The Neglected Role of Justification under Uncertainty in Corporate Governance and Finance
A big corporate governance debate today is on the so-called short-termism of publicly held companies. In response to actual and anticipated pressure from activist hedge funds companies are, some say, becoming too short-term. This debate has been highly polarized between those welcoming keeping management on their toes and those concerned about the value-destroying consequences of short-termism. Both camps seem to have a point.
The short-termism debate reflects a more fundamental issue, namely the balance between managerial discretion and accountability in corporate governance. Accountability enables shareholders to monitor managers in a principal-agent relationship. Discretion enables agents to exercise judgment as to what is in the principals’ best interest, including the pursuit of long-term goals. The balance between discretion and accountability in corporate governance depends on the legal distribution of powers. Once it is set, this balance is difficult to alter over time even though the company would benefit from a different balance.
In our recent paper, Claire Hill and I argue that there is no such thing as a general short-termism problem in corporate governance. Because the right time horizon for a company is not known, managers complaining about activists’ short-termism might well suffer from long-termism, i.e. postpone the realization of underperformance indefinitely. However, to the extent that managers have to justify to investors, hedge fund activism and the threat thereof create a short-term bias. This short-term bias cannot be efficient for every company in every point in time. In particular, justification-minded managers tend to avoid uncertainty. To fend off activists, managers would seek short-term results or failing those, defensible procedures for decision-making. In contexts where and innovation is incremental and competition is vigorous, such accountability is desirable. However, in industries where innovation is discontinuous, playing it safe results in the neglect of longer-term profit opportunities. This may be harmful for shareholders and for the society at large.
Therefore, corporate law should enable companies to adapt the balance between managerial discretion and accountability depending on the uncertainty they face. In particular, companies should be able to enter into dual-class recapitalizations with an effective veto by institutional investors. By default, the control enhancement of dual-class shares should be limited in time, unless companies choose to establish it indefinitely.