A New System of Corporate Governance: The Quinquennial Election of Directors, Essays (university) of Corporate Finance

Download A New System of Corporate Governance: The Quinquennial Election of Directors and more Essays (university) Corporate Finance in PDF only on Docsity! A New System of Corporate Governance: The Quinquennial Election of Directors Martin Lipton and Steven A. Rosenblumt- INTRODUCTION Corporate governance is a means, not an end. Before we can speak intelligently about corporate governance, we must define its goals. In much of the recent academic literature on corporate gov- ernance, however, the goals are either ill-defined or assumed with- out examination. Academic writers commonly assume that a corpo- rate governance system should be designed primarily to ensure that the actions of a corporation’s managers and directors accu- rately reflect the wishes of its stockholders.’ This assumption rests in turn on the premise that stockholders, as owners of the corpora- tion, have the intrinsic right to dictate the corporation’s course and receive its profits. Once this premise is accepted, the recognition of the separation cf ownership and management as the central char- acteristic of the modern public corporation2 leads inexorably to the conclusion that the central goal of corporate governance is to disci- pline managers, that is, make managers conform their actions to the desires of stockholders. This line of academic analysis has coincided with the rise of hostile takeovers. Ignoring the quite varied sources and motiva- tions of hostile acquirers, academic writers have embraced the hos- tile takeover as the free-market device to rid corporations of bad managers and give stockholders their entitled profit in the pro- t Members of the Firm of Wachtell, Lipton, Rosen & Katz, New York. The authors’ colleague, Yvonne M. Dutton, assisted in the preparation of this Article. ’ See, for example, Frank H. Easterbrook and Daniel R. Fischel, The Proper Hole o/ o Target’s Management in Responding to a Tender Ogler, 94 Harv L Rev 1161, 1191, 1201 (1981) (managerial passivity in response to takeovers best serves stockholder interests); Ronald J. Gilson and Reinier Kraakman, Reinuenting the Outside Director: An Agenda Far Institutional Investors 31-32, 38, 46-48 (John M. Olin Program in Law and Economics, Stanford University Law School, 1990) (on file with U Chi L Rev) (proposing a corps of professional outside directors dependent on institutional stockholders, not management, for their positions); Louis Lowenstein, What’s Wrong with Wall Street: Short-term Gain and the Absentee Shareholder 209-18 (Addison-Wesley, 1988) (institutional stockholders should nominate 20-25 percent of board, to encourage their participation in corporate governance). ’ See generally Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (Hercourt, Brace & World, rev ed 1968). 187 188 The University of Chicago Law Review [Sk187 cess.3 Accordingly, these writers have proposed corporate govern- ance rules designed to ensure that corporate managers and direc- tors cannot impede a hostile takeover. Upon examination, however, the unspoken premises of this body of academic literature are seriously flawed. First, there is no basis for the assumption of intrinsic rights and entitlements in the corporate structure. The Anglo-American corporate form is a crea- tion of the state, conceived originally as a privilege to be conferred on specified entities for the public good and welfare. While the cor- porate form became more widely available as the economy de- manded it, and is now generally available to any business, it re- mains a legal creation. As with any legal construct, we must justify the rules governing it on the basis of economic and social utility, not intrinsic rights. If alteration of those rules benefits the eco- nomic system and, in the long run, the corporatiors themselves, notions of “intrinsic rights” should not stand in the way. Second, the academic literature has vastly overstated the ben- efits of the hostile takeover. Even if one accepts the priority of dis- ciplining managers, the hostile takeover has proven a particularly destructive and inefficient means of such discipline. Hostile take- overs have not led managers to manage more effectively or to cre- ate more successful business enterprises. Instead, together with the increasing dominance of institutional stockholders, hostile takeover activity has led to an inordinate focus on short-term results and a dangerous overleveraging of the American and British economies, the ill effects of which are only beginning to emerge. The present lull in hostile takeover activity provides an oppor- tunity to reexamine our system of corporate governance relatively free of the high emotions of the 1980s. But the need for reexamina- tion remains pressing. While the pace of hostile takeover activity has slowed, reflecting in part the current recession, hostile take- overs remain very much a part of the corporate landscape and managerial thinking. Moreover, the growing power of institutional stockholders, and their increasing willingness to exercise that J See, for example, Easterbrook and Fischel, 94 Harv L Rev at 1198 (cited in note 1) (managerial passivity in response to tender offers forces managers to put stockholder wealth ahead of their desires to protect their own positions); Lucian A. Bebchuk, The Case For Facilitating Competing Tender Oglers, 95 Harv L Rev 1028 (1982) (supporting a rule of auctioneering, rather than passivity, in which incumbent management solicits competing bids); Ronald J. Cilson, A Structural Approach to Corporations: The Case Against Defen- siue Tactics in Tender Offers, 33 Stan L Rev 819, 878-79 (1981) (proposing a rule that limits management’s ability to interfere with stockholders’ decision to accept or reject tender offers). 19911 Quinquennial Election 191 radic and non-systematic, and has engendered much criticism from academic circles.’ In this Part, we analyze three intellectual underpinnings of the managerial discipline model: the paradigm of the stockholder as property owner; the notion that managers are self-interested and require external discipline in order to run their companies well; and the view that the hostile takeover is an effective instrument of discipline. We conclude that’ each of these concepts is deeply flawed, and that the managerial discipline model is thus inade- quate as the basis for a system of corporate governance. A. The Stockholder as Property Owner The managerial discipline model of corporate governance rests in large part on the paradigm of the stockholder as owner of the corporation, standing in much the same relationship to the corpo- ration as the owner of any item of private property stands to that property.s One of the fundamental principles of a capitalist legal system is that the owner of private property may do with that property as he wishes, so long as he does not harm third parties. Once one accepts the premise that stockholders own the corpora- tion in the same manner as they own any other private property, Transfer Binder] Fed Secur L Rptr (CCH) 1 94,334 at 92,173 (Del Chant 1989) (directors need not pursue immediate maximization of share value by redeeming rights plan at ex- pense of long-term business plan). Chancellor William T. Allen of the Delaware Chancery Court noted in a recent speech, “The assumption that we want corporation law to more perfectly align manager action with shareholder interest is fundamental to the traditional legal view of the domain of corpora- tion law. But that assumption was tested in the takeover setting in the 1980s and guess what? As George Gershwin put it, it ain’t necessarily so.” William T. Allen, Competing Con- ceptions of the Corporation in American Low 9 (Rocco J. Tresolini Lecture in Law, Lehigh University, Ott 29, 1990) (on file with U Chi L Rev). Because about 50 percent of the major public companies are incorporated in Delaware, the Delaware courts, more than any others, have been compelled to be the judicial arbiters of the corporate governance debate. Chancel- lor Allen, in his decisions and speeches, has demonstrated a keen understanding of corpo- rate governance issues and the ramifications of judicial decisions on the business and poli- cies of corporations. Together with the Delaware Supreme Court, he has fashioned a series of decisions, including the Time and 7%’ Seroices cases cited above, that have enabled boards of directors to blunt, if not defeat, some of the ill effects of the takeover wave of the 1980s. ’ See, for example, Easterbrook and Fischel, 94 Harv L Rev at 1190-92 (cited in note 1) (criticizing the view of some commentators that, in responding to a tender offer, the target board should consider the interests of various non-investor groups); Gilson, 33 Stan L Rev at 862-65 (cited in note 3) (rejecting the argument that responsiveness to non-stockholder constituencies justifies management discretion in preventing tender offers). a See, for example, Frank H. Easterbrook and Daniel R. Fischel, Takeover Bids, De/en- siue Tactics, and Shareholders’ Welfare, 36 Bus Law 1733, 1733 (1981) (“corporations exist and conduct their affairs for the benefit of the shareholders”). 192 The University of Chicago Law Review [58:187 the conclusion that the wishes of the stockholders must be the par- amount focus of the corporation follows, constrained only by the limitation on injuring third parties embodied in concepts such as environmental or products liability tort principles. From this start- ing point, the descriptive observation that separation of ownership and management is thelcentral characteristic of the modern public corporation leads to the normative conclusion that the primary goal of corporate governance is to ensure that managerial actions conform to the wishes of stockholders. If the corporation is simply private property for the stockholders to do with as they please, the directors and managers of the corporation should, ideally, be no more than implementers of the stockholders’ desires. This line of reasoning, however, suffers from two major flaws. First, the corporation, particularly the modern public corporation, is not private property like any other private property.“ Rather, it is the central productive element of the economies of the United States and the United Kingdom. The health and stability of these economies depends on the ability of corporations to maintain healthy and stable business operations over the long term and to compete in world markets.‘O The corporation affects the destinies of employees, communities, suppliers, and customers. All these constituencies contribute to, and have a stake in, the operation, success, and direction of the corporation. Moreover, the nation and the economy as a whole have a direct interest in ensuring an envi- ronment that will allow the private corporation to maintain its long-term health and stability. Rules of corporate ownership and governance must take account of many more interests than do the rules governing less complex property. The origins of the public corporation reinforce this contrast with ordinary private property. Corporations came into being in England and the United States as quasi-public entities, granted legislative charters to serve specific public as well as private pur- poses.” Companies such as the British East India Company and @ Professor Berle divides property into two classifications: (1) consumption property and (2) productive property--“property devoted to production, manufacture, service or commerce, and designed to offer, for a price, goods or services to the public from which a holder expects to derive a return.” Berle and Means, The Modern Corporation at xi (cited in note 2). lo Copitolism, The Economist 5, 6 (May 5, 1990) (“Capitalism”) (“The proper ‘micro’ in microeconomics is the individual firm. How well it does, multiplied by thousands and millions of times, determines how well the economy does.“). ” Berle and Means, The Modern Corporation at 120 (cited in note 2). For an overview of the corporation in American law, see generally Lawrence M. Friedman, A History of American Law 511-25 (Simon & Schuster, 2d ed 1985). 19911 Quinquennial Election 193 the Hudson Bay Company were political instrumentalities as well as profit-making enterprises.‘* Legislatures granted charters to early American corporations so that religious, educational, and charitable organizations could hold property and act as indepen- dent legal entities. Later charters established banks, canal compa- nies, aqueduct companies, and other businesses essential for trade and city development.13 General incorporation statutes did not be- come predominant until the late nineteenth century.” This au- thorization of general incorporation rights reflected a policy choice to encourage the general aggregation of capital by freeing the owner/stockholders from the risk of unlimited liability. Given the corporation’s origins as a historical and legal con- struct created for specific public policy reasons, the state naturally may choose to condition the use of the corporate form upon com- pliance with rules that advance societal goals, even if those goals clash with stockholder interests. For example, corporations must observe laws governing polluting, worker safety, child labor, the right of workers to unionize, foreign corrupt practices, product safety, and a host of other corporate behavior that affects society at large. There is no a priori reason why rules of corporate gover- nance should not similarly take account of public purposes. To the extent there is an intrinsic nature to the corporation, it is more akin to that of a citizen, with responsibilities as well as rights, than to that of a piece of private property. Second, the managerial discipline model tends to ignore or dis- miss the implications for corporate governance of the changing na- ture of corporate ownership. Just as the corporation is not analo- gous to ordinary private property, neither is the stockholder in the modern public corporation analogous to the owner of ordinary pri- vate property. The stockholder owns an interest in a share of stock, a financial investment granting no direct control over the properties, equipment, contract rights, organizational structure, and other elements that make up the corporation itself. That share may entitle the stockholder to a percentage of the profits and Ia Samuel Williston, History of he Law of Business Corporations Be/ore 1800, 2 Harv L Rev 105, 108-11 (1888). Ia James Willard Hurst, The Legitimacy of the Business Corporation in the Lau, o/ the United Stales 1780-1970 13-20 (Virginia, 1970); Ronald E. Seavoy, The Origins o/ the American Business Corporation, (1784-1855~ 5-7 (Greenwood, 1982). See also Liggett Co. u Lee. 288 US 517. 545 (1933) (Brandeis dissenting) (early charters granted only when neces- sary to procure some specific community benefit). ” See Berle and Means, The Modern Corporation at 126-27 (cited in note 2) (discuss- ing the appearance of the early general incorporation statutes). 196 The University of Chicago Law Review [Sk187 fering perspectives as to the appropriate direction and business plan of the corporation. While a stockholder seeking a short-term premium may object to takeover impediments, antitakeover provi- sions can be a quite rational tool for a board of directors seeking to preserve the corporation in the face of an attempted takeover that is likely to be detrimental to the long-term health of its business. Similarly, while a stockholder with a short-term investment hori- zon may object to a business combination that initially hurts the corporation’s earnings per share, the business combination may re- flect the good faith judgment of the corporation’s directors and managers that the step is necessary to position the corporation to prosper over the long term. The managerial discipline model also dismisses the substantial common law and statutory legal strictures already in place that ad- dress overt self-dealing or self-interestedness. Transactions with the corporation in which a director or manager has a personal fi- nancial interest receive close scrutiny.** Insider trading rules23 and short-swing profit recovery*’ guard against the misuse of informa- tion in stock trading by directors and managers. Moreover, sub- stantial existing financial and social incentives motivate directors and managers to seek the business success of the corporations they direct or manage. Incentive compensation based on appreciation of the stock of the corporation, or based on increasing earnings and exceeding budget targets, provides managers with financial rewards ‘* See, for example, Fliegler u Lawrence, 361 A2d 218, 221 (Del 1976) (where defend- ante stood on both sides of transaction, burden was on defendants to demonstrate transac- tion’s intrinsic fairness to the acquiring firm and its stockholders); AC Acquisitions Corp. u Anderson, Clayton and Co., 519 A2d 103, 111 (Del Chant 1986) (board with financial inter- eat in transaction adverse to corporation bears burden of proving the transaction’s intrinsic or objective fairness); Cuth u Loft, Inc., 23 Del Chant 255, 5 A2d 503, 510 (1939) (rule demands of a director the most scrupulous observance of his duty to “refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasona- ble and lawful exercise of ite powers”). In addition to case law, approximately three-quarters of the states have enacted statutory provisions governing contract.9 with interested directors. See. for example, 8 Del Code Ann 5 144 (1990). ‘a Section IO(b) of the Securities Exchange Act of 1934, 15 USC 5 78j (1988) and Rule lob-5 promulgated thereunder, require that an insider who possesses material nonpublic information about a company make appropriate dieclosure of the information or abstain from trading in the company’s stock. See In re Cady, Roberts & Co., 40 SEC 907, 911 (1961). ” Section 16(b) of the Securities Exchange Act of 1934, 15 USC 5 78p(b), provides for a rule of strict liability, entitling an issuer to recover any profits realized by a director, officer, or beneficial owner of ten percent of an issuer’s outstanding stock, from the purchase or sale of any equity security of the issuer. 19911 Quinquennial Election 197 tied to the success of the corporation.2b An executive’s social sta- tus, and the respect of fellow executives, typically depend in large part on the success of the corporation he or she manages. Indepen- dent directors’ reputations, and to some extent their opportunities to serve on other boards, are tied to the business success of their corporations.2e The managerial discipline model’s emphasis on reining in managerial self-interest is thus just as flawed as its emphasis on conforming the actions of managers to the desires of the stockhold- ers. The greater problem, or challenge, is to design a system that gives managers the opportunity and the incentive to work in part- nership with stockholders and the corporation’s other constituen- cies in improving the long-term business performance of the corpo- ration. The quinquennial proposal advanced in Part IV addresses this problem. C. Hostile Takeovers as an Instrument of Discipline Academic proponents of the managerial discipline model of corporate governance tend to embrace the hostile takeover as the primary instrument of managerial discipline. They argue that bad, inefficient, or self-interested managers, or managers who fail to heed the wishes of the stockholders, will find themselves vulnera- ble to a hostile takeover. If the state does not permit incumbent management to interfere with stockholders’ freedom to accept tender offers, the argument continues, the fear of a hostile take- over will make bad managers good, inefficient managers efficient, and self-interested managers responsive to stockholder desires.*’ In p1 The quinquennial proposal set forth in Part IV suggests tying these financial incen- tives to the performance of the corporation over five-year periods as part of the effort to reorient the corporation towards long-term business performance. See Part 1V.E. I0 See Eugene F. Fame, Agency Problems and the Theory of the Firm, 88 J Pol Econ 288, 294 & n 3 (1980) (discussing market for outaide directors: “Like the professional outside director, the welfare of the outside auditor depends largely on ‘reputation.’ “I. But see Gilson and Kraakman, Reinoenhg the Outside Director at 22-23 & nn 41-42 (cited in note 1) (arguing that no effective market for outside directors exists). While perhaps not as developed as the market for outside auditors, our experience is that reputation is important in creating opportunities for outside directors. ” See, for example, Cilson & Kraakman, Reinventing the Outside Director at 12-13 (cited in note 1) (mere threat of hostile offer is likely to improve target management); Eas- terbrook and Fischel, 94 Harv L Rev at 1169 (cited in note 1) (“tender bidding process polices managers whether or not a tender offer occurs”); ALI, Principles of Corporate Goo- ernance: Analysis and Recommendations part VI at 98 (Tent Draft No 10, 1990) (“ITlender offers are mechanisms through which market review of the effectiveness of man- agement’s delegated discretion can operate.“). See also Finnegan o Campeau Corp., 915 F2d 824, 831 (2d Cir 1990) (“Congress realized ‘that takeover bids should not be discouraged 198 The University of Chicago Law Review [58:187 practice, however, the hostile takeover is not a particularly effec- tive or efficient means of motivating or disciplining managers. The enthusiasm for the hostile takeover as the primary instru- ment of managerial discipline rests heavily on the efficient capital markets theory that has dominated the academic literature over the last two decades. This theory holds, in essence, that the market price of a corporation’s stock at any given time accurately reflects all available information about the corporation and its anticipated future income stream. Accordingly, the argument continues, the market can neither undervalue nor overvalue a corporation’s worth.** The willingness of an acquirer to pay a premium to the market price, then, necessarily implies that the acquirer can in- crease the value of the corporation by managing the assets better, thus demonstrating the inefficiency of the existing management. In recent years, however, the efficient capital markets theory has become increasingly discredited, especially since the stock market crash of October 1987.2e A growing body of economic litera- ture now accepts that the stock market can and does misprice par- ticular stocks, groups of stocks, and even stocks in general for ex- tended periods of time. so The new literature recognizes the great degree of subjectivity, and even irrationality, among investors who set the demand for and the price of stocks.31 Recent literature also because they serve a useful purpose in providing a check on entrenched but inefficient man- agement.“‘) (quoting legislative history of the Williams Act, S Rep No 90-550, 90th Cong, 1st Sess 3 (1967)). *O See, for example, Easterbrook and Fischel, 36 Bus Law at 1734 (cited in note 8) (“[T]he notion that stock is priced in the market at less than its true value is implausible.“); Werner F.M. De Bondt and Richard H. Thaler, A Mean-Reoerting Walk Down Wall Street, 3 J Econ Persp 189, 189 (1989) (“Few propositions in economics are held with more fervor than the view that financial markets are ‘efficient’ and that the prices of securities in such markets are equal to their intrinsic values.“). *O Andrei Shleifer and Lawrence H. Summers, The Noise Trader Approach to Finance, 4 J Econ Persp 19.29 (1990) (“[S)tock in the efficient markets hypothesis-at least as it has traditionally been formulated-crashed along with the rest of the market on October 19, 1987,” when “a 22 percent devaluation of the American corporate sector” occurred in one day.). a0 See Stephen F. LeRoy, Effcient Capital Markets and Martingales, 27 J Econ Lit 1583, 1616 (1989) (“The most radical revision in efficient-markets reasoning will involve those implications of market efficiency that depend on asset prices equaling or closely ap- proximating fundamental values. The evidence suggests that, contrary to the assertion of this version of efficient markets theory, such large discrepancies between price and funda- mental value regularly occur.“); E. Victor Morgan and Ann D. Morgan, The Stock Market and Mergers in the United Kingdom 74 (David Hume Institute, 1990) (“There are powerful reasons for believing that equity markets, in the UK and elsewhere, are unlikely to be fun- damental-valuation efficient but, in view of the difficulty of testing and the paucity of fac- tual evidence, the question must remain open.“). ” See, for example, Shleifer and Summers, 4 J Econ Persp at 19-20 (cited in note 29) 19911 Quinquennial Election 201 bad, inefficient, or self-interested management is the sole or pri- mary source of this takeover activity. The anecdotal evidence supports this conclusion. In recent years, well-managed corporations have been just as likely as poorly managed corporations to become the target of a hostile takeover. For example, AMR Corporation (the parent of American Airlines) became the subject of a takeover attempt by Donald Trump, al- though the chairman of AMR is generally recognized as the best manager in the airline industry.‘O Georgia-Pacific Corporation ac- quired Great Northern Nekoosa Corporation even though Great Northern Nekoosa’s return to stockholders for the prior ten years exceeded that of Georgia-Pacific and the industry as a whole.41 Georgia-Pacific’s stock price and earnings have since declined.‘* Even noted raider Sir Gordon White, Chairman of Hanson Indus- tries, in defending hostile takeover activity, notes: “There are a large number of companies which are regarded, by and large, as well run. Of course, these companies can be taken over as the re- sult of a hostile bid but the shareholders can and do demand a very high price.“43 If poor or inefficient management is not the primary impetus for hostile takeovers, it follows that takeovers do not generally mo- tivate managers to manage better or more efficiently. Rather, the hostile takeover motivates managers to combat the undervaluation of their stock by leveraging the corporation, avoiding investments that do not immediately add to reported earnings, selling assets, or otherwise boosting short-term earnings, regardless of the possible harm to the corporation over the long term.44 Even to the extent l O See Judith H. Dobrzynski, Why Eoen Well-Run Companies Can Be Easy Prey, Bus Week 56 (Ott 23, 1989); Erik Hedegaard, Fasten Your Seatbelt, Bob, It’s Going to be a BUMPY Year, M Inc. 61 (Jan 1991) (“American Airlines’ Robert Crandall is considered the best in the business.“). ” See Great Northern Nekoosa Corporation Letter to Shareowners (Nov 13,1989), filed with the Securities and Exchange Commission as Exhibit 15 to Great Northern Nekoosa Corporation Schedule 14D-9 (on file with U Chi L Rev). ‘I Jacqueline Bueno, Georgia-Pacific Earnings, Stock Price Take a Tumble, Atlanta Bus Chron 3A (Sept 3, 1990). The authors’ law firm represented AMR and Great Northern Nekoosa in these takeover matters. While these two examples do not demonstrate that all takeovers are bad, they do undercut any close linkage between takeovers and incentives for competent management. ‘S Sir Gordon White, Why Management Must Be Accountable, Financial Times 5 1 at 11 (July 12, 1990). ‘* See, for example, Richard Lambert and Anatole Kale&sky, Jam Today Is What Shareholders Want, Financial Times 5 1 at 21 (July 12, 1989) (“The last-ditch defence against hostile takeovers has thus been for existing managements to steal the raider’s thun- der by arranging a leveraged buy-out.and recapitalisation themselves. . . . Ironically, in many cases it is the existing management, rather than the outside raider, that ultimately ‘-ads a company up with greater debts and becomes the more ruthless liquidator.“); Chris- 202 The University of Chicago Law Review [58:187 mismanagement does contribute to hostile takeover activity, the threat of a hostile takeover is far more likely to create an attitude of defensiveness on the part of managers than to create an open- ness to the kind of change and new ideas that might serve to im- prove business performance.‘” Some hostile takeovers may replace bad managers with new ones who may or may not be better. But the threat of a hostile takeover is unlikely to improve the perfor- mance of bad managers.40 Finally, as we discuss in Part II, hostile takeovers and related short-termism have imposed substantial an- cillary societal costs. In sum, the managerial discipline model of corporate govern- ance is not compelling. We must turn, then, to the examination of the corporation’s proper place in our economy and society, the challenges for corporate governance, and the question of how best to reconcile the interests of the corporation’s various constituents and our economy and society as a whole. II. THE INTEREST OF THE CORPORATION IN ITS LONG-TERM SUCCESS AND THE SOCIETAL COST OF SHORT-TERMISM In this Part, we offer an alternative to the managerial disci- pline model. We argue that the corporation has an independent interest in its own long-term business success. Classical economic theory suggests that this interest, multiplied by many individual topher Farrell, The Bills Are Coming Due, Bus Week 84 (Sept 11, 1989) WSG Corp. “beat back a takeover raid last year through a 82.2 billion recapitalization. . . . USG has slashed its research-and-development staff and expenditures in half, nearly halved capital spending, cut its work force from 21,000 to 16,000, reduced the management ranks by lo%, and sold assets worth $600 million-including highly profitable Masonite Corp. . . . Competitors smell blood.“). *I John C. Coffee, Jr., Regulating the Market for Corporate Control: A Critical Assess- ment of the Tender Offer’s Role in Corporate Gouernance, 84 Colum L Rev 1145, 1242-43 (1984) (The work of Douglas McGregor and “a legion of other social scientists” suggests that “management will be more effective if it creates an environment that stresses support and encouragement rather than constant threats of dismissal. . . . In this view, the constructive deterrent value of the takeover lies more in its ability to function as the corporate guillotine, amputating swiftly and finally an inefficient management, and less in its general deterrent effect as a motivating force by which marginal managements are spurred to greater effort.“). ” Melvin Aron Eisenberg, The Structure o/ Corporation Law, 89 Colum L Rev 1461, 1497-99 (1989) (threat of a takeover may make some managers more efficient, but “the take- over market neither adequately aligns the interests of managers and shareholders, nor ade- quately addresses the problem of managerial inefficiency”); Coffee, & Colum L Rev at 1192- 95 (cited in note 45) (capital market is only an effective monitor in cases of massive manage- rial failure); Michael L. Dertouzos, Richard K. Lester and Robert M. Solow, Made in America: Regaining the Productive Edge 39 (MIT, 1989) (“Only an extraordinary optimist could believe, for example, that the current wave of takeover activity is an efficient way to deal with the organizational deficiencies of American industries.“). 19911 Quinquennial Election 203 firms, is also society’s interest and therefore supplies the proper organizing principle of corporate governance. The ascendancy of the institutional stockholder and the hostile takeover, however, creates an emphasis on short-term results that makes it increas- ingly difficult for the corporation to maintain the long-term focus necessary to its own and society’s well-being. The efficient capital markets theory that underlies academic support for takeovers, and that dismisses the distinction between short-term and long-term interests, has become increasingly discredited. The short-term bias imposed by institutional stockholders and takeover activity is real, and this short-term bias has substantial corporate and societal costs. In this context, the priorities of the managerial discipline model threaten to exacerbate the problems of short-termism. In- stead, our rules of corporate governance require the sort of funda- mental reform that will align the interests of all corporate constitu- ents toward the long term. A. The Interest of the Corporation as a Business Enterprise At the most basic level, the corporation is no more than a spe- cific legal form of business enterprise. It is a concatenation of fac- tors of production-property, equipment, employees, contract rights, and the like-organized to produce goods and services effi- ciently. To the extent that the enterprise is able to attract and re- tain consumers of its products or services who are willing to pay the enterprise more than it costs to produce the products or ser- vices, the enterprise will make a profit. The greater the amount of goods or services the enterprise can sell, and the greater the differ- ence between what the consumer is willing to pay and what the goods or services cost to produce, the greater the profit that inures to the enterprise. Viewed in this light, the corporate enterprise has an independent interest of its own in the successful operation of its business, with success measured in terms of present and expected profit. The notion of “the best interest of the corporation” refers to this interest in the present and continuing vitality of the enterprise.*’ Classical economic theory looks to the profit interest of propri- etors to ensure the health of business enterprises and, in turn, of ” TW Seruices, Inc. u SWT Acquisition Corp., [ 1989 Transfer Binder] Fed Set L Rptr (CCH) ll 94,334 at 92,178 (Del Chant 1989) Y[D]irectors . . . may find it prudent (and are authorized) to make decisions that are expected to promote corporate (and shareholder) long run interests, even if short run share value can be expected to be negatively affected.“). 206 The University of Chicago Law Review [58:187 long-term operating success of the corporation. They tend to focus instead on the current market price of the corporation’s stock. Most institutional stockholders will support a hostile takeover, a sale of assets, a leveraging recapitalization, or any other transac- tion that boosts the immediate price of the corporation’s stock. The critique of short-term bias is a critique not of the motives or integrity of institutional stockholders, but of the system that has failed to respond to the changing nature of stock ownership. While proposing a corps of professional directors to be nominated and elected by institutional stockholders, Professors Gilson and Kraakman recognize that institutional stockholders currently have little opportunity or incentive to take an interest in the long-term business development of the corporations whose stock they own.64 However, they would accept the short-term bias of institutional stockholders and seek to guarantee that the board of directors, in the name of heeding the wishes of stockholders, reflects this bias. In contrast, this Article suggests that the corporate governance system must attempt to counteract this short-term bias and realign the interests of stockholders with the interest of the corporation as an ongoing business enterprise. Several constraints operate on the institutional stockholder to produce a short-term bias. First, as their stock portfolios have grown in size, institutional stockholders have increasingly lost the ability to assess adequately the business performance of each port- folio company .bb For these stockholders, the market price of the corporation’s stock has become the only important valuation mea- sure for the corporation, and any step that boosts the short-term price of a portfolio company’s stock has become viewed as intrinsi- cally desirable. Second, institutional stockholders assess the performance of the investment managers who control their stock portfolios over a short time frame, typically quarter to quarter or year to year, on the basis of the change in the portfolio’s market value during the specified time period. b6 The investment manager trying to out- perform the market average in each quarter or each year will al- M Gilson & Kraakman, Reinoenting the Outside Director at 6-8 (cited in note 1). 61 Id at 6-7 (growth of funds under the management of institutional investors whose investment strategy is simply to track the general performance of the market reflects the inability or unwillingness of those stockholders to track the performance of individual cor- porations); Taylor, Harv Bus Rev at 72 (cited in note 53) (“Of the $40 billion in equities owned by the New York funds [three pension funds for retired state and local employees], $30 billion are in indexed portfolios.“). ” See Dertouzos, Lester, and Solow, Made in America at 62 (cited in note 46) (fund 19911 Quinquennial Election 207 ways have an incentive to accept, even seek, a short-term premium for a portfolio stock.67 This competition among investment manag- ers exacerbates a situation analogous to the “prisoner’s dilemma,” in which cooperation produces optimal results but rational, self- interested behavior does not. 68 Even if the investment manager un- derstands that stockholders as a whole would be better off encour- aging and promoting the long-term business development of all corporations, he will still accept, even seek, short-term premiums on his portfolio stocks in an effort to outperform competing invest- ment managers in any given quarter or year. Finally, the institutional stockholder faces liability constraints. The typical institutional stockholder has a fiduciary duty to the beneficiaries of its portfolio and must act solely in their interest.69 While fiduciary status does not intrinsically require a short-term orientation, to the extent the courts and government agencies such as the Department of Labor have accepted the managerial disci- pline model’s short-term bias, the institutional stockholder may fear exposure to liability if it fails to seek or accept the short-term premium for its portfolio shares.6o managers rapidly turn over stock holdings since judged on current value of investment port- folio). See also Lipton, 136 U Pa L Rev at 7-8 (cited in note 6). b’ See Crockett, Takeooer Attempts at 8 & n 8 (cited in note 32) (short time horizons of institutional stockholders result from “emphasis . . . placed on short-term performance in evaluating and rewarding fund managers”). eB See generally Anatol Rapoport and Albert M. Chammah, Prisoner’s Dilemma: A Study in Conflict and Cooperation (Michigan, 1965). Bs The Department of Labor (DOL) views the Employee Retirement Income Security Act of 1974 (ERISA), 29 USC I$ 1001 et seq (19881, as requiring plan fiduciaries to consider only the economic interests of the plan participants and beneficiaries in the shares held by the plan when deciding whether to tender shares in a tender offer. While the DOL has stated that plan fiduciaries may weigh the long-term value of the target company in this decision, it also warns that it will monitor plan fiduciaries to ensure that they do not violate ERISA’s requirements and are aware of the liability that can result from any such viola- tions. See Press Brie/kg on ERISA and Takeooers, in 6 Pension & Profit Sharing (Prentice- Hall) !l 135,649 at 136,971 (1989). See also David George Ball, Assistant Secretary, Pension & Welfare Benefits Administration, The Importance o/ Corporate Governance (speech to United Shareholders’ Association, Sept 17, 1990) (on file with U Chi L Rev). In practice, the DOL.9 statements have resulted in pressure on plan fiduciaries to tender their shares for the immediate premium, in order to avoid liability for incorrectly assessing the long-term value of the target corporation and its prospective return to stockholders. a0 See, for example, statement of David Walker, Assistant Secretary of Labor, in 6 Pen- sion and Profit Sharing at 136,971 (cited in note 59) (plan fiduciaries must look solely to economic interests of the pension plan, with purpose of maximizing retirement income for beneficiaries); Thomas Gilroy and Brien D. Ward, The Institutional Inoestor’s Duty Under ERISA to Vote Corporate Proxies, in Proxy Contests, Institutional Investor Initiatiues, Management Responses 1990 853, 866 (PLI, 1990) (DOL generally claims that ERISA’s prudence requirement “obligates the fiduciary to consider only economic factors that affect the value of the plan’s investment. For example, the decision to vote for a shareholder initi- 208 The University of Chicago Law Review [58:187 Commentators outside of academic circles have for some time noted the problem of short-termism.@” Because of the influence of the efficient capital markets theory, however, the academic litera- ture has tended to ignore the problem. Under the efficient capital markets theory, the short-term price of a stock reflects the present value of the corporation’s long-term results. Adherents of this the- ory thus define out of existence the distinction between short-term and long-term values or investor orientations.62 It is only with the recent undermining of the efficient capital markets theoryB3 that the academic literature, particularly the eco- nomic literature, has begun to examine the effects of short-term biases and short-term investment horizons. Professors Shleifer and Vishny, for example, have demonstrated that the short time hori- zons of arbitrage investors, who focus on short-term assets because they are relatively less expensive to arbitrage, may result in severe market underpricing of a corporation’s equity. This phenomenon in turn imposes a short time horizon on managers, who avoid long- term investments that depress share prices over the short term and that thus make the corporation vulnerable to hostile takeover.” They conclude that the “clustering” of arbitrage on the trading of short-term assets “leads to systematically more accurate pricing of short-term assets than of long-term assets, even though efficient capital allocation and managerial evaluation might be better served by the opposite bias.“e6 Other academic writers identify additional sources of short- term pressures and biases. Stephen LeRoy points to the recent literature on cognitive psychology for the proposition that stock- holders “systematically overweight current information and under- weight background information,“6e thus producing an artificially ative in the belief that it will support management’s commitment to stimulate job growth in a targeted sector of the economy may, in the DOL.9 view, violate [the fiduciary duty].“). ERISA provides that a plan fiduciary is “pereonally liable” for any breach of fiduciary duty. ERISA 5 409(a), 29 USC 5 1109(a). This provision may be enforced either by a plan partici- pant or beneficiary or by the Department of Labor. ERISA 5 502(a)(2), 29 USC 8 1132(a)(2). ” See, for example, John G. Smale, What About Shareowners’ Responsibility?, Wall St J 24 (Ott 16, 1987) (“by focusing on the short term, our publicly held bueiness enterprises will see their competitive position decay”); Alan Greenspan, Takeovers Rooted in Fear, Wall St J 28 (Sept 27, 1985) (“Excessively high discount factors place a disproportionate share of the value of a company’s stock on near-term earnings and dividend flows.“). *a See note 28 and accompanying text. ” See notes 29-32 and accompanying text. O’ Shleifer and Vishny, 80 Am Econ Rev Pap & Proc at 148 (cited in note 32). *O Id at 153. ” LeRoy, 27 J Econ Lit at 1616 (cited in note 30). 19911 Quinquennial Election 211 term adverse effect of these measures on the ability of our corpora- tions to compete against business enterprises whose ownership structures, and whose countries’ economies, promote investment in the future is apparent and becoming more severe. In his monumental study of global competition, Michael E. Porter identifies the growth of institutional investors in the United States to a position of dominance over the major business corpora- tions as the most significant factor in the decline of American industry: Unlike institutional investors in nearly every other advanced nation, who view their shareholdings as nearly permanent and exercise their ownership rights accordingly, American institu- tions are under pressure to demonstrate quarterly apprecia- tion. Pension consultants have grown up that collect fees by assisting funds in changing asset managers whose recent per- formance is deemed inadequate. Asset managers, in turn, re- ward their employees based on the appreciation of their port- folio in the last quarter or year. With a strong incentive to find companies whose shares will appreciate in the near term and incomplete information about long-term prospects, port- folio managers turn to quarterly earnings performance as per- haps the single biggest influence on buy/sell decisions. . . . Managers have become preoccupied with heading off take- overs through boosting near-term earnings or restructuring. While restructuring has often led to beneficial sales of un- derperforming assets, cost cutting, and sometimes the weeding out of poor managements, the completion of restructuring starts the same pressures running again. The taking on of sub- stantial debt in the course of restructuring, with proceeds paid to shareholders instead of invested in the business as was the case in highly leveraged Japanese companies, often leads to risk aversion and a slowing of true strategic innovation.76 The focus on the short term has also led to the overleveraging of our economy. 76 The last decade saw an unprecedented wave of r6 Michael E. Porter, The Competitive Aduantage of Nations 528-29 (Macmillan, 1990). ‘* See Farrell, Bus Week at 84 (cited in note 44) (There “is growing evidence that steep leverage is beginning to hobble management, a worrisome trend because Corporate America, in this decade, has retired nearly $500 billion in equity while piling on almost $1 trillion in debt.“). While determining the “right” level of debt is difficult, the leveraging wave of the last decade is particularly disturbing in that, historically, in times of economic expansion, 212 The University of Chicago Law Review [58:187 leveraged transactions, in the form of debt-financed acquisitions, leveraged buyouts, and leveraged recapitalizations. These transac- tions resulted in large measure from the demand for short-term stock premiums, regardless of the long-term consequences. In the rush to profit from leveraging or breaking up the corporation, ac- quirors and stockholders ignored the long-term implications of these actions. Leveraged transactions allow the acquirer to pay a premium to acquire a corporation using the corporation’s own as- sets as collateral. They allow the corporation to boost short-term value by paying stockholders a large special dividend, or to boost short-term stock prices by repurchasing a large portion of its stock. But these leveraged transactions also exacerbate the need to cut expenditures and future investments in order to produce short- term cash flow, and leave our corporations less able to weather eco- nomic downturns. The bankruptcies and workouts now in the news are the legacy of these leveraged transactions.” The increasing activism of institutional stockholders may well worsen the corporations’ preoccupation with the short term. Influ- ential groups such as the Council of Institutional Investors, the California Public Employees’ Retirement System (CalPERS), and the United Shareholders’ Association have historically promoted takeovers. Organized by these groups, large numbers of institu- tional stockholders have increasingly embarked on proxy voting agenda designed to remove takeover defenses and other impedi- ments to takeover premiums. 78 While takeover defenses have no intrinsic merit, they often provide the only means by which a cor- debt levels have decreased, providing a cushion for the next downturn. See Henry Kaufman, The Great Debt Ouerload Will Keep tire Recovery Feeble, Fortune 23 (Dee 31, 1990) (“The credit quality of American corporations deteriorated throughout the just-ended business ex- pansion. That is unprecedented; normally the financial condition of business improves when the economy grows.“). ” See Business Failures Increase 14.5% in First 9 Months, Wall St J B2 (Nov 2, 1990) (recent report by Dun & Bradstreet indicates that United States business failures rose 14.5% in the first nine months of 1990, to 43,836); Sharon Reier, A Banquet for Fat Cats: Bankruptcy, Financial World 36 (Ott 16, 1990) (blaming LBOs for the fact that the past two years have produced 13 of the nation’s 25 largest bankruptcies, accounting for close to $50 billion in assets); Daniel Wise, Workouts, Bankruptcy Work Replacing Junk Bonds Practices, NY L J 1 (Nov 2, 1989); Fred R. Bleakley, Many Firms Find Debt They Piled On in 1980s Is a Cruel Taskmaster, Wall St J Al (Ott 9, 1990) (belt tightening engendered by debt load is forcing cutbacks in capital expenditures, new ventures, and new product lines, and could deepen the unfolding slump in the United States economy). ” See Investor Responsibility Research Center, Inc., Major 1990 Corporate Couern- ante Shareholder Proposals (Feb 20, 1990) (on file with U Chi L Rev) (listing by sponsor proposals to redeem rights plans, opt out of state antitakeover laws, prohibit greenmail, ban golden parachutes, reduce supermajority requirementa, etc.). 19911 Quinquennial Election 213 poration and its directors and managers can seek to protect the long-term business needs of the enterprise against the pressure for short-term premiums. To the extent these defenses are removed without taking steps to reorient the stockholders’ perspective to the long term, the ill effects of the current short-term bias will be exacerbated. Similarly, CalPERS and the United Shareholders’ Association have proposed comprehensive revisions of the SEC’s proxy rules, intended to increase the role of institutional investors in the proxy process and corporate governance.7e Any reform in this area, how- ever, must be part of a larger effort to reorient stockholders toward a long-term perspective. Otherwise, the increased activism of insti- tutions in the proxy process is likely to promote a continued short- term outlook, with all its negative consequences.e0 C. Hostile Takeovers and Short-Termism The hostile takeover wave of the last decade both caused and resulted from stockholders’ short-term bias. A dominant stock- holder population anxious to accept a takeover premium encour- ages the hostile acquirer with the likelihood that a premium bid will succeed or that a higher bid will prevail, allowing the first po- tential acquirer to profit on shares of the corporation it purchased prior to making its bid. Moreover, the short-term bias tends to re- sult in greater discounting by the market of the long-term profits of the firm, leaving the market valuation of the corporation well below the true value of the enterprise. The acquirer is thus able to make a bid that is below the corporation’s value (measured in terms of the future income streams but discounted at a lower rate than that typically produced by the short-term bias). Yet the bid, ‘@ See letter from CalPERS to Linda C. Quinn, Director, Division of Corporation Fi- nance, Securities and Exchange Commission (Nov 3, 1989), reprinted in Institutional lnoes- tars: Passioe Fiduciaries to Actioist Owners 454 (PLI, 1990); letter from United Sharehold- ers’ Association to Edward H. Fleischman, Commissioner, Securities and Exchange Commission (Mar 20, 1990), reprinted in id at 485. Compare letter from The Business Roundtable to Linda C. Quinn, Director, Division of Corporation Finance, Securities and Exchange Commission (Dee 17, 1990) (on file with U Chi L Rev) (opposing revisions to the proxy rules). O0 Philip R. Lochner, Jr., Commissioner, Securities and Exchange Commission, Improu- ing Corporate Governance for the Nineties: The Role of Institutional Investors and Proxy Rejorm 6 (speech to City Club, Sept 20, 1990) (on file with U Chi L Rev) (If proposed proxy reforms are adopted and provide institutional stockholders with greater power to influence boards, institutions might “use their newfound muscle . . . to break up and sell off compa- nies in order to yield higher short-term returns.“). 216 The University of Chicago Law Review [58:187 III. THE REALIGNMENT OF INTERESTS: LESSONS FROM HOME AND ABROAD A long-term view on the part of stockholders and managers is necessary to permit public corporations in the United States and the United Kingdom to invest in the future, maintain their vital- ity, and compete in the world economy.86 Corporations must be permitted to sacrifice some immediate value to investments in cap- ital assets, research and development, new ventures, or market share. To the extent the corporation is not permitted to invest in the future, it will inevitably lose customers and profits to those corporations that are permitted to do ~0.~~ In this Part, we discuss elements of the Japanese and German systems of corporate gov- ernance, and the “patient capital” approach of American investor Warren Buffett, to demonstrate the advantages of long-term emphasis. A. The Need for a Long-Term View The long-term health of the business enterprise is ultimately in the best interests of stockholders, the corporation’s other con- stituencies, and the economy as a whole. The institutional stock- holder typically invests in a large number of stocks whose overall performance, like that of index funds, tends to mirror the perform- ance of the market and the economy. 87 Moreover, the large institu- ‘B Brady, Remarks before the Business Council at 2 (cited in note 6) (American corpo- rations “can’t innovate and produce the products needed to capture world markets by focus- ing on results one quarter at a time.“); Alan 0. Sykes, Corporate Takeovers-the Need /or Fundamental Rethinking 21 (David Hume Institute, 1990) (“The inevitable consequence of ‘City’ short-termism is long-term damage to the City on the back of far greater long-term damage to the [United Kingdom’s] corporate sector as a whole.“); Lord Alexander of Weedon, Q.C., Chairman of National Westminster Bank and former Chairman of the City Takeover Panel, The Changing Nature of Finance 9 (speech for the Lombard Association 60th Anniversary Dinner, Ott 4,199O) (on file with U Chi L Rev) (“Concern about takeovers may inhibit medium- to long-term planning and, as some say, research and development. The future of companies may undoubtedly be settled on the basis of short-term considerations.“). a8 See, for example, John J. Curran, Hard Lessons from the Debt Decade, Fortune 76 (June 18, 1990) (“Says Douglas Watson, head of industrial ratings at Moody’s Investors Service: ‘I’ve been seeing signs that once a company leverages, it invites predatory behavior from ita rivals.’ For example, most major supermarket chains are stocked to their fluorescent lights with debt. Thus they’re in no shape to respond as A&P, one of the few grocers with a clean balance sheet, aggressively expands into their markets.“). ” Gilson and Kraakman, Reinventing the Outside Director at 6-8 (cited in note 1) (in- stitutional investors increasingly “hold the market,” whether through indexing or simply by virtue of the size of their portfolios, thereby eliminating the likelihood of benefits from ac- tive trading). 19911 Quinquennial Election 217 tional stockholder is a long-term investor in the market as a whole. Unless it divests itself of equities altogether, it will have an equity stake in a substantial portfolio of corporations regardless of how long it maintains a stake in any one corporation. To the extent the economy as a whole thrives over the long term, the portfolio should thrive, regardless of the performance of, or the availability of take- over premiums for, any individual stock. Professors Gilson and Kraakman cite several studies for the proposition that takeovers provide long-term benefits to stockhold- ers. “[O]n average,” they claim, “target shareholders lose signifi- cantly when offers are defeated and the company is not subse- quently acquired by an alternative bidder. . . . [T]he data resolves the charge that a favorable orientation to premium tender offers reflects a short-term orientation.“s8 It is unclear, however, why one should limit the sample to companies “not subsequently acquired by an alternative bidder.” The corporation that defeats a takeover bid retains the value of control, on which it may realize a premium by selling the corporation at any time. The corporation that is ac- quired, of course, loses the asset of control. More importantly, all the studies cited by Professors Gilson and Kraakman necessarily measure stock market effects within the existing system of corporate governance. In the current environ- ment, corporations that successfully defeat a takeover attempt (as well as corporations seeking to avoid a takeover attempt) may take steps to boost short-term earnings or value whether or not these steps are in the long-term interests of the corporation. The studies cannot measure the benefits of a new system that would encourage all the corporation’s constituencies to work toward the long-term success of the corporate enterprise. It may well be rational under the current system for any individual investment manager to focus on short-term results,8e but the short-term bias remains irrational for the economy as a whole. The takeover activity of the last decade did not enhance the development of productive assets. Instead, it produced a reshuf- fling of assets, large gains to the sponsors of and advisors to the reshuffling, large gains (and losses) to the arbitrageurs who bet on the outcome of the transactions, substantial societal dislocations, and a legacy of heavy debt burdens.Bo In some cases takeovers did u Id at 11 & n 16. a0 See text at notes 55-60. O0 Lester C. Thurow, Let’s Put Capitalists Back into Capitalism, Sloan Mgmt Rev 67, 68 (Fall 1988) (lack of productivity growth during takeover era demonstrates that acquisi- 218 The University of Chicago Law Review [58:187 shift assets to more efficient uses, but the studies that claim take- overs generally have this positive effect tend to measure very short time spans, not long-term effects.e1 Even some proponents of hos- tile takeovers doubt that they are the best way to bolster the long- term health and productivity of our corporate economy.** The healthy economies of Japan and Germany result in large part from effective, stable management and long-term capital investment.e3 Unless the corporate governance systems of the United States and the United Kingdom can engender a similar long-term orientation, the relative health of American and British corporations, and the relative wealth of their stockholders, will inevitably erode. The following illustrations are not intended to imply that ei- ther the Japanese or German corporate regime can or should be transplanted to the American or British corporate setting. Rather, these examples are meant to demonstrate successful alternatives to the managerial discipline model of corporate governance. B. Japan and Germany There are many reasons for the economic health and success of Japan and Germany relative to the United States and the United Kingdom. e4 It is not possible, of course, to determine pre- tions are a redistributive activity, not a productive activity); Stout, 99 Yale L J 1235 (cited in note 32) (takeover premiums may be a natural market phenomenon rather than evidence of efficiency gains). *’ See, for example, Gregg A. Jarrell, James A. Brickley, and Jeffrey M. Netter, The Market for Corporate Control: The Empirical Evidence Since 1980, 2 J Econ Persp 48, 66 (1988) (“premiums in takeovers represent real wealth gains and are not simply wealth redis- tributions”); Michael C. Jensen, The Takeouer Controuersy: Analysis and Euidence, Mid- land Corp Fin J 6, 6 (1986) (attributing takeovers to “productive entrepreneurial activity that improves the control and management of assets and helps move assets to more produc- tive uses”). ‘* See, for example, Gilson and Kraakman, Reinventing the Outside Director at 14 (cited in note 1) (“the hostile takeover is an expensive and inexact tool for monitoring man- agers that is better suited for correcting mistakes than preventing them”).. ” See Even Herbert, How Japanese Companies Set R&D Directions, Res Tech Mgmt 28 (Sept-Ott 1990) (Japanese corporate governance system enables corporations to suffer prolonged losses until R&D pays off); Brian O’Reilly, America’s Place in World Competi- tion, Fortune 80 (Nov 6, 1989) (In 1987, Japan’s capital spending was approximately 22 percent of GDP, West Germany’s was approximately 17 percent of GDP, and the United States’ and the United Kingdom’s were approximately 13 percent of GDP.). V’ Factors that have been cited include higher levels of saving, lower costs of capital, and cultural work ethics. See generally G.C. Allen, The Japanese Economy (St. Martin’s, 1981) (emphasizing the importance of political and social factors in Japan’s economic growth); Porter, The Competitive Advantage of Nations at 368-82 (cited in note 75) (educa- tion, research, and worker commitment, as well as corporate governance structure and na- ture of capital markets, contributed to German economic success). 19911 Quinquennial Election 221 adding to their enormous power. lo3 Like the keiretsu, the German structure insulates management from short-term pressures. It con- centrates the control of shareholdings within a group capable of effective monitoring, but oriented toward the long-term business health of the corporation.104 3. Applicability of the Japanese and German examples. Even if we favored the full-scale transplantation of the Japa- nese or German models into the Anglo-American corporate envi- ronment, which we do not, we recognize that present antitrust and banking statutes would forbid it and that the American and Brit- ish political systems would probably reject the concentration of corporate power in such small groups.1o6 But some of the concepts of the Japanese and German structures can be applied to the American and British systems. Professors Gilson and Kraakman describe the Japanese and German structures as the “banker model.” They dismiss the banker model as “inapposite to the cir- cumstances of the American institutional investor,” claiming that it “unifies, rather than bridges, ownership and contro1.01o6 loa Id at 783 (“It is hardly possible for private investors to effectively control the exer- cise of voting rights by banks, and in practice they do not do so. This enables banks to pursue their own interests when exercising voting rights, for ins+%nce, voting with a view to their lending or investment business.“); Dirk Schmalenbach, Federal Republic o/ Germany, in Lufkin and Gallagher, eds, International Corporate Cooernance at 109, 111 (cited in note 98) (“As a general rule the banks tend to exercise their power in support of management which . . . will often make shareholder activism and attempts by shareholders to maximise shareholder value in a way which is contrary to the present poiicy of management, seem futile. . . In their role as lenders the banks prefer a long-term increase in the substance of the company rather than the distribution of high yield dividends.“). IQ( See, for example, Kahfass, 1988 Colum Bus L Rev at 790-91 (cited in note 102) ‘(“Bank representatives are thus involved in filling positions on managing boards and in making important business decisions. The resulting stability of control reduces the pres- sures on managers, freeing them to pursue medium to long-term corporate objectives.“); Porter. The Competitive Adoantage o/ Nations at 376 (cited in note 75) (“Sustained com- mitment to the business is reinforced by the nature of German capital markets. Many com- pany shares are held by banks and other long-term holders, who often plcy a prominent role on boards. . . . The concern for quarterly earnings, in preference to actions required to sustain the long-term position, has been ail but absent, in contrast to the United States.“); Andrew Fisher, Banks Facing Up to Foreign Competition, The Banker 22, 39 (Apr 1987) (“The country’s two biggest banks, Deutache and Dresdner, played important roles in the nursing back to health of Germany’s largest shipping group, Hapag-Lloyd. . . . At AEG, the electrical and electronics giant now controlled by Daimler-Benz, banks were also instrumen- tal in preventing a collapse into bankruptcy.“). loa See Gilson and Kraakman, Reinventing the Outside Director at 28 & n 52 (cited in note 1) (noting political and cultural barriers to use of Japanese and German structures in the United States and United Kingdom). loa Id at 27. 222 The University of Chicago Law Review [58:187 The German banks and the Japanese keiretsu, however, con- stitute monitors, not managers, of the public corporation. Owner- ship and management remain separate, but the structure of stock ownership ensures the alignment of the interests of the managers and stockholders around the long-term interests of the business enterprise, and creates a stockholder presence capable of shielding management from short-term pressures and monitoring managerial performance. There is no reason that the systems of the United States and United Kingdom cannot be reconstructed, by far less radical means, to serve the same goals: alignment of stockholder and corporate interests around the long-term health of the corpo- ration as a business enterprise, insulation of management from short-term financial pressures, and effective monitoring of the long-term business performance of the corporation’s managers. C. Leveraged Buyouts In the United States and the United Kingdom, the replace- ment of public with private ownership structures, particularly through leveraged buyouts (LBOs), has become a common means of reuniting ownership and management, and has been cited as a means of improving corporate efficiency.“’ Substantial equity stakes for managers, active monitoring by the LB0 sponsor/inves- tor, and freedom from the preoccupation with reported quarterly earnings and takeover defenses often combine to cause substantial improvement in the newly private corporation’s business opera- tions.‘O* The financial incentives and risks for the management of the post-LB0 corporation can motivate quite effectively: the man- ager who takes personal loans, perhaps even mortgages his house, to participate in the equity of a buyout has a more direct financial stake in the corporation’s success than the manager who is insu- lated from personal financial risk. lo’ Michael C. Jensen, Eclipse of the Public Corporation, Harv Bus Rev 61, 65 (Sept- Ott 1989) (“[Tlhese organizations’ resolution of the owner-manager conflict explains how they can motivate the same people, managing the same resources, to perform so much more effectively under private ownership than in the publicly held corporate form.“); Frank H. Easterbrook and Daniel R. Fischel, Corporate Control 7ionsactions, 91 Yale L J 698, 706 (1982) (when firms go private they eliminate or substantially reduce the separation of own- ership and control). ‘- See, for example, Brett Duval Fromson, Life After Debt: How LBOs Do It, Fortune 91 (Mar 13, 1989) (describing how O.M. Scott & Sons, Borg-Warner, and other companies substantially improved their operating performances in response to the pressures and op- portunities created by LBOs). 19911 Quinquennial Election 223 The current recession demonstrates, however, that LBOs also entail enormous risks for corporations and the economy as a whole. Overleveraging engendered by the LB0 wave has left many corpo- rations in dire straits as the economic growth of the 1980s has slowed or reversed.‘Oe Even those newly private corporations that are not facing bankruptcy often find that massive debt and inter- est payments siphon off the cash they need to invest in productive uses. The debt burden of the LB0 arguably forces managers to operate efficiently in order to meet their payments.“O But LB0 debt imposes a decidedly short-term discipline. Lenders in an LBO, unlike the lender/stockholders of the German and Japanese systems, are attracted by the initial transaction fees and seek a quick repayment of their loans.11’ The LB0 thus replaces the short-termism of the institutional stockholder and the hostile take- over with the short-termism caused by the need to pay down debt quickly. Even proponents of the LB0 as a promoter of efficiency recog- nize that “the LB0 capital structure is simply inappropriate . . . for !arge numbers of public corporations that require the cash flow flexibility to fund [research and development] or to compete in growing markets.“112 Moreover, the corporation taken private in an LB0 typically goes public again within a matter of a few years.l13 Indeed, taking the LB0 company public is the only way the LB0 investor can realize the 30-40 percent annual equity re- turns promised by LB0 sponsors. Returns at that level depend on high leverage and quick resale of the equity. Thus, the LB0 does not offer a widely applicable, long-term answer to the problems of corporate governance. D. Patient Capital A more promising model for the United States and the United Kingdom is the “patient capital” philosophy exemplified by War- ren Buffett and Berkshire Hathaway, of which Mr. Buffett is chair- man. Like the LB0 sponsor and management investor, Mr. Buffett Ioe See sources cited in note 77. ILo Jensen, Harv Bus Rev at 66-67 (cited in note 107). I” See Staff of House Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce, 1Olst Cong, 1st Sess, Leuernged Buyouts and the Pot of Cold: 2989 Update 148 (Committee Print, 1989) (testimony of L.W. Seidman, FDIC Chairman) (substantial origination fees and selling fees are significant inducements to banks’ competi- tion to lend for LBOs). ‘I’ Cilson and Kraakman, Reinventing the Outside Director at 25-26 (cited in note 1). IIs See Louis Lowenstein, Management Buyours, 85 Colum L Rev 730, 731 (1985); Les- lie Wayne, ‘Reoerse LBO’s’ Bring Riches, NY Times Dl (Apr 23, 1987). 226 The University of Chicago Law Review [58:187 corporation’s outstanding shares, or shares having a market value of five million dollars or more, would have the same access as the incumbent board to the corporate proxy machinery, in support of any candidates they wished to nominate. This access would include corporate payment of proxy contest expenses to the same extent as incumbent expenditures. In the year of the quinquennial meeting, within 75 days after the corporation’s fiscal year ends, the corporation would send to its stockholders a detailed report on its performance over the prior five years compared to its strategic plan, together with industry averages and other relevant data. The report would also detail the corporation’s projections for the next five years, the assumptions underlying those projections, expected returns on stockholder in- vestment, and the management compensation plan. At the same time, an investment bank, accounting firm, or other outside advi- sor selected by the board would send stockholders a detailed, inde- pendent evaluation of both the corporation’s performance for the prior five years and its projections for the next five years. Stock- holders would have 60 days after the mailing of the report and evaluation to decide whether they wish to nominate candidates for election as directors. Because the quinquennial proposal would eliminate coercive takeovers, it would also eliminate the panoply of private takeover defenses and state legislation. It would make moot the issue of whether and the extent to which directors can consider non-stock- holder constituencies: decisions on takeover bids would lie in the hands of the stockholders at the quinquennial meetings, and would be at the discretion of the board between meetings. It would also affirm the “one-share, one-vote” provisions currently embodied in Rule 19c-4 under the Securities Exchange Act.“’ In sum, it would make the quinquennial election a true, unobstructed stockholders’ referendum on the corporation’s performance and plans. The quinquennial system would strengthen the board’s inde- pendence by requiring a majority of outside directors. The system would look to outside directors to provide an effective monitoring function over the operations of the corporation. The increased “O 17 CFR 5 240.19c-4 (1990) (Rule 19c-4 seeks to deter corporate action, including issuance of new class of securities, which “[has] the effect of nullifying, restricting, or dispa- rately reducing the per share voting rights” of existing common stock shareholders.). But see The Business Roundtable u SEC, 905 F2d 406 (DC Cir 1990) (Rule 19c-4 invalidated because SEC exceeded its authority under the Securities Exchange Act of 1934 in adopting the Rule.). 19911 Quinquennial Election 227 ability of stockholders to replace directors at the quinquennial meeting would lead directors (and, at the directors’ insistence, managers) to work far more closely with major stockholders than they typically now do. To avoid the risk of replacement at the quinquennial meeting, directors would carefully monitor the corpo- ration’s progress against its long-term plan and maintain a close dialogue with stockholders with respect to the corporation’s ongo- ing performance. Meanwhile, the five-year period between elec- tions, and the extremely limited ability to replace directors other- wise, would leave stockholders with little choice but to work cooperatively with directors during the five-year period, within a structure that focuses all parties on the long-term business per- formance of the corporation. Lack of information for outside directors, as well as lack of time or expertise to evaluate corporate information, often limits directors’ ability to monitor managerial performance.12o The five- year report would lower the information barrier for directors as well as stockholders, and encourage managers and outside advisors to consult more often with outside directors on the corporation’s performance and direction. Many corporations today present their directors with an in-depth annual review by management and outside advisors of the corporation’s business plan and objectives, its historical success or failure in meeting these objectives, and the steps it plans to take in the future. The quinquennial system would encourage this type of healthy in-depth analysis. The quinquennial system would make the corporation’s five- year performance, including its success in meeting its five-year plan, the sole basis for incentive compensation. It would eliminate the annual or biannual incentive awards now common. Managers would receive substantial rewards, well in excess of current com- pensation levels, only if the corporation met or exceeded its goals. Given the increased demands on their time and resources, outside directors would receive more compensation than they now gener- ally do, with an incentive system similar in concept to management’s. The quinquennial system would benefit the corporation’s other constituencies, which prosper if the enterprise’s business op- Iso See, for example, Lorsch, Pawns or Potentates at 55-58 (cited in note 19); Gilson and Kraakman, Reinventing Ihe Outside Director at 22 (cited in note 1). See also William L. Gary and Melvin A. Eisenberg, Cases and Materials on Corporations 215-16 (Founda- tion, 5th ed 1960). 228 The Unioersity of Chicago Law Review [58:187 erations prosper over the long term.‘*l Moreover, by eliminating hostile takeovers and removing the pressure for excessive leverag- ing, the quinquennial system would ameliorate the societal disloca- tions that resulted from the takeover and leveraged buyout wave of the last decade.‘** At the outset, we suggest limiting the quinquennial system to large corporations, such as the Standard and Poor’s 500 or the Business Week 1000, which are more heavily held by institutional investors. After experience with these corporations, the quinquen- nial system could then apply to a broader group. The quinquennial proposal would not entrench directors or managers. It is not designed to prevent changes in corporate con- trol, but rather to channel nonconsensual changes in control into a more healthy forum. The primary defect of the takeover activity of the past decade is not that it allowed for the replacement of direc- tors and managers, but that it forced an external, short-term focus on companies, directors, managers, and their stockholders. The quinquennial system, by making the corporate proxy machinery available to substantial stockholders who wish to nominate a com- peting slate of directors, would actually enhance the ability of stockholders to replace incumbent directors and to change corpo- _ rate strategy. But it would provide this opportunity within a framework that permits the corporation to carry out long-term plans, and permits stockholders to assess their results before de- ciding whether they are satisfied with their directors’ performance. Removal and replacement of directors would occur by means of an orderly stockholder vote, based on full information. The quinquen- nial framework would thus prevent the hurried decisionmaking im- posed on corporations and their stockholders in the context of hos- tile takeover battles123 and would eliminate the type of abusive, coercive takeover activity prevalent in recent years. The remainder of this Part develops in more detail the ele- ments of the quinquennial proposal and the rationale underlying each element. ‘*I See Part 1I.D. I” See Parta 1I.B. and KC. “* See 17 CFR § 240.14e-l(a) (1990) (tender offer may be completed in as little aa twenty business days). This is hardly a time frame within which to decide intelligently the deetiny of the enterprise. 19911 Quinquennial Election 231 Corporate elections need not be a sham, however. The quin- quennial meeting structure removes the chilling effect of an ever- present takeover threat on long-term planning. Once election con- tests are no longer simply another short-term coercive takeover tactic, they can become a meaningful referendum on the corpora- tion’s business plans and performance. The combination of free ac- cess to the corporate proxy machinery, and the provision of the detailed information contemplated by the five-year report, dis- cussed in greater detail below, would effect this restructuring. It would also eliminate the free rider problem, by allocating the costs of the information gathering and the proxy process to the corpora- tion and thus, effectively, to all stockholders. The quinquennial proposal would grant free access to the cor- porate proxy machinery in connection with the quinquennial meet- ing to any stockholder or group of stockholders with at least five percent of the outstanding shares, or shares having an aggregate market value of five million dollars or more. These thresholds are high enough to exclude “gadfly” stockholders, but low enough not to impede the serious, substantial stockholder who wishes to pro- pose nominees or a slate of directors in an election contest. Access to the corporate proxy machinery would include the corporation’s payment of the challenger’s proxy expenses, up to the amount that the incumbent directors spend on the proxy contest. This would place institutional stockholders on the same footing as the corpora- tion’s board with respect to nomination and election of corporate directors, thereby radically improving the ability of these stock- holders to participate meaningfully in the selection of directors. The guinquennial proposal does not, however, anticipate the frequent, wholesale replacement of directors every five years. The very credibility of the quinquennial election would lead directors and managers to develop a working relationship with the corpora- tion’s major stockholders. And once the stockholders are placed in a structure that promotes a focus on the long-term business opera- tions of the corporation, they will be more inclined, except in ex- treme cases, to try to influence the incumbent directors and man- agers rather than risk the disruption to business operations of a wholesale change in senior personnel. The quinquennial proposal would also eliminate SEC Rule 14a-8, which generally allows any holder of $1,000 worth of a cor- poration’s stock to require inclusion of a proposal in the corpora- of candidates.“). See also Easterbrook and Fischel, 94 Harv L Rev at 1170-74 (cited in note 1). 232 The University of Chicago Law Review [58:187 tion’s proxy statement. la8 While intended to promote stockholder interest in corporate governance, in practice this rule has become the tool of gadflies who seek to promote special interests.12e Stock- holders may espouse any cause they wish, but the corporate proxy machinery is rarely the appropriate forum for such expression. More recently, institutional investors have also used Rule 14a- 8 to address voting procedures and takeover-related issues and de- fenses. The last few years have seen a spate of proposed stock- holder resolutions dealing with rights plans, confidential voting, and golden parachutes. Iso The quinquennial proposal would largely supersede this agenda by eliminating takeover defenses and limit- ing nonconsensual changes of control to the quinquennial meeting, at which major stockholders or groups of stockholders would have full and free access to the corporate proxy machinery. Moreover, the availability of the quinquennial meeting as a realistic means for institutional stockholders to replace directors would increase responsiveness to institutional concerns during the interim periods. Rule 14a-8, accordingly, would become unnecessary. 2. Proxy access only desirable as part of fundamental reform. Access to the corporate proxy machinery as contemplated by the quinquennial system is desirable only in conjunction with the other elements of the proposal. Granting substantial stockholders free access (including coverage of reasonable expenses) to the cor- porate proxy machinery, without reorienting those stockholders away from a strictly short-term perspective, would only exacerbate the short-term pressures and detrimental effects of the takeover activity of recent years. If stockholders continue to view their in- vestment as a gambling chip and any takeover premium as a jack- pot, then the stockholders’ increased ability to nominate and elect their own directors would only worsen the problems of short- termism. I*’ 17 CFR § 240.14~8 (1990). I*’ See, for example, Jesse H. Choper, John C. Coffee, Jr., and C. Robert Morris, Jr., Cases and Materials on Corporations 647 (Little, Brown, 3d ed 1989) (rule recently used to address issues relating to discrimination, nuclear power, pollution, and divestment from South Africa). Ia0 John J. Gavin, Changes in Corporate Control and Gouernance Communicated through Proxy Power, in Institutional Investors: Passive Fiduciaries to Activist Owners 91, 95-96 (PLI, 1990) (215 governance proposals submitted by institutional investors and voted upon at annual meetings in 1989); Dennis J. Block and Jonathan M. Hoff, Emerging Role of The Institutional Investor, NY L J 5 (Apr 12, 1990) (listing confidential voting, repeal of poison pills, and golden parachutes as top three subjects of governance proposals). 19911 Quinquennial Election 233 Professors Gilson and Kraakman, for example, propose the de- velopment of a class of professional directors elected by and re- sponsible to institutional stockholders, suggesting that these direc- tors could be recruited and monitored by a clearinghouse initiated by one of the existing “shareholders’ rights” groups such as the Council of Institutional Investors or United Shareholders’ Associa- tion.13* These organizations, however, have been particularly vocal in their short-term orientation and pro-takeover bias.132 Gilson and Kraakman’s proposal ignores the pressing need for directors to adopt a long-term measure of performance or success. Unless the orientation of institutional stockholders shifts away from the short term, then directors beholden to these stockholders will simply re- present a potent constituency seeking a fast return. If selling or busting up the corporation generates this return, so much the bet- ter. Only when these stockholders redefine the success of their in- vestment in terms of long-term operating returns, rather than takeover or other short-term premiums, will increasing their power to influence directors and managers promote the long-term health of the corporation. D. The Five-Year Report Institutional stockholders typically lack the resources to inves- tigate and evaluate the performance of each company in their port- folios, limiting their ability to participate effectively in corporate governance.133 The five-year report contemplated by the quin- quennial proposal would reduce the need for investigation by pro- viding detailed information on the corporation’s performance and business plans. The critique of the five-year report by independent advisors would fulfill the evaluation function, minimizing the need for stockholders to expend their own resources in order to judge the validity of the corporation’s own report. Is’ Gilson and Kraakman, Reinuenting the Outside Director at 39-42 & n 71 (cited in note 1). For example, Professor Cilson was co-chairman of the USX Corporation share- holder committee, formed by corporate raider Carl C. Icahn “to press for the rapid sale or spinoff of the USX Corporation’s steel business.” Gregory A. Robb, Icahn Croup to Urge USX Sale of Steel Unit, NY Times D5 (Nov 15, 1990). Is2 See text at notes 78-80. IS’ See, for example, Jensen, Harv Bus Rev at 66 (cited in note 107) (too costly for institutional investors to become involved in major decisions and long-term strategies’of the companies in which they invest); John Plender, ‘The Limits to Institutional Power, Finan- cial Times f 1 at 20 (May 22. 1990) (institutional stockholders in the United Kingdom lack industry-specific expertise and information needed to play a role in corporate strategy). 236 The University of Chicago Law Review [58:187 holder investment objectives likely to be met by successful imple- mentation of the plan. The advisor would have the benefit of the same safe harbor as the corporation, and would be permitted a customary indemnifica- tion from the corporation, which would exclude acts of negligence. As in the case of independent accountants evaluating a firm’s fi- nancial reports, possible liability for negligence,13’ and, more im- portantly, the concern for reputation, would motivate care by the advisor. 3. Benefits of the report and evaluation. The report and evaluation would encourage stockholders to view their shares as a stake in the operating performance of the corporation rather than as a mere financial instrument. Along with the long-term orientation imposed by the quinquennial election of directors, the report and evaluation would give institutional stock- holders the means to understand the strategic direction and corpo- rate objectives of their portfolio companies, and to intervene or sell their shares if they differ with these plans.138 The discipline of the five-year report would also improve the quality of annual reporting. Stockholders would demand annual reports that analyze where the corporation stands within the five- year framework, the causes and consequences of any discrepancies between performance and projections, and what changes, if any, are necessary for the business plan. Managers and directors inter- ested in retaining their positions at the quinquennial meeting Ia’ See, for example, Schneider u Lazard Freres & Co., 159 AD2d 291, 552 NYSLd 571 (1990) (investment bankers who advised a Special Committee of the board of directors in a sale-of-control context could be liable in negligence to the company’s stockholders). For crit- icism of the court’s holding, see Herbert M. Wachtell, Eric M. Roth, and Andrew C. Hous- ton, Inoestmenl Banker Liability to Shareholders in the Sale-of-Control Context, NY L J 1 (Mar 29, 1990); John C. Coffee, Jr., New York’s New Doctrine of ‘Constructive Priuity’, NY L J 5 (Jan 25, 1990). See also Rachel Davies, Bidders Can Sue in Takeover Case, Financial Times 33 (Ott 30, 1990) (reporting on 1990 English Court of Appeal decision holding that the financial advisors and auditors of a company may be liable to an unwanted takeover bidder for allegedly negligently prepared financial statements and forecasts issued before and during the pendency of the bid, on which the bidder could foreseeably rely in deciding whether to make or increase its offer). ‘= For excellent suggestions on how to reform corporate reporting, see generally Peter N. McMonnies, ed, Making Corporate Reports Valuable (Kogan Page, 1988) (urging reports that encourage a long-term perspective). The study, prepared by the Institute of Chartered Accountants of Scotland, notes the need for an increased level of independent assessment of corporate reports. The study suggesta, as is contemplated by the quinquennial proposal, that the assessor’s role be expanded far beyond the role of the typical outside accountant in the current corporate reporting scheme. Id at 84. 19911 Quinquennial Election 237 would naturally provide this sort of useful information in the in- terim years. The expanded information contained in the five-year report and evaluation, and the improved quality of annual reporting, would enable analysts to better assess the performance and pros- pects of each corporation, and would increase investor confidence in the expected performance of an investment. Perceived invest- ment risk to stockholders should decline in turn, resulting in a lower risk premium and a lower cost of capital to the corporation. The additional information would also assist stockholders in more closely matching their investment objectives to the objectives of the corporations in which they invest, thereby further reducing the risk premium and the cost of equity capital. Ultimately, the quin- quennial proposal would bring institutional investor knowledge in the United States and the United Kingdom closer to the level now seen in Japan and Germany. This could bring the return on equity demanded by investors in our markets, and the cost of capital, more in line with that of the Japanese and German markets.139 Some corporations may argue that the requirements of the five-year report are too onerous, or that wide distribution of pro- jections or the advisor’s evaluation would damage the corporation. Well-managed corporations, however, should welcome the five-year reports and the quinquennial proposal as a whole. Most well-man- aged corporations today develop, at least internally, detailed stra- tegic plans and five-year projections. Any corporation seeking fi- nancing must go through such a process; a well-managed corporation and its management should want to develop a detailed long-term strategic plan and measure its performance against this plan. Nor can the argument that publication of projections and stra- tegic plans would harm the corporation withstand analysis. On the basis of information already available to them, most good analysts can develop projections for the corporations they follow. These projections do not produce the same investor confidence as man- agement’s own projections, but they typically come very close to what the corporation itself would prepare. The quinquennial pro- posal does not require disclosure of trade secrets or competitively Iso See, for example, Short-termism, part 20, The Economist 76 (June 30, 1990) (cost of capital is higher in United States and United Kingdom than in Japan and Germany); Gary Hector, Why U.S. Banks Are In Retreat, Fortune 95 (May 7, 1990) (from 1983 to 1988 the cost of capital for United States companies was twice that of competitors in Japan and West Germany). 238 The University of Chicago Law Review [58:187 vital business information. Sophisticated investors understand, and the five-year report would emphasize, that projections constitute a framework, not a crystal ball. Even with such a qualification, how- ever, the framework set forth in the projections and the strategic plan would be of great value in assessing the performance and di- rection of the corporation. The real objection of some corporations is likely to be their reluctance to establish a concrete framework against which to judge management’s performance or to have management publicly critiqued by an outside advisor. Yet an effective system of corpo- rate governance depends on the ability to evaluate the business performance and direction of the corporation and its management. The corporation least willing to expose itself to such an evaluation probably needs it most. E. Management Compensation 1. Compensation linked to performance. The revision of compensation structures would reinforce the long-term time horizon contemplated by the quinquennial system by directly aligning the managers’ personal financial interests with the long-term success of the corporation. Financial incentives and risks for managers in leveraged buyouts contribute significantly to the performance of those buyouts that succeed.14o And the dissatis- faction of many managers who want a more significant share of any increase in value generated by the business success of the corpora- tion fuels strong management interest in participating in these buyouts.141 Today, managerial compensation is not adequately related to the long-term results of the corporation’s business operations. Ob- servers note the “dearth of financial incentives for top manage- ment to make the costly and risky decisions that can promise sub- stantial long-term payoffs for the shareholders.“14* They also complain that high levels of managerial compensation persist in ‘*’ George Anders, Leaner and Meaner Leveraged Buy-Outs Make Some Companies Tougher Competitors, Wall St J Al (Sept 15, 1988) (financial risks at stake in LB0 force management to be more aggressive). See also Jensen, Harv Bus Rev at 69 (cited in note 107). “’ Capitalism at 12 (cited in note 10); Sykes, Corporate Takeovers at 11-12 (cited in note 85). “’ Graef S. Crystal, Cracking the Tax Whip on C.E.O.‘s, NY Times Meg 48 (Supple- ment on the Business World, Sept 23, 1990); see also Sykes, Corporate Takeovers at 11-12 (cited in note 85); Jensen and Murphy, Harv Bus Rev at 39 (cited in note 21). 19911 Quinquennial Election 241 rectors would not be removable except for criminal conduct or will- ful misfeasance. In addition, no stockholder could acquire more than ten percent of a corporation’s stock without the board’s con- sent. The would-be acquirer therefore could not purchase a con- trolling stake in a corporation and then coerce a “consensual” change of control, making the next quinquennial election a fait accompli. Correspondingly, the quinquennial system would prohibit takeover defense devices and repeal takeover-related state legisla- tion. It would thus eliminate share purchase rights plans,“* stag- gered boards,14e supermajority “fair price” provisions,15o standstill provisions,‘6’ control share acquisition statutes,162 and business combination moratorium statutes.1”3 It would reinstate the sub- stance of SEC Rule 19c-4, limiting the ability of public corpora- tions to issue equity with disproportionate voting rights.164 “’ Such plans deter control acquisitions not approved by the corporation’s board of directors by making inexpensive new shares available to current shareholders other than the acquirer, diluting the acquirer’s stake and increasing the leverage of the board in responding to an unsolicited acquisition attempt. Share purchase rights plans were first developed by one of the authors as a response to abusive takeover tactics. In the context of the quinquen- nial system’s restrictions on changes in control, the protections afforded by rights plans would be unnecessary. I” In these arrangements, one-third of the board typically comes up for reelection each year. Under Delaware law, members of a staggered board may only be removed for cause, unless the charter provides otherwise. 8 Del Code Ann $8 141(d), (k) (1990). ‘VJ These provisions, found in many corporate charters and some state statutes, impose a supermajority voting requirement on mergers, sales of assets, liquidations, and recapitali- zations between the corporation and an “interested person” (typically defined as a lo-20 percent stockholder) unless the transaction meets specified price requirements. See, for ex- ample, Ill Ann Stat ch 32, 3 7.85 (Smith-Hurd 1990). “’ Under these provisions a stockholder agrees to vote with management at election meetings, or agrees not to contest management’s proposals or nominees, in exchange for some corporate concession or as a condition to the corporation’s sale of newly issued securi- ties to the stockholder. Ia’ Control share acquisition statutes provide that shares acquired in a “control share acquisition,” defined as the direct or indirect acquisition of shares constituting voting power in the target corporation of at least 20 percent, 33% percent, or 50 percent, automatically lose their voting rights unless a majority of the disinterested holders of each class of stock approves. See, for example, Ind Code Ann §f 23-1-42-1 to 21-I-42-11 (West 1989); CT.8 Corp. IJ Dynamics Corp. of America, 481 US 69 (1987) (upholding constitutionality of Indi- ana statute). lb* New York’s statute prohibits certain in-state corporations from entering into a busi- ness combination, including certain self-dealing transactions as well as mergers and consoli- dations, with a 20 percent stockholder for five years after the 20 percent threshold is crossed, unless the board grants approval in advance of the 20 percent acquisition. NY Bus Corp Law § 912 (Law Co-op Supp 1989). See also Amanda Acquisition Corp. u Universal Foods Corp., 877 F2d 496 (7th Cir 1989) (Easterbrook) (upholding constitutionality of simi- lar Wisconsin statute). ‘I’ See note 119. 242 The University of Chicago Law Review [58:187 The quinquennial proposal would also repeal all constituency statutes. Because hostile takeovers could only occur as a result of stockholder balloting at the quinquennial meeting and, absent bad faith, self-dealing, or fraud, the board’s decision to accept or reject a takeover proposal in the interim would not be subject to review, the board would not have to face the issue of whether it could le- gally consider the interests of non-stockholder constituencies in re- sponding to a takeover attempt. Board, management, and stock- holders would focus not on the threat of takeovers, but rather on the long-term business success of the corporation, an orientation that itself protects the interests of non-stockholder constituencies.166 The elimination of hostile takeovers and takeover defenses would channel all nonconsensual changes of control into the quin- quennial meeting. This would allow stockholders to focus more clearly on the rationale for any proposed change of control, its likely consequences and its desirability. Stockholders could make a considered decision free of coercion from the acquirer or interfer- ence from the incumbent board or management, making it less likely that institutional investors would replace good managers simply to get a takeover premium. The quinquennial meeting would become an effective referendum on the business and invest- ment sense of the proposed change of control. To the extent more than one bidder emerged at the quinquennial meeting, the corpo- ration could establish auction procedures, and the courts could de- velop rules on permissible postponements of the meeting in re- sponse to material developments.156 The elimination of takeover battles between quinquennial meetings would also dramatically reduce the amount of manage- ment time and and other corporate resources now spent on preventing takeovers and developing takeover-related protections. The quinquennial system would insulate directors and managers for substantial enough periods to permit them to develop their fu- ture plans, while at the same time creating a periodic forum in which the directors would be totally uninsulated and subject to re- call by the stockholders. While it is possible that the quinquennial meeting could become a focal point for hostile takeover activity, the closer relationship between managers and institutional stock- lb0 See Part 1I.D. IM See MAI Basic Four, Inc. o Prime Computer Inc., CA No 10868 (Del Chant, June 13, 1989) (permitting board to postpone contested election meeting in light of material changes in challengers’ takeover bid shortly before scheduled date of meeting). 19911 Quinquennial Election 243 holders that the quinquennial system fosters would reduce the likelihood of frequent takeover battles. At worst, the quinquennial system would still free the corporation for substantial periods from preoccupation with the threat of a takeover. The quinquennial proposal would not permit incumbent direc- tors or management to spend corporate funds in litigation or simi- lar challenges to an opposing slate of directors. The SEC through the federal proxy rules, not incumbent management through pri- vate litigation, would police false or misleading statements in the opposing sides’ proxy materials. The SEC has policed proxy fights quite diligently. 16’ Whatever additional enforcement benefit pri- vate litigation might add, the principle of neutrality toward quin- quennial changes in control that underlies the quinquennial system could not permit one side of the proxy contest to use corporate funds to litigate against the other in a litigation initiated by the incumbents. Incumbents could, however, use corporate funds to defend litigation initiated by the opposition. Eliminating the takeover battleground should remove much of the current friction between managers and institutional stockhold- ers, which is often centered around takeover battles and antitake- over defenses. Institutional stockholders have mounted anti-poison pill stockholder resolution campaigns. Incumbent boards have adopted a panoply of takeover defenses. Legislatures have enacted antitakeover legislation. Stockholders complain that directors are simply trying to entrench themselves. Managers complain that stockholders only care about takeover premiums. The whole de- bate engenders a degree of distrust and hostility that undermines the necessary spirit of patience and partnership essential for long- term operating success in today’s business world. Under the quinquennial system, institutional stockholders would have to take at least a five-year perspective, or dispose of their investment. Incumbent directors would have to justify the five-year performance and plans of the corporation or risk being voted out of office at the quinquennial meeting. The frequency of the incumbent directors’ vulnerability would diminish, but the vul- nerability, when it arises, would be heightened due to the existence of easily measured goals and the elimination of takeover defenses. The net result would be that the focus of directors, managers and ‘W See David A. Sirignano, Reuieu of Proxy Contests by the Stafl o/ the Securities and Exchange Commission, in Proxy Contests, Institutional Investor Initiatives. and Manage- ment Responses 261, 263 (PLI, 1990) (SEC staff acta to “assure that the security holders receive the information they are entitled to under the proxy rules and are not misled.“). 246 The University of Chicago Law Review [58:187 would insist on the sort of interim reporting and analysis that will help them push the corporation toward its five-year goals, and jus- tify any deviation. Experience in the last few years shows that directors are very responsive to a proxy fight or even the threat of a proxy fight. Sev- eral recent proxy fights/consent solicitations have led to conces- sions by, or the ultimate sale of, the target corporation. For exam- ple, BTR plc’s combined proxy contest and tender offer for Norton Company resulted in the sale of Norton to a third-party bidder; Georgia-Pacific Corporation’s proxy contest and tender offer for Great Northern Nekoosa Corporation resulted in the sale of Great Northern to Georgia-Pacific; Gemini Partners’ proxy contest and consent solicitation to take over the board of directors of Healthco International, Inc. resulted in the appointment of three Gemini nominees to the Healthco board and the pending sale of Healthco to a third party; and the threat by Chartwell Associates to com- mence a proxy fight with Avon Products to nominate four new di- rectors who would seek to sell the company resulted in Avon giving the dissidents two seats on the board and a stronger voice in run- ning the company.leZ The quinquennial meeting, and the knowl- edge that institutional stockholders would have access to the cor- porate proxy machinery to challenge directors with whom they are dissatisfied, would strengthen the unity, and thus the power, of the outside directors in taking an active role in monitoring the corpo- ration’s business performance. In this manner, the remaining barri- ers to effective monitoring by outside directors would be lowered. Given the outside directors’ heightened monitoring role, the quinquennial proposal would limit the number of boards on which an outside director could serve to three, and would increase their compensation. In addition to an increase in base compensation, the outside director-like managers-would participate substantially in stock-based incentive compensation tied to the corporation’s five-year performance. Such provisions would further motivate the corporation’s outside directors to fulfill their role as monitors of the corporation’s long-term direction and business performance, loa Randall Smith, Storming the Barricades With a Proxy, Wall St J Cl (May 10, 1990); Healthco to Give Gemini Partners L.P. 3 Seats on New Board, Wall St J C8 (Sept 21, 1990). See also Phillip A. Celston, New Developments in Proxy Contests, in Tenth An- nual Institute: Proxy Statements, Annual Meetings and Disclosure Documents 651 (Pren- tice-Hall, 1988) (citing examples of proxy contests to promote a policy of selling or restruc- turing the company). The authors’ law firm represented Norton in its proxy contest with BTR, and Healthco in its proxy contest with Gemini. 19911 Quinquennial Election 247 and would meet the complaint of some institutional investors as to the minimal share ownership of most outside directors. 2. The perils of special-interest directors. Professors Gilson and Kraakman argue that traditional outside directors cannot be effective monitors of managerial per- formance because, through the nomination process and through so- cial ties, they are tied too closely to the management they monitor, and because they are too independent of stockholders.‘63 The first part of this argument reflects a view that managers and directors must have an adversarial relationship in order for the monitoring function to be successful. In fact, the opposite is true. The direc- tor-manager relationship must be a cooperative one, not an adver- sarial one, in order to be effective. While the adversarial director or board may have the ultimate threat of firing to enforce their poli- cies, the likelihood of full and successful responsiveness by manag- ers to the views of directors is much greater when the manager is motivated by respect and friendship than when motivated by fear.‘64 The second part of the argument reflects the view that an outside director cannot be responsive to a corporate constituency without being nominated by, or specially designated to represent, that constituency. The quinquennial proposal responds to this con- cern by aligning the interests of the various corporate constituen- cies-stockholders, managers, employees, and the corporation it- self-around the corporation’s long-term business success. It is not necessary, and indeed it would be divisive, to elect separate classes or groups of directors to represent the various cor- porate constituencies, or to have any constituency have a separate special right to nominate or advise on the nomination of direc- tors. 165 A board monitors best when it works as a cohesive whole, each director viewing himself as representing all constituencies.“” Once the corporation’s various constituencies all center on the long-term health of the enterprise as their common goal, then traditional outside directors would have ample incentives to work cooperatively with inside directors, management, stockholders, and ‘OS See Gilson and Kraakman, Reinoenting the Outside Director at 21 (cited in note 1). ‘O’ See note 45 and accompanying text. loo Compare Cilson and Kraakman, Reinoenting the Outside Director (cited in note 1) (recommending election of professional outside directors by, and beholden to, institutional stockholders). ‘- Lorsch, POWIS or Potentates at 41-54 (cited in note 19) (the more directors explic- itly agree about in whose interests they are governing, the more they will feel empowered as a group). 248 The University of Chicago Law Review [58:187 the other constituencies to improve the corporation’s operating performance. For similar reasons, it is not necessary that the chair- man of the board be someone other than the chief executive officer.le7 H. Implementation The best way to implement the quinquennial system would be through a comprehensive legislative package, adopted in the United States by Congress and the state legislatures and abroad by Parliament in the United Kingdom, or by a Directive of the Euro- pean Economic Community to all its member states, including the United Kingdom.‘68 This comprehensive approach would require the corporate world and the institutional investor world in each country to work together toward adoption of the new system. In this Section, we discuss the roles that various groups in the United States could play to make the quinquennial proposal a reality. We then briefly discuss the implementation of the quinquennial propo- sal in the United Kingdom. 1. Congress. The best hope for coordinated nationwide implementation lies with federal legislation. This legislation could take one of three forms: a) a substantive federal corporation law that would essen- tially replace existing state law; b) legislation that mandates the quinquennial concept but leaves specific implementation to the states; or c) legislation that complements, but does not mandate, implementation at the state level. We favor the second approach. While a federal law of corpora- tions is within the power of Congress,‘6e such radical change is un- necessary. There is no need to transfer the responsibility for, and the burden of, corporation law as a whole to the federal govern- ment and judiciary. On the other hand, non-mandatory legislation would encourage but not ensure uniform adoption of the quin- ‘O’ But see id at 184-85 & n 5 (proposing separation of the offices of chairman of the board and chief executive officer). ‘W EEC legislation may take several forms, including Regulations and Directives. Regu- lations are immediately binding and directly applicable to all member states. Directives bind member states to achieve certain specific results. The results can be achieved in many ways, usually by enacting the appropriate legislation in that member state. IeD See, for example, Donald E. Schwartz, A Case for Federal Chartering of Corporo- tiorq 31 Bus Law 1125, 1146 (1976) (substantial federal interest in operation of large corpo- rations would overcome any Tenth Amendment objection to federal chartering of corporations). 19911 Quinquennial Election 251 rate governance proposal by many of the state’s large corporations, their major stockholders, and the state bar groups would virtually guarantee passage. 3. The Securities and Exchange Commission. Development of the federal proxy and disclosure provisions of the quinquennial system would fall naturally within the domain of the SEC. Congress could delegate to the SEC the job of developing detailed rules governing the five-year report and the advisor’s eval- uation, just as the SEC has historically developed disclosure and reporting rules under existing securities 1aws.173 The SEC would also develop rules governing the access of major stockholders to the corporate proxy machinery just as it currently develops and enforces the federal proxy rules.174 The SEC could take the lead in implementation of the quin- quennial proposal by developing and advising on federal or state legislative proposals for such implementation. The staff of the SEC has extensive experience with a number of the issues raised by the quinquennial proposal. Representatives of the SEC could serve on the congressional advisory panel charged with developing a federal legislative proposal. Alternatively, the SEC could work with the Treasury task force, or conduct an independent study of the pro- posal and offer recommendations for improving it. 4. Corporations and institutional investors. Corporations and institutional investors would serve primarily as advocates for adoption of the quinquennial system. Through public statements, private discussion and legislative lobbying, they could play a key role in developing political support for the propo- sal. Those who opposed the proposal could engage in similar ef- forts, encouraging proponents to either accommodate or rebut sig- nificant objections. Business groups such as The Business Roundtable and the National Association of Manufacturers, institutional stockholder groups such as the Council of Institutional Investors, and major public investment funds such as CalPERS, provide preexisting ve- ITa See, for example, 17 CFR $8 240.13a-1, 240.13a-11 and 240.13a-13 (1990) (requiring annual, quarterly, and other reports on prescribed forms); 17 CFR J 240.13d-1 (1990) (re- quiring disclosure of beneficial ownership in excess of five percent of a corporation’s shares); 17 CFR § 239.11 to 239.34 (1990) (setting forth forms prescribing disclosure requirements for registration statements under the Securities Act of 1933). I” 17 CFR 55 240.14a-1 to 240.14a-102 (1990). 252 The University of Chicago Law Review [58:187 hicles for discussion of the quinquennial proposal. The identifica- tion of these groups with fixed positions in the corporate govern- ance debate, however, may create obstacles to constructive dia- logue. Accordingly, we also encourage discussion among individual corporate leaders and institutional stockholders. The congressional advisory panel, or any other legislatively appointed panel or com- mission, would provide an appropriate forum for such discussion. 5. The United Kingdom. Parliament could enact the entire quinquennial system through a comprehensive amendment to the Companies Act, the principal regulatory statute governing public companies in the United Kingdom.“* The extensive relationships among industry, merchant banks, institutional stockholders, and governmental agencies such as the Bank of England-for example, in their roles on the City Panel on Takeovers and Mergers”“-would permit these groups to work together toward implementation of the new system. Alternatively, the United Kingdom’s role as a member of the EEC may make it more appropriate to implement the quin- quennial system through an EEC Directive to member states. This approach would be analogous to federal legislation in the United States mandating enactment of the quinquennial system but leav- ing implementation to the states. As in the United States, the key would be to gain the support of both the corporate world and the institutional investor world. Recognition of the corporate governance problem is high in the United Kingdom, and the perceived need for reform is great. The quinquennial system responds to the concerns voiced in the United Kingdom by participants in the corporate governance debate; ac- cordingly, adoption of the system may be possible. ‘Ia Companies Act 1985, II Palmer’s Company Law ?l A-051 at 1011 (1985). See also Companies Act 1989, II Palmer’s Company Law !l A-110 at 1509 (1989) (incorporating amendments that reflect, among other things, certain EEC directives). I70 The Takeover Panel is a non-statutory body that regulates takeovers through its interpretations of the City Code on Takeovers and Mergers, an industry code containing general principles and specific rules relating to takeovers. Members of the Takeover Panel include representatives of merchant banks, investment fund managen and institutional in- vestors, professional accountants, the Bank of England, the Securities Association, the Stock Exchange and the Confederation of British Industry. See generally Tony Shea, Regulation of Takeouers in the United Kingdom, 16 Brooklyn J Intl L 89 (1990); Lord Alexander of Weedon, Q.C., Takeouers: The Regulatory Scene, 1990 J Bus Law 203. 19911 Quinquennial Election 253 CONCLUSION The intensity of the corporate governance debate in the United States and the United Kingdom reflects a deep-seated con- cern with the present system. Virtually all participants in the de- bate recognize that the present system will not meet our needs in the 1990s and beyond. We cannot afford to repeat the financial chaos of the 1980s or the crises that inevitably follow such a specu- lative frenzy. While corporate governance is only one factor in de- termining the success of our business corporations, it is a key fac- tor. It is imperative that we rebuild the corporate governance system to promote the long-term health of the corporations that form the backbone of our free-market economy. At the theoretical level, this task entails rejection of the mana- gerial discipline model of corporate governance, which places stockholder wishes, stockholder profit, and the promotion of take- overs on an undeserved pedestal. This model encourages the sort of short-term obsessions that continually undermine the ability of American and British companies to compete in world markets over the long term. In place of the managerial discipline model we pro- pose a theory centered on the corporation’s own interest in its long-term business success. This interest, when multiplied many times over, in classical economic theory mirrors the interest of all corporate constituencies and society as a whole. At the practical level, we urge adoption through the coordi- nated efforts of many actors-state and federal, public and pri- vate-of a quinquennial system of corporate governance. This sys- tem would reserve essential decisions of corporate control and strategy for stockholders to decide every five years, in a meeting dedicated to rational and unfettered consideration of the corpora- tion’s long-term interests. Not all aspects of the quinquennial sys- tem would find favor with corporations or with institutional stock- holders; it is not designed to meet the wishes of either. But it would meet the needs of our economies, and lead both corporations and institutions to act in the national interest.