Corporate governance reform – By what right?

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This past week Massachusetts Senator Elizabeth Warren, clearly the most persistent and articulate advocate in this generation for the reform of corporate governance and social responsibility, has outlined in a recent Wall Street Journal opinion (behind a paywall) a series of proposals that both need to be taken seriously and will undoubtedly raise fierce opposition from the business community. Matthew Yglesias from Vox has published a great summary of these proposals, called “the Accountable Capitalism Act.” [1]

The primary opposition I read to these measures, which I summarize below, is best summarized by the question, “By what right can the U.S. government tell corporate shareholders what they can and cannot do with their money?”  The answer to the question is surprisingly easy, and that is the point of this post. Corporations have been increasingly held as sacrosanct and exempt from tighter regulation or substantive taxation by right-wing ideologues, at times supported by the courts. Bad Supreme Court decisions like Citizens United and recent tax law changes slashing corporate taxes to the bone have fueled the common Republican philosophy that American corporations are “free agents” in a “free economy.” They are wrong. Read on.

Improving corporate governance

A recent study has shown that average CEO pay at the biggest U.S. corporations is now 312 times the average worker pay. [2] This figure dwarfs that same ratio in other developed countries. most of which are well below 20 times. A significant reason for this is that in countries like Germany, for instance, there is a requirement for employee representation on corporate board of directors, a principle called “co-determination” or “worker participation.” Senator Warren proposes that workers in large corporations be given up to 40% of the Board of Director seats. While employees are usually not significant “stockholders,” they are very much “stakeholders,” especially when the company looks to moves production abroad or unilaterally slashes employee benefits such as pensions.

Senator Warren has also proposed limitations on how corporations can compensate executives with stock after significant stock buybacks, which have been occurring at record levels following recent corporate tax reductions, in order to encourage companies to reinvest those savings rather than giving them to executives. Political activity would also be restricted unless approved by 75% of both shareholders and directors.

The pushback

In the United States, corporate chartering since its founding has been primarily the province of the state governments. As I have written in an earlier post, the major downside of this approach is that some states, notably New Jersey and Delaware, started a “race to the bottom” in corporate governance requirements starting in the late 19th century, which has made all states loath to impose any meaningful restrictions or penalties on corporate misbehavior. This has been going on for so long now that most people see this as “normal,” but if you want to be an “originalist” in terms of corporate law, corporations at the time of the nation’s founding (and before under the King) were very much products of political and social obligation in return for their limited liability protections.

As a result of this “race to the bottom,” we have seen some states, such as West Virginia and Wyoming become politically captive to dominant business interests such as mining. Corporate mergers and consolidations often result in major industries abruptly leaving small towns across America with impunity, decimating local tax bases, schools, and family wage security. Increasingly, the courts have supported the “economic freedom” of corporations to act as they choose, as separate “legal persons.”

Poorly regulated corporate banks and private equity investment entities crashed the Savings and Loan business in the U.S. in the mid-1980s, [3] and crashed the housing market (with numerous other casualties) in 2008. “Cash cow” companies like Toys-R-Us regularly disappear from the business landscape, viable one day and gone the next, “milked” to death by private equity owners. [4]

The courts have almost always sided with the corporations in these cases, or perhaps more correctly, in the right of the states to not hold their chartered corporations responsible for the “collateral damage” of their bad actions. A key part of the Warren proposal is the creation of an “Office of United States Corporations” to charter corporations with in excess of $1 billion in revenue, which is the set of entities that would be required to implement the other proposals.

Taxpayer-financed failure insurance

And so, by what right can the large corporations be so handcuffed by politicians and the non-shareholder public? The answer is embedded in the term used to identify corporations in the United Kingdom and other countries: “Limited.”

As I have written in earlier posts, the integral corporate concept of limited liability is, in reality, a taxpayer-funded insurance policy freely given to companies to protect them against the worst downsides of bankruptcy. For most “good actor” businesses, this is a good deal both for the community and the company, allowing the corporation to grow and employ more people.

For “bad actors,” of which there are now many, limited liability allows the creation of corporations with very little stockholder equity in relation to debt financing, leveraging profits but also leveraging risks to unsustainable levels. These companies often fail, not because they generate insufficient cash from operations, rather because they don’t generate enough additional cash to pay the high interest costs on the debt, despite the generous tax-deductibility of the interest payments. By the time of bankruptcy, there is usually little stockholder equity left to lose, but bankruptcy law protects the “bad actor” management from dealing with “torches and pitchforks” from debtholders, employees, and local governments who are harmed, even bankrupted themselves, when the company goes belly-up.

Taxpayer-supported limited liability is the primary mechanism by which we have “socialized losses” in the United States while “privatizing gains,” despite their beneficiaries loud touting of “American capitalism.” [5] And that socialization is the primary rationale and leverage that the American people have over “bad actor” corporations. I proposed in an earlier post that the “underwriting cost” of this “failure insurance policy” needs to be quantified and assessed, like any insurance policy. One way to do this is via a “risk-adjusted” form of corporate taxation, according to the default risk and “moral hazard” posed by the corporation, which I have also written about in an earlier post.

The best alternative to effective risk-adjusted taxation of corporations being floated is Senator Warren’s “Accountable Capitalism Act.” The “By what right?” question for either action is, “Because you have contracted that the people of the United States will socialize your losses.”


Notes:

  1. Yglesias, Matthew. “Elizabeth Warren Has a Plan to Save Capitalism.” Vox, 15 Aug. 2018.
  2. Rushe, Dominic. “US Bosses Now Earn 312 Times the Average Worker’s Wage, Figures Show.” The Guardian, 16 Aug. 2018.
  3. I wrote about the Savings and Loan debacle recently in a post called, “Bank deregulation: Wash, rinse, repeat.”
  4. I wrote about the looting of “cash cow” companies in this earlier post about “How to milk a cash cow.”
  5. See my recent posts on “Humpty Dumpty words: socialism and capitalism.”

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