«Lobbying, Pandering, and Information in the Firm Adam B. Badawi* I. INTRODUCTION In their classic and insightful article on team production in corpo- ...»
Lobbying, Pandering, and Information in the Firm
Adam B. Badawi*
In their classic and insightful article on team production in corpo-
rate law, Margaret Blair and Lynn Stout identify the minimization of
rent-seeking as one of the chief benefits of vesting ultimate authority
over a firm with the board of directors.1 In their analysis, this problemat-
ic rent-seeking arises when parties need to divide the gains from produc- tion after the fact. The squabbling that is likely to ensue may threaten to eat away most, or all, of the gains that come from productive activity. If parties know that this sort of rent-seeking will occur, they may not en- gage in productive activity in the first place. Parties view the board’s ability to act—or threaten to act—as a neutral arbiter to divide the gains from production as a mechanism that preserves the incentive to engage in productive activity.
While this is a creative and plausible account of the board’s role and of its enduring success, the presence and prominence of the board introduces new opportunities for rent-seeking and other similarly distor- tive activity. In this Article, I identify the rent-seeking and related prob- lems that the board creates rather than solves. Like Blair and Stout, I draw on insights from the theory of the firm literature to understand the incentives that firm managers may have to shade, contort, and otherwise manipulate the information that the board receives. These theories sug- gest why managers are likely to engage in this behavior and how boards are likely to respond.2 This exercise is not an indictment or criticism of the board. As an institution, the board has been remarkably successful, and it is important to understand the reasons for that success. Nevertheless, the presence of * Associate Professor of Law, Washington University in St. Louis, Law School. I thank Scott Baker, Tony Casey, Jill Fisch, and Lynn Stout for their helpful comments and suggestions.
1. Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA.
L. REV. 247, 249–51 (1999).
2. Throughout this contribution I use the terms rent-seeking and lobbying interchangeably.
215 216 Seattle University Law Review [Vol. 38:215 an independent board encourages potentially problematic behavior that would probably not occur in the board’s absence. To understand the board’s role and its place in corporate law, it is important to comprehend how managers will respond and adapt to the behaviors the board’s pres- ence enables. Doing so, this contribution claims, will naturally lead to quite modest claims about what the board can do to limit squabbling and agency cost concerns.
The jumping-off point for this analysis is the observation that the CEO and other high-level managers are the information conduit for an independent board.3 As other scholars have noted, this ability to control information impacts how effective boards can be as monitors of managers and as providers of strategic advice.4 The specific pathways and behaviors that this control over information enables have received less attention, and it is those pathways and behaviors that I analyze in this piece. I focus on two specific behaviors that the informational dynamic between managers and the board engenders: lobbying and pandering.5 The institutional problem that underlies lobbying is that those who are affected by a decision may have stronger preferences than those with the authority to make that decision.6 If a superior has the right to make a choice that a subordinate deeply cares about, that subordinate may spend time trying to cajole the superior into making a decision that favors the subordinate. This danger may be particularly acute if the superior must rely on information from the subordinate in order to make that decision.
This lobbying can pose costs to the firm because time spent lobbying could be devoted to more productive tasks.
These circumstances map quite neatly to the problems faced by a board of directors as it monitors firm management. As corporate scholars
3. There are some quite elegant formal models of this process. For example, Adams and Ferreira, infra, show that the strategic and monitoring roles of the board can lead a CEO to share less information with an independent board. This result arises from the CEO’s fear that sharing too much with a tougher monitor (i.e., a more independent board) can adversely affect the CEO’s well-being.
See Renée B. Adams & Daniel Ferreira, A Theory of Friendly Boards, 62 J. FIN. 217, 217 (2007).
4. Arnoud W.A. Boot & Jonathan R. Macey, Monitoring Corporate Performance: The Role of Objectivity, Proximity, and Adaptability in Corporate Governance, 89 CORNELL L. REV. 356, 370 (2004) (“Management not only has the time and resources to cultivate the board, it also presents the board with the information necessary to make decisions. Over a wide range of issues, all management must do to sway the board’s decision is present information in a manner likely to generate support or to achieve effective capture of the board. It is not surprising, therefore, that boards often lack objectivity.”).
5. I use the term lobbying to refer to managerial efforts aimed at influencing the decision of supervisors. I use pandering to refer to the possibility that subordinates will strategically use private information to recommend projects that are not in the firm’s interests.
6. See Adam B. Badawi, Influence Costs and the Scope of Board Authority, 39 J. CORP. L. 675 (2014).
2015] Lobbying, Pandering, and Information in the Firm 217 have long recognized, senior management has most of its human capital bound up within the firm.7 These circumstances often lead managers to have intense preferences over firm decisions. Yet it is the board of directors that wields the ultimate authority within the corporation. Directors may have preferences over firm outcomes that are less strong than managers’ preferences and, consequently, those managers may intensely lobby directors. These attempts to influence can take away from other productive tasks that managers might otherwise perform, and this lobbying may exert drag on firm performance. I argue that understanding these lobbying concerns can help to explain why boards tend to limit the amount of authority they exercise. Lobbying costs may also help contribute to an explanation of why the move toward more independent boards has been a muted success and why corporate law takes a handsoff approach in imposing liability for duty of care violations.
The second problem, pandering, arises when decisionmakers must rely on private information supplied by subordinates. Models show that, under certain conditions, subordinates will recommend projects that they know are objectively inferior for both the principal and the agent.8 Subordinates may do so even though the decisionmakers know they are pandering in this way. While the pandering models are relatively complex, the circumstances that trigger pandering share similarities with the interactions between noninsider directors and senior managers. These firm outsiders operate at an informational disadvantage when compared to insiders. That those insiders may make recommendations that put their own interests ahead of firm-wide interests is a concern that is at the heart of corporate law. The pandering models help to understand the depth of the pathologies that this informational disadvantage can create.
The difficulties directors face in obtaining truthful information from subordinates may help justify some important facets of corporate law.
The possibility that management will recommend suboptimal projects and that directors can do little to wrest the truth from management lends credence to the insulation provided to directors by the business judgment rule. If directors struggle to get accurate information, it may not be desirable to make them liable for the decisions they make on the basis of that information.
The pandering phenomenon also provides some support for Delaware General Corporate Law § 141(e). This rule insulates directors from liability when they rely in “good faith” on the reports of managers and
7. See infra note 48.
8. See infra Part II.A for a more complete description of the model and its sources.
218 Seattle University Law Review [Vol. 38:215 employees of the firm.9 Good faith may be understood as requiring directors to make reasonable efforts to ascertain the truth. If directors have done so, they should be able to avoid liability even though managers and other employees may not give accurate information.
The remainder of this Essay proceeds as follows. Part II describes the literature on influence costs and applies that literature to the problems faced by the board. Part III works through a recent model of pandering and analogizes that model to the interaction between the board and management. Part IV concludes by relating the problems of lobbying and pandering to the team production model of corporate law.
II. LOBBYING IN THE FIRMInternal politics are a fact of organizational life.10 Subordinates may cajole, persuade, or otherwise influence their superiors into making decisions that benefit those subordinates. Control over information is a chief way to engage in this type of influence; limiting or manipulating information can affect decisions made by superiors.11 People presumably engage in this sort of lobbying because it works, at least with respect to improving the lot of those who can effectively influence others.12 The literature on influence costs explores the potential downsides of this behavior.13 When managers spend time manipulating information, it takes away from time they could devote to more productive activities.
Theorists argue that firms may adapt their institutional structures in a way that helps to minimize these influence activities.14 One way to do
9. DEL. CODE ANN. tit. 8, § 141(e) (2014).
10. As suggested earlier, this section draws substantially from the analysis in my earlier work on influence costs. See Badawi, supra note 6.
11. See Louis Kaplow, Direct Versus Communications-Based Prohibitions on Price Fixing, 3 J. LEGAL ANALYSIS 449, 471 (2011) (“Many [firm] decisions are based on soft information or are made despite seemingly contradictory information, perhaps because the information is seen to be unreliable, because there are overriding considerations, or because of incompetence.... Firm politics may... play a role, reflecting that employees are not perfect agents of the owners.”).
12. See, e.g., David B. Wilkins & G. Mitu Gulati, Reconceiving the Tournament of Lawyers:
Tracking, Seeding, and Information Control in the Internal Labor Markets of Elite Law Firms, 84 VA. L. REV. 1581, 1618 (1998) (“[W]e should expect tournament winners to be selected as much on the basis of politics as on firm efficiency.”).
13. See generally Robert Gibbons, Four Formal(izable) Theories of the Firm?, 58 J. ECON.
BEHAV. & ORG. 200, 200–01 (2005) (comparing and defining the four classical theories of the firm:
a “rent-seeking” theory, a “property-rights” theory, an “incentive-system” theory, and an “adaptation” theory); Michael Powell, An Influence-Cost Model of Firm Boundaries and Organizational Practices (Nov. 1, 2012) (revised Ph.D. thesis, Massachusetts Institute of Technology), available at http://static.squarespace.com/static/5097d207e4b06cb305096ef3/t/5097ee9be4b0c4855bdf00ee/1352 134299819/InflCst%20Oct%2031%202012.pdf.
14. See Powell, supra note 13, at 4 (explaining the choice between rigid and flexible institutional practices may depend on influence cost concerns).
2015] Lobbying, Pandering, and Information in the Firm 219 this is to vest authority in parties that have intense preferences over a given set of decisions. If these parties get to make the decisions, they do not need to lobby anyone. Likewise, companies may institute policies like lockstep promotion that sharply diminish the gains from effective lobbying.15 This dynamic is likely to exist between the board of directors and the senior managers of a firm. The board has plenary authority over the firm, but it may also delegate that authority to managers. Because the board will typically rely on managers for information about the firm, managers will have an opportunity to shade that information in a way that suits their interests. It takes time and energy to engage in this sort of lobbying, and as managers do more of it, it can affect firm performance.
The drag on firm resources posed by lobbying suggests that there is a trade-off that comes with the board’s ability to police agency costs.16 The advantage of a board is that concentrating authority with directors helps to avoid the free riding and conflict that comes with having a dispersed group of shareholders control the corporation.17 But boards must deal with managers who have most of their human capital tied to the firm.18 As a consequence, managers are likely to have intense preferences over firm decisions. When managers do not have authority over a choice that will affect their well-being, they are likely to lobby those that do have authority. Excessive amounts of this sort of lobbying could have a detrimental effect on firm performance.
The potential for lobbying may help to explain why boards take measures to insulate themselves from the firms they oversee.19 As boards
15. Id. (“[Lobbying] takes time that would be better spent on more productive tasks—the direct cost of influence activities is the opportunity cost of the influencer’s time. As such, these costs are convex—engaging in influence activities crowds out less productive tasks before more productive tasks.”).
16. See Jill E. Fisch, Taking Boards Seriously, 19 CARDOZO L. REV. 265, 268–69 (1997) (“The separation of ownership and control in the modern public corporation creates agency costs that interfere with efficient corporate decision making. In an effort to reduce these agency costs, corporate law has developed a number of mechanisms to align the interests of non-owner management with the interests of shareholders. Most recently, these efforts have focused upon the board of directors.”).