The analysis of corporate governance has been a strikingly one-sided affair. The focus has been almost exclusively on ‘internal’ checks and balances, namely scrutiny of executives by the board of directors and by shareholders. In contrast, mechanisms that can operate as significant ‘external’ checks on managerial discretion have been largely ignored. My recent article, ‘Corporate Governance and Countervailing Power’, functions as a corrective to the prevailing trend. The article focuses on three historically important examples of external constraints on managerial discretion, namely state regulation of corporate activity, competitive pressure from rival firms, and organized labor. A unifying feature is that noted economist John Kenneth Galbraith took account of each when considering ‘countervailing power’ in the corporate context in the 1950s.
Shifting the analytical emphasis toward external governance mechanisms is timely. This is because it is unlikely that internal constraints on managerial discretion will become more robust any time soon. Boards and shareholders have grown considerably in potency as corporate governance players over the past 40 or so years. The momentum, however, appears to have stalled. With boards, for instance, there is little room left for restructuring that will bolster their monitoring capabilities. Most directors are already formally independent of management. With topics where objectivity is crucial, such as the auditing function, executive compensation, and the selection of nominees for board election, boards of publicly listed companies pretty much universally delegate heavily to committees staffed by independent directors.
As for stockholders, activist hedge funds have since the early 2000s been putting meaningful pressure on public company executives. Much has also been made of the influence investment funds designed to track major stock market indices are poised to wield due to dramatic growth in the percentage of shares such funds own in public companies. On the other hand, hedge fund interventions have been tailing off recently, and investors have begun to withdraw their cash from the sector due to mediocre returns. As for index tracking funds, since they are popular primarily due to the low fees they charge, they are unlikely candidates to undertake potentially time-consuming, costly engagements with management.
As for external constraints affecting public company executives, events occurring in the 1950s and 1960s illustrate their significance in the governance realm. For executives from this era, internal constraints on their discretion were more theoretical than actual. Boards deferred to management, at least absent a crisis. Most shares were owned directly by individual investors with tiny holdings and little appetite for scrutinizing companies. There correspondingly was a real risk that senior executives would exercise managerial authority in a manner that was contrary to the interests of stockholders and others closely affiliated with companies.
Despite the weakness of internal corporate governance mechanisms, the 1950s and 1960s were characterized by economic prosperity and managerial propriety. Public companies thrived amidst buoyant market conditions. Corporate scandals were rare. Why? John Kenneth Galbraith’s 1952 book, American Capitalism: The Concept of Countervailing Power, is instructive on this point. Galbraith was seeking to explain why the U.S. economy was highly successful despite many Americans having serious misgiving about the influence large business enterprises wielded. The key, he maintained, was that various sources of ‘countervailing power’ functioned as beneficial checks on large corporations and their executives.
Organized labor was one source of countervailing power Galbraith identified. During the middle decades of the 20th century unions were a powerful force in numerous industries and executives in these industries tailored managerial strategy accordingly. Governmental regulation was another important facet of Galbraith’s world of countervailing power. This was hardly surprising, given that regulators in key sectors such as banking, telecommunications, transport, and utilities were exercising control over entry, dictating standards of service, and influencing pricing.
The mid-20th century balance between internal and external governance mechanisms subsequently changed markedly. Under the mantle of ‘corporate governance’, a term first used regularly in the 1970s, internal constraints were strengthened. Boards of directors, for instance, were reconfigured from the 1970s through the 1990s to bolster the role of outside directors as monitors of management. With shareholders, the prospects for intervention improved as the ownership stakes of well-resourced mainstream institutional investors such as pension funds and mutual funds grew at the expense of individual stockholders.
While internal accountability mechanisms were fortified as the 20th century drew to a close, organized labor and regulation receded as constraints on public company executives. Unions had begun a pronounced, secular decline that has continued to the present day. As for state intervention, a deregulation trend that commenced in the late 1970s prompted the dismantling of controls in a wide range of industries. On the other hand, an additional source of countervailing power Galbraith identified, namely pressure from rival firms, was growing in importance as an external constraint. During the 1950s and 1960s, oligopolistic control in various key industrial sectors substantially compromised the operation of competitive forces. Beginning in the 1970s, however, challenges from foreign and domestic rivals intensified and ultimately substantially eroded market power that had served to insulate heretofore dominant corporations and their executives.
Competitors would remain a headache for public company management in the 2000s and 2010s. The growth of the internet bolstered firms seeking to challenge dominant incumbents by making it easier for buyers and sellers to find each other and for customers to engage in comparison shopping for the best deal. A counter-narrative has emerged recently, however. Fears are growing that America could be returning to oligopolistic market conditions similar to those prevailing in the 1950s and 1960s. The tech sector is the primary source of concern. Apple, Alphabet (the parent company of search engine Google), Amazon, Facebook, and Microsoft stand out as purveyors of market power due to operating tech platforms the popularity of which makes users reluctant to switch.
As with competitive pressure, the potency of regulation as a constraint on managerial discretion has been in flux since 2000. The deregulatory momentum in operation as the 20th century drew to a close ceased in the early 2000s and state intervention surged, particularly under Barack Obama’s presidency. A double back in favor of deregulation has occurred since Donald Trump became president. Future election results will do much to dictate whether the deregulatory push constitutes a mere hiatus in a pro-regulatory era or the beginning of a new age of deregulation.
Historical trends concerning organized labor, competitive pressure, and state intervention demonstrate clearly that the analysis of corporate governance should factor in external mechanisms to a more substantial degree than occurs at present. These are only a few examples of external accountability mechanisms potentially relevant for public company executives. Additional candidates include auditors, credit rating organizations, the media, and the prospect of being displaced due to a hostile takeover (the market for corporate control). Plenty of scope correspondingly exists for future study of the external dimension of corporate governance.
Brian Cheffins is S.J. Berwin Professor of Corporate Law at the University of Cambridge.
This post is based on his article, ‘Corporate Governance and Countervailing Power’, a working paper version of which is available here. Professor Cheffins also canvasses the topics discussed in this post in The Public Company Transformed (Oxford University Press, 2018), the opening chapter of which is available here.
This is a revised version of a post which first appeared on The Columbia Law School Blue Sky blog here.