Ethics @ Work: Democracy and corporate democracy

Use of lawsuits gains favor with shareholders.

February 4, 2010 23:05
3 minute read.
Ethics @ Work: Democracy and corporate democracy

asher meir 88. (photo credit: )

Managers of publicly owned companies are supposed to act in the interest of shareholders. But how constrained are they to actually do so? Are managers held accountable for malfeasance, negligence or plain old incompetence? The study of this question is known as “corporate governance”; another popular and apt term is “shareholder democracy.”

Just as democratic institutions should be designed to make politicians accountable to voters, so should corporate institutions be designed to make managers accountable to owners.

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The other side of the coin is that managing a country or a company requires flexibility and discretion. That is why we don’t govern by plebiscite, and why companies give managers extensive leeway in day-to-day management.

The main instrument for creating accountability is generally the board of directors. Directors don’t manage companies; they choose senior executives and oversee the most important decisions, to make sure they serve the interest of owners.

However, critics claim that boards of directors are limited as a tool for creating accountability. In the United States, in particular, the chief executive officer of large companies is usually chairman of the board as well. He also has some say in the choice of additional directors. Outside directors, who are expected to be less identified with and less beholden to the CEO than inside ones, often lack deep interest in the company’s fate.

One very important spur is the criminal law. Many kinds of malfeasance are against the law, and the threat of jail can certainly focus the mind on good conduct.

Another tool for creating accountability is the direct shareholder democracy of shareholder voting by proxy. A certain fraction of shareholders can force a proxy vote on virtually any issue. However, this tool is exceedingly weak. Unlike in a political democracy, there are few institutions to help shareholders communicate with each other and work together to propose proxies. And shareholders, much more than citizens, are likely to feel that their vote is a waste of time. Managers have also been known to actively seek to frustrate proxy votes on certain issues.

An additional tool that has been gaining a new source of support is the shareholder lawsuit. In many cases criminal prosecution is impossible. For example, the malfeasance may not be criminal, or evidence may not reach the demanding bar of proof beyond a reasonable doubt. Shareholders can sue management for causing them losses.

But this route also faces obstacles. It is rare that any one shareholder, even a large one, finds it worthwhile to finance a legal battle that will ultimately benefit all shareholders. One solution to this problem is the class-action lawsuit, in which the court authorizes one plaintiff to sue on behalf of all. But even here there is the question of who has a real incentive to invest the requisite effort.

Political democracy is now stepping in to strengthen corporate democracy. The Wall Street Journal recently reported that state attorneys general (in many US states this is an elected position) increasingly are filing shareholder suits on behalf of state pension funds. This may be mere populist anticorporate posturing, but I think the pension funds are unlikely to buy in if they don’t see a meaningful chance of a victory in court. So mostly I view this as a valuable additional tool to get shareholders over the hump in terms of filing a suit against managers.

Of course, this approach also will have a downside. Managers will demand higher compensation if they are increasingly exposed to lawsuits; they may begin to manage in an overly conservative way meant to shield them from lawsuits, rather than in an ambitious way meant to increase profits.

However, this process is subject to ordinary political accountability. If voters see that this kind of shareholder activism is counterproductive, presumably politicians will stop finding it beneficial to back it. (Another downside mentioned in the article is that it creates a new channel for political corruption, as some law firms may try to inappropriately influence elected officials to favor them to bring the suits.)

Senior managers may have many ways of flouting the will of shareholders in the short run, but in the long run there are a variety of effective governance mechanisms. Even if each alone is relatively weak, together they do a good job of keeping managers accountable to their employers.

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Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).

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