NORTH CAROLINA LAW REVIEW Volume 74 | Number 4 Article 3 4-1-1996 Corporate Governance and Managerial Incompetence: Lessons from Kmart D. Gordon Smith Follow this and additional works at: http://scholarship.law.unc.edu/nclr Part of the Law Commons Recommended Citation D. G. Smith, Corporate Governance and Managerial Incompetence: Lessons from Kmart, 74 N.C. L. Rev. 1037 (1996). Available at: http://scholarship.law.unc.edu/nclr/vol74/iss4/3 This Article is brought to you for free and open access by Carolina Law Scholarship Repository. It has been accepted for inclusion in North Carolina Law Review by an authorized administrator of Carolina Law Scholarship Repository. For more information, please contact [email protected]. CORPORATE GOVERNANCE AND MANAGERIAL INCOMPETENCE: LESSONS FROM KMART D. GORDON SMIm Modern corporategovernance scholars often extol an activist role by institutional investors in directing corporate activity. Widely viewed as a solution to the "collective action" problems that inhibit such activism by individual investors, institutional investors are praised for adding value to corporationsthrough their participationin the decisionmaking process. The ouster of Joseph Antonini as Chief Executive Officer of Kmart Corporation in 1995 might be taken as a vindication of this view, because substantialevidence indicates that institutionalinvestors played a crucial role in influencing Kmart's board of directors to remove him. In this Article, Professor Gordon Smith challenges this potential reading of the events at Kmart. Professor Smith poses the fundamental question of whether institutionalinvestor activism designed to address perceived incompetence among corporate managers consistently adds value to corporations in which such activism is present. ProfessorSmith analyzes the effect of internal and external forces on managers, particularly on Antonini. and Kmart's directors, and derives two fundamental lessons: (1) External constraints are ineffective in solving managerial incompetence; and (2) Investor activism will often be counterproductive because it destroys the value of centralized decisionmaking. INTRODUCTION .......................................1038 L JOE ANTONINI'S KMART ........................... 1046 II. KMART'S CORPORATE GOVERNANCE PROBLEM AND How THE CORPORATE GOVERNANCE SYSTEM DEALT WITH IT . 1057 A. Kmart's Corporate Governance Problem ........... 1059 * Assistant Professor of Law, Northwestern School of Law of Lewis & Clark College. Thanks to Brian Blum, Jack Bogdanski, Ed Brunet, Jennifer Johnson, Laura Lin, and Doug Newell for helpful comments and to Andrew Ognall and Lee Street for excellent research assistance. Special thanks to Randall Thomas, not only for useful comments on this Article, but for consistently good advice and encouragement generally. This Article is dedicated to Sue Smith. 1038 NORTH CAROLINA LAW REVIEW [Vol. 74 B. External Constraints on ManagerialBehavior ........ 1062 1. Capital Markets .......................... 1062 2. Market for Corporate Control ............... 1072 3. Product Markets .......................... 1075 4. Managerial Labor Markets .................. 1079 C. Internal Constraints on ManagerialBehavior ........ 1081 1. Board of Directors ........................ 1082 a. Separation of CEO and Chairman Positions .. 1083 b. Outside Directors ...................... 1084 c. Executive Compensation ................ 1088 d. Dividend Policy ....................... 1092 e. Debt Policy .......................... 1096 2. Shareholders ............................. 1099 a. Shareholder Voting .................... 1100 b. Shareholder Suits ...................... 1102 c. Institutional Investor Activism ............ 1104 III. Two FUNDAMENTAL LESSONS FROM KMART .......... 1110 A. Lesson #1: External Constraints Will Not Efficiently Solve ManagerialIncompetence .......... 1113 B. Lesson #2: InstitutionalInvestors Will Not Efficiently Solve ManagerialIncompetence .......... 1115 1. Categories of Shareholder Participation ........ 1117 2. The Value of Centralized Decisionmaking ....... 1119 3. A Theory of Representation for Corporate Shareholders ............................. 1122 C. Policy Implications .......................... 1128 1. Encouraging Board Composition Participation ... 1129 2. Discouraging Policy Participation ............. 1134 IV. CONCLUSION ................................... 1137 INTRODUCTION Three days after Joseph Antonini was forced to resign as Chief Executive Officer of Kmart Corporation, The Wall Street Journalran a front-page story with the headline: "How Wal-Mart Outdid a Once- Touted Kmart in Discount-Store Race."' The story compared Antonini unfavorably with Sam Walton, founder of Kmart-nemesis Wal-Mart Stores Inc., and declared Wal-Mart the victor in the 1. Christina Duff & Bob Ortega, How Wal-Mart Outdid A Once-Touted Kmart In Discount-Store Race, WALL ST. J., Mar. 24, 1995, at Al. 1996] MANAGERIAL INCOMPETENCE 1039 discount store competition. Although competition from Wal-Mart was instrumental in provoking Antonini's ouster, the direct impetus for his ouster was Kmart's shareholders. In June 1994, nine months before Antonini resigned, Kmart's shareholders defeated a proposal endorsed by Kmart's board of directors to raise money for the renovation of Kmart's discount stores through the sale of "targeted stock"-Kmart common stock with returns tied to the performance of Kmart's specialty retail subsidiaries, such as OfficeMax office supply stores and Borders and Waldenbooks book stores. The most vocal opponents of the targeted stock proposal claimed that Antonini was distracted by specialty retailing and that, instead of selling targeted stock, Kmart should sell its specialty retailing subsidiaries outright and focus on Kmart's core business, discount retailing. TIhe shareholder vote was quickly recognized by observers as "one of the most astonishing investor rebellions in corporate history."2 In response to the shareholder vote, Antonini agreed to adopt the strategy advocated by dissident shareholders and announced plans to sell the specialty retail subsidiaries.3 Although the shareholder vote appeared to give directors "a clear mandate to shake up top management,"4 several candidates the board considered to replace Antonini reportedly were nervous about the prospect of working under Antonini without some assurance about when they would assume leadership of the company.' Six months after the shareholder vote, having failed to find a successor for Antonini and still facing pressure from shareholders, Kmart's board of directors removed Antonini as Chairman of the Board and named Donald Perkins-a respected former chairman of Jewel Companies, Inc.-as his tem- porary successor.6 Commenting on Antonini's removal as Chairman, 2. David Woodruff & Judith H. Dobrzynski, Revolt? What Revolt?: Kmart Sticks to Its TurnaroundPlan, Bus. WK., June 20, 1994, at 42; see also Bankers Undaunted By 'No' On Kmart Targeted Stock, GOING PUB.: THE IPO REP., June 13, 1994, at 1, 5 [hereinafter Bankers Undaunted] (quoting a Kmart investment banker as saying, "This was one of the great surprises of all time"); George White, Kmart Gets Red Light on Specialty Stock Plan Retailing: ShareholdersRebuke Management's Proposal to Raise $600 Million by Selling Shares in Other Units, L.A. TIMEs, June 4, 1994, at D1, D2 (quoting Kurt Barnard, a New York-based retail economist: "This is an extraordinary slap to the face of Kmart's management .... It's a new chapter in shareholder relations"). 3. See infra notes 99-105 and accompanying text. 4. Joann S. Lublin & Christina Duff, How Do You Fire a CEO? Very, Very Slowly, WALL ST. J., Jan. 20, 1995, at B1, B2. 5. Christina Duff & Joann S. Lublin, Kmart Board Ousts Antonini as Chairman, WALL ST. J., Jan. 18, 1995, at A3; Ellen Neuborne, Kmart chief Antonini calls it quits, USA TODAY, Mar. 22, 1995, at lB. 6. Duff & Lublin, supra note 5, at A3. 1040 NORTH CAROLINA LAW REVIEW [Vol. 74 James Severance of the State of Wisconsin Investment Board (SWIB), a public pension fund and Antonini's most visible antagonist, said, "The board was too passive. If this represents the board asserting itsel, then that's good news."7 Antonini's removal as Chairman, however, appears to have been less a signal of the board's resolve than an attempt to ward off shareholder pressure. Perkins later admitted that he had hoped his appointment as Chairman would buy Antonini some time as CEO.8 And in February the board of directors appeared to have given up the search to replace Antonini as CEO.9 But Kmart's shareholders were restless. Perkins commented that, after being named Chairman, he had "a number of discussions" with shareholders about Antonini's continued role with the company.'" SWIB's Severance promised, "We are going to continue to keep Joe's and the board's feet to the fire."" On March 20, major Kmart shareholders met with Perkins. Although Perkins expressed confidence in Antonini, the shareholders' message was simple: "Joe has to go."'12 The next day, Kmart's board of directors unanimously agreed to ask Antonini to resign. 3 One view of the events at Kmart holds that this is corporate governance at its best: Institutional investors dissatisfied with the performance of a company in which they had invested took aggressive action to change the company's strategic course and replaced the CEO. Much has been written about the potential contribution of institutional investors to the governance of American corporations, 4 7. Id.Trading in Kmart common stock