The CORPORATE GOVERNANCE Machine

“[W]e suspect that a shift in culture would need to drive concrete legal and institutional changes and alter multiple components of the machine if a paradigm shift were to manifest.”

ELIZABETH POLLMAN, Professor of Law

In “ The Corporate Governance Machine,” published in the Columbia Law Review, Pollman and Dorothy S. Lund of the USC Gould School of Law provide an original account of the complex system of law, institutions, and culture that make up the U.S. system of corporate governance for public corporations. Their account generates insights about the past, present, and future of corporate governance.

The Concurrent Rise of Corporate Governance and Shareholder Primacy

The authors begin by tracing the historical and intellectual underpinnings of the term “corporate governance” and charting its rise alongside shareholder primacy. As they explain, legal historians tend to pinpoint the 1920s and 1930s as the foundational era for early corporate governance debates, when influential thinkers such as Adolf Berle and Gardiner Means oriented corporate law and theory around the issue of the separation of shareholder ownership and managerial control, but without elevating the importance of shareholders in the balance. In the mid-twentieth century, “managerial capitalism” reached its zenith, and it was in this period that the term “corporate governance” first arose in the context of business ethics and for the purpose of furthering a theory of corporations consistent with the ideals of a democratic society.

In the 1970s the tide started to turn, and, for different reasons, both the political left and right embraced the idea that corporate managerial power must be constrained by checks and balances. Some argued that giant corporations needed to be tamed to serve the public interest, while others bemoaned weak corporate boards and poor shareholder returns. Academics started to inject the economic concept of agency costs into scholarly discourse about corporations and quickly a normative gloss was added that “good” corporate governance should serve shareholder interests.

Through the Deal Decade of the 1980s, pursuing shareholder value or wealth maximization became regularly identified as the core corporate objective and ingrained in general understanding of corporate governance. And, in the decades that followed, with the rise of investing through intermediaries, the potential for shareholder influence increased as stock ownership became increasingly concentrated in mutual funds and other institutions. While the term “corporate governance” initially arose in discourse about constraining corporate power for the benefit of the public or democratic ideals, it subsequently developed to embody a particular view of the internal workings of the corporation, with shareholders paramount and directors and managers serving as their agents.

The Corporate Governance Machine

After setting out these historical and intellectual foundations, Pollman and Lund argue that three crucial components of the corporate governance machine — law, institutions, and culture — orient the system of contemporary corporate governance towards shareholders.

First, the authors outline the ways in which the multi-faceted legal regime of Delaware, Congress, the Securities and Exchange Commission (SEC), and the Department of Labor (DOL) have maintained

a shareholder-oriented equilibrium. Second, institutional investors, investor associations, industry associations, proxy advisors, stock exchanges, stock indices, and ratings agencies also reinforce the shareholder primacy viewpoint through their influential viewpoints and actions. Third, and potentially most significant, is culture. Professional education, media, and politics have amplified the prevailing normative belief that corporate governance should primarily serve shareholder interests.

For the authors, culture is notably the “most in flux,” as more scholars and professionals have begun to call for changes that move away from shareholder primacy. These proposals have been observed in the media and increasingly echoed in political proposals. It is uncertain, however, whether culture alone could drive a paradigm shift.

“[W]e suspect that the complementary institutional components that enshrine shareholderism will hamper a shift to a new paradigm if cultural forces alone are at play,” write Pollman and Lund. “Instead, we suspect that a shift in culture would need to drive concrete legal and institutional changes and alter multiple components of the machine if a paradigm shift were to manifest.”

Building on this account of the relevant legal, institutional, and cultural components, the authors use three examples to illustrate how the corporate governance machine functions to shape corporate activity and policymaking.

First, legal and extralegal institutional standards converge to effectively homogenize public company boards of directors consistent with a monitoring model.

“After ideas incubated in academia led to an evolving cultural understanding of corporate governance, major institutional players — including the SEC, the stock exchanges, and influential proxy advisors — adopted rules that brought the monitoring model into the mainstream,” write Pollman and Lund. “By force of these developments, all U.S. public company corporate boards have a significant percentage of independent directors and view their role as safeguarding the interests of the corporation and its shareholders.” The authors observe that this shift in public board composition occurred despite a lack of consensus or conclusive empirical evidence that director independence yields better board decision making and oversight.

Further, debate about corporate social responsibility (CSR) that for decades had been focused on social obligations started to shift to discussion of the Environmental, Social, and Governance (ESG) movement in the early 2000s. A multitude of entities and market players have embraced the idea of value-enhancing ESG and effectively propelled it into the mainstream — a phenomenon that the authors observe “reveals how the corporate governance machine took a concept that was unlinked from shareholders, and through law, institutions, and culture, reshaped it, and in so doing, allowed it to thrive.”

Finally, the authors turn to benefit corporations — a wholly new twenty-first-century form of business organization specifically for organizations that aim to pursue profits and a social purpose — to illustrate how the corporate governance machine “forced alternative

conceptions of corporate purpose into an entirely separate form of incorporation.” Despite the alternative that a benefit corporation offers the corporate landscape, its existence ultimately reinforces the directional focus of corporate governance on shareholder interests.

Implications and Future Paths

The implications of the reigning system of U.S. corporate governance are broad; not only does it affect regulatory trends, but it also impacts public and private corporate structures, activities of public companies, and corporate governance innovation.

Denoting how the corporate governance machine shapes the development of corporate regulation in a predictable shareholderist direction, the authors explain that even advocates for corporate governance reform couch their ideas in pervasive language of shareholder primacy. For example, advocates who urge the SEC to require ESG disclosures emphasize the information’s materiality to investors — something Pollman and Lund determine to be “a wise strategic move in our existing system that prioritizes investor interests.”

Further, they write that “the corporate governance machine pushes many firms toward one-size-fits-all governance solutions” which are “are often embodied in corporate governance codes adopted by industry groups, as well as the voting guidelines adopted by proxy advisors and major institutional investors.” Companies that elect not to follow industry “best practices” guidelines incur pushback, and the corporate governance machine “constrains value-enhancing experimentation in governance when that innovation threatens shareholder rights.”

Notedly, many private companies follow uniquely tailored processes in their own operation prior to going public, at which point they tend to reorganize themselves to align with principles promulgated by the corporate governance machine. Considering this, the authors surmise that its “influence should be viewed as not only contributing to the trend of companies staying private longer and pushing for dual-class structures but also shaping the activity of those in the public realm.”

Finally, the corporate governance machine unquestionably impacts the future of corporate governance by pushing stakeholder models to fit their reforms into existing infrastructure. Acknowledging that a shareholder-dominated system of corporate governance is far from inevitable, the authors underscore the myriad interconnected ways in which the system perpetuates this orientation.

“As shareholder primacy has evolved from a rule to a system, it has generated a reinforcing momentum,” write Pollman and Lund. “In particular, the institutional framework that encompasses the corporate governance machine substantially increases the costs associated with moving to a new paradigm. As such, stakeholderism is unlikely to dethrone shareholder primacy; however, it may gain ground by shaping the meaning of shareholder primacy to encompass stakeholder interests.”