The Future of Shareholder Democracy in the Shadow of the Financial Crisis

• Publication year: 2012
• Citation: Vol. 36 No. 02

Washington Law ReviewVolume 36, No. 2, WINTER 2013

The Future of Shareholder Democracy in the Shadow of the Financial Crisis

Alan Dignam(fn*)

"The rule is, jam to-morrow and jam yesterday - but never jam today."

"It must come sometimes to 'jam to-day'," Alice objected.

"No, it can't," said the Queen.

"It's jam every other day: to-day isn't any other day, you know."

"I don't understand you," said Alice. "It's dreadfully confusing!"(fn1)

TABLE OF CONTENTS

I. INTRODUCTION...............................................................................640

II. THE SHADOW.................................................................................641

A. The Financial Crisis............................................................641

B. Bank Corporate Governance...............................................645

C. The Reform Process............................................................655

III. VULNERABLE BOARDS...................................................................659

A.Directors' Discretion..........................................................660

B.Directors' Duties.................................................................662

C.The Shareholder Coup........................................................668

D.The Larger Context: Cultural and Theoretical Change.....672

IV. OWNERLESS CORPORATIONS OR SHAREHOLDERS ON STEROIDS?. 682

V. CONCLUSION..................................................................................688

I. INTRODUCTION

This Article argues that the U.K. regulatory response to the financial crisis, in the form of "stewardship" and shareholder engagement, is an error built on a misunderstanding of the key active role shareholders played in the enormous corporate governance failure represented by the banking crisis. Shareholders' passivity,(fn2) rather than activity, has characterized the reform perception of the shareholder role in corporate governance. This characterization led to the conclusion that if only they were more active(fn3) they would be more responsible "stewards" of the corporation. If, as this Article argues, shareholder activity was part of the problem in the banks, then encouraging increased shareholder action and exporting it outside of banks, as we have subsequently done in the United Kingdom, risks a wider systemic corporate governance failure. In short, we have learned the wrong lesson about shareholders from the banking crisis.

In setting out this proposition, this Article proceeds in five parts, which includes this introduction, Part I. Then, Part II, "The Shadow," examines the corporate governance issues that were present in the U.K. banks that preceded and contributed to the financial crisis. Part III, "Vulnerable Boards," examines the historic vulnerability of U.K. boards of directors to shareholder power given the legal, cultural, theoretical, and practical constraints on their discretion to run the company. In particular, this Part argues that the Takeover Panel, in eliminating board discretion, has had a strong dampening effect on the development of board discretion in the United Kingdom.

In Part IV, "ownerless corporations or Shareholders on Steroids," this Article considers the proposition that rather than the regulatory assumption that the United Kingdom has a passive ownerless-corporation problem, the United Kingdom has, as illustrated by the banking collapse and the more recent shareholder "spring," a growing problem of shareholders on steroids. combinations of newer, passive overseas shareholders and vulnerable boards have allowed activist shareholders and traders to focus on the short term. Regulatory responses such as stewardship and shareholder empowerment are inappropriate because they risk accelerating this short-term trend.

Part V concludes by offering technical solutions in removing key problematic agency-cost-reduction measures such as the takeover panel, and allowing a judicial balance to re-emerge in the development of directors' discretion to manage the company. These solutions will not, however, fix the systemic flaw in a corporate governance system designed around current shareholders with a diminished role for the board of directors, the employees, and the community. A rebalancing is needed, whereby both the board and the state are reinvigorated in terms of their influence on a rematerialized corporation.

II. THE SHADOW

The financial crisis has cast a particular shadow over the recent general corporate governance reform in the united Kingdom, resulting in an emphasis on encouraging the long-term engagement of shareholders through the nebulous concept of stewardship. Encouraging stewardship is problematic in the U.K. context because of the deep imbalance in the power structure of U.K. companies, which has focused on current shareholders to the detriment of board independence. This imbalance makes corporations particularly vulnerable to shareholder activism, which may be focused on short-term gains to the detriment of the longer-term interests of the company. The corporate governance problems in U.K. banks, which led to the financial crisis, as well as the regulatory-reform response provide an illustration of how short-term shareholder activism can be problematic and how the regulatory response, in terms of stewardship and shareholder empowerment, is misplaced. This Article considers these issues in turn.

A. The Financial Crisis

Banks have certain unique features as organizations. First, banks operate with an explicit and implicit state guarantee, which heavily subsidizes their activities.(fn4) Without this subsidy, most U.K. banks would be unable to trade on the scale they do.(fn5) Second, this government guarantee was explicitly exercised in the case of three major and two minor U.K. banks in 2008.(fn6) consequently, these banks now effectively operate as state-owned enterprises. Third, because of their history and funding, banks have significantly different internal corporate governance issues, as compared to other large listed companies.(fn7) Their unique status also provides an example of the extremes within the U.K. private-shareholder-agent model and allows some insight into why shareholder-focused solutions may be part of the corporate governance problem rather than the solution.

Between the 1970s and the global financial crisis in 2008, a combination of technological advances and the removal of capital controls on an almost global scale concentrated the world's financial capital in just 145 banks.(fn8) Almost all of these banks were universal banks, with business across the full range of the financial sector, holding total firm assets of over £100 billion each.(fn9) To put this capital concentration in perspective, there are some twenty-four nation-states that do not have individual GDPs in excess of £100 billion.(fn10) By 2008, the world's five largest banks held 16% of global-banking assets.(fn11) The U.K. banking sector in particular had grown enormously, from 50% of the country's GDP in the 1970s to 500% by 2010.(fn12)

The growth of these banks and the public subsidy of their activities were intricately linked. Mervyn King, the governor of the Bank of England, described it in 2010:Institutions supplying such services are quite simply too important to fail. Everyone knows it. So, highly risky banking institutions enjoy implicit public sector support. In turn, public support incentivis-es banks to take on yet more risk, knowing that, if things go well, they will reap the rewards while the public sector will foot the bill if things go wrong. Greater risk begets greater size, most probably greater importance to the functioning of the economy, higher implicit public subsidies, and hence yet larger incentives to take risk -described by Martin Wolf as the "financial doomsday machine."(fn13) The significance of each of these banks was not just that they were "too big to fail" (TBTF), but also that a government bailout of a TBTF bank would still have a destabilizing systemic effect on the global financial system. In other words, the sizes of the banks meant that a government could not safely handle the collapse of one TBTF bank or, in a worst case scenario, manage the failure of multiple TBTF banks, even with a coordinated international effort.(fn14)

By 2007, this "doomsday machine" nearly achieved the goal of its internal systemic logic. Artificially low interest rates first fuelled a boom. Then, the collapse of the U.S. housing prices by the same year led to the crisis in weak U.S. mortgage-backed securities (subprime), which had been widely sold to and insured throughout the world's major financial institutions.(fn15) Major financial institutions began to struggle as high-debt and low-equity ratios left them seriously exposed to subprime losses.(fn16) By August 2007, central banks around the world were pumping liquidity into the financial system as interbank lending began to dry up amid fears of a TBTF collapse.(fn17) In September 2007, the U.K. bank Northern Rock had to be supported by the Bank of England, which led to a run on Northern Rock-the first on a U.K. bank in 150 years.(fn18) In 2008, as banks and their insurers began to announce major subprime-related losses, the Bank of England widened its financial support for banks and lowered interest rates.(fn19) As the crisis intensified, the government nationalized...