Tomorrow's Corporation

The Aspen Institute

TOMORROW'S CORPORATION

CORPORATE CONSTITUENCIES AND STRUCTURE
SESSION V

Robert A. G. Monks July 22-25, 1993 Aspen, CO

What do U.S. share owners really want? What should be the roles of the different stakeholders such as employee owners and institutional investors? In what ways will ownership structures change? What tools will be available for motivating employees, managers, share owners, etc.? What will be the structure of tomorrow's corporation?

Before we ask what shareholders and stakeholders want from corporations, we should step back and ask what our society wants, or better yet, take two steps back and ask what our societies want. From that perspective, it is fairly clear. We want jobs that pay a decent wage and goods and services that meet our needs. We want challenges to our creativity and ingenuity, and when we meet those challenges, we want to feel proud of the results and we want to be rewarded. We want corporations to work with us to keep the work place and the environment healthy. We want a continual sense of progress and growth from our corporations. We want our interest in the company, whether as employee, customer, supplier, shareholder, or neighbor, to be designed for the long term.

Two connected sets of laws govern the relationships of these constituent groups to the corporation. One set is the rule of law imposed by the legislature. These vary tremendously from state to state and country to country, creating the famous "race to the bottom" competition between states in the US, who compete for corporate chartering business through increasingly diluted provisions for oversight. The state anti takeover laws enacted hastily to protect local companies from the prospect of a contest for control (sometimes, as in Massachusetts, signed by the governor in the headquarters of the company in question) are just one example. On a larger scale, American companies reincorporate offshore for tax reasons. The free trade agreements in Europe and (likely) Northern America are creating a "borderless world," where a company's domicile relates to nothing but its own convenience.

The second set of laws is the law of the marketplace. No matter where a company is located and what it produces, these laws affect, even determine, every decision made by its directors and officers. We would call this the law of economics, if we could use that term without then limiting ourselves to the narrow vocabulary and assumptions of that academic specialty. This set of laws reacts to and influences the first set. When a company changes its domicile for tax reasons, for example, that is a function of economics. Like a consumer selecting a car, the corporation's choice of domicile is based on an evaluation of the costs and benefits of all of the options. The same kind of evaluation applies to compliance with regulations governing occupational safety, environmental, and other standards, and with decisions about whether to invest in research and development or whether to update a local factory (or retrain local workers) versus reducing costs by moving the operation abroad.

As corporations operate -- and compete -- in virtually all parts of the world, we must develop some governing law. And the purpose of that law should be, whenever possible, to integrate the legislatively imposed standards with the realities of the marketplace so that all incentives promote the overall goals outlined above -- or at least so that they do not conflict with them. The law should be process-oriented, not substantive, and its focus should be the relationships between the corporation and its constituents, to reduce conflicts of interests (agency costs) and make sure that the right people are making the decisions (or at least are able to monitor the results of the decisions) that affect them most.

One of the problems that is presented by this task is finding some way to balance the need for long-term planning with the need for present-day assurances that whatever is planned for the long term is indeed likely to happen. Corporations must have as their primary and overriding goal the generation of long term value. A commitment to the satisfaction of employees, suppliers, customers, and the community is essential for achieving this goal. But calibrating that commitment to achieve maximum value in the long-term is a daunting task. No one can predict the future. In the last decade alone we have seen both new and long-established corporations achieve market dominance and extraordinary growth and vitality, only to fall into disaster, sometimes beyond recovery. How do we know that today's commitment to a long-term research and development project is going to produce a Mustang instead of an Edsel? More important, how can the rule of law best be designed to increase the likelihood that it will be the former instead of the latter?

At some point, any commitment to corporate constituents beyond that required by law and, indeed, any long-term strategy, will seem at odds with profit maximization. And there are so many opportunities for mistakes and even self-dealing that this is a crucial point for oversight and accountability. The key must be finding the right system of checks and balances. A board that will blithely okay paying for a $120 million art museum with the shareholders' money is one that is operating without such a system. A CEO who will spend $TK on developing an (ultimately disastrous) smokeless tobacco cigarette before informing his board is operating without such a system.

Corporations can give away money, voluntarily increase their workers' compensation over competitive levels, spoil their customers and act as benefactors in the communities where they function, all to the extent that these activities can be credibly related to increasing the long term value of the enterprise. To the extent that they drive up costs to make the company's products and services less competitive, they cannot be credibly related to profit maximization. The extent to which corporations can pursue objectives that are by definition not related to value generation must be severely limited, both as a matter of law and as a matter of economics. We give this level of authority to impact society to the government, which derives its legitimacy from its accountability through the political process. And when it does not earn that legitimacy, the citizens disregard the laws and create a new government. We therefore allow the legislature to make trade-offs. We have laws allowing a certain level of permissible emissions from factories, despite documented health risks and attendant costs, after determining that those costs are exceeded by the benefits of the factory's products and jobs (and contributions to the tax base). Another example of this is the requirement of German law that all materials involved in the production process be recycled. An American company, in the absence of a comparable law, would not act properly in taking up this practice, unless it .could be correlated with a reasonable prospect of enhancing value (which would seem difficult to do based on the early results of the German experience).

David Engel [32 Stanford Law Review 1, (1979)] argues persuasively that non-value driven corporate activity be limited to four areas: (i) compliance with law, whether or not so doing is cost effective; (ii) disclosure of information about the impact of corporate functioning on society (beyond the extent required by law); (iii) restraint in participating in the election and law making process; and (iv) acting, when failure to do so would permit the continuance of indisputably damaging conduct. As Milton Friedman said, the obligation of a corporation is to maximize profits within the constraints imposed by law. Corporations, therefore, should be structured so as to maximize their long term value as defined from time to time by the law of a governing jurisdiction having effective independent authority.

"One of the basic problems is that management has no way to judge by what criteria outside shareholders value and appraise performance -- the stock market is surely the least reliable judge or, at best, only one judge and one that is subject to so many other influences that it is practically impossible to disentangle what, of the stock market appraisal, reflects the company's performance and what reflects caprice, affects the whims of securities analysts, short-term fashions and the general level of the economy and of the market rather than the performance of a company itself" (private letter from Peter F. Drucker to Robert Monks, 6/17/93). Peter Drucker, along with former New York State Controller Ned Regan and others, has advocated periodic "business audits" by expert outside parties to provide perspective in evaluating a company's performance. My own view is that there is no such thing as "independence" in professionals. Under the immutable law of the marketplace, they belong inevitably to the person paying them (or, at least the person most likely to pay the largest bills in the intermediate run). Even if they are people of unexceptional integrity and insight, by the time they do the study and produce the report, it may be too late. "Performance measurement" must be a flexible and changing concept. What is suitable for one time or company is wrong for others. It is in the "creative tension" between the informed, involved and .empowered monitors -- the board of directors in the first instance and the owners ultimately that the corporation's performance can best be monitored on an on going basis.

Like performance measurement, corporate structure must be dynamic and easily adaptable to changing times, technologies, and demands. This is one of the most important requirements of the law of the marketplace, no less Darwinian than the law of the jungle. No one structure is right for all corporations, or even for any one corporation during different stages of its development, and the question of the appropriate structure must be constantly re-evaluated and fine-tuned. The very nature of legislatures based in a system of accountability is that they move slowly and carefully, and at the end of the process they produce what is at best a compromise and what is at worst the lowest common denominator. Furthermore, legislatures themselves operate outside the economic reality of the marketplace and cannot be expert in its demands and operations. They are hopelessly unsuited to second-guessing or imposing substantive requirements on corporations. All they can do is make sure that the system will encourage good changes and discourage bad ones, and get out of the way. But the very need for a dynamic structure makes these decisions vulnerable to abuse by those who have the power to make the decisions. The abuses by both raiders and managers during the takeover era were just one example. Therefore, the only unchanging component of corporate structure is that those exercising power over the enterprise must be accountable to some outside entity. This will only happen if there are meaningful incentives for owners, directors and officers to perform the tasks and discharge the responsibilities assigned to them.

This means that all corporate structures must ensure that those having power over the corporation must be accountable in a meaningful way to parties not under their control. These parties must be both informed and empowered to act.

By law and tradition, at least in theory, management is responsible to the owners. In practice, shareholders have not been able to discharge their traditional function of overseeing the managements to whom they have entrusted their money. While it is clearly in the interest of all shareholders that this function be performed, it is equally clearly diseconomic for any one shareholder actually to expend the time and money necessary. This "collective action" problem has resulted in the reality, commented on for the last half century, that the managers of large publicly held American corporations are ultimately accountable only to themselves. The results range from Fortune's cover story about "the Pharonic CEO" to outrageous CEO compensation to "CEOs for life" who continue to stay in office as their companies collapse.

An acceptable structure for the corporation of the future will minimize obstacles to collective action. But today, all too often, the laws of chartering states and the by-laws and charter of corporations themselves make it difficult, even impossible, for the shareholders, even if they can overcome "collective action," to enforce their oversight responsibility. There must be both a carrot and a stick -- meaningful incentive for those who are given important responsibilities and authority to act under the corporate structure.

How does that fit with our current capital structure? More than half of the "ownership" of the largest American companies is held by trustees of one kind or another. Any one of them holds many times the stock held by the largest individual investor. Consider the position of the trustee/shareholder. He is a fiduciary, acting under the strictest standard imposed by our legal system. By law, the trustee's compensation is limited to a fee; he is not allowed to structure incentive compensation based on performance. That standard ignores positive results, ignores marginal results, and punishes bad results. The law is draconian with respect to the liability of trustees for "imprudent" conduct. This trustee balance with no upside incentive and drastic penalty on the downside creates overwhelming aversion to risk. Why would a trustee take a chance, if he can do nothing without being legally exposed? These shareholders cannot do the job of monitoring unless they have both a carrot (some incentive compensation) and a stick (some liability if they fail to monitor when it would be cost-effective to do so). Monitoring must be seen as an investment choice like any other, with the burden of proof on those who do not wish to participate.

Shareholders have failed to perform their "legendary role of supervision." Directors have done little better. The board has plenary power to conduct the business of the corporation. But the directors are picked by the CEO. And the CEO usually serves as chairman of the board, so he controls the agenda and information. In almost every case, the directors are capable, honorable people, but they operate in a structure that impedes effective oversight. And, for the reasons described above, the shareholders are unable to provide effective oversight of the board. Their job in the United States is limited in time to a dozen day long meetings a year at most. They are paid a fee, and, while payment in company stock is increasingly popular as a mode of compensation, the amounts are relatively trivial. Absent some meaningful accountability through the electoral process, there seems no substitute for requiring a meaningful investment in companies by directors, meaningful in the context of the particular director's circumstances. Harvard Professor Robert B. Stobaugh suggests a level of five to ten times the director's annual compensation; others talk of a quarter of the director's net worth. Investment in the company is a far better way to ensure the focus, attention, and energy of the directors than any definition of "independence" or Trans Union style formal requirements for deliberation. Limiting shareholder monitoring to imposing such a requirement also makes their role more practical.

With just this minor change to the system, the odds that long-term planning will pay off profitably will be increased. But just as the corporation must itself adapt to changing times, the context in which it operates must be constantly re-evaluated and re-considered. We must question our assumptions, and ask, from time to time, not whether shareholders can or should do more, but whether the contract between contributors of capital and managers should be completely different.

United States shareholders currently enjoy an enviable amalgam of rights:

#1 - The right to enjoy the residual benefits of the enterprise (after all other claims are settled) for an indefinite period of time, including all distributions with respect to capital;

#2 - Liability limited to the amount of investment. Not only does this foreclose capital assessment, but it frees shareholders from any legally enforceable responsibility with respect to the portfolio company;

#3 - Free transferability; and

#4 - The exclusive franchise. Of all the affected constituencies, only shareholders have the right to vote with respect to the governance of the enterprise.

There are so many different categories of shareholders with differing characteristics that it makes sense to question the continued wisdom of automatically conferring the same bundle of rights on to all of them.

#1 - individuals

#2 - Trustees - private trusts
- private employee benefit plans
- public employee benefit plans

#3 - Insurance companies - state charter

#4 - Mutual Funds (1940 Act - federal regulation)

#5 - Foundations, Universities, Endowments.

Within each category, there are particular holders with differing propensities as to the appropriateness, extent and efficacy of "active" involvement in the governance of the venture.

Some "shareholders" are analogous to the holders of betting slips on a horse race. They have no interest in the underlying venture and view share ownership merely as an efficient way of gambling. The house take is small and performance seems free of being rigged. By contrast, there is an emerging class of "permanent owners." Institutions control assets that make up more than a majority of the total ownership. Meanwhile, the "real owner" - the pension plan participant or mutual fund investor or insurance plan customer, the person whose economic stake is ultimately at risk - has been filtered out of participation by various classes of trustee. It is these trustees, like pension fund fiduciaries and the money managers to whom they delegate authority, who have the legal authority and responsibility to exercise the franchise that is an intregal aspect of stock ownership. Trustees, who have come to be the majority owner of American industry, have no voting concern in common beyond the avoidance of risk.

The employee benefit plan trustees are - in the case of private plans - nominees of corporate management, In the public sphere, they are apt to be selected through the political process. Many of these trustees -- for political or economic reasons - invest through an "index", and will, therefore, never sell out of a particular equity unless the stock performs so disastrously that it is dropped from the index. If they are unhappy with a company's performance, their only alternative is active use of ownership rights. Yet the index funds, who by definition have virtually identical returns, can compete only by reducing fees. It is difficult for them to justify the expense of activism, when they get at best a pro rata share of any returns. The collective choice problem presents them with an almost insuperable barrier.

The risk/reward ratio of each class of shareholder is different. The private pension plans are "permanent owners" and, therefore, have no alternative but to become involved in the governance of portfolio companies; for individuals and mutual funds, liquidity is a compelling consideration and acting as "owner" could well involve unacceptable constraints; employees have a particular perspective in their role as owners. This brief analysis suggests the desirability of offering a variety of instruments to today's owners rather than treating demonstrably different interests as if they were the same.

In this context, we should consider why common stock should have the characteristics spelled out above. Was this the result of a reasoned process or is it simply the result of unchallenged evolution? Adolph Berle repeatedly suggested that shareholders, by their disinvolvement in the enterprise, had in effect abandoned their entitlement to have their ownership rights "protected" by the law. This theme has been picked up by other scholars, including Chayes, Kaysen, and Lodge. And there has been no real marketplace test of the viability of stock having less than the full panoply of powers enumerated above, though the controversies over the "one share, one vote" rule and the short-lived unsuccessful attempt at "unbundled stock units" suggests that at least some parts of the market place significant value on these rights. Would a time-limited right to certain of these rights be .marketable; would non-voting stock on a wide scale be feasible; would some buyers waive the limitations on liability to the extent of agreeing to commit some resources to active involvement in the venture?

There is significant evidence that the nature and value of an enterprise depends on the nature of its shareholders. Regardless of the mechanism involved, a corporation having informed and effectively involved owners is worth more than one without. Warren Buffett has been successful in persuading company managements to create new classes of security for his investment. These are usually convertible preferred stocks with a large dividend provision (i.e. American Express, Champion Paper, U.S. Air, Solomon Brothers, etc.). They are not publicly traded or otherwise available to existing shareholders. Of course, they represent a very expensive cost of capital (the preferred dividend being an after tax expense, in contrast to the pre-tax nature of interest paid on debentures) which would normally have the effect of depressing the price for the underlying equity. However, the "Buffet Effect" has been exactly the reverse and the market values companies in which he has taken a position at a significant premium. Buffet is simply collecting in advance a fee to compensate himself for the "free ride" that his involvement gives to all other shareholders.

Significant work, most recently published by the Gordon Group in January 1993 in an analysis of activist investing for the Public Employee Retirement System of California, suggests that share prices predictably are revalued upward by the market on the evidence of involvement by a credible activist investor. Because ownership involvement confers new and additional value to the enterprise, there is scope for subdividing equity investment between those who contribute to this increase and the rest.

The challenge then is to align different species of investors with attractive risk/reward alternatives for equity participation. Index funds and defined benefit plans have no need for liquidity and a fiduciary obligation to function in some way as "owner" of portfolio companies. Clearly, a category of "common stock" that rewarded their long term involvement would be attractive, as it would involve little more than a premium for their present -- .unpaid for -- posture. Individuals and mutual funds, with an ongoing need for liquidity, are in no position to make commitment to additional involvement.

A further challenge is to provide a realistic incentive for the majority holdings now held in trust to act as effective monitors. As noted above, the common law trustee, and particularly the ERISA trustee who must meet the standards of the common law and ERISA, is virtually the antithesis of an effective monitor. By its very structure, the trustee's position combines conflicting interest and endemic absence of economic incentive. Possibly, the mechanism provided under ERISA for fiduciary delegation to an "investment manager" provides a mechanism that could be used with a new subset of "ownership managers." In other words, fiduciaries would meet the requirements of prudence with respect to their ownership responsibilities by delegating to a special purpose organization. These "ownership managers "would be special and limited purpose fiduciary organizations who would be rewarded primarily as a function or their ability to increase market value of portfolio companies. (The existing ERISA statutory provision for "investment managers" may permit this already.)

It is possible that we will end up with a situation in which shareholders are given a choice of publicly traded securities with differing bundles of rights and obligations:

1. Some may elect (in the style recommended by Michael Porter in his 1992 report for the Council on Competitiveness) to give up some rights of liquidity and to commit the resources so as to be able to participate in the governance of the venture -- relationship investors. They will need to receive compensation, along the lines indicated by Warren Buffett's style of preferential stock;

2. Others may treat their ownership as the equivalent of betting slips, choosing liquidity and limited liability, and using traditional buy/sell as an investment strategy.

Trustees probably need more precise definition of the scope of their responsibility. It should be clarified that they are legally obligated to exercise ownership responsibilities:

- first, they should be required to demonstrate an absence of conflict of interest in exercising ownership functions;

- second, being risk averse, they should be provided with mechanism to delegate ownership responsibilities to new entities who have (i) economic incentive, and (ii) no conflicting interests;

- third, they need specific authorization to expend trust funds in aid of extra value through activism; and make decisions - needs to be addressed;

- fourth, the ERISA contradiction relating to employee ownership - i.e. employees must be protected, and, therefore, are disempowered from authority to make decisions - needs to be addressed.

Corporations may wish to experiment with limited term ownership (providing for reversion to the corporation itself, or to employees, or otherwise) certificates and ascertain whether this represents a cost effective source of capital.

RETURN TO PAPERS & SPEECHES LISTING

The Aspen Institute

TOMORROW'S CORPORATION

CORPORATE CONSTITUENCIES AND STRUCTURE SESSION V

CORPORATE CONSTITUENCIES AND STRUCTURE
SESSION V