For a long time it has been possible for investors to bet that the American economy would continue to prosper through the purchase of shares of common stock. As a child, I remember going to my Great-Grandfather's office and being told solemnly that the great man never purchased any securities other than common stock, and that I shouldn't either. To do otherwise was not merely stupid, it was a breach of faith. Deep in the consciousness of many generations of Americans is the optimistic exuberance of the early days of the Republic and its translation into the confidence that business will grow and that the value of ownership will increase accordingly. Buying common stock was buying America.

Common stock as a mode of investment was easy to understand - after all obligations of the corporation had been settled, what was left belonged to the common stock holders. Other securities, such as bonds or preferred stock, had characteristics that were specifically detailed in comprehensive writings; employees had such rights as were stipulated by contract; also, suppliers, customers and host communities had definable relationships to the corporation, that could be expressed in numbers. Because everybody else gets paid first, the shareholder occupies the unique position of being ultimately at risk. The leverage of ownership was very great. Thus, the rising tide that lifts all the boats, lifts the shareholder's most of all. To pursue the metaphor, in a falling tide, the shareholder is the most certain to drown.

The common stock holder is entitled to a pro rata share of all distributions made with respect to capital stock, the right to transfer his shares and the right to vote. Transferability of shares is a vital factor in making the corporation an attractive medium for investment. It allows capitalists to diversify the risk of investment among several ventures and to change their perception of risk freely. Through their power to vote for directors, owners have traditionally been considered to be the ultimate source of authority in corporation. Those whose money is at risk are deemed the appropriate possessors of power to control decisions on the direction of the enterprise. The common stock holder asserts his primacy through requiring that management loyally and competently run the venture so as to generate long term value enhancement. The courts were available to enforce the shareholder's entitlement to this bargain. So when the first Henry Ford wanted to sell his cars for below market value out of social concern, the courts would not permit it. Nor, until the most recent times, was management legally free to make charitable contributions. That there is theoretic capacity to require accountability is essential: "But the fact remains that the power, even if rarely exercised, and then only under extreme provocation, was there; and every once in a blue moon some resolute individual or stockholder could rise in his place and organize a protective committee or dissenting group - and, in

nothing else happened, at least there was a thorough ventilation of what sometimes proved to be a musty or unsafe tenement."¹

The traditional correlation between entitlement to receive the benefits from a venture and responsibility for its impact on society was most charmingly put the beginning of the century in the voice of a father advising his son in Main Street and Wall Street : "Now, Junior, before you go to college I want to give you my investment in the Boothbay Harbor Electric Light Company. This concern serves our old neighbors and friends, and I want you to feel a continuing interest in, and a responsibility for, our share in this local enterprise. If properly managed it should be a benefit to this community; and it will yield you an income to be applied to your education through the next few years. But you must never forget that you are partly responsible for this undertaking. Our family had a hand in starting it. that responsibility is an inseparable part of your ownership. I read something the other day, in an opinion by Justice Brandeis of the United States Supreme Court, which bears this out: ' There is no such thing to my mind... as an innocent stockholder. He may be innocent in fact, but socially he cannot be held innocent. he accepts the benefits of the system. It is his business and his obligation to see that those who represent him carry out a policy which is consistent with the public welfare.' He is right in that. This accountability for wealth underlies and justifies the whole institution of private property upon which the government of our great country is founded. "² There was a certain equilibrium in the traditional characteristics of common stock: investors could limit their risk of loss and enforce their entitlement to management's loyal and competent attention; management could secure the capital necessary for a successful enterprise; and society could be confident that what was good for business was good for the citizenry at large.

This remembered sense of balance accounts for the continuing interest in reiterating the myth of shareholder sovereignty, notwithstanding that it is apparent to all that such does not exist. The theory suited to such an extent that no one had real incentive to call it a lie. Shareholders have a vague sense that they ought to monitor companies in which they invest. Half a century ago, Graham and Dodd plainly stated "the choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being as in becoming a stockholder."³ Shareholders took sufficient comfort from the continual recitation that indeed they had the undoubted power to require accountability to continue inactivity. Also, it cost less. Managements have in fact been effectively accountable to no one, a phenomena abhorrent to a democratic society; the ability to rebut charges that they have too much power with the cliche of ownership sovereignty was a conveniently available defense. The government has not recently been anxious for a test of strength with the private sector - that it might well lose. That shareholders do not function as owners has been taken as justification for legally downgrading their "right" to primacy among corporate constituents.

It has long been noticed that through lack of exercise, shareholder power has indeed become flaccid. Berle and Means accurately put it over half a century ago: "[T]he owners of passive property, by surrendering control and responsibility over the active property, have surrendered the right that the corporation should be operated in their sole interest - they have released the community from the obligation to protect them to the full extent implied in the doctrine of strict property rights. "⁴ The theory was always clear, stock ownership like citizenship in a democracy remains intact only to the extent that it is effectively exercised. This is sometimes expressed by calling the modern shareholder, "shirking" or "laggard" and echoing Berle & Means in concluding that because shareholders have abandoned their legitimating role, they "deserve"⁵ diminished rights. So quick are analysts to denigrate shareholder status that they fail to appreciate the huge social cost of so doing. It has been little noted that the great short term beneficiary of his castigation has been the modern shareholder who now freely trades his security without the slightest reduction in value on account of the costs of any externalities - such as monitoring. The loser is society as a whole. Indeed, it loses twice, first in being host to corporate entities having a value system that encourages judgements based on the society as a whole, rather than the appropriate corporation, having to pay for the costs of externalities. There is no apparent way to those who profit from corporate operations fairly to share some to their bounty to pay for related social costs. This raises the question as to whether society ought to permit the continued existence of shareholders, with their characteristic of non- involvement or whether it should reimpose the notion of collective responsibility. In summary, with all the discussion of "shirking" shareholders and the according appropriateness of their diminished status, we have all been unwitting players in a gigantic "shell game" in which the "losing shareholders" have managed to foist off all manner of liability on to society as a whole. Is the monitoring of corporation functioning by owners a "right" to be discarded, if inconvenient, or is it a "responsibility" on whose discharge society will insist.

To the extent that managers could be demonstrated to be accountable to owners, there was diminished concern as to whether direct government supervision was necessary to insure the compatibility of corporate power and the public interest. There has long been concern in America that the incorporated venture on account of its size and its indefinite duration would overwhelm the interests of individual citizens. Adam Smith first comforted with the notion that individual pursuit of self interest would assure the collective interest through an "invisible hand". Louis Brandeis, in more modern times, has eloquently warned: ' The prevalence of the corporation in America has led men of this generation to act, at times, as if the privilege of doing business in corporate form were inherent in the citizen; and has led them to accept the evils attendant upon the free and unrestricted use of the corporate mechanism as if these evils were the inescapable price of civilized life, and, hence to be borne with resignation. Throughout the greater part of our history a different view prevailed. Although the value of this instrumentality in commerce and industry was fully recognized, incorporation for business was commonly denied long after it had been freely granted for religious, educational and charitable purposes. It was denied because of fear. Fear of encroachments upon the liberties and opportunities of the individual. Fear of the subjection of labor to capital. Fear of monopoly. Fear that the absorption of capital by corporations, and their perpetual life, might bring evils similar to those which attended mortmain. There was a sense of some insidious menace inherent in large aggregations of capital, particularly when held by corporations."⁶

Traditionally, common stock comprises three elements: entitlement to receive the residual value of the enterprise; authority to control its direction and, therefore, responsibility for its impact on society; and transferability. Although mythology persists, none of these components remains intact today. The process by which common stock has lost these traditional attributes began over half a century ago with the advent of virtually total liquidity in the trading markets.

Universal transferability critically changed the nature of the shareholders' relationship to the corporate structure. As an investor, the stockholder had to look to corporate performance for protection and enhancement of his investment; he had to consider the efficacy of capital investments; he was directly influenced by the way the corporation conducted itself and how society perceived it. In the absence of readily available "exit", the traditional shareholder used "voice". "... [T]he corporation with transferable shares converted the underlying long-term risk of a very large amount of capital into a short-term risk of a very large amount of capital into a short-term risk of small amounts of capital. Because marketable corporate shares were readily salable at prices quoted daily (or more often), their owners were not tied to the enterprise for the life of its capital equipment, but could pocket their gains or cut their losses whenever they judged it advisable. Marketable shares converted the proprietor's long-term risk to the investor's short-term risk..." (emphasis added)⁷ Two aspects of transferability must be emphasized: henceforth, the interests of shareholder and manager will not necessarily coincide; indeed, they are based on incompatible premises; and the American corporate system was initially based on the permanence of investor capital; while many profit from the current state of liquidity, ultimately, it may well be that we welcome the reintroduction of elements of stability in ownership.

The costs implicit in acting as an owner are far easier to justify in the case of a long term holder. It is virtually impossible to argue that extensive monitoring is cost-effective for investors whose profit is principally derived from buying and selling in the short term. The prospect of buying low and selling high is so beguiling that a lucrative industry of "active money management" has flourished notwithstanding the reality that institutional investors "are the market", and, therefore, cannot hope to beat its performance. Hope always exists for any particular institution that they can be the exception and can beat the averages. This hope, rather than any statistical evidence ("Investment management, as traditionally practiced, is based on a single basic belief: Professional investment managers can beat the market. That premise appears to be false, particularly for the very large institutions that manage most of the assets of most trusts, pension funds, and endowments, because their institutions have effectively become the market."⁸ ),accounts in part for the change in shareholder self perception from that of owner to that of speculator (or investor). Another component is short term self interest. Monitoring involves the commitment of resources; it is understandable that most institutions would be glad of an excuse not to do so. In the longer term, this has involved a high price for the business system as whole.

The capacity for shareholders to discharge what James WIllard Hurst has called "their legendary function" of monitoring has been substantially diluted. The first element of dilution arises out of the number of shareholders. When the number of shareholders must be counted in the hundreds of thousands - even the millions - it is virtually inconceivable that a single shareholder will be able to afford effective monitoring. Secondly, management, in arbitrating the inherent conflicts of interest in its relationship to shareholders, has an incentive to increase the number of holders so as to reduce the incentive of each to gather information and effectively monitor. Third, with the institutionalization of ownership, shareholding is now further subdivided between trustees, who are legally responsible, and beneficiaries who are financially interested. In these times of tax aided savings, beneficiaries often have no say in who will be their trustee. Let's consider the nature of the interest of a participant in a defined benefit pension plan's equity holdings, because this is, after all, the largest single class of ownership, comprising perhaps fifteen percent of the total outstanding equity.⁹ The participant really has no legally enforceable interest with respect to a particular holding of the plan; the plan's obligation to pay him a "defined benefit" is unconditional; whether or not the plan is funded or how the promise is collateralized is irrelevant to the underlying obligation to pay a specific amount. His only right is to require that the trustee act loyally and competently is his interest. The trustee, which itself may have all manner of conflicting relationships with the issuer of the security in question, bears little resemblance to the traditional "owner". He has no economic interest whatsoever in the quality of his voting decision, beyond avoiding liability. Because he is a trustee, he will earn no incentive compensation no matter how much energy and skill he devotes to ownership responsibilities. In addition to these problems of dilution, we will consider later in substantial detail the further inhibitions to shareholder activism arising out of the problems of "collective active" and "free riding", the pervasive problem of conflict of interest by institutional trustees, the legal obstacles imposed by the federal "proxy rules" and state law and state court acquiescence to management entrenchment.

Notwithstanding the apparent difficulties, it has been proven in recent times that shareholders can intervene effectively and can create value in so doing. The 1989 Honeywell proxy solicitation, in which ISS and a stockholder group distributed our own proxy material to successfully challenge two of the company's antitakeover proposals, was an historic achievement for several reasons:

• It was the first time that institutional shareholders defeated a corporation's antitakeover proposals without the presence of a controlling shareholder;

• It was the first time institutional shareholders joined forces with private investors for a proxy initiative; and

• It was the first time an institutional shareholder initiative helped achieve a substantial improvement in share value.

In short, the 1989 Honeywell solicitation demonstrates the value of strategic shareholder involvement in corporate governance.

We have set forth below a much condensed summary of the events leading up to the Honeywell proxy solicitation in 1989.

• Late 1980s Honeywell's poor performance was a source of concern to shareholders. A major restructuring announced in 1986, which helped to improve performance in the company's control division, but did not help improve performance in the defense division. In February 1987, restructuring costs resulted in the company's first loss, of $500 million. Honeywell's 1986 acquisition of the Sperry group from Unisys resulted in more major losses. Honeywell eventually sued Unisys for misrepresentation. Stock analysts, however, placed the blame with Honeywell, saying it had not studied the acquisition adequately. The company entered into fixedprice contracts with the Defense Department, and major cost overruns led to more losses. In late 1988, the company's chief financial officer resigned, shortly before the announcement of another $500 million fourth quarter loss. Throughout this period, Honeywell stock languished.

• Spring 1989 ISS learned that at Honeywell's upcoming annual meeting, the company intended to propose to eliminate the annual election of directors and to classify its board, and to eliminate shareholders' ability to act by written consent. We thought this an inappropriate response from a management team plagued with problems; it appeared to be an entrenching strategy, rather than a constructive response to its problems. Around the same time, ISS was contacted by Edward S. Lampert of North American Partners, L.P., owner of 4.4% of Honeywell common, and his colleague Richard Rainwater, former financial advisor to the Bass brothers. Lampert and Rainwater shared our views, and we agreed that some concentrated shareholder initiative might convince the company that its shareholders were dissatisfied, which would encourage the company to take positive steps to improve share value. A stockholder group was formed that included the California Public Employees' Retirement System and the Pennsylvania Public School Employees' Retirement System, as well as North American Partners and ISS. The group retained Georgeson & Co. as its proxy solicitor.

While our explicit purpose was to defeat the two proposals, we were much more interested in presenting to management hard evidence that the majority of its shareholders were unhappy with management's performance and expected something better; defeating the proposals would be the best evidence available.

• April 1989 The stockholder group notified Honeywell management of its concerns and expressed its desire to meet to discuss ways to improve share value. Management declined to pursue discussions, and the stockholder group filed its preliminary proxy material with the SEC.

• Thursday, April 27 We were informed that the SEC would clear our proxy material the next day, and Georgeson started its "search card calls." These were calls to stockbrokers, custodian banks and the Independent Election Corporation of America (IECA), to inform them that a countersolicitation was about to begin, and that they should notify their own clients. Since our proxy material had not yet been cleared, we were not allowed to indicate the subject matter of the solicitation, or to say who was behind it. Trading volume was high that day, but at the time nobody knew what was behind it.

• Friday, April 28 Our proxy material was cleared, and we immediately distributed our news release to the press, and, even more important, to the wire services. Within minutes, every analyst knew what we were doing. Trading volume in Honeywell was over 500,000 shares, double Honeywell's "normal" daily trading volume of 250,000 shares. Honeywell common closed that day at $72.50, up 2.3% from Thursday's close. Trading volume remained unusually heavy the next week, and Honeywell common continued to show abnormal price gains.

• Monday, May 1 to Friday, May 4 Principals from the stockholder group and Georgeson completed over 300 phone calls to major company stockholders, while Georgeson staff ensured that all of the group's proxies were properly executed and delivered on time. Trading volume was heavy all week.

• Friday, May 5 Lastminute votes were telefaxed to the Honeywell annual meeting. Too close to call, the announcement of the vote results on the antitakeover proposals were postponed for a week. After the meeting, the stockholder group repeated its invitation to discuss valueenhancing strategies with management.

• Friday, May 12 Honeywell announced that its proposals had been defeated. That day, Honeywell volume was nearly 700,000 shares, and Honeywell common rose $1.625, up over 2% from the day before.

• Monday, July 24 Honeywell announced a major corporate restructuring. Honeywell stock jumped $3.88 on volume of 1.9 million shares.

throughout the entire period, and perhaps Honeywell management would have announced its restructuring even without external pressure. But we believe our demonstration of shareholder concern and power played a substantial part in the gains realized.

The 1989 Honeywell initiative - like a landscape lit up by a burst of lightening - is an unforgettable tableau of corporate governance based on meaningful involvement by owners. Notwithstanding dilution and other obstacles, common stock owners can still in the last decade of the nineteenth century importantly impact the governance of "their" corporations.

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