09 August 2011

Closely Held Public Companies

The stereotypical publicly held company has few, if any, of the people who provided the company with cash in exchange for equity still on its shareholder rolls, have few shareholders who hold blocks of stock even as big as 5%, would need hundreds or thousands of shareholders to agree simply to secure a majority in interest in a shareholder vote, have a board of directors that is effectively self-perpetuating and owes its allegiance primarily to senior management, and have investors who are mostly operating according to the "Wall Street Rule" of selling shares in companies that are ill-managed rather than trying to reform the company by influence members of its board of directors. Institutional investors in these companies generally choose to provide a rubber stamp to management rather than expressing opinions on management issues, in part, out of fear of the securities law implications of doing so.

The famous separation of ownership and control in this companies is at the heart of the criticism of American corporate governance which is prone to excessively compensating senior executives, providing senior executives with poor incentives that can encourage systemic risk in the economy as a whole, and not holding mediocre management teams accountable for their suboptimal management of their companies.

But, this isn't description isn't a good match to an important subgroup of public companies which I oxymoronically call "Closely Held Public Companies." A new Pennsylvania State University College of Business Administration study entitled "Are Busy Board Detrimental?", looks at the subclass of newly public companies whose IPOs were launched by venture capitalist firms.

These firms, a thousand of which are reviewed, don't fit the stereotype. Almost all of the new investors either directly supplied cash equity to the company in exchange for stock (an average of $72 million each). The average seven board members own or control 33% of the stock of these companies, and the average "busy" board member, defined as serving on three or more board, has an investment of at least $5 million in the company. The typical board has four venture capitalist firm executives (who disproportionately serve on audit and compensation committees and as chairmen of the board), two insider executives who are directors, and one other outside director (who two-thirds of the time serves on no more than one other board and usually serves on that board of directors alone). The board membership was typically determined by an investment bank that took the company public, a venture capital firm, and senior management in a negotiated effort to please IPO investors. Typically, a few dozen shareholders control a majority in interest of the company's shares and even the big investors who do not have directorships know each other personally. The senior management team, rather than being appointed by the board after a talent search, is typically the group of individuals whose efforts as managers grew the business until it could be attractive enough to outside investors to go public. The venture capital firms that own a large share of these newly public firms have a business model that calls for active management of the newly public firms for at least a medium term time frame (ca. 3-5 years at least), in order to continue to grow their hands on, long term investment in active indirect management of the company so it can thrive, as do the employee-owner senior managers who usually expect to spend at least as many more years running the firm that they took public.

While these firms are nominally publicly traded because they have made a public offering of securities and have some small time passive investors, their governance arrangements are more like closely held private companies with significant non-employee investors, than they do like stereotypical publicly held companies. Most importantly, they do not have a meaningful separation of ownership and control.

So, while the study purports to ask if "Busy Boards" are detrimental, the confounding variable in the study is very strong director financial interest in the venture upon which the director serves and generally good corporate governance standards of new VC launched IPOs, avoid the criticisms of busy boards raised with more established firms.

The 95% of the directors of these firms aren't really busy they have day jobs that include being a director, either incident to their role as a venture capital firm executive, or incident to their job as a senior executive of the board's firm, or because they serve on only one board, or because they don't have a day job for some reason. Only 5% or less of the directors of these firms (just 20% have even one such person) are outsiders who aren't VC executives who serve on three or more boards and have a day job as well, and the world does still have a few overachievers left who can somehow handle that burden gracefully, and if they can't, they have six other board members who can pick up the slack.

Thus, busy directors seem like a non-issue in this study mostly because the term was defined in an inappropriate way that disregards the nature of the director's day job, and because the governance positives in these closely held public companies overwhelm any governance negatives that may flow from having busy directors. Not surprisingly, indicators of accountable management, like lower than average CEO pay and higher than average company performance are typical of these newly public companies.

The serious corporate governance problem in the American economy is not with newly public firms that have just completed IPOs, but with firms whose long term investors have sold their shares, whose initial dynamic management team has been replaced by executives chosen in interview rather than exceptional performance building this very business, whose highly financially interested venture capitalist directors and insider directors have been replaced by toadies of the new management team with a weak financial interest in the firm's performance, and whose new institutional investor owners have abdicated a role as active supervisors of the senior management team, in part because corporate and securities law discourages this, and in part because this isn't a part of their business model. Once this stereotypical separation of ownership and control takes hold, pressure on management to refrain from self-dealing and perform or be replaced is gone. The new focus starts to center on providing an unattractive target to hostile takeovers by means unrelated to actual financial performance and on growing the scale of the business without regard to profitability, because scale rather than profitability or management performance, drives the ability to pay senior executive compensation in these firms (for which cash flows are great enough to sustain large executive pay packets even when the company is doing poorly).

Typically, once a firm gets its initial infusion of IPO equity, retained earnings and corporate bond offerings, rather than new equity offerings, are the main sources of new capital for the firm, except at points in the business cycle where the company is performing well and appears to be overvalued in the long run, allowing it to secure a rare major new infusion of equity from the public with a modest number of shares. Since it generally doesn't need shareholders to raise new capital, can get away with not giving shareholders any meaningful role in the appointment of its board of directors or executive compensation, and can discourage hostile takeovers with poison pills and other barriers to changes in control and ownership even when it would make economic sense in the absence of those self-created barriers, these firms can get away with giving shareholders very little and the pressures from above on senior management are far too weak to be optimal.

The most visible symptom of this governance problem is the overcompensation of self-dealing senior executives. But, the deeper issue that matters more to the economy is the opportunity cost associated with lax ownership permitting mediocre executives who always are at the held of some share of big businesses to managing the assets of big business less well than another management team that knew that it would be held accountable for its performance could. Since large, publicly held companies make up the vast majority of economic activity and employment in the United States, even a modest subset of poorly managed big businesses are a critical problem for the health of the American economy as a whole.

The solution is to find ways to well established large publicly held companies to act more like the closely held public companies whose IPOs have just been launched by venture capitalist firms.

* Control needs to be vested more firmly in institutional investors with strong financial incentives to do so, who take the kind of interest in and have the expertise in monitoring and holding accountable the senior management team in performance, compensation and transparency, are capable of the kind of collective ownership action, and invest at least for the medium term in the way that venture capital firms do. The biggest barriers to this are (1) in the proxy rules for nominating director candidates and information about them, and getting this on a ballot sent to all shareholders (the current norm is a Soviet style director's ballot), and (2) in the securities laws that could construed collective shareholder action as some form of securities law violation or other civil wrong.

* Publicly held companies need to have incentives to left shareholders, rather than senior management, decide how to reinvest profits from the firm. Further, the tax and corporate law incentives that favor debt over equity, which increase systemic risk during recessions, need to go, if effective shareholder governance is possible. Securities law plays a role here as well. Equity holders can bring securities fraud suits when stock prices suddenly plunge as a result of the late disclosure of material information about a company. Debt holders can bring securities fraud suits, in general, only when the company defaults, and by then it has usually declared bankruptcy and there is nothing to collect out of in a securities fraud action once the bankruptcy is complete. So securities fraud liability analysis favors debt financing over equity financing.

* Public companies need to have at least a balance between incentives to split up and incentives to merge, in both the tax law and in corporate governance practice (e.g. executive compensation practices) so that companies do not grow big simply for the sake of being big. We need to remove systemic incentives to become too big to fail and to unduly concentrate the market with fewer bigger firms (even when this doesn't mean that a firm has a monopoly or near monopoly in any given product market).

* The law needs to discourage poison pills and other barriers to hostile takeovers that prevent the market from disciplining poorly performing firms. For example, it needs to end the race to the bottom choice of law rules that make management friendly Delaware corporate law the norm on corporate governance issues. It may be most sensible to simply require that all publicly held companies have their governance conducted according to a federal corporate code, rather than state law, with Congress acting pursuant to its commerce clause powers, given the indubitable interstate commerce impacts of federal corporate law, which securities laws have already effectively taken control of in many important respects.

The market is stumbling in a Coasian way towards this end.

* Greater leverage prevents profits from being entirely reinvested in the firm even if it is suboptimal to do so, holds management accountable to minimum performance measures, is easy for investors to monitor and act collectively on behalf of, minimizes the kinds of disclosures that materially impact the value of the assets in light of information asymmetry, and uses principal payments to force borrowing companies to continually renegotiate the terms of their financing in order to continue to operate.

* Going private transactions remove the debt-equity imbalances that face publicly held companies and permit the more functional corporate governance regime of privately held companies to apply.

* Pre-packaged bankruptcy plans and corporate auctions facilities with bankruptcies allow overleveraged companies to survive economic downturns by sacrificing some share of long term subordinated and general bond creditor's investment.

But, the measures cobbled together in the private sector under current law are half measures that still leave big business much less well governed than it should, and successful reform is necessary for the long term prosperity of the American economy.

No comments: