Restoration of Trust

Previous Chapter - Table of Contents

Restoration of Trust
Avoiding a Global "Race to the Bottom"
Corporate Governance in the 1990s and Beyond
The Visclosky Approach: Right Question, Wrong Answer
ERISA's "Fundamental Contradiction" Redux
A New Federal Law of Ownership
Pension Funds: Permanent Shareholders
The Shareholder Agenda and Its Limits
The Shareholder Agenda for Corporate Crime
Removing the Impediments to Shareholder Action
The Ownership Focus
From the Belzbergs to Ma Bell: Another Kind of Corporate Raider
Power and Accountability
Endnotes

Restoration of Trust


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Corporate power without accountability creates two distinct problems. The first is financial and operational: Can the products and the securities of corporations like these be competitive in the world economy, or will corporations use their political power to create enclaves of protection, as predicted by Adam Smith? The answer is exemplified by the automobile industry's Voluntary Restraint Agreement of the 1980s and the other examples in Part II of this book. Without accountability, corporations will continue to "book" profits and simply decline to compete. Finally, they will just decline.

The second problem is political. How much political legitimacy can a system of corpocracy have? Business's size, focus, and resources - access to the money and talent for persuading, lobbying, and electing - raise the question of whether we have, or can continue to have, independent government.

Concerns about the failure of corporate governance as the foundation of corporate legitimacy go back more than a half-century. Proposed solutions range from Harvard professor Michael Jensen's suggestion that we have come to the end of the time of the public company, to the "focused shareholder" approach, as when Lester Pollack and Warren Buffett acquired preferential stock as compensation for monitoring on behalf of the whole class of owners (the Cummins Engine resolution is another example), to Martin Lipton's proposal for election of boards every five years instead of annually. All of these solutions assume that, because of collective choice, "rational ignorance," or the Byzantine labyrinth of the proxy voting system, it is out of the question for shareholders to assume their "legendary supervisory role."

We agree that change is necessary to permit this "legendary supervisory role." Healthy corporations need long-term commitment from involved owners. The solution is the undiluted fiduciary obligation of corporate managers and directors to shareholders who are themselves fiduciaries - the institutions. The existence of appropriate long-term shareholders and the restoration of the law and tradition of trust would create a kind of permanent financial infrastructure along the lines of the German banks and Japanese cross-ownership. It would provide support for long-term strategies and for directors committed to shareholder interests.

The good news is that no legislative action is required to make this happen. We can think of some legislation that would make things clearer, easier, or faster, but it really is not necessary. Change must come from the corporations themselves. This cannot happen without the leadership of the private sector, the heads of the great corporations who can recreate a healthy system of governance by establishing standards of ownership with respect to the portfolio holdings of their own pension plans. These corporations are, in a sense, as much a part of a system of cross-ownership as the Japanese. If they act, as fiduciary shareholders, to bring back the accountability of the companies they invest in, on behalf of their pension participant employees, corporate governance will be based on the "care, skill, prudence, and diligence" of those who, as corporate managers, have the best, most current understanding of trends, transactions, and business.

Trustees for the public and private pension systems are the long-term holders of 20 percent of the total equity of American corporations. Their beneficiaries have definable interests that are substantially congruent with those of society as a whole. They don't just want to retire with a comfortable income; they want to retire into a world where they can breathe the air and drink the water, where the economy is stable, the streets are safe, and criminals go to jail. In exercising their fiduciary responsibilities of ownership, pension fund trustees can restore accountability and global competitiveness to American business. They can provide a strong base of support and accountability. In this chapter, we show how it can be done, and we conclude with recommendations for making it happen.


Avoiding a Global "Race to the Bottom"


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Our recommendations reflect the emerging global economy. Negotiations are proceeding with the Japanese to lower all manner of barriers to free trade. Among these are obstacles to access to capital markets and, ultimately, to control over corporations. At the same time we are trying to harmonize our governance notions with the Far East, the European Community (EC) is rapidly trying to develop common governance standards in anticipation of its 1992 consolidation. (Compare this to our own "race to the bottom" system of state control of corporate law.) Since EC rules will apply to all nations - our own as well as Japan - who wish to acquire companies located within the Community, they represent a kind of "world law of governance." This has required accommodation of the very different circumstances and legal structures now existing in the member states, such as the polar positions of the United Kingdom and Germany, so the compromises may well be precursor to how the United States, Japan, and the rest of the industrialized world ultimately decide to conduct their international governance. The principles underlying the emerging EC rules have been succinctly stated by Booz-Allen in a study submitted to the XVth Directorate in January 1990.


The Seven Principles of the EC

In our view, seven key principles should guide the development of a European Model for takeovers. They stem from the principles of a modern European democracy applied by analogy to the micro world of corporations and takeovers.

  1. "Ownership Democracy": This means that majority (51%) should rule. There should exist mechanisms both for control and changes of control to ensure, for example, that defense measures are sanctioned by a majority.
  2. "Periodic Reendorsement of Control Restrictions": The possibility of self-imposing limitations/restrictions to control structures (agreement rights, preemptive rights, . . . ) should be available provided they are originally enacted, and periodically reendorsed, by a majority.
  3. "No Institutional Self-Control": Mechanisms whereby companies control themselves either directly (self-control) or indirectly (subsidiaries owning shares in parent, cross and circular ownership within same group) should be banned: they are unhealthy by definition .
  4. "Equal Opportunity for Shareholders": This principle ensures that all shareholders are treated fairly in that they all benefit from value creation either as recipients of dividends/stock appreciation or as stock sellers in a takeover bid....
  5. "Mutual Transparency ~ All stakeholders should be accountable to each other; specifically, full disclosure of management accounts, free access to shareholder lists, disclosure of shareholders agreements, percentage holdings above certain thresholds and the like should be common practice in all Member States.
  6. "No Internal EC-Discrimination": Executing a takeover in any of the Member States should be possible for any EC company under an "equal national treatment" principle.
  7. "Common Front to non-EC Countries ". As far as practicable, Member States should adopt a common policy vis-a-vis non-EC companies acquiring in the EC.

The United States and Britain are unusual in the industrialized world because public equity markets exist in which control over the listed companies can be acquired at an attractive price. In both countries, rules and governance norms have been developed to conform to the continuing existence of a market for the transfer of corporate control. As the European Community gains momentum, Britain must come to grips with the incompatibility of its governance structure with those of other Community members, where public markets involving access to corporate control do not exist. It now seems probable, for example, that its "takeover code," an immensely successful mechanism for coping with the potential for inequity in takeover situations, will be subsumed into a Community-wide requirement for formal legislation and a court-monitored system. Britain has to cope with the arithmetic of being in a unique situation, and part of the price it pays for membership in the Community will be loss of its distinctive governance institutions.

Similarly, it is unlikely that the United States, in its ongoing negotiations with Japan concerning nontariff barriers to trade, will be able to change the keiretsu system by which dominant voting power is retained in the "nonpublic" corporate constituents. Both Britain and the United States are presently confronting the reality that all other significant industrialized countries, lacking a pattern of publicly accessible portions of corporate equity, will need to have a different system of ensuring the compatibility of corporate power and the public interest. This presents three choices: we will continue to be different, they will change to become more like us, or we will change to become more like them.

We cannot continue to be different. If we continue to live in a world where our currency and credit are relatively weak and control of our corporations can be acquired by anybody with enough money, we will quickly lose control over our industrial base. Our only protection would be recourse to political action; for example, the President could determine that a particular acquisition is contrary to the national interest. In turn, this would inevitably lead to erection of barriers elsewhere. Conceivably, as the post-World War II generation of corporate entrepreneurs dies and Japanese and German ownership patterns "mature," larger percentages of total share capital will be available in public markets. It does seem doubtful, however, that the significant percentage - in the range of 20 percent - held by the German banks and the Japanese keiretsu will disperse, at least so long as their governance practices continue to correlate with success in international competitiveness.

That leaves a choice between making them more like us or making ourselves more like them. There is no conclusive evidence as to which school of thought best serves the long-term interests of a democratic society. The German/Japanese model, where accountability is internal within a financial/industrial grouping, runs the risk of "inefficiency." Close ties between companies and financial and industrial affiliates raise questions of conflict of interest between equity holders and lenders on the one hand, and between equity holders and "group" members providing goods and services on the other. The involvement of banks as industrial operators can lead to an undesirable concentration of power.

The inefficiency of the system of accountability to public shareholders is documented throughout this book. What does seem to work, though, is accountability to a category of "permanent" shareholders, whether the public shareholders of the United Kingdom, the banks of Germany, or the cross-ownership of Japan. In the United States, the institutional investors, particularly the pension funds, can play that role.

The key to effective accountability today appears to be the existence of a class of "permanent" owners, holding approximately one-quarter of the outstanding equity, who have an incentive to monitor the operations of the corporation. This is essentially the system in Germany, Britain, and Japan. As both corporate operations and ownership seem likely to become increasingly transnational, the need for countries to be able to assert a purely national interest becomes more acute. In the United States, encouraging a pattern of domestic institutional ownership will be a way of ensuring the continuance of effective governance. The challenge, then, for the United States is to identify its "permanent" shareholder institutions and to ensure that they have the incentive and the ability to perform the monitoring function. This involves at the outset a clear expression of national policy so that the trustee institutions can assert authority and allocate resources within the parameters of their risk-averse nature. It further involves a need to clarify the desirability of institutions acting collectively in discharging their ownership responsibilities. At this point, the United States will have an institutional governance structure finely attuned to the competitive challenges of the world of the 1990s and beyond.


Corporate Governance in the 1990s and Beyond


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The Institutional Monitor

After all. the monitoring financial institutions of which we speak are themselves corporations with disperse owners. Why should they not succumb to the same agency problems that affect public corporations? As a realistic matter, they often will succumb. But as long as their agency difficulties do not correlate with those difficulties afflicting the industrial companies in which they own stock, then beneficial monitoring could occur. The auditing analogy is again instructive. It suggests that an outside monitor without day-to-day operational involvement can provide a check often enough to be worthwhile.

Mark J. Roe


Source: Legal Restraints on Ownership and Control of Public companies, paper presented at The structure and Governance of Enterprise conference, Harvard university, March 29-31, 1990, p. 30.
All of the ingredients now exist for the reestablishment of a traditional system of trust on which an ongoing and productive system of corporate governance can be built. The essential elements are a stable base of permanent shareholders represented by trustees who exercise care and loyalty. We will begin with the trustees and the emerging federal law of ownership that guides the way they function, then discuss the shareholders and the appropriate substantive agenda.

So far, no legislative or judicial thought has been given to how ERISA trustees should function as "owners" of portfolio companies. During the 11 years of Congressional consideration of this extraordinarily important statute, it was briefly recognized that ERISA funds would be very large would indeed be the largest holders of American equity securities - but no specific attention was focused on the responsibilities of ownership.

Had they thought about it, they might have asked some of these questions: Should ERISA trustees follow the time-honored Wall Street rule and sell securities in companies whose management they do not approve, or should they function as the "legendary supervisor" and require meaningful corporate accountability that will address competitiveness and legitimacy? Put another way, can the country afford to let a huge percentage of corporate equity ignore its opportunity to become involved, which would be the result of a traditional view of ownership responsibility for ERISA trustees? Is ownership a useful concept for the governance of corporations? Is there a relationship between involved (real) owners and national competitiveness? Can we afford to condone any longer the single-minded mode of profit maximization in the stewardship of one-third of the nation's long-term capital?


The Visclosky Approach: Right Question, Wrong Answer


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In the last two sessions of Congress, Peter Visclosky (D-Indiana), a junior member of the House Subcommittee on Labor-Management Relations (who was, in fact, "bumped" off of the committee later in the session due to a seniority technicality), proposed legislation to change the trusteeship provisions of ERISA. Under the current system, the trustees are the top managers of the employer sponsoring the pension plan. Visclosky's proposal would require an equal number of employee and employer representatives as trustees. That the bill has made little legislative progress is not as important as the debate its introduction has engendered. From the point of view of ERISA corporation "plan sponsors," the proposition is intolerable. They are ultimately responsible for making up any shortfalls in the defined-benefit plan promises. If they are to lose control over plan administration, their liability appears unacceptably open-ended. (This is just another question of accountability, this time with corporate management on the right side.) Those opposing this bill appropriately pointed to the poor performance of pension plans that employ this kind of shared trusteeship, the joint employer-employee plans called "Taft-Hartley" plans. Why bring the better performers down to that level?

The reason we have pension plans, instead of relying on employees to make their own provisions for retirement, is that we believe there is some benefit to expertise. Just because Trip knows how to forecast the weather, make sneakers, compute accounts, design marketing plans, practice law, or play the violin does not mean that he knows how to manage money. We as a society do not want to bear the risk that he might make a mistake, because we know who would have to support him if he did. Although Congressman Visclosky was right in suggesting that the investment and management of pension fund assets should reflect the concerns of the employees who are the beneficial owners, he had the wrong approach. (The original proposal mandated an even split between the employer and employee trustees, guaranteeing gridlock.) The trustees should be financial experts. But the broader needs of the employees should be reflected in the trustees' actions.

Visclosky's proposal raises fundamental questions. In view of the emerging reality that funds held subject to ERISA are so immense that no planning or evaluation of the country's fiscal health or programs can be made without consideration of the pension system, is the continued total control over these assets by corporate plan sponsors tolerable? Is the criterion of achieving mathematically maximum investment results too narrow in view of the size of the assets and the other needs of society? Because the Pension Benefit Guaranty Corporation (PBGC) insures payments if the corporation fails, the public treasury carries the risk of loss. So the question of who should be trustees and how the assets should be managed is one with which the public is already concerned. The agglomeration of pension assets continues to be a tempting target. Eternal vigilance will be required to protect the primary mission of the statute - the funding of the pension promise - which has been so spectacularly achieved.


ERISA's "Fundamental Contradiction" Redux


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ERISA has provided a useful legal structure with explicit provisions on delegation of responsibility. Typically, this has resulted in a "named fiduciary" an officer or board-level committee of the "plan sponsor" who then delegates the investment and management responsibilities to outside firms. Other consultants are hired to "monitor" the first group. As long as Trip's employer's involvement is limited to choosing outside professionals, who actually make the buy-sell-hold-vote determinations, and as long as that choice is prudently made (not the CEO's brother-in-law, working out of his garage) and diligently monitored (someone has to make sure they do not run off with the money), Trip's employer will not be liable for any problems.

If, however, Trip's employer decides to handle the pension fund in-house, his actions will be more carefully scrutinized. The Labor Department will need to determine whether the plan is being administered "solely. . . and for the exclusive benefit of the plan participants." Although this is the same standard applied to the consultants that Trip's employer hires, the fact that he is both running the business and managing the pension fund makes it a little tougher to meet. Whatever business Trip's employer is in, he will now also be managing stockbuying, selling, voting, evaluating shareholder lawsuits - in his competitors, his customers, his suppliers, companies he might consider taking over, and companies that might consider taking him over. Was a pro-management vote in aid of a higher share value of the company, in which case it complied with fiduciary obligation to Trip and his fellow employees, or was it a way to cement a relationship with a valued customer? If the latter, it still could be justified as enhancing long-term value but could no longer be characterized as the "exclusive" or "sole" reason for the fiduciary act.

Assistant Secretary David Ball recently wrote me to express the Department of Labor's sensitivity in this area: "While I agree that the potential for a conflict may exist in certain investment decisions for the corporate plan sponsor who is also a plan fiduciary . . . I believe that you should note that the current system of plan sponsor control does not appear to have led to major abuse, because of ERISA's rules against self-dealing. [But] to be silent about this issue could encourage those who believe that pension assets are fair game for suggesting that, under current law, plan fiduciaries are not required to discharge their duties solely in the interest of participants and beneficiaries."1 ERISA thus makes difficult direct involvement by corporations as owners of portfolio securities in their ERISA plans. To be completely free from the appearance of self-dealing, the plan sponsor should recuse itself from acting in situations where business relationships exist. This could mean that a corporate officer would not be able to vote securities held in his corporation's customers, suppliers, and competitors. For the large companies, this will involve a great many situations in which they will have to find an ad hoc trustee to perform the requisite ownership functions.

ERISA was designed to encourage delegation to prudently chosen professional specialists, particularly "investment managers." If plan sponsors like Trip's employer want to manage the assets themselves, they must be prepared to take extraordinary care to protect themselves against real or apparent conflicts of interest. That is, after all, what it means to be a fiduciary. This care could include retaining an "ownership expert" and working with other shareholders on a common agenda. This both provides something of a reality check on exercise of ownership rights and helps to circumvent the collective choice problem. There is not much in the marketplace in the way of "ownership" expertise, and there is little experience with communication among institutions (due, in substantial measure, to the restrictions designed to level the playing field in contests for control); there is virtually no experience of working together. Yet both skills are well within the capacity of corporations to develop in a prudent and cost-effective manner.

To the extent that the ERISA plan sponsors prove capable of organizing themselves to deal with the potential conflicts of interest and of acting as owners in a manner that accords with the public interest, there will be decreased justification for amendments along the lines of Visclosky's proposals. What his initiative assumes is that the viewpoint of plan sponsors will be so short-term, narrow, and minimalist, so little concerned with a spacious view of the public good, that the only alternative is to add an essential supplementary viewpoint in the composition of the board of trustees. We have elsewhere discussed the plan sponsors' "taking back" ownership responsibility and the composition of boards of several public pension systems. Ironically, the liberal Democrat Visclosky may well have provided the answer to the question of Undersecretary Robert Glauber (referred to in Chapter 6): "How can we create other boards like CalPERS?" The ultimate guarantee is that the trustees, however they are selected and composed, be held to a fiduciary standard that is clear and consistent. So long as the trustee - whoever he may be - understands that his exclusive concern is to act in Trip's long-term best interest, ownership rights - whether exercised by investment managers or by Trip's employer - will give corporations the legitimacy, accountability, and support originally contemplated in the design of the corporate structure.


A New Federal Law of Ownership


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Empty Skyscrapers

We have nothing left but our great empty corporation statutes towering skyscrapers internally welded together and containing nothing but wind.

Bayless Manning


Although our recommendations do not require legislative action, they could certainly benefit from some, particularly at the federal level. Traditional arguments for leaving regulation of corporations to the states have, after 200 years, begun to erode, as we showed in our discussion of the race to the bottom in Chapter 4. It is increasingly evident that the current abuses are made possible by the failure of the states to enact effective laws. That is because the traditional justification of worthwhile experimentation being incubated by competition among the states has become overtaken by events like the antitakeover laws adopted specifically to protect local companies. As we explained in Chapter 4, competition and experimentation in state corporate law work only if the states must bear the costs of the benefits they provide to entice corporations. Delaware can make its laws as liberal as it wants because it bears such a tiny proportion of the consequences, and that proportion is vastly outweighed by the benefits of the tax revenue.

State after state has responded to the prospect of takeover of a local company - or the opportunity to get some of Delaware's corporate tax revenues - with self-serving antitakeover legislation. State laws governing the relationship of shareholders and management reflect the fact that state legislators, like corporate managers, have little accountability to shareholders, and the states have been shown to be powerless or worse in dealing with questions of abuse. We would like to see a federal law for corporations that sets minimum standards, with the states allowed to experiment and compete by imposing higher ones. There must be a point below which the race to the bottom cannot go, and only the federal government can establish it.

But we recognize that states jealously guard their franchise in corporate law. And there is an alternative that does not require new legislation. As traditional corporation law at the state level deteriorates into a kind of manual for management entrenchment, a new, possibly helpful trend can be detected in the emergence of a federal law of ownership, one that is set by regulation. Institutional investors subject to federal regulation now control a majority of the equity of American corporations. This has provided a foundation for meaningful recreation of corporate self-regulation through precise definition of the obligations of fiduciary owners to involve themselves in corporate affairs. The majority of fiduciary owners are obligated to manage their trust assets with the care of a "prudent expert" and with loyalty solely to their beneficiaries. As the obstacles to collective action by the institutional owners are reduced, it will come within their power to create a corporate governance system restoring the "constructive tension" of fiduciary responsibility. Through development of the specifics of a federal law of ownership, a national code for the effective self-regulation of corporations will emerge.

Traditionally, shareholder attributes have been defined by state corporate law.2 However, several classes of shareholder - pension plans, investment companies, bank trusts - are fiduciaries under federal law. The nature and extent of their trustee responsibilities are matters of federal regulation, which supersedes the provisions of state law. Our consideration of this important trend begins with the private pension system, partly because it is the biggest category of institutional investor, and partly because the Pension and Welfare Benefits Administration (PWBA) of the Department of Labor (DOL) has taken the lead in outlining the new ownership law. ERISA creates a new law of governance because it preempts state corporation law in areas of conflict. The provisions of ERISA, therefore, and their interpretation by PWBA constitute an emerging federal law of ownership to the extent they require a code of behavior by fiduciaries. This standard has received general support from other federal agencies with jurisdiction over institutional investors, including the Internal Revenue Service, the Office of the Comptroller, and the Securities and Exchange Commission.

Although a federal law requiring shareholder-trustee involvement in corporate affairs is well developed in theory, there are only the beginnings of practical definition. PWBA has insisted that some entity must accept and discharge ownership responsibilities with respect to all outstanding shares of stock. PWBA considers ownership responsibilities "plan assets" under ERISA, and it will deem failure to discharge those responsibilities as a breach of trust. Fiduciaries, subject to federal law, are required to act as informed owners, if for no other reason than to forestall erosion of values,3 and they must do so in ways that are unmistakably incremental to trust values.4 Beyond this rests the challenge to develop a structure permitting efficient collective action and the commitment to form and maintain responsive institutions.


Pension Funds: Permanent Shareholders


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Corporate managers love to justify their neglect of shareholders by describing the institutional shareholder as "a 26-year-old in front of a CRT, ready to pounce on every quarter-point, with a 6-second attention span and a 10-second position in anything." Or, as Henry Schacht put it to us most compellingly, "They are not owners; they are investors." Although this, too, is something of a convenient myth (at least one study showed that takeover targets had lower-than-average institutional ownership),5 as with most myths there is an element of truth in it. The short-term pressure is the result of two factors. First is the commercial pressure - money managers compete for business by pointing to last quarter's results. Second is a misunderstanding of a fiduciary obligation - the belief that it requires managers to jump at any premium. A major factor in the breakdown of the corporate form of organization is the conflict between institutional investors, who are seemingly obligated to act as short-term holders, and corporations, which need long-term commitment from owners. This is a classic case of unintended consequences . The effort to adapt a time-honored legal system - in this case, the law of trusts - to modern times has produced muddled results.

The law of trusts was conceived as a way for wealthy Englishmen to insure their descendants against the theft or neglect of inherited assets. It was called "the law of dukes." No one dreamed that it would one day constitute the operational force underlying half of all the equity capital of the United States. Trustees are directed to avoid risk; they are prohibited from sharing in the gains that result from successful risk taking; they are surcharged for losses caused by failure to act in the same manner as others similarly situated. Under traditional and present trust theory, a trustee, whether of a $4,000 portfolio managed on behalf of Aunt Mary's cats or of a $40 billion portfolio managed on behalf of the Chicago teachers, cannot refuse an offer of $20 in cash for a share of stock trading at $15. It is this factor, the essential short-term perspective of the trustee, that has damaged the corporate fabric. Ironically, lawyers like Marty Lipton try to tell corporate directors that they can "just say no" to such an offer, and at the same time Treasury and Labor department officials tell the ERISA fund managers they can do the same thing. But no one believes them, and until such a refusal is challenged and upheld - or, even better, until the acceptance of such an offer is challenged and overturned - no one will. Until then, they will continue to topple like dominoes.

We can try to resolve this dilemma by considering carefully the real needs of the largest institutional owners, the pension funds, and coming up with an expanded notion of fiduciary obligation by trustees that is designed for billion-dollar pension funds rather than feudal dukedoms.

Let's return to Boothbay Harbor and see how Trip fits in. Trip wants to be able to retire in 15 years in a country that has a stable and robust economy, a healthy environment, and a strong defense. He wants to be able to maintain a decent semblance of his preretirement standard of living. All the vagaries of inflation and foreign exchange mean little to him. Can the promise of a "real" pension for Trip be kept?

The many analyses of investment performance over the history of the United States share one conclusion: over the long run, common stocks outperform all other modes of investment. It is only by sharing in the growth of business enterprises that a passive investor has a chance to keep pace with inflation and to maintain purchasing power. Trip, therefore, wants his plan assets to be substantially invested in corporate equities. How should they be managed, and how can he be confident that he has picked the best person to do so?

Recent studies have made clear that active management of pension assets has not resulted in increased values for the participants and beneficiaries.6 Wilshire Associates surveyed its data base of 222 live accounts over 7.5 years representing $40 billion in equities as of June 30, 1986. The performance of each stockholding in every portfolio has been calculated by Wilshire, representing 1,700 quarterly observations and a half million separate performance calculations. They came up with the following results: "the net management effect is zero."7 One must come to grips with the stark reality that, notwithstanding the optimistic expectations and billions of dollars in fees paid to money managers, consultants, and all manner of professional service providers,8 the economic consequences for the objects of governmental bounty - the pension plan participants, our Trip - have been no better than if all the equity portion of the funds had been invested in market indexes.


Equity Managers' Box Score

How Managers Add (Subtract) Value

Management Activity             Incremental Performance
_______________________________________________________
Market timing                           (0.8%)
Sector weighting                         0.7%
Stock selection                          0.6%
Trading                                 (0.5%)
_______________________________________________________
Net management effect                    0.0%

Source: Wilshire Associates.
If Trip's pension resources are invested in an equity index, he in effect becomes a permanent owner of corporate America. Although his interest is very small, it is real and can be understood by his trustee. What this means is that the ERISA fiduciary of indexed stocks has a very distinct blueprint of the beneficiaries' interests. Like Trip, they are American, they have a long-term interest in the prosperity of American business, and they are well served by commercial decisions that are sensitive to the quality of life at the time of retirement. All of the research, all of the theories, all of the fees that go into active management could be devoted to responsible exercise of governance rights to support and guide the corporations. This is at least as likely to protect and enhance share value as churning the shares by buying and selling.

Index funds are long-term shareholders. Indeed, they are permanent shareholders, unless, for some reason, one of the component companies drops out of the index. Many pension plans today are "indexed" with respect to their equity investments. Such prominent funds as the California Public Employees' Retirement System and State Teachers Retirement System and the public employees' fund of the State of New York are indexed. Congress has mandated by law that its own pension fund (FERSA) must be indexed. There are no definitive records of the extent of indexing, but based on those funds that can be identified, it is possible that 10 percent of total equity investment is held in index form.

There are two goals for pension fund investments. The first is to provide the best returns possible for the employees who participate in the plan. The second is to provide a stable, responsible base of equity investment. Both are best accomplished through index funds. We are not suggesting in any way that all ERISA funds should be indexed. Index funds benefit in part from the active managers. And fiduciaries should diversify. Even the ones we mentioned have separate portfolios, even more than one kind of index. But we would like to encourage greater investment in indexes. The best way to do this is for the secretary of labor, as the government official ultimately responsible for defining fiduciary standards under ERISA, to rule that investing the equity portion of a portfolio in an index constitutes a prudent "safe harbor." This would leave managers free to invest in any manner they deem appropriate but would leave them with the burden of proof that investment results that did not achieve the levels of the index were prudent, a burden that someone like GM's Gordon Binns could certainly satisfy.

It is worth noting that the only substantive investment provision in ERISA requires "diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so."9 Indexing is the ultimate diversification, so the incremental restriction on trustee discretion involved in the adoption of an indexing "safe harbor" rule is not startling. Indexing the pension portion of the equity markets would reduce short-term trading and would provide a base of "permanent ownership" with a long-term view for American business. If the index used were the Wilshire 5,000, for example, pension plan capital would be available to all publicly traded companies. At some level of indexing, the question would arise as to whether the balance of market participants would be able to establish meaningful market prices on which to base the index.

As we noted in Chapter 4, pension funds have characteristics markedly different from those of other classes of institutional investors. For example, mutual funds, with their offer of daily sale or repurchase, have a self-evident need for liquidity. Private trusts, endowments, and insurance companies are all long-term investors but have varying needs for liquidity. Pension funds (specifically, defined-benefit plans) uniquely can extrapolate needs for cash into the future and thus confidently commit a portion of their assets "permanently" to the equity markets. We have shown that there is no evidence that participation through index funds, in contrast to active management, would cost beneficiaries.

"Permanent shareholders," constituting more than one-fifth of the total equity in American industry and a far higher percentage of the larger companies, could have a positive impact in several respects. They would constitute a filter for consideration of takeovers both by foreign and by domestic interests; they would provide a stable constituency to encourage managements to take a long-term view in their direction of companies; they would provide the foundation for a system of corporate governance based on ownership. As we discussed in the previous chapter, the enormous amounts of money building up in the pension system have stimulated interest from politicians and others who have imaginative ideas as to its better use. It now seems that the optimal use of the equity portion of pension assets is as the long-term owner of America's corporations.

This is where the leadership and participation of American corporations is indispensable. Their pension assets are the largest single element of institutional ownership. Public plans, notably CalPERS and those overseen by New York's Ned Regan, have developed ownership agendas and useful programs to promote governance concerns. However, in the absence of a parallel or even complementary effort from the ERISA plans, needless and unproductive polarity has been created. On the one side are the public plans; on the other is corporate management. Public and private pension plans have more in common as "owners" than they have differences. They should reflect this by working together on an agenda that benefits them both. 10


The Shareholder Agenda and Its Limits


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Shareholders, as a matter of law and policy, must keep to a very limited set of issues. They do not have the expertise, the resources, or the right to become involved in matters of day-to-day management. Their liability is limited to the amount of their investment. Their only involvement should be to make sure that the interests of directors and management are aligned with those of the shareholders, and that when a conflict of interest is presented, the shareholders make the decisions themselves.

Benjamin Graham and David C. Dodd, over a half-century ago, described the agenda for governance activity. They said that shareholders should limit their attention to matters where:

the interest of the officers and the stockholders may be in conflict. This field includes the following:
  1. Compensation to officers - Comprising salaries, bonuses, options to buy stock.
  2. Expansion of the business - Involving the right to larger salaries, and the acquisition of more power and prestige by the officers.
  3. Payment of dividends - Should the money earned remain under the control of the management, or pass into the hands of the stockholders?
  4. Continuance of the stockholders' investment in the company Should the business continue as before, although unprofitable, or should part of the capital be withdrawn, or should it be wound up completely?11
We would add that governance must concern itself with preserving the full integrity - and value - of the characteristics of ownership appurtenant to shares of common stock. For example, the right to vote may be diluted by a classified board or by dual-class capitalization, and the right to transfer the stock to a willing buyer at a mutually agreeable price may be abrogated by the adoption of a poison pill. These kinds of issues, not contemplated at the time of Graham and Dodd's first edition, can also present conflicts of interest, as shareholders are interested in accountability and officers and directors are interested in protecting themselves.

This agenda says much about the powers, responsibilities, and intended relationship among shareholders, directors, and officers. It contemplates the restoration to owners of the power to make the critical decisions about a corporation, to resolve the conflicts of interest inherent in the corporate form of organization, and to be the source of nominations for director. The way for shareholders to affect corporations is through election and monitoring of appropriate individuals as directors. The fiduciary shareholder, in voting to elect directors, can hardly be said to be acting "prudently" by empowering a board that would dilute the ownership standards of the trustees themselves.


The Shareholder Agenda for Corporate Crime


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The issue of corporate crime deserves separate consideration. Like the issues just discussed, it is one where shareholders and managers have a conflict of interest. One can argue that limited liability is conferred on shareholders on the express condition that the corporation not create liabilities for society to bear. To the extent that a corporation is enabled to avoid the consequences of activity for which an individual would be personally responsible, society is accepting the burden. Because the corporation itself has limited liability, it is impervious to court judgments, which may well encourage conduct not in the interest of society. As the corporation creates "externalities," the burden of its owners to abate those liabilities should increase. What will happen is that the cost structure of products will change. The citizenry may face higher product prices, but the net expense will not change. Consumers will explicitly pay for what they are now being charged in the form of higher government costs and diminished quality of life.

As we discussed in Chapter 4, no one has been able to design a system of appropriate deterrence to corporate violation of the law. Although many ingenious solutions have been suggested, including the "equity fine,''12 none has been able to impose meaningful accountability.


Diffused Accountability

Companies have two kinds of records: those designed to allocate guilt (for internal purposes), and those for obscuring guilt (for presentation to the outside world). When companies want clearly defined accountability they can generally get it. Diffused accountability is not always inherent in organizational complexity; it is in considerable measure the result of a desire to protect individuals within the organization by presenting a confused picture to the outside world. One might say that courts should be able to pierce this conspiracy of confusion. Without sympathetic witnesses from within the corporation who are willing to help, this is difficult.

John Braithwaite


Source: Corporate Crime in the Pharmaceutical Industry, Routledge & Kegan Paul, Boston, 1984, p. 324.
There have been various efforts to place corporations "on probation," to require payments to societally useful causes, even to jail executives, but it is plain that nothing really works and that the problem is becoming more acute. Surely those with the largest stake in making societal and corporate interests compatible are the long-term owners.

Unless the long-term shareholders conclude that it will be "cost-effective" to continue to deal with the problems caused by corporate criminality on an ad hoc basis, some significant self-regulatory effort should be contemplated. There will always remain a need for legal sanctions: "[S]ome executives abstain from bribery because they are afraid of being punished. Most abstain from bribery because they view it as immoral. One reason that they view it as immoral is that executives who bribe are sometimes punished and held to public scorn. Do away with criminal punishment and you do away with much of the sense of morality which makes self-regulation possible. Self-regulation and punitive regulation are, therefore, complementary rather than alternatives.''13 And yet, "the firm is better positioned than the state to detect misconduct by its employees. It has an existing monitoring system already focused on them, and it need not conform its use of sanctions to due process standards. Indeed, if the penalties are severe enough, the corporation has both the incentive and, typically, the legal right to dismiss any employee it even suspects of illegal conduct."14

What is the role of the shareholder? Even in the days of Junior's investment in Boothbay Harbor, shareholders had no interest in and no ability to develop or impose internal corporate procedures. How a corporation establishes information flows, incentive systems, or review structures is far beyond the role of the shareholders. Their concern is to hold managements accountable for their conduct of the business in compliance with the law. Indeed, even Professor Milton Friedman's well-known aphorism that management's sole obligation is to maximize the value of the firm is conditioned on doing so "within the rules."

In a simplistic way, shareholders hire managers to run their business in a way that will encourage a governmental and societal climate supportive of capitalist enterprise.15 An increasing level of corporate criminal activity is hostile to an attitude of public support in the future. Conceivably, management has been so caught up in the pursuit of short-term profit (institutional shareholders have their share of blame in this regard) that it has failed to grasp the utter unacceptability of a situation in which corporate criminal activity not only is rampant but apparently is beyond the power of any constituency to abate. Shareholders need to make unmistakably clear to those they hire that continued corporate crime will not be tolerated.

The best way to do that is in the election of directors. The most fundamental criterion in approving the continued service of particular individuals as directors is that they require the corporation to take every step to channel critical information within the corporation (in its extreme, this entails access of top management to "whistle blowers") and to structure incentives and penalties to ensure a crime-free environment. Setting forth the conditions of eligibility for service on the board of directors appears uniquely appropriate for shareholder concern and bylaw implementation. There is no question that the board of directors has the authority, indeed the responsibility, to promulgate basic corporate policies.


Specifying the Director's Role

More active stockholder participation might force greater corporate compliance with the law in some areas, although, as we have pointed out, their primary concern is often corporate stock growth and dividends.... Far reaching corporate reform, however, depends on altering the process and structure of corporate decisionmaking. Traditional legal strategies generally do not affect the internal institutional structure.... At present few clear functions are usually specified for corporate boards of directors; they frequently have served as rubber stamps for management. If a functional relationship and responsibility to actual corporate operations were established, directors would be responsible not only for the corporate financial position and stockholder dividends but also for the public interest, which would include the prevention of illegal and unethical activities undertaken in order to increase profits.

Marshall B. Clinard and Peter C. Yeager


Source: Corporate Crime. Free Press, New York, 1980, pp. 306-307.
Professor Christopher Stone's Where the Law Ends is perhaps the best known work on this general subject. He concludes that the suspension of directors is the most effective way of dealing with the problems of corporate criminality.

Why is this better than what we have now? For one thing, the magnitude of the potential liability today has become so draconian that when we try to make the law tougher on directors the more likely effects are that corporate lawyers will develop ways to get around it, judges and juries will be disinclined to find liability, and many of the better qualified directors will refuse to get involved and serve. The advantages of the "suspension" provision, by contrast, are that it is not so easy to get around; it is not so severe that, like potential multi-million-dollar personal liability, it would strike courts as unthinkable to impose; but at the same time it would still have some effective bite in it - the suspendees would be removed from the most prestigious and cushy positions ordinarily available to men of their rank, and would, I suspect, be object of some shame among their peers. 16


Removing the Impediments to Shareholder Action


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Now that we have a stable base of permanent shareholders, led by corporations themselves, operating under a consistent federal regulatory structure, and limited to a restricted agenda, the final element is some structure for them to work together, to minimize the collective choice problem.

Institutional investors are apprehensive about collective action, and so are the corporations they invest in. We have already noted the extensive American tradition of mistrust of centralized financial power. Public plan trustees have set the pace so far. Inevitably, though, the leaders of corporate America will not permit that to continue. The Business Roundtable's initiative to get its members to reclaim the right-to-vote proxies from the investment managers responsible for their ERISA portfolios is just the first step. And the only way to develop effective governance through this process is to surmount the collective choice problem through collective action, through working together to share information and other resources, and to develop policies and initiatives.

The logistics of collective action are daunting as well as expensive. As we have already discussed, government policies favoring worthwhile goals such as liquidity (the registration of securities in "nominee" form) and privacy (laws protecting beneficial owners from having their identity disclosed) have led to a system where it is almost impossible for shareholders to identify each other, much less communicate. Another practical aspect, one that has become less of an impediment but is still significant, is the logistics of corporate elections. Corporate management counts the votes and sees how each proxy is voted and by whom. Although a small fraction of publicly held companies have adopted confidential voting procedures, most corporations are very aware of how each shareholder votes. There have been abuses in which corporate management has exploited commercial relationships to get money managers and banks to vote with them.17 Beneficial owners, who do not know how votes are cast on their behalf, have no way to object. The one exception so far are the institutional investors of California, who, beginning in 1990, must report to their beneficiaries how they voted shares held in trust portfolios.

Once the legal and practical problems of collective action have been successfully overcome, there remains the reality that the proxy process itself is far from evenhanded. Shareholders underwrite both sides of any disagreement with management. A shareholder resolution may be included in the company's materials; however, management has the opportunity to respond to shareholder proposals, but the shareholders do not have the opportunity to respond to management proposals. The suitability of any particular subject for a shareholder proposal it cannot be about "ordinary business"is often the subject for expensive and technical quarrels before the SEC. Even when a proposal is permitted, it is only precatory; a company is free to disregard even a unanimous vote. Election of directors is even more troublesome. Edward J. Epstein points out that shareholder elections "are procedurally much more akin to the elections held by the Communist Party of North Korea than those held in Western democracies.18 Except in the rarest of cases, there is only one slate of directors running for office, and management nominates the slate, controls the voting process, and counts the votes. Management has the opportunity to use the company materials to nominate directors; shareholders do not.

A firm commitment to act as a fiduciary, using ownership rights "for the exclusive benefit" of plan participants, fortified by a firm commitment from the Labor Department, SEC, and other agencies to enforce the policies and standards already in place, is the best way to counter the commercial pressures we described in Chapter 6.

The structure could follow the lines of the highly effective British National Association of Pension Funds or the Association of British Insurers. A small permanent staff is maintained to act as an information clearinghouse and analysis center for issues of interest to the members. Officers are "seconded" by the Bank of England and other sponsoring institutions, so the association never assumes a bureaucratic life of its own. Issues are closely analyzed, but all member institutions retain the full fiduciary responsibility to vote. As such, an association becomes supported by all of the institutions, and the problems of collective action are abated, if not eliminated.


The Ownership Focus


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Imagine the difference it would make if pension funds, public and private, were enthusiastic and informed about ownership responsibility. Their ownership focus would have two special characteristics. First, it would be universal. The institutions not only own all of the companies that make up a particular industry, they own all of the industries that constitute the business component of the nation's economy. This permits decisions to be made on a larger scale than we are accustomed to. In considering the consequences of any act, the trustees must look at it from the perspective of the business segment as a whole. Thus, questions of pollution, unemployment, job training, and research and development expenditures can be considered from the perspective of the system as a whole. Second, these owners have a long-term viewpoint - that of their pensioner beneficiaries - and are literally permanent owners. What has changed is their view of creating value. Rather than picking and trading stocks, they organize themselves as owners to pursue long-term objectives that are characteristic of their beneficiaries' and society's real long-term interest.

We already have in the United States all of the elements that have been essential components for a competitive business climate elsewhere in the industrialized world. Management needs to be made accountable to someone who has the power, the motive, the perspective, and the ability to represent the public interest effectively. We have in the pension systems the necessary core of long-term shareholders. They should be committed once and for all to the long-term ownership of the country's companies. Once there is agreement on the ultimate use of pension assets, appropriate institutional development will be forthcoming. In the meantime, equity investment through indexes and reinforcement of the "exclusive benefit" rule for both public and private pension funds will provide direction and momentum. So long as trustees consider solely the long-term interests of plan participants, America can continue to have a competitive and legitimate corporate establishment.

Because trustees are by nature and profession risk-averse and are poorly suited to be out in the front of any pack, the federal government must make it clear that institutional responsibility as owner is their policy. With the assurance that what they are doing is "prudent," institutions may well be able to make significant progress. The Securities and Exchange Commission has indicated that it plans to undertake a comprehensive review of its proxy rules, drafted for a time when the technology and the average shareholder were very different. This initiative could remove several regulatory obstacles to institutional collective action. Above all, what is needed is leadership from America's corporations. Corporate managers are the people who hire (and fire) the money managers. They can set the policy for investment and exercise of ownership rights. They must recognize that a system based on institutional ownership - with American business, through its benefit plans, the largest owner - is the best guarantee of competitiveness and productivity in the global economy.


From the Belzbergs to Ma Bell: Another Kind of Corporate Raider


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Henry Schacht unsuccessfully tried to get his shareholders to act like owners, but found that they acted like investors. Junior would have stayed with him, but Trip cannot, or will not. In this environment, there are four possibilities.
  1. There will be no more publicly held American industrial companies in cyclical industries with high requirements for capital and time (this is roughly Michael Jensen's point).
  2. There will be semi-privatization along the lines that Cummins ultimately took, a keiretsu-like ownership pattern, with according voting restrictions.
  3. The few - Ford, AT&T - will acquire the rest.
  4. We will meaningfully deal with the "core issue" and take steps to make institutional investors genuinely long-term. There have been many suggestions in this direction: taxation for short holding periods and time weighted voting; our preference is "indexing."
The AT&T/NCR saga is both timely and topical. NCR says it is not for sale. "Ma Bell," the apotheosis of "touchy-feely" sensitivity for constituencies, is making an all-cash offer and staging a proxy battle for board seats. The line of questioning, the vocabulary of accountability, now comes from the heart of corporate America, rather than the maverick raiders. This is not the shouting of fringe characters with an ax to grind; this is the central question of corporate legitimacy being raised by the principal American corporation today. Will the combination of state legislatures, federal lassitude, and contrived governance provisions create an effective barrier to an all cash offer for all shares by the hypothetically ideal acquirer?


Power and Accountability


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The dysfunction of the corporate paradigm in the United States is based on two factors. The first is failing to preserve "trust" as a relevant category in establishing the duty of directors and officers. The second is the tendency to "monetize" relationships, which inevitably focuses on the short term - in reality if not in theory. Both of these mistakes stem from failure to consider that corporations, are not simply another interest group whose demands and requirements can reliably be made compatible with societal interest through need to accommodate other interest groups. We have allowed corporations to become a separate source of power, a law unto themselves, and there must be within the corporation the element of "trust," or, looked at another way, accountability.

Our products and our investment instruments now compete in the global market. As that market becomes more global, the dominant mode of the expression of power in the world will be decreasingly political and increasingly economic, less military and more corporate. An escalating percentage of corporate activity will be conducted by companies having operations that cross national boundaries. The effective combination of culture, public opinion, and law that, in the past, has ensured the compatibility of corporate power with the public interest, will be insufficient for that purpose in the future. Restraints on corporate power based on the law of a particular domicile will tend to follow the pattern in the United States of a "race to the bottom" and will have little impact. We must therefore ensure a structure adequate to compel accountability of those in charge of corporations to some source outside of their organizations - and we have to accept that it cannot be left to individual countries' political systems. In law, economics, tradition, and common sense, the best place to start is with owners.


What Should Be Done Now




Endnotes


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1 Personal letter from David Ball to Robert A.G. Monks, September 4, 1990.
2 See CTS Corp. v. Dynamics Corp. of America, 107 S. Ct. 1637 (1987), respecting the voting power of shareholders in certain takeover situations.
3 For example, by not voting in a takeover, a shareholder in effect "gives" value to those who do.
4 A trustee would have a difficult burden defending action that was for the common interest of all owners if it resulted in charges that diminished the trust estate.
5 John Pound, Kenneth Lehn, and Gregg Jarrell, "Are Takeovers Hostile to Economic Performance?" Regulation, September/October 1986, pp. 29-30.
6 Richard A. Ippolito, Pensions, Economics and Public Policy, Dow Jones-Irwin, Homewood, Il., 1986; Richard A. Ippolito and John A. Turner, "Turnover, Fees and Pension Plan Performance." Financial Analysts Journal, November-December 1987 ("A CAPM-based analysis of the data reveals that, net of investment fees and turnover expenses, private pension plans underperform the S&P 500 by approximately 44 basis points per year"), p. 16; Stephen A. Berkowitz, Louis D. Finney, and Dennis E. Logue, The Investment Performance of Corporate Pension Plans, Why They Do Not Beat the Market Regularly, Quorum, Westport, Conn., 1988.
7 The Equity Manager Box Score, Wilshire Associates, Santa Monica, CA, 1987, p. 3.
8 Just how large this sum is may be approximated from Wilshire's work. "Brokerage commissions and even the impact of trades are small in comparison to the amount of fees paid to managers. Wilshire's clients tend to have large funds so the fee component for equity management is only about 0.4%" (Ibid., p. 3). Total pension funds approximate $2 trillion, so fees might approach $8 billion per year.
9 ERISA Sec. 404(a)( 1 )(C) .
10 Any doubt as to the legality of corporations acting collectively with respect to their ownership responsibilities for securities held in their employee benefit plans was dispelled by the ruling of (then) Assistant Attorney General Charles Rule to ISS in August 1987.
11 Benjamin Graham and David L. Dodd, Securities Analysis, 1st ed., McGraw-Hill, New York, 1934, pp. 510-511.
12 John C. Coffee, "No Soul to Damn, No Body to Kick: An Unscandalized Inquiry into the Problem of Corporate Punishment," Michigan Law Review, 79, January 1981, pp. 413 424.
13 John Braithwaite, Corporate Crime in the Pharmaceutical Industry, Routledge & Kegan Paul, Boston, 1984. p. 319.
14 Coffee, "No Soul to Damn, No Body to Kick," p. 408.
15 "Through the generally more active participation of their shareholders, cooperatives also offer the consumer greater control over management decisions than is provided to shareholders in large corporations" (Marshall B. Clinard and Peter C. Yeager, Corporate Crime, Free Press, New York, 1980, pp. 324-325).
16 Christopher D. Stone, Where the Law Ends: The Social Control of Corporate Behavior, Harper & Row, New York, 1975, p. 148.
17 The Department of Labor's Enforcement of the Employee Retirement Income Security Act (ERISA), Subcommittee on Oversight of Government Management, Committee on Governmental Affairs, U.S. Senate, April 1986, S. Prt. 99-144, pp. 53-58.
18 Edward Jay Epstein, Who Owns the Corporation? Management vs. Shareholders, Priority Press, New York, 1986, p. 13.