Last week, this post noted Henry G. Manne’s op-ed regarding the myth of shareholder democracy being some sort of panacea to all sorts of corporate agency cost problems. As if on cue, Professor Manne’s op-ed was followed by Home Depot’s announcement that it was terminating the contract of CEO Robert Nardelli, which triggered Nardelli’s right to receive about $210 million in exit compensation under his contract.
Of course, Nardelli’s rich exit comp generated the typical wails of woe from various business media pundits who contend that an executive profiting from failure is concrete evidence of a defect in corporate governance that needs to be addressed through more regulation. A typical reaction is this one from Chronicle business writer Loren Steffy:

That cuts to the heart of recent hot-button executive pay issues. From options abuses such as backdating and repricing to lavish perks, all tend to be awarded with a sense of entitlement.
It’s as if executives deserve ever-increasing pay packages simply because they’re executives.
How many of us, failing to meet our bosses’ expectations, are given a bonus or a raise equal to last year’s?

But as Ted Frank points out, self-righteous egalitarians such as Steffy miss the point. Nearly all of Nardelli’s $210 million was part of Nardelli’s original employment contract that he negotiated when the Home Depot board lured him from General Electric, where Nardelli had been a star and one of the three executives competing to succeed Jack Welch as GE’s CEO. When the GE board passed him over in favor of Jeff Immelt, Nardelli was a hot property in a market in which such talent is at a premium, sort of like Nick Saban or Carlos Lee in their markets. And, by the way, all of the terms of the rich deal to attract Nardelli were included in the annual Home Depot proxy.
So, what exactly is Steffy’s point about his so-called “Nardelli Principle?” That Nardelli’s deal should be abrogated now simply because the board concluded it made a mistake in hiring him in the first place?
Look, top executive talent — just like good football coaches and star baseball players — is hard to find, a fact that even private equity is realizing. As a result, boards are willing to pay a premium to get it. Those decisions don’t always work out — just as Drayton McLane’s final contract with Jeff Bagwell didn’t turn out well — but that doesn’t mean that the boards or McLane were wrong to pay a lot to attempt to reduce the risk of loss.
Meanwhile, bringing the discussion back to center is Professer Manne, who responds through this Larry Ribstein post to criticism that his views on shareholder activism leads to “philosopher king” board members overpaying failed cronies such as Nardelli:

. . . don’t forget that we do not want changeovers of management teams to be quite as easy as changing which grocery store (or gardener) you use. That would introduce an element of uncertainty and confusion into the management picture that no intelligent shareholders would want. I do not know the optimal difficulty to put in the way of regime changers, but I am certain that it is more than zero. I do not think there is any good substitute for allowing the market to work that matter out through unregulated experience.[. . .]
[A critic] says that “I want the system where residual claimants are able to pick their own agents.” That is exactly what we do not want. We want shareholders to have full freedom to buy or sell shares with whatever provisions lie behind them. Corporate governance is none of the government’s business; it is best left to the tender mercies of private contract unless some serious externality can be demonstrated or a market failure in the market for corporate control is shown, neither of which I am aware of. Who is being the “philosopher king” here?

Channeling one of the dynamics involved in the increasing cost of public equity, Henry G. Manne provides this excellent Wall Street Journal ($) op-ed (available free here for the next 7 days) in which he systematically disassembles the myth of corporate democracy and the current media fascination with the supposed panacea of shareholder activism. The following are just a few of Professor Manne’s insights:

“They’re back! Every 20 or 30 years shareholder democracy ideas come back in vogue, and their time seems to have arrived again — with a vengeance.”

“The SEC is huddling on whether to facilitate direct shareholder nomination of directors through a new interpretation of its shareholder proposal rule. A prominent professor at Harvard Law School, Lucian Bebchuk, proposes, among other democratizing moves, amending state corporation laws to encourage contested elections for board members. . . . There is absolutely nothing new in any of this discussion. The real world has not changed in any significant way, and our knowledge of corporate governance has not been revolutionized by some intellectual breakthrough. Furthermore, the provenance of the “corporate democracy” oxymoron has long been understood. The idea results from the inappropriate conflation of political ideals with market institutions. Its persistence can only be attributed to the intelligentsia’s far greater comfort and familiarity with political models and events than with knowledge and appreciation of how markets function.”

“It ill behooves corporate democrats like Professor Bebchuk to deride this system as not satisfactorily monitoring managers when he knows full well that regulatory interferences are mainly responsible for poor performance in the market for corporate control and, for that matter, for much of the steep escalation in executive compensation in recent years. That they would then propose intricate regulatory provisions for more shareholder democracy is evidence of the mindset that causes the problems.”

“Perhaps many of the advocates of shareholder democracy actually have a hidden agenda, most usually either a greater degree of government control over private enterprises, or more power to unions via their control of pension funds. Neither has proved beneficial to the investing public or is consistent with a vigorous and innovative public economy.”

“We need corporate activists today more than ever, but we need them to lobby and argue for repeal of our many costly and ill-serving bits of corporate regulation.”

And I’ll leave it to the always-insightful Larry Ribstein to connect the myth to the process involved in the proposed EGL private equity buyout:

Shareholder democracy is just one of the burdens that public corporations have to bear these days (e.g., SOX). All of this is pushing more firms into the hands of private equity. Of course the shareholder democrats donít like that, any more than they liked Mike Milken and the LBO boom of a previous generation.

Finally, in this timely NY Times Select ($) op-ed, William A. Niskanen, chairman of the Cato Institute, makes the following cogent observations regarding the impact of the most well-known regulatory reaction to the Enron scandal:

Sarbanes-Oxley has seriously harmed American corporations and financial markets without increasing investor confidence. The section of the law requiring companies to perform internal audits has turned out to be far more costly than proponents projected, especially for smaller firms. These costs have led some small companies to go private, hardly a victory for public oversight, and some foreign firms to withdraw their stocks from American exchanges.

In addition, the average ìlisting premiumî ó the benefit that companies receive by listing their stocks on American exchanges ó has declined by 19 percentage points since 2002. This explains why the percentage of worldwide initial public offerings on our exchanges dropped to 5 percent last year, from 50 percent in 2000.

Other costs associated with the act may turn out to be more important. For example, more stringent financial regulations and increased penalties for accounting errors may make senior managers too risk-averse. Most chief executives are not accountants, so the requirement that they personally affirm tax reports ó at the risk of jail time should anything be amiss ó may make them reluctant to partake in perfectly legitimate activities.

Paradoxically, Sarbanes-Oxleyís strict rules on oversight by boards of directors would have been insufficient to prevent the collapse of Enron. By the actís standards, Enron had a model board; most members were distinguished professionals. The chairman of the audit committee was a former accounting professor and dean of the Stanford Business School.

Nor would the actís provisions to create a stronger Securities and Exchange Commission have made a difference. The commission had been aware of Enronís accounting techniques since 1992 and had never thought to question them. [. . .]
The negative repercussions of the act on businesses might have been worth it if the act had achieved its primary goal: substantially increasing the confidence of investors in the accuracy of the accounts of firms listed on the exchanges. But that does not seem to have happened.

The best measure of investor confidence is the price-earnings ratio ó the price that investors are willing to pay for each dollar of a companyís reported earnings. The overall price-earnings ratio for the Standard & Poorís 500-stock index, however, has declined continuously since the Sarbanes-Oxley Act was being drafted in the spring of 2002. [. . .]

Tinkering is not enough. Sarbanes-Oxley continues to discourage smaller companies from trading publicly and foreign companies from listing their stocks on American exchanges. In the eyes of investors, it hasnít cleaned up any corruption, it has only forced companies to jump through hoops. As Senator Sarbanes and Representative Oxley drift into retirement, their act should retire with them.

Any surprise that Crane is willing to assume the risk of taking EGL private?

I’ve been meaning to pass along a couple of interesting recent New York Times articles on Houston real estate entreprenuers, including this one on former Houston Rocket star Hakeem Olajuwon’s development of his Houston real estate empire, which one local observor notes was built by “buying high and selling higher.”
The other article is this one on the Third Ward’s Project Row House project, artist Rick Lowe’s ambitous redevelopment effort that utilizes contributions of services from local architectural students and members of Houston’s art and charity communities.
Unfortunately, the Times piece missed several less alluring parts of the Project Row story, which are filled in aptly by the always entertaining Slampo.
Houston has traditionally been an incubator for business entreprenuers, what with its relatively low cost of living, few barriers to entry and restrained regulatory environment. Olajuwon — despite his occasional missteps — and Lowe — despite the seemier side to his project — are actually couple of reasons why we should try to keep it that way. Progress is rarely achieved without risk. The best way to inhibit progress is to attempt to control risk-taking, which generally leads to perverse incentives. A much better policy is to encourage risk-taking and then allow the market to weed out the shysters. That some parts of that market must learn about the downside of risk the hard way is not a good reason to adopt policies that constrict creation of jobs and wealth.