The Government as Shareholder: Governance When Uncle Sam Takes Over

(This article was contributed to Corporate Compliance Insights by Jason B. Meyer, author of the blog LeadGood.org, on ethics in business leadership, and is Chair of the Ethics, Compliance, and Corporate Governance Committee of the New Jersey Corporate Counsel Association. Mr. Meyer can be contacted by email at the following address: meyer.jasonb[at]gmai[dot]com.)

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“Federal Government to Own 60% of GM”

So read the headlines at the start of this month, when the Obama Administration’s plan to revive General Motors from bankruptcy protection came to light.

It was like other headlines we’ve seen during this season of financial bailout and recovery. Talk about “bullish on America!” The feds now own a big piece of AIG, Citigroup and hundreds of other banks under TARP, and yes, now General Motors. The wisdom of such moves by the government in terms of spurring economic recovery have been well-debated, and ultimately remains to be seen.

But what about the implications within a smaller, more technical, but for business still a fundamental context: corporate governance? What does it mean to a company, its governance, and its legal and compliance teams, when the government becomes a major shareholder?

This article will review this question in theory – what could it mean to have Uncle Sam as a big shareholder – as well as in immediate practice, based on what the Obama Administration has said it will do as a shareholder.

Not unprecedented

As taxpayers and citizens, we’ve gone through this before. This wasn’t the first go-round with Chrysler, after all.

But government privatization hasn’t only happened in times of financial distress. During World War II, the US took over companies that represented enemy-owned assets: the US subsidiaries of German- and Japanese-owned companies. Many of them were household names like Schering-Plough, Rohm and Haas, and GAF, to name a few.

Other examples illustrate that the main news in all this “nationalization” talk has not been that the government has taken positions in private companies; it is that the federal government has done so. State pension funds and quasi-governmental entities have been big holders of public securities for years. CalPERS, the California public employees’ pension fund, reports that it owns almost $170 Billion in assets — and it publishes a 72-page document to explain the principles by which it will vote its proxies¹.

For now, the scale of the fed’s ownership is limited. Writing in a blog for The Atlantic, Conor Clarke reports that the government’s recent equity moves represent an investment of just over $82 Billion². That’s about half of what CalPERS holds (but that number would seem to exclude the preferred position the US has taken in TARP banks). Clarke’s point is that the feds have “nationalized” only 0.21% of the private corporate economy. But if your client winds up in that 21-out-of-10,000, or even if the government “only” holds a substantial position in your company’s debt or preferred securities, it’s still a game changer. So what are the rules of that new game?

In theory: Issue spotting and uncertainty

The theoretical effect of sudden and large-scale government ownership of a corporation can be considered in three areas: governance – the effect on shareholder voting; securities – the effect on things like shareholder litigation; and compliance – the effect on the company’s ethics and ethics programs. Each of these areas could support a thesis, or at least a good-sized law review article, but here’s an overview:

1. Will the government vote its shares only to influence membership on the Board of Directors – or use its ownership power to influence the positions the Board and management take?

Any shareholder with voting power can vote to elect a Board member. So one issue is whether the government will wield its power so directly and visibly as to change a company’s slate of Directors. All indications are that it will.

Go a step deeper. With the ability to overtly elect also comes the more subtle ability to influence. For example, J.W. Verret, an Assistant Professor at the George Mason University School of Law, raises this issue: if the Treasury Department or the White House is known to favor opening up proxy access to certain kinds of shareholder initiatives, or to shareholder-nominated Board candidates, will the sitting Directors of a government-dominated company be influenced to vote to allow such access³?

Others have asked, might the government use its majority ownership in GM, for example, to push the carmaker toward smaller, more fuel-efficient cars? Or to force the company to decrease its foreign outsourcing? (So far, the Obama Administration has said they want to avoid meddling in this level of commercial decision-making.)

We could debate whether these kinds of influences, if they happen, would be a government strong-arm, or just an expression of representative democracy (the people now own the company, the people elected the current administration, so why should the people’s companies run counter to the beliefs of the current administration). The point is, if the government is a big shareholder, it can if it chooses have the powerful influence of a big shareholder.

Commenting on TARP in a Harvard Law School blog, Phillip A. Gelston of Cravath, Swaine & Moore put it this way:

”It is foreseeable that the government will weigh in on a range of issues not historically subject to close regulation, including compensation practices, business lines and acquisitions and divestitures. …At the very least, the presence of the government as shareholder could influence a financial institution’s decision-making process.”

So if you or your CEO already have a rule to never put your counterpart at CalPERS (or TIAA-CREF, or Berkshire Hathaway, or the local hedge fund, etc.) on hold, you don’t need a lawyer to tell you to pick up the phone when the White House is calling. But then again, you would have taken that call even if the feds didn’t own stock.

2. What happens in securities litigation: will the Feds be a lead plaintiff, a deep-pocketed defendant, or sit on the sidelines?

According to Professor Verret, institutional investors are the lead plaintiffs in 60% of all securities class actions. So as the mother of all institutional shareholders, will the US now turn to one of its big in-house law departments (like the SEC or DOJ) and start litigating? And would the government be subject to the pesky restrictions on plaintiffs under the Private Securities Litigation Reform Act?

Or, since the government took its large positions in certain companies explicitly to save them from ruin, will the US turn out to be an especially feckless shareholder, reluctant to go to court for fear of starting a battle it doesn’t really want to win?

This knot is particularly Gordian because, as a Control Shareholder, the US is theoretically subject to becoming a defendant in complaints brought by other shareholders asserting a breach of fiduciary duty. Verret sees a problem with such cases: “Although a clever plaintiff may be able to argue otherwise, the federal government likely has sovereign immunity from control person liability that is not waived by the Tucker Act.” But he asks, will the government waive that immunity?

3. Ethics and corporate compliance: how high is the top?

Let’s say you are a corporate compliance leader (which, since you are reading this article, you probably are). You are already struggling with how to get your Directors to take training courses and fill out annual certifications. That’s got to get harder when most of the Directors that know you and (one hopes) approved your compliance program are suddenly gone, and are replaced with Directors appointed by the government.

On the one hand, those new Directors, in to clean house and represent the public interest, ought to be especially interested in a strong compliance program.

But on the other hand, if they are coldly economic about things, the government-owned companies might not need to be so gung-ho about compliance. The political pressure on the government to show a nice return for its investment in GM may be as strong a motivation to cut corners as the economic motivations that a company usually faces. Take, for example, insider trading. Prof. Verret cites Section 3(c) of the Exchange Act as making the federal government exempt from insider trading restrictions. And so he is concerned that if the government were to use inside info to decide when to put some of its shares back on the market, it would not be accountable – nor would Uncle Sam be accountable, he worries, for other bone-headed decisions as company owners.

This is really the issue that comes home to roost for us lawyers and compliance professionals. With government ownership and a government-triggered Board restructuring, the motivations of “the company” become more complex. It may not be as simple as maximizing ROI and minimizing risk, anymore.

Or maybe, for us, it is. At the simplest level of analysis, “a lawyer employed or retained by an organization represents the organization….”⁴ The comments to the Model Rules of Professional Conduct remind us that, short of something illegal or unethical, “When constituents of the organization make decisions for it, the decisions ordinarily must be accepted by the lawyer even if their utility or prudence is doubtful.”⁵

At base, then, whoever owns the company, best compliance and governance practices remain the best practices.

In reality: Not all that bad?

As one looks to see how all this theory will come down to practice, the past can offer some precedent. In that respect, at least one study suggests that US Government stock ownership may not be that big a deal.⁶

The study, published in the University of Chicago’s Journal of Law and Economics in 1997, is of a sample of those German- and Japanese-owned subsidiaries that came into government hands during World War II. The government’s ownership of these firms lasted for up to 23 years, during which the US “nominated and elected the management teams that set corporate policy.”

The study’s authors – Stacey Kole, then of the University of Rochester and now a Dean at Chicago’s Booth School of Business, and J. Harold Mulherin, then at Penn State and now at Claremont’s Drucker School of Management – ask, ‘If a privately owned firm is socialized, and nothing else happens, how will the ownership change alone affect the firm’s behavior?”

In these companies, the government took a heavy hand at the Board level, on average replacing 55% of the Board members to eliminate any enemy influence. But Kole and Mulherin found “that although government vesting was associated with substantial turnover of board members, vesting had less of an effect on the tenure of the firms’ actual managers.” Presidents were replaced at only 5 of the 17 firms studied. Indeed, the authors concluded that the government actually was much less active in influencing management than the typical block shareholder.⁷

They concluded, in short, that below the Board level, the new boss was same as the old boss.

It’s always fun for lawyers to use their imagination and technical know-how to forecast a parade of horribles. (Think back to Torts in law school – what really seemed unforeseeable to eager law students?) But the problems for the gloom-and-doomers are the simple practical realities. First, it has been rare that a corporation has been really burned for taking a good faith position on a wholly unsettled area of the law – so when in doubt, the previous best practice should still be a safe bet. Second, many of the governance challenges of having the federal government as a big shareholder will probably be brought down to size in simple conversations between company counsel and government counsel, each trying to figure out what to do to keep things manageable and get home at night. And third, there are advantages to being owned by the government, which include (as Phillip A. Gelston has pointed out when it comes to TARP)⁸ that Uncle Sam is a relatively inexpensive source of capital.

In practice: Obama pledges “hands off”

There is a final sign that things may not turn out to be that bad or unusual in the governance of government-owed companies. In the face of immediate political demands for the Obama Administration to intervene in the operation of GM for the sake of local interests (like saving specific dealers threatened with closure), the White House has sought refuge in a set of principles it can turn to justify staying out of commercial decisions.

Those principles reportedly come from an interagency task force informally called “The Government as Shareholder.” Diana Farrell, the deputy director of the National Economic Council and formerly the head of the research arm of McKinsey & Company, headed the task force.

The spirit of that task force’s conclusions may have been reflected in comments that Steven Rattner, a Treasury Department adviser, made to the New York Times, about the level of influence the White House intended to avoid at GM: “No plant decisions, no dealer decisions, no color-of-the-car decisions.”⁹

Similarly, Treasury Secretary Timothy Geithner has said that, when it comes to the TARP banks, his department will “exert our influence only on core governance issues and not on day-to-day operations.”

And in a press background briefing on May 31, the day before the government’s take-over of GM, a senior administration official outlined, “How we can expect the government to act as a common shareholder:”

“[T]he government really has no desire to own equity stakes in companies any longer than is absolutely necessary and will actively seek to dispose its ownership interest as soon as it is practical to do that….“[T]he government has decided to reserve the right to set upfront conditions …. [T]hese conditions … would focus primarily on ensuring a strong board of directors, that focuses on the right kind of management that can deliver a long-term vision, that gets these companies to be profitable….

“[A]fter those upfront conditions are in place, the government feels that it can protect taxpayers’ investment by managing its ownership stake as a hands-off in a commercial manner as possible [sic]. And so the government will not interfere with or exert control over day-to-day company operations and very much will ensure that no government employees will serve on board or be employed by the company it makes investments in.

“As a shareholder, the government will limit what it votes on to core governance issues, particularly the selection of the company’s board of directors; major corporate events or transactions. And in its effort to protect taxpayers’ resources as much as possible, the government intends to be extremely disciplined as to how it uses even these limited rights.”¹⁰

When it comes to GM, this official said, the government will put in place a new Board of Directors, only a minority of which will have been on the previous GM Board. But then, the official said, it will be up to that Board to appoint a compensation committee and monitor a management team who “serves at the pleasure of the Board.” And not withstanding ex-CEO Rick Wagoner’s earlier ouster at GM¹¹, if the post-WWII experiences studied by Kole and Mulherin are any guide, management at the government-owned firms generally do not need to be in fear of their jobs.

In short, the Obama Administration appears reluctant to wield the influence over commercial affairs as a shareholder that it plainly could – at least for now.¹²

So after an initial Board restructuring, federal government ownership really might turn out to be a lot like ownership by CalPERS: with governance nudges based on a defined set of principles. And the governance and performance effect of government ownership might turn out to be as limited as it was in the formerly enemy-owned companies in the post-WWII period: elect a Board, have the Board check the management, and then get out of the way and look for the best opportunity to sell the government shares back into private hands.

As President Obama told the press on June 1, in getting GM back on its feet he has two goals for the government: “take a hands-off approach and get out quickly.”

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Jason B. Meyer is the author of the blog LeadGood.org, on ethics in business leadership, and is Chair of the Ethics, Compliance, and Corporate Governance Committee of the New Jersey Corporate Counsel Association. Meyer currently provides compliance consulting services. He is the former Chief Legal Officer of Kaplan EduNeering, and was the founder, President and General Counsel of the LAWCAST® audio legal news services.

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¹ – California Public Employees Retirement System, “Global Principles of Accountable Corporate Governance,” March 2009 (available at http://www.calpers-governance.org/marketinitiatives/adopt-governance).

² – C. Clarke, “What Socialism Looks Like,” The Atlantic (blog), June 3, 2009 (http://correspondents.theatlantic.com/conor_clarke/2009/06/what_socialism_looks_like.php).

³ – See, e.g., Verret, J.W., “The U.S. Government as Control Shareholder of the Financial
and Automotive Sector: Implications and Analysis,” Geo. Mason Univ., Mercatus Center (white paper; available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1348256). See also, Verret, J.W., “Why The Bailout is Self-Defeating,” Forbes.com, March 5, 2009 (http://www.forbes.com/2009/03/04/bailout-bank-treasury-opinions-contributors_frozen_options.html.).

⁴ – ABA Model Rule of Professional Conduct 1:13.

⁵ – Id., comment 3.

⁶ – Kole, Stacey R., and Mulherin, Harold J., “The Government As A Shareholder: A Case From The United States,” J. L. & Econ., Vol. XL (April 1997), at 1.

⁷ – Id., at 6-9.

⁸ – Gelston, Phillip A., “Throwing Off the TARP: Implications of Repaying Uncle Sam,” The Harvard Law School Forum on Corporate Governance and Financial Regulation (blog), May 26, 2009 (http://blogs.law.harvard.edu/corpgov/2009/05/26/throwing-off-the-tarp-implications-of-repaying-uncle-sam/).

⁹ – Sanger, David E., “Obama’s Test: Restoring G.M. at Arm’s Length,” The New York Times, June 1, 2009 (http://www.nytimes.com/2009/06/02/business/02assess.html).

¹⁰ – Background Briefing By Senior Administration Officials On The General Motors Restructuring, May 31, 2009 (available at http://www.whitehouse.gov/the_press_office/Background-Briefing-on-GM-Restructuring-May-31-2009/). The report of the task force itself appears to be as yet unpublished.

¹¹ – See, e..g, Allen, M. and Gerstein, J., “GM CEO resigns at Obama’s behest,” Politico, March 30, 2009 (http://www.politico.com/news/stories/0309/20625.html).

¹² – It is interesting that the Administration’s recent push to restrict executive compensation is occurring through the regulatory process generally, and even as it applies to the government-owned companies has (thus far) not been presented as a required matter for Board action. See Puzzanghera, J., “Obama administration targets executive pay,” Chicago Tribune, June 11, 2009 (http://www.chicagotribune.com/business/chi-tc-biz-exec-pay-0610-0611-jun11,0,7381414.story).

Tags: corporate governance, government, President Obama