1. Law for a Competitive Economy (Section 2.4)

The United Kingdom has the opportunity to be the domicile of choice for multinational companies in the twenty first century. In the same way as Delaware is the choice of the managers of U.S. corporations, so the UK can be the choice of owners of worldwide enterprises. The question as to whether "manager" or "owner" interests will prevail should be determined by the market place. At present, the long time hegemony of management has been confronted by the emergence of a conscious, long term, coherent, fiduciary ownership class, which is only beginning to define itself and an appropriate role in corporate and societal governance.

From the perspective of investors, the United Kingdom has for many years been recognized as the most favorable domicile in the world. Davis Global Advisors has rated the UK #1 for three years running (the U.S. is a distant #2). In passing, we should remember Peter Drucker’s recent comment in Forbes magazine that only in the U.S. and the UK is there a serious legal and managerial commitment that enterprises be run for the benefit of the owners.

It is worth reflecting on whether the UK has a stronger world competitive position as owner rather than manager of large companies. The combination of full funding of public and private pension schemes, the pattern of allocating 70% or more of total assets to equities; and an inveterate comfort with investment abroad have given the UK a disproportionately large position as international owner. The relative attractiveness of the UK to investors must be an important element in the future prospects of London as a world financial center. This suggests that what I refer to as the UK Corporate Governance Advantage ("UKCGA") might be the basis for a strategy to persuade institutional investors to cause multi national corporations to domicile in the UK. Pursuing an "owner friendly" strategy runs the risk of managements of companies presently domiciled in the UK using their leverage to change the place of domicile – but in a world that increasingly equates shareholder involvement positively with value and in which shareholder votes are ultimately determinative, it may be felt that this risk is tolerable.

The choice of domicile ("charter") is within the power of shareholders according to the laws of the various United States and many countries. Traditionally, top management has made this choice in the U.S. because technical considerations (U.S. Securities Exchange Act of 1934 – Section 14a-8) and the need for extensive legal assistance about shareholders placing items (particularly such sensitive matters as domicile) on the agenda for Annual Meeting consideration have discouraged initiatives. The chartering business is much desired by the various states, so there is tendency to tailor the laws to be protective of those who make the decision as to domicile. Delaware is rumored to collect as much as twenty percent of its total tax revenues from this source. This does not take into account the beneficial impact on the judicial system – lawyers and courts alike. During the "hostile takeover" extravaganza of the late ‘80s, a most unusual "shareholder – friendly" court decision in Delaware drove the resourceful management counsel – Martin Lipton – to write his clients suggesting that they consider reincorporating in New Jersey (Later developments involving the attempted takeover of Armstrong International right at election time drove the Pennsylvania Legislature into paroxysms of protectionism that have resulted in the virtual disenfranchisement of shareholders in that Commonwealth.). The controlling dynamic has been the perceived self-interest of the incumbent management. This dynamic can be changed by coordinated action on behalf of the beneficial owners of corporations.

U.S. domicile shopping can be extrapolated on to a worldwide stage with the emergence first of a single European and later of an OECD-wide world. The same "race to the bottom" with respect to governing laws can also be expected. The difference lies in the reawakened condition of the institutional investors. Particularly, the large pension funds of the Anglophone (including Holland) countries have come to discover not only that they literally have a majority ownership in their home country industries, but also they are becoming the dominant shareholder in the balance of the OECD and Third World. They are moving towards an appreciation of their position as the legendary "customer" with the luxury of choice. Shareholders have formed effective organizations to coordinate their capacity to initiate and support an ownership agenda – the Council of Institutional Investors in the U.S. and the International Corporate Governance Network are activists; the NAPF and ABI in the UK are trade associations for the pension fund and insurance investors. There are several special purpose professional organizations enabling economical voting and ownership participation.

A few extracts from the current draft of OECD Principles of Corporate Governance illustrate the importance of "pension fund capital" in this new world, dominated by investment considerations:

Shareholder monitoring is in aid of enhanced value of corporations by the market place. This proposition impresses as being intuitively correct, but there have been too few committed activist institutional investors to provide the evidence for formal statistical proof. There needs to be further consideration of the simple proposition – a company having informed and effectively involved owners is worth more than one without. This would appear to be the unarticulated basis of the current UK Corporation law, but, as we discuss in the balance of this paper, specific endorsement of the principle is necessary in order to encourage rational ownership involvement and to overcome the collective action and conflict of interest problems that are presently inhibiting. Owners have been encouraged so long to persist in inactivity that some explicit finding or even directive from policy makers is desirable that informed and effective involvement by shareholders in corporate governance is in the public interest.

To recapitulate briefly, we are becoming aware of a world in which

• a relatively few fiduciary institutions (many of them based in the UK) control the preponderance of investment capital in the world -
• the involvement by shareholders as effective monitors of management adds value –
• shareholders control the decision as to where a corporation is to have its legal domicile –
• The United Kingdom is the most attractive corporate domicile from the perspective of owners ("UKCGA")

It requires but a small leap to conclude that fiduciary shareholders have an obligation to use their voting power in such a way as to cause the corporation to be domiciled in that jurisdiction where the governing laws provide the most value adding environment. Institutional Investors as a class, even UK fiduciaries acting alone, have large enough stock holdings in underperforming companies in other countries effectively to require consideration of a change in place of incorporation.

1. The Main Arguments for Reform – Sections 5.1.7 et seq.

What is the question? It is not whether the various corporate constituencies have equal entitlements or whether any one of them should have preference. It is not whether the interests of each group are necessarily to be quantified in a definition of long-term value for the enterprise. It is – rather - whether corporate management is effectively accountable to any informed, motivated, independent and effective entity. Having the correct question in focus, we can proceed to ask – which ones of the various corporate constituencies possess the ingredients necessary to function as a value-adding monitor of management.

The free rider problem inhibits the commitment of resources by any single member of a group. What incentive is there for an individual to take all the risk, commit all the resources, with the prospect only of a pro rata share of the gain in the event of success and all the loss in the event of failure? This is not an attractive prospect for individual components of all constituency groups. It is severely inhibiting for fiduciaries. Beyond this barrier is the reality of subordinate relationship to corporate management. Employees have the collective bargaining process; beyond that, they are dependent on management’s determinations as to continued employment and promotion. Suppliers essentially have to please their customers. It would be difficult for even the most impeccable supplier to take on the role of monitoring his own customer. Nor is the situation of the customer any more robust. What is his incentive to argue with a particular supplier rather than to find another? Communities are classically in competition with each other to attract the tax and employment base of companies. They are primarily concerned with the political consequences of their acts and are, therefore, not credible monitors. We are frequently reminded that the only constant in business is change and the need to adapt to it. The entrenchment of constituency interests will inevitably inhibit flexibility in the interest of ameliorating current anxieties. All constituencies have the "free rider" problem. Only shareholders are sufficiently motivated, independent and long term oriented to have the necessary qualifications for effective monitoring.

Only when meaningful enforceability is established can there be generated a spacious language of accountability that encourages long term value maximization within the interests of society. Before consideration of norms is practical, there must be real capacity for someone to hold management to account. At present, the existence of real accountability of management to members to produce long term value is the "competitive advantage" of UK chartered companies ("UKCGA"). It can be the basis for expanding notions of corporate responsibility.

 

2. 5.1.10 - The Enlightened Shareholder Value and the Pluralist Approach - with a new subtitle - The largely overlooked and undefined "members"

Neither the statute nor the Document devote more than passing attention to the "members". In at least three respects, this neglect has had the impact of creating substantive standards that may or not have been intended:

• failure to differentiate between different categories of members
• failure to enforce fiduciary requirements of loyalty on behalf of pension plan and trust beneficiaries (section 5)
• "members’" actual, in contrast to supposed, role in nominating directors (discussed in section 4)

By posing the alternatives as between "shareholder" and "stakeholder", the Document usefully points out that the creation of multiple entitled corporate constituencies "…would dangerously distract management into a political balancing style at the expense of economic growth and international competitiveness." [5.1.26] This same analysis could well be extended to the class of shareholders. The interests of an arbitrageur are different from those of a participant in an index fund; an option holder has different considerations than someone borrowing stock; a tax-exempt institution has a different calculus of value than individual investors. All are different and all are shareholders. For whose benefit should management focus its strategy? Plainly, there cannot be a strategy that will be equally attractive to all elements in the ownership spectrum.

The law makes no distinction between the different kinds of shareholder, apparently unconcerned by the anomaly of mandating broad accountability to a class without common interests. The report refers "to the high level of concentration of shareholdings in the hands of institutional investors which we see today." [5.1.9] All fiduciary institutions are characterized by a division between legal and beneficial ownership; a trustee holds and administers shares for a variety of beneficiaries - the plan participants in pension schemes, the beneficiaries of various mutual funds, participants in insurance plans - but all share a fundamental interest that the corporation in which they hold shares generates long term value. The largest component of "institutional investment" - both from the perspective of size of assets and number of participants - is the pension system. There is fairness, therefore, in posing the hypothesis that managements should consider the beneficiaries of pension schemes to be those shareholders for whose benefit they manage the enterprise. This hypothesis does not appear contrary to the interests of other classes of shareholder.

By formally identifying a coherent object for management duty, we begin to make some of the fiduciary relationships - the obligation of fiducairy owners to beneficiaries, for example - susceptible of articulation and meaningful enforcement. Pension participants have common needs and interests - they need to have "real" wealth on retirement to a clean, safe and civil world. Their trustees plainly should consider long term policies in aid of these objectives. To what extent should beneficiaries be consulted about the action that trustees propose to take. How is information to be disseminated? Should trustees continue their traditional "paternalistic" role or should they be bound to follow the instructions of informed plan participants? The technology of the INTERNET makes these questions worth raising. Involvement of a large portion of the population in the governance of large corporations could go far to reverse current trends of their increasing unpopularity.

It is plain that relatively few institutions in the Anglophone world comprise numerical control of the preponderance of multi national corporations. Frequently, it is recited that each of these owners faces the classic conundrum of collective action – that what is plainly in the interest of the class as a whole is nonetheless not attractive to each individual component of the class. (Discussed above in Section 2.) Less frequently is there open dialogue around the conflict of interest problems arising out of the dual functioning of financial conglomerate organizations – both as fiduciaries for pension participants as well as providers (and hoped for providers) of services to the plan sponsor companies. The conflict between the sponsor corporation and beneficiaries of its sponsored pension funds is an admitted contradiction that is accepted in order to induce employers to set up defined benefit retirement plans. In the United States, one looks in vain over the last twenty years for a single shareholder initiative emanating from those who manage money in the private company pension system. In both the UK and the U.S. the plain fiduciary duty of trustees to act solely in the interest of their beneficiaries has been watered down in the case of pension funds and their delegate managers to the point that the inaction of this large portion of company ownership is condoned.

The "market place" of shareholder rights does not work because its largest component is allowed to decide not to participate out of regard for its own interests and without regard to those of the ultimate owners. Government inaction in enforcing the trust laws has created this obstacle to market functioning. It is incumbent on government to remove the obstacle. The choice is clear: either enforce relationships within established trust traditions or stop misleading the public and participants and find a more appropriate legal vocabulary to define the existing situation.

It is certain that conflicted trustee shareholders are not going to concern themselves with changing corporation domiciles from a location agreeable to those who hire them to one less agreeable. This question of conflict of interest needs to be squarely addressed if the UK is going to be able to take advantage of its competitive advantage in corporation law and practice to encourage creation of long term values. The occasion of the revision of the corporation laws gives the UK a head start on the rest of the world and the opportunity literally to begin to create the new corporate law based on ownership. ("UKCGA")

1. "…control over directors’ appointments…" - Section 5.1.4 (p 32)

 

Shareholder monitoring is transformed into effective corporate change through the board of directors. Under UK law, shareholders have the power to change the board virtually at any time and for any reason. Ten percent of shareholders can call an Extraordinary General Meeting ("EGM") for any purpose (Section 368); 50% of the shareholders present at such meeting can replace any or all of the company directors (Section 303). In this respect, UK law is unique in the world and is an invaluable contributor to national competitiveness. This is particularly evident in contrast with the laws of the various United States, virtually all of which make it impossible for shareholders both to call extraordinary meetings and to terminate directors for any reason, short of a job related felony conviction. There is agreement in the UK management sector of the appropriateness of shareholder monitoring. "Shareholders can, however, test strategy, performance over time and governance, and can and should hold management accountable provided they do this with integrity." One can say with confidence – the UK has got it right.

The reality is that in all countries, notwithstanding contradictory verbiage, boards of director are self-perpetuating. The extent to which boards are directly involved in managing businesses varies sharply, but in the UK with a board dominated by executive (i.e. management) directors, the unambiguous conferral of immediate removal power on shareholders gives great leverage to the non-executive directors (i.e. change of CEO at the Mirror, February 1999). Shareholders can confer directly with non-executive directors about personnel and strategy in the context of having full power to effect desired changes. This enables prompt, pertinent and discrete exchange of views; consideration of alternative strategies; and deliberate execution of agreed solutions. This direct linkage from public owner to manager is missing in other systems – the U.S., Germany, Japan.

2. "Members with long term vision…in their own enlightened self interest…."

Having suggested in Section 3 above, that we should identify pension plan participants as the beneficiaries to whom trustees, unburdened of conflicting interest, owe the duty of long term value maximization, we must ask whether the law of trusts is sufficiently spacious to permit the development of societally useful norms by fiduciaries. Can we be comfortable with the juridical realm of trust practice to define the scope of corporate functioning? Are the Chancery courts better able to exercise this critical function than - say – legislative agencies specially created for the purpose?

We first need pause to consider how the present situation has come to pass. It is disquieting that plain and continuous breaches of trust have been tolerated over a long period of time. Nobody intended that law be violated, the situation should be viewed as an unintended, but not inconvenient, by-product of several unrelated developments, some of them historical, others of the kind that appeal mostly to lawyers. No one expected that the preponderance of the OECD world’s savings would be agglomerated in pension schemes governed by trust law which had been developed in simpler times for a far smaller and more homogenous asset base. There is the problem of proof. How can it be proven that the vote or failure to vote, of a single shareholder caused a specific amount of damage. Even in those exceptional cases, where a particular shareholder’s vote was the difference between whether a motion carried or failed, how can it be proven that the fate of this one resolution, was the reason that loss was incurred. And votes are the most tangible of shareholder prerogatives – the problems of proof and causality become more attenuated when talking of questions like replacing board members or changing strategy. If the courts are to be the instrument of enforcing a law of ownership, the legal structure will have to be articulated differently than at present.

Earlier, we have suggested that it is essential for a specific decision to be made by government that the existence of informed and effective owners is in aid of public policy. The problems of proof alone make it highly unlikely that the beneficiaries of pension schemes will be able to compel accountability from their trustees with respect to their duty of monitoring portfolio investments. Beyond this are the problems of collective action and conflict of interest.

In the traditional pension scheme, the board of directors of the sponsor company selects a majority of the trustees for the plan. These trustees in turn are authorized to delegate responsibility and authority for managing plan assets to professional money managers. All of these parties have fiduciary obligations to the plan participants. The conflict of interest that we will consider is that between the money manager and the trust beneficiary in cases where the money manager is part of a financial conglomerate that has (or wants to have) relationships with companies beyond holding their stock in portfolios. Clearly, any party that has a financial interest in being able to sell additional products to a management will be inhibited in aggressive monitoring of that same management. It is clear that this conflict of interest exists and that historically the "financial conglomerate fiduciaries" have not been activist shareholders. When the Goode Report states: "Negligence includes failure to exercise reasonable care in selecting a fund manager."(4.9.31), the question should be asked whether appointing a manager with known impediments to managing a significant trust asset is actionable? The Hampel Commission specifically found that the right to vote portfolio securities was an important component of the value of shares of stock. It is clear that conflicts exist in profusion; it is clear that these conflicts relate directly to the value of the trust res. It can hardly be in the public interest to tolerate a structure that neuters the exercise and value of property rights.

The Goode Report (4.5.54) explains that conflicts of interest are endemic in the complicated relationships of the modern world and that the fiduciaries will know how best to deal with them. Does it seem appropriate that a fiduciary having an indisputable conflict of interest should have the burden of proving that this conflict was unrelated to any losses incurred? Under circumstances where experience has shown the efficacy of shareholder involvement and none was evident, is it not fair to ask the conflicted trustee to demonstrate that the losses should not be laid at his door. If the well-known logical problems of trying to prove a negative are considered too cumbersome, possibly outright prohibition of such conflicts should be considered. In the event that beneficiaries are "liberated" to ask for judicial relief, courts can use their discretion to solve the "collective action" problem by awarding damages and costs in meritorious cases.

Courts monitoring trustee stewardship of assets talk in terms of "process" – did the trustees behave prudently? Is this process vocabulary susceptible of being applied in situations where substantive findings are necessary? "In the course of generating wealth, companies may cause various kinds of external harm of which society disapproves - damage to health and safety, abusive employment or contracting practices, environmental damage." 5.1.32 Is it felt that trustees, with the benefit of advice from informed beneficiaries, are the appropriate agents to resolve the questions of the extent to which the cost of corporate externalities should be born by society or by the corporation itself? And that courts can monitor their judgement?

The virtues of using the existent (but presently inoperative!) trust based system are large - no change in law is required, simply enforcement of existing laws. No new administrative apparatus is contemplated, simply the supervised expansion of trustees' obligations. Trustee management responsibilities have evolved judicially (and legislatively – see ERISA) around process norms like "prudence" and "loyalty". We have referred earlier to the existence of a special court system in the State of Delaware that de facto is the "national" corporation law of the United States. It is noteworthy that these courts are styled Chancery and the traditional authority and remedies of equity have proven satisfactory in the U.S. context.

3. Questions to be answered

• Is there appetite for leading the development of the New World of corporate governance based on the hegemony of fiduciary owners?

• Full development of the competitive advantage afforded by the UK’s corporation law and practice will require the explicit attention to and unfettering of ownership. Specifically, why should not the inveterate law of trusts be applied in the present context of pension fund trustees and plan participants?
• Basic questions need to be addressed

• Is the informed involvement of shareholders in the governance of corporations a desired objective of policy?
• Is the informed involvement of plan participants in the governance of pension schemes a desired objective of policy?