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Dodd-Frank and its 'colossal bet on governance'

by Robert Teitelman  |  Published September 1, 2010 at 10:33 AM

iramillstein090810.jpgThe stew tastes terrible. Try some salt. Still wretched? Try some more. Still lousy? Pour the whole damn shaker in. Governance practice lies somewhere along this continuum. Governance is a marvelous idea in search of effective practice. When the idea breaks down, the solution is always to boost the stakes, to increase the ease of shareholder input, to open access, to make shareholder governance more democratic -- that is, to increase the salt.

The latest evidence comes in a short essay by Weil Gotshal & Manges LLP's governance guru, Ira Millstein, and Stephen Davis, the executive director of Yale University's Milstein (yes, that Milstein) Center for Corporate Governance and Performance, headlined "Finally, Governance Becomes Possible" (the piece ran on The Harvard Law School Forum on Corporate Governance and Financial Regulation). The basic thrust: The Dodd-Frank financial reform package, which "affirms the U.S. Securities and Exchange Commission's authority to make it easier for investors to nominate candidates to corporate boards," represents a kind of revolution in governance, finally offering real power to "shackled" shareholders.

They describe the new situation as "a quiet upheaval." They write: "Dodd-Frank hands unprecedented rights to investors in the expectation that they will serve as a 'neighborhood watch' against corporate mismanagement."

This is pretty remarkable. Milstein and Davis are essentially arguing that until now governance has been a sham. "For decades, investors, anxious about a company gone awry, have had little choice but to complain from the sidelines, petitioning finger-wagging resolutions directors could easily ignore," they write. Their example: American International Group Inc., of all companies, which they portray as besieged by shareholders trying to get it to mend its ways "before its epic collapse." Well, that's a bit much. Shareholders were troubled by AIG's problems, which had tanked the stock, but there were few complaints while those fatal credit-default swaps were being sold in bushels, or indeed when Hank Greenberg was running a powerful, often opaque, earnings machine. The collapse of the insurer caught regulators, not to say shareholders, by surprise; it wasn't as if AIG spawned anywhere near the kind of public debate over solvency that Lehman Brothers Inc. did.

In fact, shareholders cheered the leveraged buildup with its high compensation and big risks as long as earnings, and share prices, kept rising.

And indeed, it turns out that wise governance is not really a matter of all shareholders, but of "long-term institutional investors." Milstein and Davis argue, in fact, that while boards were able to deter institutions, somehow, some way, "short-term funds," which I assume means activist or hedge funds, were able "to cherry-pick firms for proxy fights or use stock techniques to harass," and thus "piled disabling debt on companies." Now this is incoherent, surprisingly so for such eminent figures. So "aggressive" shareholders were able to have their way with boards, but institutions were "shackled"? How does that work? Investors "piled" debt on companies? All by themselves? Could it be that institutions were perfectly happy to see that debt as long as it fueled earnings? And how, exactly, can those different kinds of shareholders be distinguished?

Well, everyone knows the problem here. Institutions are passive, long-term holders that have neither the resources nor the willingness to actively participate as corporate citizens. They have such large positions, and they're so often indexed that they cannot leave a large company by selling their shares. Indeed their passivity has created a vacuum that has been filled by analytical outsourcers such as RiskMetrics Group and Glass, Lewis & Co. LLC, which is like hiring a consultant to tell you who to vote for. Besides, even if institutions do decide to join the neighborhood watch, what's to stop those same short-term activist bullies from dominating the proceedings, further empowered by greater access? And what about other classes of shareholders, particularly smaller institutions or retail? Do they have any rights? Since corporate governance is constructed along a political theory, is there any protection for minority positions?

Milstein and Davis do understand the stakes, and they outline them clearly. "Dodd-Frank places a colossal bet that shareholders will patrol the market." Proxy access is thus a gamble that the right kind of shareholders will magically reform themselves. What will get institutions, like mutual funds, to change? Well, the financial crisis was such a shock that institutions paid "a brutal price for their inattention." Their previous passive behavior was rational, they admit, but now it's in their self-interest to "drive the kind of long-term performance that benefits American savers."

That's a big change to be built on a hope. Institutional passivity is like regulatory capture: It's a condition that may not appear in the wake of disaster, but will creep in with time, a return to "normalcy" (however defined) and prosperity and a fading memory. Let's face it, there has not been a scintilla of evidence post-crisis that institutions have changed their ways in any fundamental fashion; and as Dodd-Frank shows in its entirety, the fear and panic that might have forced a more fundamental reform effort have long since passed. As a result, this is all just wishful thinking. When in doubt, more democracy please. Oh, and pass the salt. - Robert Teitelman

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