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The US Corporate Governance Framework

Literature on Corporate Governance (Corpgov) often comes from the US; many Corpgov institutions have been born in the US; the big controversies regarding board effectiveness, executive pay, and any other Corpgov matter are often raised in the US…..but what is the Corpgov framework in the US? I have ofter read about the US Corpgov without having a systemic knowledge about the framework that defines it. I will try to learn and offer a view of that in the present post. (1)

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The era after SOX (Sarbanes Oxley Act in 2002) unveils differences between the USA Corpgov system, (regulatory or hard law and “one size fits all” regime) and the UK one, (based on soft law or codes, and the “Comply or Explain” principle). Differences also affect gatekeepers, (subject to regulation by Agencies such as the SEC) and the market for corporate control.

 

  1. Peter V. Letsou describes the shared regulatory responsibility in the USA by the States and the Federal Government.

The role of the States.

In the XIXth century the states adopted Incorporation laws, which gave rise to the use of corporations; as a result the States took the responsibility of defining their internal affairs. The state corporate regulation can be described by the four following topics:

  1. Choice of State of incorporation: the choice is free but the rule of the state of incorporation decides on the ruling of internal affairs of the corporation, regardless of where the business or assets are located. Many firms have thus chosen Delaware for several reasons: a) rules are manager friendly; b) Delaware offers litigation efficiency; c) Regulation is stable as Corporate Law change requires super-majorities in the two legislative houses and because the State is dependent on the fees the business provides.
  2. Allocation of authority: although the bylaws define it, state law acts as a default allocation system. In general power is allocated to the board, while day-to-day operations are run by officers chosen by directors and other employees; shareholder`powers are often limited to elect directors, amend the bylaws, and vote all relevant corporate changes, (mergers, asset disposals, dissolution…). Bylaw alterations very often have further restricted shareholder rights, …, but they are today a means to increase these rights, (majority voting, proxy access, staggered boards, …(2)
  3. Constraints on Managerial Authority: corporate law and particularly judge-made common law tries to reduce abuse by managers; the right to vote is considered unwaivable, so that it constitutes a barrier for shareholder rights; derivative suits by shareholders against directors and officers constitutes also a restriction to managerial decision powers; finally, the right to sell and the market for corporate control also restrain managerial arbitrariness.
  4. The evolution of state corporate law relies on the debates on the effectiveness of the above restrictions: a) Effectiveness of voting rights: dispersed shareholdings impose huge costs to any shareholder communication, to convince other shareholders, etc.; b) Effectiveness of derivative suits: there are restrictions such as standing requirements –cost and benefits-, demand requirements –plaintiffs need to present their case to the board first, which very easily finds its way for judges to reject the shareholder right to sue directors or officers- and the Business Judgement Rule, -which represents a big defense, even more as the presumption that the BJR requirements are met favors directors- (3).  c)  Effectiveness of the market for corporate control: directors are generally enabled to raise barriers to bidders, such as poison pills and others.

The role of the Federal Government.

Its role was limited to the outward firm behavior related to Competition, Trade, Labor law, Corporate reorganization, Tax…but as a result of the 1929 crisis two Acts were promoted by the Federal Government that somehow affected this internal context:

  1. The Securities Act in 1933: it forced issuers to provide investors with a prospectus with detailed information among others things about its Corpgov, and to avoid providing other pieces of (confusing perhaps) information. Even after the SEC regulations since 1933, the act remains in force today.
  2. The Securities Exchange Act in 1934: although also based in disclosure (for the secondary market active firms) it also included abidance by the SEC rules, granting the SEC the power to control the methods firms used to communicate with shareholders and particularly over the proxy solicitation.

A critique of the Dual Corpogov system described above has been constant since 1974 Professor Cary`s atack on state competition for lower Corpgov standards. As a response the SEC and Congress have increased their role through the years: (i) SEC has used its 1933/1934 capacities to require disclosures on management´s integrity, which has indirectly shaped the boards and its activities; (ii) the 1942 SEC “Shareholder Proposal rule”; (iii) the 1961 SEC´s decision on insider trading; (iv) the Foreign Corrupt Practices Act by Congress in 1977; (v) the 1979 SEC “Going Private” regulation; (vi) in 1999 the SEC required disclosures regarding the Audit Committee role that somehow changed the board´s practices; (vii) the 2002 Sarbanes-Osley Act reacted to the Enron and Worldcom cases: it created the Public Company Accounting Oversight Board, (to monitor Audit firms); it gave the SEC authority over Audit Committees, (independence  and responsibility over the auditor relationship); it increased the CEO/CFO responsibilities over financial information and prohibited certain actions by officers and directors related to the auditors; it also prohibited loans to directors and officers; it authorised the SEC to require Internal Control reports in the Annual Report.

Even after SOX the dual system remained in many aspects of the Corpgov regulation.

2. In the meantime, the internal affairs of companies in the USA suffered changes and transformations. Jackson analyzes the recent Corpgov history in the US, dividing the period 1960-2001 in several subperiods:

  1. 1960´s and 1970´s: he defines the period as one of Managerial Capitalism, as he understands the fact that different states engaged in competition for incorporation decisions raised the bar for shareholder rights, among them voting rights and director election. Boards were made of insiders, of Ceos belonging to the “Old Boys` networks”, and only in the 70´s listing requirements included Audit Committee members to be independent (from managers). Compensation was much more related with size than performance, which helped conglomerates flourish. Some sort of stakeholder capitalism was allowed by this insulation from the capital markets.
  2. 1980´s: the Investor Capitalism or Deal Decade. In this period, stagnation, foreign competition and other factors pushed for shareholder power, given the rise of institutional investors (II) and the takeover wave. II did not like conglomerates as their portfolios were diversified and started to use “voice” instead of only “exit”. The two phenomena together put managers under pressure. Boards also saw a change, with more outsiders, although they continued to be controlled by Ceos. Shareholder value increased its relevance and required more alignment by managers (stock options, golden parachutes, etc). Reinvestment and paternalism turned into downsizing, dividends.
  3. 1990´s: Executive defence and Shareholder Value: managers reacted isolating companies from the capital markets, (poison pills), aligning with shareholders and the shareholder value paradigm. II started to vote more actively, activism grew, federal regulation eased shareholders communications, outsiders increased their role in takeovers….., but hostile takeover bids reduced their role, (junk bonds markets fell, and golden parachutes gave rise to agreed procedures). In brief managers reacted adapting to the shareholder value idea, aligning with shareholders, but keeping their power. In 1997 the OECD Corpgov principles adopted the US Corpgov practices.
  4. Enron: its failure exposed the inconsistencies of the US Corpgov model. Shareholders didn`t value the firm correctly, the board didn`t monitor correct disclosures, directors were pushed to manage earnings by their huge equity incentives, gatekeepers failed, ….This introduced some pressure over the Shareholder Value paradigm.
  5. The debate on Shareholder Value: some academics like Stout and Blair (with their Team Production model) tried to oppose its dominance, (as a concept linked to the Agency Cost Theory). Nevertheless, the most effective changes were expected to come from efforts to improve its deficiencies:
    1. Shareholder Activism: II don`t use voice or engagement often enough, for several reasons that could lead to understand activist investors as a solution for this market failure, (4).
    2. The bad performance of the market for corporate control.
    3. Board independence. Independents act as monitors given the lack of voice from shareholders.
    4. Incentives for boards. Their lack of alignment and independence may be at the root of excessive executive pay and its consequences.
    5. Gatekeepers: audit firms, credit rating agencies, investment bankers and analysts face problems that endanger Corpgov.
    6. The absence of employee voice.

3. What changed in the USA Corpgov after the 2008 financial crisis?

 The Congress passed the The Wall Street Reform and Consumer Protection Act of 2010 in which several Corpgov “federal” rules were introduced, further eroding the state law dominance. Following Prof. Bainbridge (5) and Barry and Kairis (6) we will draft the main reforms in the known as Dodd-Frank act:

  1. Say on Pay. Public firms must have an advisory vote on executive compensation and also on golden parachutes every three years, (and decide the frequency every six). It is a mechanism that has proven results, in a wider than expected range of Corpgov issues as sometimes shareholders use their advisory vote to reject other Corpgov practices.
  2. Compensation Committees. The SEC is entitled to require stock exchanges to include in their listing standards the obligation that companies have independent Compensation Committee members, with concise definition of independence; also to grant authority to these committees to retain independent compensation advisors.
  3. Pay Disclosures. Proxy statements must include a detailed report on executive compensation, the internal rules regarding hedging, the Ceo pay ratio to the median employee wage, etc.
  4. Compensation Clawbacks. SOX forced CEO and CFO of listed companies to return incentives received if accounts had to be restated for cause of misconduct. D-F expands the policy to other officers in connection with material non-compliance with federal disclosure requirements.
  5. Proxy Access. The SEC was granted authority (based on disclosure considerations) to regulate proxy access rights for shareholders. Regulation was challenged and rejected. But an amendment allowing shareholder proposals related to proxy access was approved, so that since 2014 companies started to pass these proposals (the famous 3% for three years tenure ones).
  6. Board Structure disclosure: companies are required to explain their CEO-Chairman roles, and explain why the roles are not separated if this is the case.

This is thus the nature and current situation of Corpgov in the USA…for now.

 

  1. We will follow two basic pieces on USA Corpgov: (i) “Understanding Corporate Governance in the USA”, by Gregory Jackson, downloadable at https://www.boeckler.de/pdf/p_arbp_223.pdf and (ii) Letsou, Peter V., The Changing Face of Corporate Governance Regulation in the United States: The Evolving Roles of the Federal and State Governments (January 5, 2010). Available at SSRN: https://ssrn.com/abstract=1531859 or http://dx.doi.org/10.2139/ssrn.1531859
  2. See: https://corpgov.law.harvard.edu/tag/shareholder-rights-project/
  3. See my previous post: https://joaquinbarquero.wordpress.com/2017/01/29/the-business-judgement-rule/
  4. Rose, Paul and Sharfman, Bernard S., Shareholder Activism as a Corrective Mechanism in Corporate Governance (August 28, 2015). Brigham Young University Law Review, Vol. 2014, No. 5, 2014; Ohio State Public Law Working Paper No. 225. Available at SSRN: https://ssrn.com/abstract=2324151 or http://dx.doi.org/10.2139/ssrn.2324151
  5. Bainbridge, Stephen M., The Corporate Governance Provisions of Dodd-Frank (October, 27 2010). UCLA School of Law, Law-Econ Research Paper No. 10-14. Available at SSRN: https://ssrn.com/abstract=1698898
  6. http://www.gelaw.com/wp-content/uploads/2015/02/Shareholder-Rights-Dodd-Frank.pdf
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