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Corporate Governance in the Great Recession

by Brian Risman, Publisher and Founder, The Law Journal UK and Consultant in International Law

What does corporate governance mean after the financial meltdown? In the article below, we explore the expansion of corporate governance as the Obama-led public intervention in the corporate world grows. What does this transformation mean for company and securities law?

Corporate Governance is a concept whose boundaries are not fixed. It is fluid, and in fact keeps expanding and changing as the environment around it similarly changes. 

For example, up until the mid-19th century, companies held little distinction between the members/owners and the managers. In fact, in most companies they were the same group of people. Moreover, most companies, other than those create by Royal Charter, had little if any impact on the welfare of the nation as a whole. In the case of companies created by Royal Charter, these companies operated for the most part outside of England. In fact, these companies, in their areas of operation, acted as the government of those areas. An example is the Hudson’s Bay Company in large areas of British North America.  

Hence, there were really two types of companies. First, those within England, where governance was irrelevant, since the ownership and the management were the same. Second, those operating outside of England, which operated as a de-facto government, facing no real authority – and in fact acting as the governmental authority in many cases. 

A similar situation existed in the United States. Companies such as the United Fruit Company ruled much of Central and South America. And, in the event their pseudo-governmental authority was challenged, they could rely on US government military support to enforce their wishes. 

Accordingly, there were two traditions. First, for the small firm, governance was not an issue since ownership and management were the same – and, the socio-political impact of a firm on the national welfare was minimal. Second, for the charter or large firm, governance was not part of their tradition either – there was no real authority over and above the charter company. There were shareholders of the charter company, but they were of the management group. For example, even when slavery was banned in the British Empire in 1807, companies felt free to openly ignore this law, still engaging in the slave trade. However, if they were caught by Royal Navy ships, these company ships would dump their cargo – the slaves – overboard. So much for corporate social responsibility. 

Hence, there was more of a tradition in large companies of ‘corporate governing’ as opposed to ‘corporate governance’. Companies never saw the need to consider concepts such as corporate social responsibility (CSR) or ‘corporate governance’. 

Therefore, corporate culture developed in two different streams. First, the small firm in which corporate governance was not necessary; and second, the large firm in which corporate governance did not exist, since the firm was its own authority. 

Corporate governance, then, has not been a principle that evolved with the development of companies. Rather, it has been an unnatural graft on the corporate mind and body. That graft sometimes harmonises with, but more often opposes and conflicts with the natural corporate goal of profit maximisation. 

We should realise, then, that corporate governance is not a natural component of the company. It is important to understand that attempts to implement corporate governance in the legal system will lead to concerted attempts to avoid or circumvent laws in that area.

For example, the Cadbury Committee, among others, found that attempts to implement effective Audit, Remuneration and Appointment Committees with members independent of the company, proved difficult at best. Yes, many of these members did not belong to the company. However, they were frequently in the other board member’s social circle. Hence, independence did not truly exist. 

Corporate culture, then, has actively or inherently worked to oppose the effectiveness of Corporate Governance measures. It is also clear that following past tactics and practices in implementing Corporate Governance would prove similarly ineffective. 

How, then, can the law implement Corporate Governance principles that will encourage their adherence, and not their circumvention? How can law even produce these principles when the very nature of Corporate Governance is shifting? What are the boundaries to Corporate Governance?

The evolving nature of Corporate Governance was further exacerbated by the impacts of actions subsequent to the Financial Meltdown in the autumn of 2008. Until 2008, this principle was based on protection of the shareholders, and to some extent stakeholders, by various means such as independent directors. Now, Corporate Governance has moved far beyond that point. 

Governments, including central banks, have moved beyond either the prescriptive approach to regulation of the US Securities and Exchange Commission (SEC) or the principle-based approach of the UK Financial Services Agency (FSA), to an aggressive micro-management of companies that do not follow the rules laid down by government. 

Note that many of these government controls are based on the political and financial power created by bailouts by governments and central banks. Further, many of these controls are quasi-legal, such as the “pay czar” in the US Obama Administration. In this position, the “czar” can determine the pay and remuneration packages of corporate employees. This approach is legal in a sense – the majority or controlling shareholder (now the government) has the voting power to make the rules for the company, including corporate remuneration. However, the government is not just a normal shareholder. Its goals are: return of the funds given for bailout; and prevention of any future abuses similar to those precipitating the Financial Meltdown. Further, the motivations of the Government are different from that of normal, traditional shareholders – growth, income, security. Hence the interest of traditional shareholders, reflected in Company and Securities Law, is not the goal of the new controlling shareholder. 

Hence while the letter of the law is being followed in the government interventions, the spirit of the company law is not. Instead, it is being used to actually oppose the Company Law and Securities Law goals of expediting profit maximisation while protecting shareholders. 

The move away from profit maximisation and protection of shareholders in Company and Securities Law then leads to two approaches: buying your way out of the government control, or submitting to it. The government has made it difficult to wrest the companies from their control – in a sense, a violation of the principle of ‘equity of redemption’ similar to that of mortgages. 

The government has moved into the powers beyond anything seen before. For instance, in a proposed bill before the US Congress, the Obama administration has proposed that government can seize a wide variety of financial companies in addition to commercial banks. Such cases would allow them to fire directors, wipe out shareholders and force creditors to take big discounts on their debt.

This is a vast change from past case law. In the US, in the Great Depression of the 1930s – a much more serious situation than that of today -- the Roosevelt administration’s National Industrial Recovery Act (NIRA) of 1933, the centrepiece of the New Deal, was struck down as unconstitutional by the US Supreme Court in Schechter Poultry Corporation v United States. 

In the UK, the post-WWII Attlee Labour government lost several cases where proper compensation was not paid to shareholders for nationalised companies. 

In fact, in international agreements on free trade, it is standard (for example, in NAFTA) that appropriate compensation is paid for expropriation – and that expropriation only is allowed under certain circumstances. Countries such as India have lost credibility for violating these rules on expropriation.

Moreover, the presence of the government as the majority or controlling shareholder does not justify ignoring the checks and protections in Company Law on those majority/controlling shareholders. From winding up the company s.122(1)(g) Insolvency Act 1986, to Unfair Prejudice (s.994 of the Companies Act 2006, formerly s.459 of the Companies Act 1985), protection against majority/controlling shareholders exist. Majority/controlling shareholders cannot, for example, at will wipe out the minority shareholders. 

What needs to occur is a redefinition of the law to meet the needs post-Financial Meltdown. Those changes, however, cannot, because of stare decisis -- the concept of case precedence -- wipe out statute and case law that has been in place for over a century.

Is there a better approach than this mass elimination of long established political and legal principles?

The best approach is to utilise incentives that will have effect for the good of all.

These recommendations would provide profit incentives for completion of certain goals, such as meeting certain social goals. These goals can work within the motivations of corporations – for example, acting in a manner that is profitable, but is also positive for the public welfare. This would include advisory groups that would provide guidance as to appropriate actions in society, and which would have the right to publicise wrongs being committed. It could still include the draconian measures as currently being proposed – but those measures would be limited in their application, and be heavily monitored with the appropriate sunset clause.

With this approach, corporate governance will have a reasonable chance of success. Such success can only occur if corporate governance is allowed to grow with incentives following legal traditions -- not dictates from government.

Otherwise, the approach being taken by governments will inhibit recovery, rather than help society emerge from the Great Recession.

As US Supreme Court Justice Louis Brandeis told aides to President Roosevelt after the Schechter decision noted above, “This is the end of this business of centralisation, and I want you to go back and tell the president that we're not going to let this government centralise everything."

Judge Brandeis's words in the Great Depression ring true through the ages to the current Great Recession.

Brian Risman, Publisher and Founder, The Law Journal UK and The Law Student UK

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