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closely related to the price of the stock. For the most part, the well-run firm which is an industry "leader" will have the highest takeover cost in that industry. So far as shareholder protection is concerned, that kind of high takeover cost is exactly what is called for, because it diverts competitors in the market for management control (not in the investment market) to the well-run firms. It is not enough, therefore, to say that takeover costs are high. What must be shown is that those costs are high in firms which are not well run or which are impaired competitively because of self-dealing.
The conclusion that federal chartering is necessary because takeover costs are too high to impose effective restraints on management is thus not to be quickly drawn. Costs which are attributable either to federal law or to superior management efficiency must be excluded as either not relevant to the issue or as evidence that shareholders are already well protected by these market constraints. There is every reason to believe that costs attributable to federal law and management efficiency account for a significant portion of observable takeover costs.
My argument is not that corporate management does not have discretion. Of course, it does, and that discretion roughly corresponds to the cost of a takeover. Rather, I am arguing that the relevant discretion (excluding that subsized by federal law) is directly related (but not equal) to management's efficiency in profit maximizing on behalf of the firm. Thus, that management which competes the most effectively will also have the most discretion. But shareholders in that firm also benefit because the value of the firm is high, as are stock prices, and the resultant growth will increase the firm's assets. Management discretion and shareholder benefit, therefore, go together.
Corporate critics have trouble with this analysis for a couple of reasons. One is that some, for all their hue and cry about consumers and stockholders, simply don't like success in the market place. Thus, the Nader work on federal chartering treats "superior production techniques (and) managerial talent” which permit "established firms to maintain an absolute cost advantage" as a barrier to entry with which the antitrust laws ought to be concerned. No matter how long one ponders the point, this is an argument which is wholly anticompetitive in that it penalizes the most efficient producer while protecting the least, all at a cost to consumers.
A responsible line of argument is that while management discretion and shareholder benefit move together, it does not necessarily follow that the discretion cannot be liquidated as a benefit to shareholders without impairing the efficiency of firms.
Recent work on the theory of the firm by Professors Armen Alchian and Harold Demsetz strongly suggests that the wholesale elimination of management discretion would in fact be detrimental to shareholders. While the relationship between marginal productivity and distribution of income is spelled out in economic theory, that theory simply assumes that existence of economic organizations that allocate rewards to resources according to their particular productivity. The theory in short explains how various rewards are allocated to various firms according to output. It does not explain how a similar allocative function is performed within the firm.
The issue discussed by Alchian and Demsetz is how economic organizations (firms) meter input productivity and rewards so that rewards and output correspond. The problem is best illustrated by their example of two men who jointly lift heavy boxes into trucks. The marginal productivity of each individual is very difficult to determine, and their joint product is not the sum of separable outputs by the men. Obtaining information on individual marginal productivity and rewarding accordingly is thus at best very costly. The information problem, however, if not somehow resolved, also creates an incentive to shirk, since the share a party to the effort receives may be relatively unrelated to conscientiousness,
Moving from the two men example to the more complex case of a firm, it can be seen that an essential economic function of the firm is to monitor the various inputs in the team effort so as to meter marginal productivities by arranging or examining the way inputs are used and to take steps to reduce shirking. Performance of the monitoring function requires that some group or individual be given the power within the firm to observe the performance of various input factors, to be the central party to all contracts with inputs, to alter their use in the team effort or to discontinue their use. The “monitor” thus must accumulate information on productivity and act on that information while at the same time policing the inputs so as to reduce shirking.
Because the "monitor” is a team member, a mechanism to meter its productivity and to reduce its incentive to shirk must also be created. Such a mechanism is to allocate to the monitor the residual income left after all other inputs have been paid. This creates an incentive in the monitor to bring about the most efficient use of other inputs and to reduce shirking by them, since the reward to the monitor will vary according to its success in performing those tasks.
Within the corporate framework, management performs the monitoring function. Because of the obsession with the corporate legal structure in which the shareholders are "owners" and of the view that the residual income share is associated with ownership, the discretion over corporate assets held by management has led most commentators to conclude that management receives a share to which other parties are entitled and which is unrelated to management performance.
If, however, management performs the monitoring function, the receipt of a residual share created by efficient performance is not merely understandable but quite essential. The accumulation of capital from many diffuse sources renders it impossible for investors to perform the monitoring function, even if they were interested in performing it. That function is best carried out by a centralized authority whose own reward and security in office will be directly related to its productivity in metering inputs and reducing shirking.
There is, therefore, sound reason for believing that the return to shareholders and the apparent discretion of management over its share are closely related and that the wholesale elimination of management's discretion by legal rule would adversely affect shareholders, since management's residual share is correlated to the cost of takeover, a cost which can be kept high by increasing the yield to shareholders.
The corporation is thus a device which performs both the functions of raising substantial amounts of capital and efficiently using a large, complex and diverse input. This performance, it appears, is largely independent of all but a few basic legal rules and surely does not resemble the apparent legal structure of "ownership" in the shareholders and "unaccountable" discretion in the management."
D. The proper role of law We may now turn to the question of how the costs and benefits of legal intrusion are to be determined and what the proper legal rules ought to be.
A wholly accurate determinant of these costs and benefits is, of course, impossible and, in the center of a spectrum of alternatives, several may arguably be correct. It is clear, however, that an out of hand rejection of a corporation code because it is less restrictive of management than other codes is wrong. Minimal restriction on management's discretion may maximize the yield to shareholders. It may not also, but that simply demonstrates our ignorance of the impact of law rather than the inherent worthiness of restrictions on management.
The Delaware Code is not open to the facial a priori attack Professor. Cary and others have leveled at it. While it has removed many restrictive provisions of older laws, not all limits on management have been removed. Basic protection of most shareholder expectations is written into the Code and a basic fiduciary duty is imposed on management. Moreover, Delaware procedure is geared to facilitating suits by shareholders since the situs of shares of a Delaware corporation is deemed to be Delaware. A sequestration procedure thus permits stockholder plaintiffs to obtain quasi-in-rem jurisdiction over non-resident directors. Delaware also does not require the posting of security for expenses.
Whether the Delaware or any other code is perfect is unlikely. Cases can be wrongly decided and statutes poorly drafted. A good legal system is always in evolution and absolute certainty as to what is the right rule is never attain. able. But in the case of corporate chartering there is a process which over time will reasonably guarantee to shareholders and management alike a proper legal system. That process is the very one reviled by proponents of federal chartering: the competition among the states for corporate charters.
A state which rigs its corporation code so as to reduce the yield to shareholders will merely sponsor corporations which are less attractive as investment opportunities than comparable corporations in other states. The added power which such a law allegedly gives management is not the bargain it seems Just as shareholder yield and management discretion over its share go up together, so too they descend in tandem. Low yields to shareholders mean low stock prices which mean low costs of takeover which, as explained above, reduces the parameters of management discretion. The chartering decision, therefore, will favor those states which offer the optimal yield to both shareholder and management.
Nor is it in either management's or the shareholders' long run interest to see the ability of a corporation to raise capital impaired. As Professor Baumol has noted, even a relatively small need for capital from stock issues can impose discipline on a firm. Moreover, raising capital through equity or debt are closely related since investors and lenders both are making similar judgments about the long run earning potential of the firm, and management's power to drain off assets obviously affects either judgment. In short, the lower the stock price the higher the interest rate. The availability of internal financing does not change this since the cost of using retained earnings as capital is the highest return available in alternative uses. Thus, if an alternative investment would have returned 20%, the cost of using it within the firm is also 20%.
It is not, therefore, in the long run interests of management to seek out a corporate legal system which fails to protect investors, and the competition between the states for charters is a competition as to which legal system will provide an optimal return to both interests. Indeed, only when that competition exists can we perceive which legal system is preferable for once a single system governs the nation, investors no longer have any choice and we cannot compare their reactions. Indeed, one of the ironies of the claims made on behalf of federal chartering is that it is generally federal law which impedes takeovers and thereby disadvantages all shareholders. Further moves in that direction can only be counterproductive.
This does not mean that our corporation law has achieved a final form or that no federal regulation is appropriate. Rather it means that state competition for charters permits an evolutionary process with many safeguards and that further study should be in the cause of facilitating the economic performance of the corporation and the relative economic functions played by management and shareholders rather than the pursuit of narrowing the "separation of ownership and control.”
Attention should be directed to distinguishing between the discretionary use of a residual share related to efficient management and self-dealing which impairs the firm. By and large, that should focus on the identification of specific actions by management involving a "one shot" attempt to increase its "take" without regard to the future value of the firm. For the most part, competition among the states for charters should over time facilitate movement in that direction. One exception exists, however. There may be constitutional as well as practical problems in one state regulating a reincorporation in another state and these reincorporations may involve such a "one shot” effort to take advantage of state laws which hamper takeovers, and impair the long run values of the firm. Federal regulation of reincorporations designed to prevent a takeover may thus be appropriate. II. Federal chartering as a regulatory remedy
Although some regard federal chartering merely as a means of affording shareholders more protection than is available under state law, other see in it a remedy for every ill of society, some perhaps acne. It has been suggested, for example, that federal chartering might be employed as a remedy for antitrust violation, pollution rules, employment discrimination and so on.
To the extent that the corporate charter merely restates the provisions of the various regulatory statutes, they are superfluous. To the extent that revocation or suspension of the charter proposed as a remedy for violation of such provisions, it seems wholly inappropriate. As a remedy, revocation or suspension is so drastic that its use seems very doubtful. Beyond that, it is a remedy which penalizes employees, supplies and customers as much as the firm itself.
Economic regulation, whether to the end of deconcentration, the reduction of pollution or whatever, is in no sense dependent upon the existence of federal chartering. Indeed, the issues should be kept distinct in the interest of clarity and of a full public discussion of each proposal. Lumping them all together, as some proponents of federal chartering do, can only obscure what issues are at stake and keep the public in the dark. This seems particularly so in the case of dubious proposals such as deconcentration or divestiture.
The insistence of chartering proponents on confusing these issues reflects either a desire to mislead the public or a hope that the existence of federal chartering will facilitate the introduction of even more drastic regulatory measures in the future. Because endless conditions can be attached to a corporate charter, chartering is a device by which government control can be easily widened and withont adequate debate. This is another reason for rejecting chartering.
On one issue, however, the proponents of chartering have identified a genuine problem, although the remedy they support is easily worse than the disease. There is a serious lack of adequate remedies against corporations which violate the law, a problem caused generally by the inertia and unwieldiness of large bureaucracies. But this is a problem susceptible to remedies far less drastic than revocation of the corporate charter. Congress might, for example, provide that when a District Court found a pattern of violations of partieular federal legislation or a failure or recalcitrance in taking steps to see that further violations will not occur, a monitor or trustee might be appointed to exercise the power of the court within the corporation to end the violation and take precautionary measures against the future. That sort of provision seems to me fully adequate to the purpose and far more preferable than federal chartering.
Senator DURKIN. Is Mr. Sommer here?
Your statement will be included in the record in its entirety. Why don't you proceed !
STATEMENT OF A. A. SOMMER, JR., PARTNER, JONES, DAY, REAVIS
& POGUE, WASHINGTON, D.C. Mr. SOMMER. I will summarize and read parts. I am aware of the time problem you have, Mr. Chairman.
Mr. Chairman, my name is A. A. Sommer, Jr. I am presently a partner of Jones, Day, Reavis & Pogue, Washington, D.C. From August 6, 1973, until this April, I was a member of the Securities and Exchange Commission.
During that time in speeches I made, I commented extensively on the problems of corporate directors and the manner in which they were fulfilling their responsibilities under the law, particularly the Federal securities laws.
I would like to submit those speeches and have them incorporated in the record of these proceedings. The full statement which I have submitted to the committee includes several items, including the role of directors in American corporations; and second, the desirability of Federal incorporation. I would like to focus on the director problem because it includes discussion of several parts of the Nader proposal.
Until recent years, it is fair to say that far too little attention was given to the role of directors in publicly held corporations. Before 1933, the only law which governed the relationships between directors and their corporations and the shareholders of the corporations was State corporation law, and in the eyes of many, that law did not impose upon directors heavy burdens.
The first assault upon the primacy of State corporation law was the Securities Act of 1933 which established the then revolutionary principle that those not in privity to purchasers of securities, including directors of an issuer, might be held liable for losses suffered by purchasers who were denied full and fair disclosure.
The legislative history of that act clearly demonstrates the radical nature of this proposal and the efforts made to turn it back.
There has been a critical problem with regard to the performance of directors in this country over the past decade. In many instances, it can be documented that the directors have been insensitive to their responsibilities.
In many instances they were chosen because they were well known to the chief executive officers, not because they were competent with regard to the affairs of the corporation but because they had the time to serve effectively. It became in many instances simply a badge of honor for
a person to be a director of a prestigious corporation.
The SEC staff made an extensive study with regard to the board of directors and other activities of Penn Central, a report which eventuated in the Commission suing to enjoin three directors of the corporation from violations of the Federal securities laws. It was documented in that report many of the directors of Penn Central had been indifferent to their responsibilities.
However, I think it is fair to say that as a consequence of many forces this situation happily is changing.
Among the forces that have resulted in this change have been the litigation brought by the SEC, pronouncements by the Commission, such as in the case of Stirling-Homex, and warnings that have been given by the Chairman and other Commissioners of the SEC.
In addition, directors have been charged in a number of private suits seeking to recover damages allegedly attributable to their misconduct.
In addition, there has been a tremendous outpouring of writing. Writers of books and magazines have chided directors because they have not in many instances performed in accordance with their high responsibilities.
I think all of this has heightened the sense of responsibility that directors are presently feeling.
I think now it is fair to say that the people who are asked to join boards of directors only do so after they have carefully considered the responsibilities that they are assuming, and have examined whether they have the time available to adequately perform the functions.
There was a time when investment bankers would brag that they were on 20, 30, and as many of 50 boards of directors. I think that day is gone. I don't think anyone regards that as a badge of honor, now it is regarded more as a sign of insanity.
In addition to that, corporations are aware of the necessity for greater board involvement, because of the factors mentioned, and have developed a number of techniques to provide the opportunity for better board participation by the independent directors.
Audit committees, for instance, are becoming virtually routine. I think both auditors and members of the board can testify to the effect that they have indeed been a very effective means by which the directors have been able to influence and monitor the activities of corporations.
Many corporations have also added to the number of outside directors that are on their boards, so that you have a higher proportion of people who have no significant financial affiliation with the corporation on the boards.
A number of corporations have included on their boards people who have been called "professional directors.” These are people who make their living out of being on the boards of major companies, and in