Democracy? What Democracy?

We live in a free-market, democratic republic. We hold each of these descriptors very dear, and we believe that – through trial and error, not through philosophical debate – we have found this is the most stable, prosperous, fair society we can live in.

On the other hand, we live in a world with huge enterprises larger (in financial terms) than most countries. Walmart, for instance, would be a country whose GDP (revenue) sits between that of Taiwan and Norway. As a U.S. State, Walmart would have about the same size as Virginia. Can you imagine? A company the size of a whole nation? Of one of the major American states?

Now, what is the “political structure” of a company like Walmart? Is it the best possible we know about? Is Walmart a free-market, democratic republic? Nope, not at all: Walmart, like every major U.S. corporation, is a supervised dictatorship. There is a set of dictators (the senior executives) who are supervised by a board of directors. The composition of the board of directors is determined by ownership quotas (a.k.a. shares).

I am not going to argue that one or the other system is better. I am just going to note the glaring dissonance between a free-market, democratic republic that chooses to house supervised dictatorships as a default internal construct. Supervised dictatorships which are, with a different kind of supervision, the typical model of religious states like Saudi Arabia and Iran. (Where the religious authority has the last say over the decisions of the executive.)

Why do we do that? Is that the only way to do it? How do alternatives stack up?

Why do we do that?

The reason is quite simple: because all corporations, no matter how large, start small. When they grow, they keep their bylaws, and what was the size of a small family unit becomes as large as a country – with its structure fundamentally unchanged.

The small company has owners. The owners pay money to make other people (including the owners, sometimes) do the work. The idea is that the owners keep the company, while those that do the work are paid salaries (or compensation of some sort). When the company becomes larger, its bylaws become more complicated. It all ends at the public company, where people are invested with shares, fractional ownership not unlike that of a vacation club. Shares come with all sort of rights and privileges, but basically who owns the most, makes the decisions.

Since public companies are owned by the owners of the shares, who are unknown and potentially in the millions, it is impractical to have them all make decisions. Instead, by law, public companies have two structures: an executive structure that defines the work to be done, and a supervisory structure that represents the owners. In essence, the theoretical separation of “people that do the work” and “people that put in the money” is retained. Only that those that do the work are now “represented” by senior executives, while the ones that own the place are “represented” by a board of directors. Simple enough!

Is that the only way to do it?

There are two fundamental problems with the setup described above:

1. Owners have no vested interest in a dictatorial solution for company management; we have seen with scandals like the Enron debacle that it was necessary to create a conduit between the rand and file and the board of directors, because up to that point the directors only got to hear the point of view of executives
2. All too frequently, boards are dominated by executives instead of supervising them; it is fairly common for executives of a company to be part of the board of directors, and frequently the choice of board members is driven by the executives

Other countries, notably Germany, have chosen a different legal structure for large public companies. In the German model, half the board members are chosen by the employees (with a tie-breaking member coming from the owners’ side). In the German model, while the executives remain dictators of company policies and operations, the rank-and-file (which outnumber executives in all companies) have an almost majority of the supervisory board.

How does the alternative stack up?

It is really hard to compare Germany with the United States on a general level, because the two countries are very similar and very dissimilar in a lot of different ways. For instance, labor laws are much more worker-friendly in Germany, with mandates to employers of all different kinds. Also, tax laws are much more demanding, especially in the amounts they take off the average paycheck.

Compared to neighboring countries, though, the German model has one enormous advantage: the presence of labor representatives in the halls of power has substantially reduced labor disputes, and regardless of your political persuasion, a strike is always a big productivity killer. (Witness the months of strikes at West Coast supermarket chains a few years ago.)

Compared to the American (worldwide) model, the German model has one additional advantage: it focuses the company more on the long term. You see, in general shares can be traded freely, so that the owners have in many cases only a very short-term interest in the well-being of a company. As a result, boards responsible to the (short-term) owners will focus on getting the most out of the company every quarter (when public companies report earnings). Even if the company is wrecked after that, the owners can sell their shares to someone who doesn’t understand the numbers, and their financial involvement is nil.

Democracy?

The fundamental principle of democracy as we use it is that the majority of people is a better decision-maker than a select set of them. As a people, America (and all democracies) has decided that it trusts its citizens with decisions, not an aristocracy or oligarchy.

Traditional public companies are not structured according to that principle; instead, they are formed as strong hierarchies in which most decisions are sent up and down a chain of command with only a few members at the top. These members typically all report to a single person (CEO) and can deviate from the CEO’s mandates only in their specialized function. For instance, corporate counsel is allowed (and required) to report to the board of directors in case of shenanigans.

In the German model, the employees form a compact that elects representatives to the board of directors. Since most of the employees of a company are rank and file, the voting population of these representatives is mostly formed by rank and file members. Instead of having executives elect the board (or the owners), the employees are treated equally in the selection of board members.

Summary

We have gotten used to a strange dichotomy in our midst: the structure of public governance is dominated almost exclusively by democratic processes, while the structure of private corporate governance is almost exclusively ruled by oligarchies in supervised monarchies.

The existence of the German model of governance shows that it is possible and highly successful to create a structure of private corporate governance in which democratic principles hold.