf also shall dwell with the lamb, and the leopard shall lie down with the kid; and the calf and the young lion and the fatling together; and a little child shall lead them." (2)

Without deciding who is a potential predator and who is potential prey in the corporate governance arena, one wonders if Vice Chancellor Strine's idealistic vision of a world where management and employee/pensioner investors agree to pursue common long-range strategies is, in fact, attainable.

Even with the support of labor interests, some of the corporate governance changes Vice Chancellor Strine advocates may prove impossible to implement, as the managers of activist investor funds will be unwilling to lose the forum they have for pursuing short-term strategies (and demonstrating to their clients how they are earning their management fees), and even mutual fund managers believe they must demonstrate good short-term performance. While Vice Chancellor Strine's recommendations may be in the best interests of corporate enterprises, the very focus they seek to resist may prevent their implementation.

There is, however, some reason for cautious optimism that Vice Chancellor Strine's Peaceable Kingdom dream may be realized, at least in part. Business and labor pension funds have recently taken some baby steps in recognizing their mutual interests. Labor and management have joined together in principle to support improved healthcare and retirement planning policies. Companies are expressing concern about a myopic short-term emphasis on quarterly earnings estimates and adjusting accordingly; business and public interest organizations are beginning to speak out against undue short-term shareholder influence.

1. THE STRUGGLE FOR CORPORATE CONTROL IN RECENT YEARS

   Martin Lipton was one of the first to flag the problems inherent in shareholder ownership in his seminal 1979 article "Takeover Bids in the Target's Boardroom." (3) He argued then, and continues to assert today, that, despite their equity ownership of the company, shareholders are often not in the best position to make corporate decisions. (4) With regard to mergers, Lipton points out that shareholders often accept proposals neither in the company's nor their own best interests because refusing to sell can place them in an illiquid minority position. (5) Thus, the "managerial discipline model," where corporate governance concentrates on conforming management decisions to shareholder wishes, creates neither the most efficient corporation nor a corporation focused on the long-term success of its employees. (6) Lipton and other writers have argued for a shift away from this model toward one that gives corporate boards more authority to look out for the long-term interests of the company.

   Lipton and several academics, such as Henry Hu and Bernard Black, (7) have also raised appropriate concerns about who, in fact, exercises the shareholder franchise. Nonetheless, the SEC recently chose to consider a proposal that would allow shareholders who are beneficial owners of five percent of a company for one year or more to change the bylaws governing the election of directors. (8) Shareholders could use this opportunity to amend the bylaws and thereafter nominate candidates for the board through the company funded proxy process. The SEC concurrently also approved for consideration an opposing rule that would clarify that shareholders may not use the corporate proxy to change the nomination election process--arguably leaving shareholder influence over board elections as it has traditionally been understood. (9) The Second Circuit Court forced the SEC to consider the issue in its 2006 decision allowing the American Federation of State, County, & Municipal Employees (AFSCME) to propose an amendment to the American Insurance Group, Inc. (AIG) corporate bylaws that would allow the shareholder nomination of directors in certain circumstances. (10) Thus, in these mutually inconsistent, competing proposals, the SEC has provided a time out for at least a few months in the contest between activist investors and corporate management as to the director selection process.

   In a 1991 article, Lipton also identifies the problems inherent in institutional investing. He argues that the competition among professional investment management groups creates an emphasis on short-term gains that can threaten the long-term health of the company. (11) The fact that these institutional investors hold such a large stake in the company can lead a board of directors, fearing that upsetting the investors may lead to troublesome withhold campaigns or other activist efforts, to accept the same short-sighted business model. To similar effect, a 2004 study found that 78% of corporate chief financial officers surveyed would sacrifice a profitable...