United States: Strine Proposes To Reform The Corporate Governance System

Last Updated: October 8 2019
Article by Cydney Posner

Who else but Delaware Chief Justice Leo Strine would bid his farewell to the Delaware bench with nothing less ambitious than a "comprehensive proposal to reform the American corporate governance system" laid out in a paper with longest title of any in recorded history: "Toward Fair and Sustainable Capitalism:  A Comprehensive Proposal to Help American Workers, Restore Fair Gainsharing Between Employees and Shareholders, and Increase American Competitiveness by Reorienting Our Corporate Governance System Toward Sustainable Long-Term Growth and Encouraging Investments in America's Future"?  Strine offers up his always interesting ideas: for example, he advocates setting up board committees focused on the welfare of the workforce, imposing a tax on most financial transactions to be dedicated to funding infrastructure and research, curbing corporate political spending in the absence of shareholder approval and enhancing the fiduciary duties of institutional investors to consider their ultimate beneficiaries' economic and human interests.  And here's another idea: Strine believes that the number of proxy votes each year is an "impediment to thoughtful voting" and leads to outsourcing of voting decisions by institutional investors to proxy advisory firms. Say on pay every four years?  He has a plan for that too. 

According to Strine, the current governance system "has resulted in declines in gainsharing of corporate profits with workers, a large increase in stock buybacks, skyrocketing CEO pay, and growing inequality." What has caused these effects? To Strine, if you're looking at CEOs and boards as the drivers, you're looking in the wrong place. Instead, we should direct our attention to "those who wield over 75% of shareholder voting power: institutional investors....Corporations will not give more thoughtful consideration to their employees and social responsibility—that is, our corporate governance system and economy will not change—unless the institutional investors who elect corporate boards also support doing so. Institutional investors have the most influence on corporations, and the imbalance in our corporate governance system can be fixed only by aligning institutional investors' incentives with the interests of their end investors: human beings saving for retirement and their children's college education."

This view is one that Strine has long espoused.  For example, in this 2014 article In the Harvard Business Law Review, Strine argued that stakeholder theory, the notion that corporate directors are entitled to take into consideration the interests of constituencies other than shareholders, is naïve, misguided and largely ineffective.  Why? Because these theories do little to change the incentives of directors to take the interests of these other constituencies into consideration. According to Strine, "even if it were the case that corporate directors and managers were well suited to act as the guardians of employees, consumers, the environment, and society generally, the accountability structure within which they operate in the United States is tilted heavily toward one specific constituency: stockholders." The power of shareholders under the existing corporate accountability structure is especially compelling, he believes, now that shareholders are largely led by institutions and are no longer "docile and disaggregated." (See this PubCo post.)

According to Strine. the long investment timeline for "human investors" is more consistent with the timeframe of managers building and operating a business than it is with the short-term time horizon of "companies' direct shareholders, who are money managers under strong pressure to deliver immediate returns at all times." Human investors also benefit from a clean and sustainable environment and depend on business to provide them with "access to good jobs, sustainable wage growth, and a fair share of the wealth that businesses generate. In short, human investors benefit from sustainable, long-term economic growth and gainsharing between shareholders and workers, but companies have increasingly failed to deliver on that promise."

One of Strine's answers to this conundrum is to give workers more of a say in the company—for example, through board-level committees focused on treatment of employees and through labor law reforms rehabilitating unions—and to hold companies accountable for how their employees are treated by providing more information about these issues to investors and the public. And some culpability must be attributed, according to Strine, to institutional investors that pressure companies for immediate returns without regard for employees or other stakeholder interests. Institutional investors now hold about 78% of public company stock, concentrated especially among the Big 3 or 4, and "effectively dictate U.S. corporate policy." To encourage companies "to act more responsibly toward their workers and other stakeholders, the institutional investors who are responsible for managing most human investors' money must vote with their investors' needs in mind." Although some institutions have begun to consider ESG factors, Strine contends that the acronym "ESG" should really be "EESG," with the "vital missing 'E'" being the "interests of companies' employees. That is, institutional investors must align their voting policies with the interests of their worker-investors who need not just sustainable corporate profits, but also good jobs, clean air, and safe products." Strine believes that this realignment can be fostered through "modest changes" to  the laws and regs applicable to institutional investors.

Other "complementary measures" would also facilitate this new alignment, such as changes to tax and accounting policy that have created incentives for "speculation and rapid portfolio turnover, rather than productive, sound long-term investing." The funds received from these policy changes could be used to finance new infrastructure and research. In addition, he advocates changes to laws and court decisions "that have given corporate elites an unfair advantage over working Americans and human investors, including Supreme Court and regulatory decisions that have undercut the effectiveness of labor unions, deprived Americans of their day in court and fueled a massive growth in unchecked corporate political spending."

In sum, Strine wants to see a "new accountability system that supports wealth creation within a system of enlightened capitalism—one that aligns the interests of institutional investors and corporations with those of the human beings whose capital they control." His proposal includes the following elements:

  • "Enhancing Disclosure for Operating Companies on Employee, Environmental, Social, and Governance Matters to Promote Sustainable, Long-Term Growth and Gainsharing with Workers"
    • Require companies (public and private) with over $1 billion in annual sales to provide standardized disclosure about their businesses' impact on EESG—employee, environmental, social, and governance matters;
    • To allow managers to focus more on long-term growth, require companies that release quarterly earnings guidance "to maintain, make public, and keep current a long-term plan for earnings growth and situate any quarterly guidance within the context of that long-term plan";
    • Require boards of these companies to create "workforce committees" at the board level, as a kind of "European-style 'works councils,'" designed to address workforce issues (particularly in light of the decline of unions), such as the impact of the gig economy, "fair gainsharing between workers and investors, the workers' interest in training that assures continued employment, and the workers' interest in a safe and tolerant workplace";
    • Change accounting rules to treat investments in human capital as capex, like other long-term investments, not costs, and require companies to disclose more information about human capital investments (see this PubCo post); and
    • Make the Business Roundtable's recent  Statement on the Purpose of a Corporation more concrete by having the Roundtable endorse the "benefit corporation" model and the removal of barriers to its adoption, such as supermajority votes to adopt. Strine views the model as a conservative effort to "put some actual power behind the idea that corporations should be governed not simply for the best interests of stockholders, but also for the best interests of the corporation's employees, consumers, and communities, and society generally." (For more on Strine's view of this model, see this PubCo post.)
  • "Strengthening Institutional Investors' Obligations to Promote Sustainable, Long-Term Growth and Serve the Interests of Human Investors"
    • Modify institutional investors' fiduciary duties so that they take into account "their ultimate beneficiaries' specific investment objectives and horizons, such as saving for retirement or education, as part of their fiduciary duties, and empower institutional investors to consider their ultimate beneficiaries' economic and human interest in having companies create quality jobs, and act ethically and responsibly toward their consumers and the environment";
    • "Require institutional investors to explain how their voting policies and other stewardship practices ensure the faithful discharge of their new fiduciary duties and take into account the new information reported by large companies on employee, environmental, social, and governance matters";
    • Close the 13D and other loopholes (see this PubCo post) "to prevent activists from gaining creeping control without paying a control premium before disclosing their proposal to management and other investors"; and
    • Require an SEC study on the investor protection risk from private equity and hedge funds that would assess, among other things, the adequacy of their disclosures regarding their performance histories, the fairness of their terms to all investors and "whether the universe of accredited investors and qualified purchasers is appropriately defined to include only sophisticated investors who can fend for themselves."
  • "Reforming the Corporate Electoral System to Promote Sustainable, Long-Term Growth"
    • Reduce "the continual mini-referendums occurring each year and the huge number of votes shareholders must cast each year, which encourages companies to manage to the changing whims of the stock market and institutional investors to outsource voting decisions to proxy advisory firms";
    • Allow more informed, thoughtful voting by changing say on pay to a vote once every four years (or sooner in the event of material changes), based on a pay plan applicable to the next four years, with the SEC establishing a schedule for voting by one-quarter of the public companies each year;
    • To avoid burdening the system "with unnecessary and value-destroying votes" on proposals "by shareholders with little stake in the company's future," modify the shareholder proposal rules to require proponents of economic shareholder proposals—such as elimination of takeover defenses, but excluding environmental and social proposals—to pay a $2,000 fee and hold the lesser of $2 million or 1% of the company's stock (including aggregation) and modestly increase resubmissions thresholds (to at least 5% in the first year, 10% in the second year or 20% in the third year, with a reset after five years) so that proposals that repeatedly fail by large margins are not constantly resubmitted; and
    • Require shareholders that submit shareholder proposals or solicit proxies aimed at changing a company's corporate governance to disclose their net beneficial ownership interest in the company's securities, including derivatives, so that institutional investors "have better information to know if the activists' economic interests are aligned with the interests of patient investors such as index investors and others who hold stock for the long run."
  • "Updating Our Tax System to Reduce Speculation, Address Climate Change, and Promote Sustainable Growth, Innovation, and Job Creation"
    • Adopt a five-year holding period for long-term capital gains;
    • Close the carried interest loophole by taxing the comp of private equity and hedge fund managers—in whatever form—as income, not as capital gains;
    • To "moderate excessive speculation, curb uneconomic high-frequency trading with no fundamental investment rationale that can contribute to financial system instability, encourage more thoughtful long-term investing, and discourage irrational fund-hopping by mutual fund consumers," apply a modest tax on most financial transactions, including the trading of stocks, mutual funds, bonds and derivatives; and
    • Put all revenue raised by the financial transaction tax into a newly created Infrastructure, Innovation and Human Capital Trust Fund, available to be spent only on basic R&D, environmentally responsible infrastructure designed to address climate change and workplace training.
  • "Curbing Corporate Power and Leveling the Playing Field for Workers, Consumers, and Investors"
    • Address "three sets of challenges created in no small part by the United States Supreme Court, which have amplified corporate power at the expense of American workers, consumers, and human investors," including Citizens United;
    • To ensure that human investors' money is not being spent on politics without their consent, prohibit public companies from political spending without the consent of at least 75% of their shareholders;

SideBar

Institutional investors have, for the most part, shied away from political spending proposals. In some ways, that seems to be a bit paradoxical in light of the Big 4's expressed concern with sustainability, given that corporate political spending could well be devoted to purposes inconsistent with that goal.  This reluctance of institutional shareholders to step up with regard to political spending proposals has come under fire from Strine before. The title of this 2018 paper, "Fiduciary Blind Spot: The Failure of Institutional Investors to Prevent the Illegitimate Use of Working Americans' Savings for Corporate Political Spending," communicates the bottom line pretty clearly. While Strine congratulates the Big 4 institutional investors, BlackRock, Vanguard, State Street and Fidelity, for recognizing "that unless public companies act in a manner that is environmentally, ethically, and legally responsible, they are unlikely to be successful in the long run," he chastises them for continuing "to have a fiduciary blind spot: they let corporate management spend the Worker Investors' entrusted capital for political purposes without constraint." (In the paper, "Worker Investors" are American workers that, through 401(k) and 529 plans, must invest largely in mutual funds to save for retirement and college and whose capital is effectively "trapped" until their retirement.) Why is it so important to monitor corporate political spending? To Strine, "unconstrained corporate political spending is contrary to the interests of Worker Investors. Precisely because Worker Investors hold investments for the long term and have diversified portfolios that track the whole economy, political spending by corporate managers to tilt the regulatory playing field is harmful to them, as humans who suffer as workers, consumers, and citizens when companies tilt the regulatory process in a way that allows for more pollution, more dangerous workplaces, less leverage for workers to get decent pay and benefits, and more unsafe products and deceptive services." As a result, Strine contends, the Big 4 need to "open their fiduciary eyes ... and vote to require that any political spending from corporate treasury funds be subject to approval of a supermajority of stockholders....Because of their substantial voting power, the support of the Big 4 would ensure that this check on illegitimate corporate political spending would be put in place and thus make an important contribution to restoring some basic fairness to our political process."  (See this PubCo post.)

  • To "restore shared prosperity and create an economy that benefits all Americans," changes should be made that will "make it easier for workers to organize and collectively bargain with their employers," such as by permitting "card check" elections; and
  • Amend the Federal Arbitration Act to make it more fair and restore State sovereignty over the enforceability of forced arbitration clauses so that "American workers and consumers [are not denied] their day in court by funneling them into secretive arbitration proceedings."

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