June 12, 2006
Mercer Bullard on The Corporate Governance Industry
Posted by Christine Hurt

I have asked a law professor new to our blog to comment on our paper today.  Mercer Bullard is currently a professor at the University of Mississipi, but has also been an attorney for the SEC and an associate at Wilmer, Cutler & Pickering.  In addition, Prof. Bullard is the founder and CEO of Fund Democracy, a nonprofit organization dedicated to providing information and voice to mutual fund shareholders.  Below are Prof. Bullard's comments to The Corporate Governance Industry.

Professor Rose’s stated goal in his article is to encourage academic interest in and debate about what he calls the “corporate governance industry.”  He should easily achieve this goal, for he successfully demonstrates that this burgeoning business has much to offer students of corporate governance.  In short, Rose reviews two problems in the corporate governance industry -- conflicts of interest and faulty or unsupported governance ratings methodologies -- and provides a preliminary analysis of the potential role of regulators in overseeing this enterprise.  Rose concludes that mandatory disclosure might be appropriate for conflicts of interest, but that regulation of governance ratings methodologies probably would create more problems than it would solve.

There is a rich and recent history of government regulation of corporate governance to which the corporate governance industry can be compared, and the article provides an insightful, although limited introduction to it.  Rose explains, for example, that recent regulation of analysts’ and auditors’ conflicts of interest might not be analogous because of the more transparent nature of corporate governance ratings and the practice of pre-committing to certain proxy vote positions.  His skepticism of mandatory disclosure as a potential form of merit regulation is also on point.  The SEC often brings disclosure cases to indicate disapproval of the activity in which the registrant has engaged.  Two examples that would benefit the article are the SEC’s Deutsche Asset Management case and the Egan-Jones no-action letter.  The SEC sued DeAM for failing to disclose that it received investment and commercial banking business from Hewlett-Packard while voting proxies in favor of the HP-Compaq merger.  The no-action letter effectively requires proxy advisers to disclose their potential conflicts of interest to clients.

The article’s discussion of government regulation could be deepened in other ways as well.  I was left unsatisfied with only a passing reference to the SEC’s practice under Rule 14a-8 as a kind of corporate governance merit regulation.  The SEC’s approach to politically contentious shareholder proposals raises the question of how directly shareholders should affect company policies.  The same issue is central to debates regarding the efficacy of staggered voting, poison pills, and other corporate governance practices.

The article would also benefit from considering other recent events, such as the battle over a proposal to require mutual funds disclose how they vote proxies.  The SEC adopted this proposal on the heels of an intense campaign by labor and investor advocates and equally intense opposition from mutual fund managers, who claimed that disclosing proxy votes would “politicize” the process.  As expected, interest groups have monitored fund managers’ votes and rated their performance.  It is not clear from the article where these groups would fit in the corporate governance industry, or what the role of political criteria should be in corporate governance ratings.  The proxy vote disclosure debate presents interesting parallels to the Rose’s article, especially in light of the SEC’s rejection of calls for mandatory disclosure of conflicts of interest that exist when the fund manager votes shares in companies that also provide pension or investment banking business to the fund manager.  Another version of this debate has been fought for years at the Department of Labor, which has often changed its position on the permissibility of ERISA fiduciaries’ considering non-monetary (politicized?) criteria when voting proxies on behalf of pension plans.  These examples need to be addressed because they illustrate government attempts to understand and regulate investors’ proxy voting preferences.

One would expect the corporate governance industry to compare favorably to regulation.  Critics often complain that government regulation cannot capture investors’ true preferences and that markets provide the most efficient regulatory mechanism.  The corporate governance industry puts this claim to the test by providing a true market for competing theories of optimal firm structure.

What Rose finds, however, is that corporate governance ratings do not satisfy investor preferences because they are not based on corporate governance criteria with a proven correlation to value.  Many criteria are “myths” reflecting the latest corporate governance “fashion,” rather than criteria that have a demonstrated relationship to profits.  Rose suggests that the industry should and eventually will do a better job determining what governance practices actually matter, but does not discuss the possibility that the corporate governance industry is currently giving institutional investors exactly what they want.

If governance ratings do not predict performance, then do they reflect other, possibly unexpressed preferences?  What is the role of myths and fashion, which are themselves a form of expressed preferences, in the institutional investor’s decisionmaking process?  Rose seems to assume that the industry should mitigate the influence of such unexpressed preferences.  The strategy of shaping investors’ preferences rather satisfying them, however, sounds more like a job for the SEC than the marketplace.  The SEC already maintains an electronic database of registrant data.  It could simply require the filing of standardized coding of corporate governance information and provide online analytical tools with which to generate individually customized governance ratings.  To address merit regulation concerns, the identification of the data points that are collected could be based on the presentation of empirical evidence of a correlation between the data point and economic performance.

It is not clear why this approach would not be at least as successful as waiting for the corporate governance industry to catch on, but then the market may know something we do not.  For example, if staggered boards or the separation of the chairman and CEO could not satisfy the empirical evidence test, and that data therefore was not collected by the SEC, would the corporate governance industry still find a market for that information?  I suspect that it would, but am not sure why.  Perhaps we should use this new market for theories of corporate governance to learn more about investors’ actual preferences, rather than second-guessing the market’s opinion of what those preferences are.

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