As the number of institutional investors increased, some prophets said that these investors, moved by their stakes and informed by their expertise, would begin to play in earnest the supervisory roles of the legendary stockholder. But through the 1960's [equally true through the 1990's] the record showed little to bear out the prophecies. The size of their assets commanded respect when institutional investors sought information; by their probing they introduced some fresh surveillance into corporate affairs. Nonetheless, the institutional investors generally behaved as individuals did; like individuals, they expressed dissatisfaction with the government of a corporation by selling out rather than by voting their shares for new men or different decisions. On rare occasions institutional investors cast their weight for a change in top management; rarer was evidence of their influence brought to bear on particular issues of corporation policy.

- James Willard Hurst

Source: The Legitimacy of the Business Corporation in the Law of the United States, 1780-1970 , University of Virginia Press, Charlottesville, 1970, p. 87.

What is the optimal governance balance? How extensive and pervasive should ownership monitoring of management be? To bring the attention of the board to bear on corporate underperformance? To change the board of directors if they fail?

In our current system, it is fair to characterize the governance role of the shareholders as advisory. They can ask, but they cannot insist. Their ultimate authority is merely to sell the stock. If they stay invested and exercise their rights of share ownership by asking for change or supporting a shareholder resolution, management decides the degree to which it will comply. Even under the old rules restricting the ability of shareholders to communicate with each other, they were able to produce 40 percent and greater support for particular resolutions at Annual Meetings. One resolution calling for the company's poison pill to be either rescinded or put to a binding shareholder vote won a 64 percent vote last year at HartMarx Corp.; management ignored it, as they had ignored a majority vote the year before.

Shareholder resolutions must be couched in the language of SEC requirements. They must somehow be relevant enough to the company to be meaningful without being so relevant that they fall into the category of "ordinary business." Press and public attention amplify the impact, but shareholder votes are primarily symbolic. Increasingly, over the past six years, boards and managements have chosen to respond. Shareholders have been given a lot of the credit for the dramatic developments of the past few months, including the early departures of the CEOs at IBM, GM, American Express and Westinghouse.

Lawyer Ira Millstein, advisor to the outside directors of companies like General Motors and Westinghouse, very succinctly summarizes the current "best practice" of institutional shareholder involvement in governance: "[A]n institution could focus exclusively on the boards of 'underperformers.'" He explains that institutional investors can improve corporate performance within the existing structure of the corporate governance system -- and with a minimum of effort, information and expertise -- simply by focusing their governance efforts on the board of directors and its processes. "Where there is a 'problem' company, an institution can ask for meetings with the board, pose the problem, and determine whether the board is dealing with it or ignoring it. . . . In our system, if the shareholder satisfies itself that the board is knowledgeable, diligent, aware of the problems and attempting to deal with them, generally this should suffice."¹

If the directors don't know what to do or how to do it, Ira Millstein explains that institutions can always engage professional assistance: "If the institution was uncertain as to how to evaluate the board, and sought help, such help would surely be available."

Have we thus reached the optimal "creative tension?" Or do we need to go further? Should shareholders be able to exercise the practical power to change the board or even management in egregious situations? The current system does not give them this ability, because management controls the nominating process, proxy content and professional advisors, making the shareholders' theoretical legal rights all but moot.

New York State Controller Edward V. Regan is not so sure that the present state is satisfactory. "This leaves us then exactly where we started. Shareholders, directors and the public react only after the economic damage has been done, to the detriment of the company and the nation. It leaves us with the activist pension systems presumably without the ability (and maybe the will) to stand up and oppose a company whose performance is deteriorating (not deteriorated), to force that company to turn around by attempting to fire, in a public manner, a prestigious board of directors."²

This paper will argue that a true balance of power equilibrium is essential to both the political legitimacy and the economic competitiveness of large corporations. It will explain the limitations of the current mechanisms and suggest two specific structural innovations that will go far to bring governance to the desired level by creating "empowered shareholders." Finally, it will focus on what "empowered shareholders" should do --primarily assure a board of directors suitable in personnel and agenda.

I. LEVEL ONE -- SHAREHOLDERS AND MANAGEMENT

A. The separation of ownership and control

There will always be agency costs in any corporate structure in which someone other than management owns equity. Public companies will continue to have managers with agendas different from their owners; the governance challenge is to require that the resolution of conflicts is an open process between entities that are informed, motivated and empowered.

Discussion of corporate governance resembles the well known fable of the blind men and the elephant -- each observer seems to be fixated on one small part and no one understands the whole. Extensive discussion of the subtleties of the legal, economic and political languages of governance is beyond the scope of this paper, but we must begin with enough background to identify which battle is being fought, so that we can understand the nature of victory or defeat.

The legal mode approaches governance as if it were a static game with rules of convenience that bear only coincidental relationship with what actually transpires. There are a few core myths, the most important of which is that management power is legitimated by the involvement and consent of owners. The reality is to the contrary, as well stated by Melvin Eisenberg:

[U]nder current law and practice, shareholder consent to rules proposed by top management in publicly held corporations may be either nominal, tainted by a conflict of interest, coerced or impoverished. . . . Under prevailing conditions, however, the limits on the meaningfulness of shareholder consent are so substantial that allowing those rules to be determined or materially varied by top managers with shareholder approval often would be functionally equivalent to allowing those rules to be unilaterally determined or materially varied by top managers.³

Another myth insists that shareholders elect "independent" directors and directors choose the principal executives. The reality is management's total control over the company treasury, its professional advisors, the proxy process, the nominating process and the selection of directors. The presence of these "independents" is taken as equivalent to the actual selection and election of candidates by the shareholders -- a process that in reality has never existed. Despite the fact that it works backwards, with the directors chosen by the CEOs, some observers base a governance system entirely on the effective functioning of these directors. According to lawyer Martin Lipton, premier advisor to corporate management:

Therefore the corporate governance goals of most institutional investors will be met, it will not be necessary for institutions to develop monitoring capability, experiment with relationship investing, be directly represented on the board of directors or do any of the host of other things that have been proposed, if a company has put in place a system of governance that provides a truly independent board that regularly evaluates performance and acts promptly to deal with poor performance.⁴

Of course, this begs the question of where the "truly independent board" comes from, although it doesn't seem to be the shareholders. If not from the shareholders, where? From the CEO? From the other directors?

Ultimately, no system has credibility if its underlying precepts are self-evidently false. In this case, the illusion of meaningful oversight by independent boards of directors is just enough to keep the system credible, while the reality keeps it convenient for directors and managers. Lynne Dallas describes the way this is done:

Another way to avoid dependencies is to create the illusion that demands are being satisfied. The legal system is helpful in this regard. While shareholders have the right to elect directors, which presumably they want to do, no provision is made under state law for nominations. The election amounts to a vote on one set of nominees selected by management. The illusion is created that shareholders elect directors, which is far from reality.⁵

Neither law nor economics have been able to resolve these issues. Lawyers represent corporate management. They seldom represent shareholders (and those who purport to represent shareholders by bringing strike suit litigation define "representation" as settlements with high fees for the lawyers and microscopic awards for the shareholders). Individual lawyers and the bar as a whole seem more interested in the needs of paying clients than in evaluating the current system or offering thoughtful suggestions for improving it. The American Law Institute paper on corporate governance is one recent example.⁶

With legal representation so lop-sided, it is not surprising that the courts, particularly the Delaware courts, have sided with management. They have issued increasingly tortuously reasoned decisions, in cases like Unocal , Polaroid , and Time Warner to "justify" almost any act of corporate brutality as "business judgment." Whether or not "independent" directors, whom everyone knew were independent only in the minds of the law, were critical to a decision where conflict of interest was involved is hardly a rock on which to build a governance system; whether "independent" appraisals, which everyone knows are bought and paid for by the moving party, exist is hardly a credible substitute for fairness. Whether the leveraging of a company with massive new debt just falls short of assuring its certain insolvency doesn't seem to provide useful insight into the levels of care and loyalty required of fiduciaries.

Economists have not done any better. The notion of efficient market discipline ("Yet, monitoring by exiting is done by shareholders whose individual incentive to monitor effectively is rejected by the efficiency theorist."⁷) imposed by shareholders selling their stock and depressing prices leads to yet another fiction -- the cleansing hostile takeover. To the extent that takeovers did provide effective discipline during the 1980s, that discipline was all too easily thwarted by state antitakeover legislation (supported by management with the shareholders' money), by-law and charter amendments (including "poison pills," designed by Mr. Lipton, adopted by more than 1,000 companies without shareholder approval) and the end of the junk bond era.

We must remember that it is not as though anyone ever made a decision that companies would work better if we separated ownership and control. There was no conscious choice in favor of treating stock as though it was so many betting slips for races that were over at the end of each day. The wedge driven between ownership and control of American corporations was the all but incidental consequence of what we then thought of as progress, of the technological and procedural changes we made in order to meet the needs of a rapidly expanding economy. In order to make that economy work, and in order to keep it expanding, we placed a premium on liquidity. It was not until decades later that we began to understand that a system built around liquidity was inevitably going to be as short-sighted as a cat chasing its own tail.

Every "improvement" in the system for owning stock was designed to make it easier to trade. No one seemed to notice or care that each of these "improvements" also made it harder to exercise the ownership rights that had once been thought of as equal to the right to sell in the "invisible hand" that kept the marketplace operating efficiently.

The growing recognition that there was something wrong was an almost incidental consequence of the takeover era. Indeed, many people believe that the takeover era itself was a symptom of the problems created by the failure to link ownership and control. The abuses of shareholders by both managers and raiders made it clear that there was not enough accountability to shareholders, and that this lack of accountability was detrimental to the competitiveness and vitality of American companies. But the fact that the disconnect was inadvertent was irrelevant to one important fact -- it was convenient, even ideal, for those whom it most benefited. When efforts to reconnect ownership and control began in the mid-1980s, shareholders found that the very problem of their inability to act made it all but impossible to regain their ability to hold corporate management accountable, especially when corporate management had no interest in changing the system that was working very well from their perspective.

As some shareholders, particularly public pension funds, reacted by developing increasingly focused programs for responding to these abuses, the ineffectiveness of the system and the impenetrability of the obstacles to accountability became more clear. While shareholder initiatives gained increasing support over the past decade, that support only highlighted the limitations of the process. When empirical data links shareholder initiatives to increases in value in many cases, but shareholder resolutions receiving well over half the votes can be ignored without so much as a public statement (as was the case at HartMarx), it is clear that something more is necessary.

The industrialized (G7) world is already aware that a system of corporate governance establishing significant accountability makes more sense than management autocracy. It is almost axiomatic that a system tying actions to their consequences will not only benefit commercial competitiveness but will also aid in making sure that corporate activity is in the interests of society as a whole. But what does accountability mean? Accountability to whom? How will it be implemented, and by whom? In the words of the classic Aesop fable, we all agree that the cat should be belled, but who is going to do it?

As we examine the global markets, it is clear that tradition and culture play a significant role in answering that question. In Germany accountability is manifest in the role of the Hausbank which combines being the principal source of both equity and debt capital with having its officers serve on the Supervisory Board of the companies for whom the bank provides capital through investment and loans. The Bank is extremely knowledgeable about the affairs of the corporation. Bank executives understand that their own careers depend on the company's success and are therefore very focused on their monitoring responsibility.

In Japan there is interrelated ownership among the members of the Kereitsu. Suppliers, financiers, customers and employees all participate in a strong and perpetual sense of group responsibility. In both Japan and Germany, long-term focus is built into the system.

This mode of ownership -- known as "relationship investing" --contrasts sharply with the stereotype of the American shareholder who is depicted as an off-track bettor with no interest in his horse beyond the results of the daily race. "Betting slip" shareholding is not a promising base for responsible ownership. The combined status of ownership and commercial relationship gives particular investors a sufficiently significant stake in the venture to assure an effective presence.

"Relationship investors" become informed and interested partners insisting on competitiveness -- meaning long-term superior returns. The long-term perspective reflects the fact that their fate is inextricably linked with the enterprise in which they invest. Investors like pension funds are not just permanent investors, they are permanent consumers, employees, and neighbors, and that makes them permanent partners. A pension fund with a significant stake in the company has no interest in short-term cost cutting that increases pollution, reduces research and development to undermine future productivity or eliminates jobs. They will feel the adverse effects of "savings" like these in excess of any short-term benefits in dividends or share price appreciation.

Various constituencies, including members of the community, employees, suppliers, and customers, have interests that are broader than those of shareholders. A system of broadened accountability is necessary to assure that corporate interests are consistent with those of society at large. While the several connections -- ownership and business relationship -- in Japan and Germany create a bundle of complimentary interests, effective involvement ultimately depends on the motivation and competency of the shareholder.

A uniquely American solution is arising to corporate governance concerns, in which the existing system is made better by incremental improvements in how institutional investors behave, how corporations behave and how existing rules are used to forge new solutions between investors and corporations. . . . The variety of private solutions that are appearing is rich, varied, and vivid. . . . We are not opposed to vigorous attempts to market new, specific ideas to individual corporations and investors in the private market. Such an effort constitutes the essence of a process of market-based, evolutionary progress in corporate governance. Ideas that stand the test of the market, and indeed are adopted, will prosper, and we endorse the notion that at this critical time in the history of corporate governance, participants in the process should offer a wellspring of ideas to market participants to hasten change. In this way, most of the real changes in corporate governance will ultimately come not from policy -- which sets only the broadest and loosest restraints on the behavior of participants in the governance process -- but rather from the actions of forward-thinking investors and corporations who see the opportunity to "do the right thing."⁸

Growing dissatisfaction with the existing system in the United States has generated serious consideration as to whether, and how, "relationship investing" might improve our corporations. A beginning point and the subject of this paper is whether institutional investors, the owners of a majority interest in the largest American enterprises, can be effective "relationship investors."

B. The Way We Were

Company managements have enjoyed unique control over corporations in the United States for most of the twentieth century. Fortune magazine, in an article entitled "The King is Dead",⁹ summarized the three score and one years since the publication of Berle and Means' famous The Modern Corporation and Private Property :

The passing of generations had attenuated the power of founding families, the two Columbia University scholars noted, while the rise of the public corporation had spread ownership among tens of thousands of individual shareholders, none of whom could cast a meaningful vote in the governance of their companies. The result, Berle and Means showed, was a new class of professional managers who owned little of the corporation they nevertheless controlled. The merest whim of the imperial executive echoed like thunder down a valley. The CEO has to be careful, ran an old joke at General Electric; if he asks for a cup of coffee, somebody might run out and buy Brazil.

Until the most recent times there was little change. For decades, law professors and judges opined that the system worked because shareholders elected the directors and the directors chose the company's top officers. Somehow, with rare exceptions like Berle and Means and Edward J. Epstein, they never acknowledged that it was the corporate officers themselves who chose the directors. Management nominated candidates who ran unopposed, and management counted the votes. Management even saw the votes ahead of time, and did not hesitate to call and "persuade" shareholders who did not vote the way they wanted them to. Ownership was disparate, uninformed and ineffective. Economists coined an irresistible oxymoron to describe shareholder inactivity -- "rational ignorance." It was not "rational" for shareholders to become educated about corporate performance, much less to act on that education, because it cost more than it was worth to them as holders of tiny fractional interests. The law discourages institutional holdings of more than nominal percentages of large enterprises; no one wants to pay all of the costs of information and activism for only a pro rata share of the returns (if there are any); in any event, returns are unlikely because management has all of the advantages of the corporate treasury and access to its shareholders.

During the decade of the 1980s the faults in the governance system, primarily the conflicts of interest between incumbent boards and management and shareholders, were revealed in a series of headline-making battles. In 1990, for example, the top managers of Time, Inc. more than doubled their personal compensation (to say nothing of that of the late Steve Ross) by denying to their shareholders the opportunity even to consider an offer of $200 per share. Three years later, management is still promising that the wait will be worth it, but the shares still hover at values significantly below. In cases like this one, governance -- meaning an effective system of accountability to informed and involved owners -- is inextricably linked to value. In this case, the inability of the shareholders to monitor effectively cost them all a great deal of money.

It is important to emphasize that monitoring by shareholders does not mean micro-management by shareholders. What I mean by governance is oversight in those areas where managers, directors, and shareholders have conflicts of interest, including the election of directors, very general supervision of CEO pay and somewhat more focused supervision of director pay, and the overall structure and direction of the company. Shareholders are not there to appoint the CEO or second-guess his or her decisions. They are there to make sure that the directors perform those functions effectively and in their interests, and to replace them if they fail. We have made some progress with the first of these goals, but not much with the second.

Even the limited progress to this point has made a difference. This kind of accountability increases the marketplace's estimate of value in two ways: it lowers the cost of capital and it aids competitiveness. During 1992, shareholder and director pressures on management were met with enthusiasm by the market and reflected in increases in stock price. The directors of General Motors first limited the power of the CEO and then replaced him. The Sears board reversed its commitment to conglomeration and acceded to ownership pressure to divest some financial services divisions. They also brought in an outsider to run the troubled merchandising division (taking over from the CEO and Chairman of the company as a whole). Under his leadership, the division began to make some major restructuring decisions. The Westinghouse board also announced plans to divest its financial division, and pushed out the CEO. James Robinson of American Express was also pushed out by his board (with a little help from the shareholders, when he tried to stay on as Chairman). These fundamental changes in some of America's largest and most important companies were all influenced by shareholders and all produced immediate and significant increases in price.

Just a few years ago, calls from institutional shareholders were ignored or passed on to investor relations staff. But in a startling departure from past practices, CEOs not only return phone calls, but regularly meet with institutional investors and publicly acknowledge the value of ownership involvement. Governance changes (like confidential voting) are readily agreed to; sensitivity to correlating executive compensation to performance is acute; directors are held publicly responsible for poorly performing companies. This climate suggests that at least some portion of the benefits of owner activism are being realized. Yet the key to the credibility and legitimacy of this system, like any principal/agent relationship, is the ability to replace directors who do not perform.

In the United Kingdom, the Cadbury Committee on the Financial Aspects of Corporate Governance recently released its final report¹⁰. Their findings impress a foreigner as being the apotheosis of the first stage of governance, which I refer to as Level One. The realities of board self-perpetuation are no different in the United Kingdom than in this country. Yet the Report (Article 6.1) insists "The formal relationship between the shareholders and the board of directors is that the shareholders elect the directors . . . . Thus, the shareholders as owners of the company elect the directors to run the business on their behalf and hold them accountable for its progress. The issue for corporate governance is how to strengthen the accountability of boards of directors to shareholders."

The Report suggests (Article 6.5) that "[S]hareholders can make their views known to the boards of the companies in which they have invested by communicating with them directly and through their attendance at general meetings." United Kingdom shareholders are notably more articulate than their counterparts in the United States and spirited discussion is not unknown at Annual General Meetings. However, power remains in the management. Whether any response to shareholder questions is forthcoming is entirely up to the incumbents. And the Cadbury Report does not contemplate the transfer of real power to owners. Indeed, the Report specifically (Articles 6.2 & 6.3) declines to entertain the notion that "shareholders should be more closely involved in the appointment of directors and auditors through the formation of shareholders' committees." We would like to reiterate that the balance of governance resulting from the Cadbury Committee may well be entirely appropriate to the needs of companies in the United Kingdom. The discussion here is to provide perspective to alternatives in the United States, which has already begun to move beyond Level One.

II. LEVEL TWO -- FROM SHAREHOLDER RESOLUTIONS TO BOARDROOM DISCUSSIONS

In the winter of 1992-93 it seemed that leaders everywhere fell like dominoes. Even the Bush administration and the House of Windsor fell victim to incompetence and insensitivity. As the "imperial CEOs" fell from power, a new mythology of effective ownership by shareholders shared the headlines.

But these reports are still overly optimistic. To paraphrase Mark Twain, the news of shareholder success has been greatly exaggerated. Real shareholder victory consists not in toppling ineffective CEOs but in creating an environment of revitalization that makes these upheavals unnecessary. Some of the obstacles to strong performance may have been cleared away, but the real work still lies ahead.

Shareholders can now get the attention of management, and, perhaps even more important, of the board of directors. This is an astonishing step forward, and we must not forget the effort it took to get to this point. But is it enough? There are no agendas, structures or institutions to provide continuing context for shareholders to act as effective owners; institutional investors have not yet acquired the "focused energy" to assure management cooperation. How far in this direction should shareholders go? And is that far enough to solve the problem?

No one is suggesting that shareholders should second-guess corporate managers on "ordinary business" decisions. The contract between shareholders and the companies they invest in provides, in essence, that in exchange for limited liability shareholders will have a limited scope of authority and a limited agenda. Shareholders are not there to tell corporations how to run their business; they should be there, and they are beginning to be there, to tell corporations that they need to do better.

In the late 1980s, shareholders emerged like Rip van Winkle from decades of sleep as a group capable of value-creating activity. This reflects the culmination of several longer-term trends. Some are idiosyncratic to this particular time; others have evolved over decades. They include:

(1) Increasingly persuasive analyses and empirical data conclude that corporations with active and informed owners are more valuable than those without.

(a) The writings of Columbia Professor Bernard Black, among others, provide a thoroughly reasoned and documented argument for the efficacy of ownership involvement.¹¹ Former Treasury Corporate Finance Director Michael Jacobs forcefully argued in an influential 1991 book¹² that poor governance results in a higher cost of capital that in turn inhibits competitiveness.

(b) This same theme is reflected in Harvard Business School Professor Michael Porter's portion of the Council on Competitiveness report released in June 1992¹³. A similar conclusion, based on global analysis, was reached by consulting group Oxford Analytica in its Fall 1992 study of the G7 countries¹⁴. That report found that in order to compete for capital, corporations will have to give investors more of a role in governance.

(c) The Gordon Group's "Active Investing in the U.S. Equity Market: Past Performance and Future Prospects"¹⁵ provides the most persuasive analysis to date of the value to be realized from effective shareholder activism. The report exhaustively considers the massive traditional literature on the subject and considers several new approaches. It concludes: "[A] partnership catalyzing such activity [proxy initiatives, board candidacy] can expect to provide a return substantially above the baseline expected return on a passive equity investment." The report goes on to quantify this potential return as high as 30 percent in excess of the S&P.

(d) In early 1992, Wilshire Associates' Steve Nesbitt analyzed several years of CalPERS' shareholder initiatives and concluded that the effort was highly profitable to the system; a program costing $500,000 resulted in $137 million extraordinary (beyond the S&P 500) returns. Significantly, the initiatives did not have to be "successful" (meaning gain majority support) in order to produce those returns¹⁶. And the market saw other examples of the "returns" on activism. The stock of Sears, Roebuck went up eight percent on the day that the management acceded to shareholder pressure to stick to its core business and divest the financial services divisions.

(2) Widely publicized abuses in CEO pay exacerbated the perception of unsatisfactorily resolved conflicting interests between management and ownership. Pictures of the Bush visit to Tokyo in early 1992 with the automobile CEOs spoke more than a million words. Here were the self-proclaimed chieftains of free enterprise seeking political protection from their much less compensated -- and much more successful -- Japanese competitors. This was the first corporate governance issue to go from the business pages to the front pages to the editorial pages to the comic pages -- even "Doonesbury" got into the act. The issue was unignorable, to the extent that massive changes to the rules for disclosing executive pay were issued by the SEC, despite the overwhelming objections of the corporate community. Just as important, the momentum behind these rule changes fueled the passage of a major reform of the shareholder communications rules as well, changes which sharply reduce the costs and increase the benefits of shareholder activism.

(3) Effective ownership advocates -- the Council of Institutional Investors for the public pension plans and the United Shareholders Association for individuals -- showed fine strategic and tactical instincts and a great gift for public relations. The activist shareholders made few mistakes and effectively capitalized on the appetite of the press for "David fights Goliath" stories. The public plans enjoyed high quality leadership. They did not get bogged down in a "social agenda" or use the Annual Meeting to achieve what they couldn't win at the bargaining table, but instead focused in a disciplined and sustained effort on companies generally conceded to be underperforming.

(4) Democratic victory in the Presidential elections created a realistic prospect of government involvement in governance. The "benign neglect" and deregulatory spirit of the Reagan/Bush years was one reason for the Clinton election. Corporate management realized that if it did not move itself, the government would take care of it for them.

(5) We cannot ignore a more cynical explanation, related to the last point, which is that the business community has an interest in promoting the idea that shareholder successes are significant enough so that further changes by the government are not necessary.

The relationship between shareholders and management in a large public corporation is then one of formal cooptation. The purpose of formal cooptation is to provide a "front" or "aura of respectability" for the powerholder. This objective is obtained by providing participation by the coopted group in a governance structure, while limiting the ability of that group to exercise true power . . . . substantive power is not transferred to public shareholders . . . . That managers intended shareholder participation to provide legitimacy for the exercise of their power and not to confer real power is evidenced by the response of managers to tender offers. When large shareholders sought to exercise power through tender offers, managers responded with a vast array of defensive maneuvers. The use of these maneuvers has publicly exposed the enormous amount of power residing in corporate managers. They have tarnished the "aura of respectability" in which managerial power has been cloaked. This unveiling, in turn, has fueled efforts to find other bases of legitimacy for the exercise of managerial power.¹⁷

A less cynical view is that there are some other advantages for corporate managers and directors in being able to point to the risk of shareholder activism to justify changes in the structure or replacement of the CEO.

These are external changes. But the shareholders themselves changed as well. The Department of Labor's declaration that fiduciaries are legally obligated to vote their proxies (and, by inference, to exercise other share ownership rights) with the same "prudence" as they manage decisions to buy, sell or hold assets created a pressure felt well beyond its jurisdiction over ERISA assets. Trustees could no longer simply decline to act, just because it was expensive or inconvenient to do so.¹⁸

At the same time, the institutional investors themselves mushroomed. Even with widely diversified holdings, their stakes in particular companies were large enough for them to credibly argue that the expense of activism was compensated by an increase in the value of their holdings. One category of institutional investor -- the public employees' pension plans -- made its presence felt during the last decade with a large and increasing equity portfolio that had no commercial conflicts of interest in acting as a focused owner. Unlike other institutional investors -- the banks, insurance companies, mutual funds and even the great universities and foundations -- the public plans are little restricted by the threat of commercial reprisal from holding the management of client or potential client enterprises to strict accountability.

It is safe to say that shareholder activism would have made little progress without the California Public Employees' Retirement System (CalPERS) and a handful of other public pension funds.

There might be lots of noise and action, and there might be talk about all the new, awakened shareholders and institutional investors, but there's really not much more than a dozen public pension funds involved. And they call the tune. In fact if you took the CalPERS and the New York City pension fund and TIAA CREF out of the equation along with our fund and Wisconsin, Pennsylvania and to some extent Florida, you might have very little activism at all.¹⁹

Neither foundations, nor universities, insurance companies, banks, trust companies, nor the trustees of private pension plans have been able (or have been forced) to exercise their ownership responsibility in the face of conflict with their commercial interests. So, the public plans are the leading institutional activists by default; and among the public plans, CalPERS (with its supportive board, its committed staff and its fine leadership) has carried through a most effective program.

CalPERS' success is firmly based on a realistic assessment of the limits of its practical ability to force issues. "We have a strong predisposition to accommodation," CalPERS' CEO Dale Hanson explained, in a lecture to the Harvard Business School.²⁰ The political realities (both internally, in his relationship with his own board and his fiduciary obligation to plan participants, and externally, as a government agency reporting to the governor) placed a premium on compromise. The economic realities ("rational ignorance") may place an even larger premium on compromise.

And the overall system places a premium on compromise as well. Victory can only be lasting when the loser doesn't lose too much, when loss doesn't simultaneously generate the energy for the next war. This is the context of the current "shareholders' victory." Despite some strong rhetoric on occasion, CalPERS' "demands" are quite modest, and managements and boards are able to acquiesce without loss of real power. CalPERS does not ask for board seats, the removal of CEOs, or even specific strategic initiatives. It asks only to be met with, to be listened to, to get some commitment to meaningful accountability.

Mr. Hanson found that his "kinder, gentler" 1992 program of attempts to schedule informal discussions without the threat of shareholder resolutions was unsuccessful, and has returned to a program of submitting shareholder resolutions to selected companies that have underperformed over the long term. But these proposals are just a way to get in the door, and any meaningful willingness to compromise is enough to persuade CalPERS to withdraw them. Successful negotiations often result in the adoption of relatively non-controversial provisions allowing confidential voting of proxies, creating a nominating committee of independent outside directors, etc.

Ned Regan announced in February that his fund had selected an underperforming company to target with a shareholder initiative. His announced intention is to solicit shareholders to withhold votes for the reelection of the board at his target company, A&P. This initiative illustrates the essentially symbolic nature of the current state of shareholder activism. Even if the target was not controlled by a single 52 percent shareholder, as this one is, it is impossible, as a matter of law, to prevent the election of a management-sponsored candidate unless someone is running against him.²¹ What Mr. Regan can do is put the pressure of publicity on the board. The board may very well react (as did the boards of IBM, GM, Westinghouse, and American Express). As Mr. Regan said, "The point is to alert board members that a significant number of shareholders do not believe they are doing their job." Perhaps the shareholder movement's most significant contribution is to make the world an uncomfortable place for a director of an underperforming company. "Hanson is adamant that he does not seek to oust CEOs . . . . Also CalPERS insists it does not seek to name its own people to boards, although it does push hard for independent directors."²²

While I do not underestimate the value of this kind of initiative -- or its importance as a quantum leap forward -- we have to recognize that

(1) CalPERS, the New York State Common Retirement Fund, and their colleagues, as highly political entities neither can nor should be able to act more directly than this as the dominant owner of American industry. There are many factors limiting the public pension funds' ability to act. Public employee pension plans across the United States have different structures, but all are to some extent creatures of government and all have certain fundamental aspects in common. Federal tax policy subsidizes the growth of their assets; state taxes provide their periodic funding base; local legislatures determine the mode of selecting trustees, often mandating places for themselves and other elected officials. All, of course, are fiduciaries who must exercise "care, skill, prudence and diligence" in administering and investing plan assets, and who must do so for the "exclusive benefit" of plan participants. The Wisconsin Investment Board announced that it would urge other Paramount shareholders to join it in withholding votes for director candidates. The Wall Street Journal noted, "The effort by the pension fund, which owns 100,000 shares of Paramount's 118 million outstanding, is mainly designed to send a message to the movie and publishing company's management that it is unhappy with the company's stock performance, rather than to remove the four directors, since there are no alternate candidates for the board and the fund isn't putting up its own slate of directors."²³

The more dramatic the exercise of "control" by public plans, the greater the concerns about "back door socialism." These concerns about the prospect of government ownership and control of private enterprise were reflected in the legislation establishing the federal employees' pension system. Following testimony raising the specter of the politically-influenced exercise of ownership rights, Congress expressly prohibited the exercise of ownership responsibilities by current or former federal employees in the Federal Employees' Retirement Security Act of 1986.²⁴

(2) It would be all but impossible for any of the other current forms of institutional investors to go as far as this. Even if confidential voting becomes widespread, the commercial conflicts and structural limits present an insuperable barrier.

(3) The optimal balance of corporate governance may require more.

Progress toward this point has been evolutionary and almost completely linear. Each step has built on what has gone before and each has moved incrementally forward in a consistent direction. The shareholder movement that began with gadflies like the Gilbert brothers and Evelyn Davis and took something of a detour into social policy issues like doing business with South Africa became in the late 1980s a mechanism for involvement by large shareholders on issues relating to shareholder value. As the takeover era passed, the connection between shareholder initiatives and shareholder value strengthened, and the support for these initiatives broadened. The shareholder movement had exceeded the dreams of even some of its most enthusiastic participants.

We can call the present situation Level Two. This level of change has achieved its goal: shareholders have the attention of management, and, perhaps even more important, of the board. However, we have not yet arrived at "relationship investing." While in some cases, where the company is near disaster, shareholders have been able to develop a constructive "creative tension" between management and ownership, management still characterizes the situation as ad hoc and impermanent, as a nuisance instead of a resource, as a distraction instead of a permanent part of the system. We may have the beginning of a system that can act in case of crisis, but we have not come close to a system that can prevent crisis.

III. LEVEL THREE -- FROM HERE TO RELATIONSHIP INVESTING

Now, then, is the time for careful consideration of where we have come and where to go next. I do not believe that the movement will or even can continue the direction and pace of the past few years. The initiatives led by public pension funds like CalPERS have gone about as far as they can go. While this is an excellent place for them to reach a plateau, and there is much for them to do and contribute at this level, I believe there is still more that can and should be done, and that this can only be accomplished through a mechanism that differs in material ways from any of the current models.

One attempt is the new group financed by Harvard Law School. As described by the New York Times: "In an attempt to smooth the often contentious relationships between corporations and their shareholders, a group has been formed based at Harvard University, to create a road map for communication without confrontation. The group, called New Foundations, draws its members from the top ranks of American corporations, institutional investors and academia."²⁵ This reflects the perspective of convener John Pound, of Harvard's John F. Kennedy School. Professor Pound has suggested that the future CEO will be more like a politician than a monarch, building consensus from the different parts of the corporate constituency. In "The Rise of the Political Model of Corporate Governance and Corporate Control"²⁶ he removes consideration of governance from the static proscriptions of law and economics and cogently analyzes past development and future prospects from the dynamic perspective of the political process.

The correct way to view the political process of corporate oversight is the same. The expectation is not that the bare-bones power to vote the board of directors out of office is the nexus of the shareholder oversight process. Instead, the existence of this baseline voting entitlement allows shareholders to pursue a wide variety of less structured, ongoing monitoring tactics that do not revolve directly around the election of the board.

The problems of expanding institutional participation in governance are well known. A majority of the ownership of the major U.S. companies is held by trustees, who are by nature and by duty constrained to a sort of lowest common denominator of behavior. In a system where the beneficiaries do not know how they vote (or exercise other ownership rights) but the companies they invest in (and who have the power to impose commercial reprisals) do know, it is easier, safer, and therefore more "prudent" to go along.

That is one reason public pension plans have been ideal leaders for Level Two governance initiatives. They are large, long-term, virtually permanent holders in every possible kind of company and security. Their freedom from commercial conflicts of interest has made it possible for them to be visibly critical of poor management in a way that their counterparts in the private pension system cannot. The limitations imposed by political, financial, and legal restrictions, in combination with their own strong leadership, have kept their demands modest and their focus on value. They have laid the foundation for a stronger relationship between shareholders, managers, and directors. But like Moses, they may be able to see the promised land but not be able to enter it.

The very limits which have established the credibility of this movement, by requiring its development to be slow and incremental, themselves pose a barrier to its further advancement. The system of governance will have no real meaning unless shareholders can lead and sustain a governance initiative in the face of resistance by corporate management. But neither the legislative nor the political mandate of the public plans is likely to permit this level of activism.

The trustees of a public plan would find it all but impossible to sustain opposition to the management of a large local employer, for example. Wisconsin Investment Board officials recount that during the late 1980s their filing of a critical shareholder resolution for consideration at the Annual Meeting of a prominent automobile company was followed by a visit from the company CEO with the Governor of the State to suggest that plants under consideration for that state might be at risk. The resolution was withdrawn and the pension fund executive took another job --and not at a state pension fund. When another state pension fiduciary voted against incumbent management (along with a majority of the other shareholders) in a proxy contest, front page stories in the local press accused him of selling his vote on the basis of campaign contributions.

CalPERS, on the other hand, did support the dissident slate at Lockheed, a local company with much political support, at least until management agreed to some governance concessions. But not even CalPERS can undertake and sustain a shareholder initiative beyond a precatory shareholder resolution.

It is interesting to note that while CalPERS had an early and visible role in raising issues of concern with James Robinson of American Express, the institutional shareholders who pushed him to leave the company, after he was able to overturn the board of directors on that point, were not the public pension plans but the white-shoe Wall Street funds like Alliance Capital and J.P. Morgan. Two very different kinds of shareholders played two very different kinds of roles, each one the other could not play. CalPERS could play a public role in identifying the problems, but could not follow through with something as specific and even radical as insisting that the CEO step down. CalPERS' equity portfolio is almost entirely indexed. They in essence replicate the market. Their investment is not based on any particularized knowledge about the individual companies. If they select a target, based on poor performance, they must then invest the time and resources in trying to understand the company and its problems. As they speak with any CEO about their holdings in the company he heads, they understand that they own all of his competitors, suppliers, corporate customers, potential takeover targets or acquirers. They also hold other securities issued by the company, bonds, derivatives, etc. Even if they could become sufficiently informed about their holdings to make recommendations about strategic issues (assuming they could do so without violating insider trading restrictions, triggering concerns about "pension fund socialism" or exceeding the limits of the legitimate shareholder agenda), they would be limited by the inherent conflicts of their holdings. Public pension plans can be visible, but they cannot be very specific. For this reason, they focus on issues of process -- confidential voting, annual election of directors, the independence of the directors on key committees, for example. They are also particularly well constructed to take a leadership role in the efforts to develop better sources for finding independent directors. CalPERS' work with the Business Roundtable and Directorship on a survey of directors is an important step in the right direction. The BRT is also working with the Council of Institutional Investors on developing resources to find directors. One initiative may someday replicate the successful ProNED firm in Great Britain, funded by institutional investors, which acts as a clearinghouse and headhunter to find good director candidates.

The Wall Street firms are on the other end of the spectrum. They are stock-pickers. They buy into the company because of what they know about it, not because it happens to be on the index. Their "investment" in learning about the company is made already; it's a sunk cost. These institutional investors could not make public statements or file shareholder resolutions, but they were willing and able to meet with the new CEO of American Express to insist that James Robinson must leave. The latest rumor is that they are involved in the CEO search at IBM as well. This will increasingly be the pattern. After all, these same firms are very used to negotiating what are in essence governance issues on the bond side of the business. As governance is more unignorably translated into value, this will become a part of the equity side as well.

The third level I envision can work more effectively than either the public funds or the Wall Street funds. Importantly, however, it cannot work without their support. As many of the raiders of the 1980s learned, shareholders will support management unless there is a very compelling case to do otherwise. An early venture into this arena was my effort to create change at Sears, first through attempted election to the Board of Directors in 1991 and then through support of shareholder resolutions in 1992. CalPERS' consistent, courageous, and public endorsement gave our initiative credibility. The support of other investors (reaching more than 40 percent on two of the shareholder resolutions) sent a powerful message to the directors, who adopted some of the initiatives after the meeting. I think it is fair to say that these efforts contributed significantly to the Sears' Board's September 1992 decision to restructure and the whole series of steps -- most recently the public sale of Dean Witter stock on an oversubscribed basis -- that have created such dramatic value increases for shareholders.

Again, this was a case where synergy was created between entities that made different contributions. CalPERS' executives and trustees are not in a position themselves to run as board candidates, with the level of public scrutiny, the lawsuits, and the expense that goes with it. It is all but unthinkable that a fiduciary organization would be able to spend the $100,000 it cost us to publish the full page ad (see Appendix C) in the Wall Street Journal that many observers credit with finally getting the full attention of the Board of Directors. But the size of their holdings and their reputation were indispensable in getting my initiative the attention and support I needed. And the quiet support of the other institutions (which was more than twice the level predicted in the trade press) made the difference between a gadfly and a legitimate representative of the owners.

As this example shows, Level Two cannot proceed further without the involvement of other categories of institutional investor. Their collective ownership is large enough to mitigate significantly the "free rider" problem. "It's too early to prove the value of relationship investing conclusively, but the evidence looks favorable. Investor-inspired revampings have sent the stocks of many companies climbing, suggesting that the market believes long-term prospects have been enhanced. The shares of Avon, Kodak, Sears, and Lockheed, for example, have soared."²⁷ But the "carrot" of increased shareholder value is not enough to make it happen, in a world where the collective choice problem and political and economic reprisals present overwhelming obstacles.

There will be no change without a "stick"; the regulatory agencies (DOL, SEC, bank regulatory agencies and state agencies) must take the initiative to enforce the fiduciary obligation of trustees to their beneficiaries. If fiduciaries are genuinely "required" to vote independently, and to justify or even disclose their votes, the obstacles to effective exercise of ownership rights will be sharply reduced. For example, the Department of Labor, which has authority over ERISA funds, could require private plan trustees to demonstrate affirmatively that they have acted "for the exclusive benefit of plan participants" in their voting and governance actions. Once a fiduciary standard is created and rigorously enforced for one category of fiduciary --and the private plans are the largest single category of institutional owner -- there is momentum to extending the same duty to other categories like mutual funds, banks and insurance companies.

But as a practical matter, even an enforceable legal mandate can only result in meaningful compliance if the plan sponsor corporations view involvement as being in their self-interest (the "carrot"). And they will view it that way if they recognize that leaving the entire responsibility for governance to the public pension plans assures that the perspective of other institutions will not be expressed. Banks (as in Germany) and insurance companies (as in Great Britain) have experience and knowledge valuable to an optimal governance program. Are the trustees of the private pension system subject to ERISA behaving prudently? ERISA's one substantive requirement is diversification. Are they failing to diversify by putting all of their equity investments with managers who ignore ownership rights? Are they prudent in allowing -- by default -- the public plans to define the ownership agenda?

Ultimately, the failure of ERISA plans to participate in governance may become intolerable as a matter of macro-economics, politics, and, most important, money. Evidence of the investment value of activism might support charges of trustee negligence in declining at least to support activism, if not to initiate it. The long-tolerated blatant conflict of interest involved in allowing plan sponsor corporations exclusive power to name their own trustees may no longer be politically tolerated if the conflict continues to be resolved contrary to beneficiaries' interest.²⁸ But, until then, major corporations (including those where the 1992 shareholder "victories" occurred) will continue to leave the leadership role to CalPERS. Shareholder involvement is still an anomaly.

The Economist sums up what the new models should be able to accomplish:

So everything now depends on financial institutions pressing even harder for reforms to make boards of directors behave more like overseers, and less like the chief executives' collection of puppets. . . . Financial institutions must also fight to restore their rights as shareholders, lobbying for the dismantling of state takeover restrictions which have provided no protection to workers, only to top managers. Institutions should also demand that shareholder democracy be allowed to operate . . . . But there is more to be done. In the age of the computer, access to shareholder lists should be cheap and simple, not jealously guarded by the boss; that would make it easier to solicit support from other shareholders. Institutions would then be able to use their clout in big firms to elect directors, who would be obliged to represent only their collective interest as owners. Chief executives would still run their firms; but, like any other employee, they would also have a boss. And when they failed at their jobs, they would face the sack.²⁹

Structures created to accommodate the intrinsic weakness of public pension plans necessarily reflect the limitations of those plans -- incapacity to initiate and carry through to success a program for "problem companies" beyond ad hoc use of publicity and non-binding shareholder resolutions or "withhold votes" in a small number of cases. Even if they could hire lawyers, as Ira Millstein suggests, even if they could hire those as truly gifted as Ira Millstein himself, it would not be an acceptable substitute for workable overall structure.

Lou Lowenstein, Marty Lipton, Mel Eisenberg and others have said that the only solution is genuine shareholder choice of directors, and John Pound says it is that right which makes the exercise of lesser rights effective. In theory this is what the system is already set up to provide, but making the theory into reality is quite a challenge. In a footnote, Mr. Millstein suggests that "Shareholders should be able to at least informally suggest candidates to the board's nominating committee, and boards should listen."³⁰ But it takes money to hire consultants to evaluate the directors or generate candidates, and Mr.Millstein does not explain how these shareholders are going to develop the resources to overcome the collective choice problem (or the administrative problems stemming from governance of the shareholder initiatives themselves) to make this possible. And what if the boards decide not to "listen," then what?

Another thoughtful approach is included in the recent "Report of the Twentieth Century Fund Task Force on Market Speculation and Corporate Governance", allowing "free access to the management proxy statement for full-fledged proxy contests by groups owning as little as three percent of the shares."³¹ The Task Force found that "it would be valuable to reserve seats on boards of directors for directors who are nominated as elected representatives of sophisticated shareholders and to enable such shareholders easier access to each other."³²

IV. NEW STRUCTURES

For many years, it has been recognized that corporate governance would never develop along the needed lines until appropriate structures evolved. Harvard Law Professor Abram Chayes said in 1960:

Institutional arrangements which -- like the party system -- could make it possible for many scattered individuals to concert their suffrages on issues sufficiently defined to warrant meaningful conclusions about an expression of their will, these institutions are absent in the relation of the shareholder to his corporation.³³

In this, he echoed Carl Kaysen: "The development of mechanisms, which will change the internal organization of the corporation, and define more closely and represent more presently the interests to which corporate management should respond and the goals toward which they should strive is yet to begin, if it is to come at all."³⁴

If shareholders are no longer able to ignore the obligation and the benefits of meaningful monitoring, inescapable obstacles will continue to prevent all but the most reactive and modest initiatives. I can think of two new structures which can be designed to bridge the gap between the level of activism that is optimal for individual shareholders (even large ones) and that which is optimal for maximum corporate performance. One involves the corporation's adopting by-laws which enable long-term shareholders to monitor the overall direction of the enterprise, "rational involvement" instead of "rational ignorance." The other involves the creation of an investment vehicle specifically created for the sole purpose of monitoring "focus companies." Because owners profit from the existence of an effective governance system, they should be motivated as a class to take appropriate steps to assure that such a system, in fact, is in place.³⁵

This is the theme underlying a by-law amendment I proposed for the 1992 Exxon and the 1993 Eastman Kodak Annual Meetings.³⁶ The by-law provides a structure pursuant to which long-term substantial shareholders are able to inform themselves "rationally" (that is, without bearing disproportionate cost or risk) and to propose solutions to value-inhibiting problems. It creates, admittedly in an arbitrary fashion, a class of so-called "long-term shareholders" (for this purpose, defined as those holding a minimum level -- $5 million -- of common shares for a minimum holding period -- three years). These criteria can be altered as appropriate. What is clear is that certain levels of investment maintained for a particular minimum holding period classify the holder as "owner" in contrast to speculator, short-term holder or even "hostile takeover" prospect. These long-term shareholders are empowered to nominate candidates for a special committee, for approval by all shareholders.

The committee members are compensated at one-half the level of company directors and have a budget of one cent per share to engage professionals to aid in their task of monitoring the board of directors. Finally, the committee has access to the company proxy statement for a brief statement of its findings and recommendations. Probably, the by-law should contain a further provision limiting its being invoked to, say, once every three years. The objective is to allow ownership to be effectively exercised when it is necessary. This does not mean that shareholders will start acting as another board of directors or as officers. It is essential to avoid the creation of yet another self-perpetuating body with predictably diminishing energy and focus: a new bureaucracy to monitor an old bureaucracy. The limits to the agenda for this kind of monitoring are set forth in greater detail below in Section V.

Arising out of different legal and social traditions, the public company law in Germany recognizes the need for an intermediary organization between ownership and management. "Owners" (defined under German law as stockholders and "works councils") elect directly members of the Supervisory Board, which in turn selects the Managing Board and the CEO. The statutory definition of responsibilities of the Supervisory Board (see Appendix D) closely resembles the "monitoring" function contemplated by activist shareholders in the United States. "Influence on management, its decisions, its appointment and dismissal is not exercised directly by the shareholders but by the supervisory board. Therefore, seats on the supervisory board are crucial for every shareholder or institution that wants to have a say in corporate governance, obtain relevant information, etc. . . . As to the rights and powers of the supervisory board and its members . . . . It has to monitor the management."³⁷

The second new structure is a partnership organized for the purpose of capturing the profits available due to inefficiencies in the market place relating to governance. It is what Michael Porter described when he recommended that institutional investors increase the size of their stakes and create special funds to test these new (governance-based) investment approaches.

There are companies that perform poorly and are badly governed. LENS "focuses" on these companies, invests, negotiates and effects change. It is the agent of turnaround in the post-takeover era. It can act before the company is at the brink of disaster. The partnership's funding is provided by institutional investors with indexed or broadly-diversified equity holdings; and its general partners are compensated only to the extent that they "turnaround" focus companies sufficiently to outperform market indices.

It is increasingly clear that large and regulated institutional investors may be best able to enhance governance through the creation and funding of new entities specially created as effective monitors. Over the last fifteen years since the creation of "index funds," the mode of equity investment by large institutional investors has increasingly become "passive." Instead of buying stock in companies that they think is going to go up and selling stock in companies that they think is going to go down, investors simply buy into a portfolio that replicates the market as a whole, knowing that the likelihood is that the market as a whole will go up (and reflecting empirical data that "active" management has seldom outperformed the market, over time). Indexation has become so popular that it has changed both the way that the market responds to new developments and the way in which trustees view their ownership responsibilities. If a trustee has given up the opportunity to make money (or to send a message to management) by selling the shares, exercising ownership rights is the last chance he has left. He can do nothing and watch an underperforming company sink lower and lower in the index, or he can do something to try to make it do better.

This opportunity to earn profit through the effective exercise of governance is what motivated my partners and me to form the LENS fund in 1992. LENS is a partnership that takes positions in "focus companies," which it identifies in a disciplined manner using criteria developed with Batterymarch, among others. LENS principals, including former Lazard partner Robert Holmes, governance expert Nell Minow, and myself, communicate with management in an effort to encourage changes that create value. Partnership "profit" depends entirely on the focus companies performing better than an agreed-upon index -- say the S&P 500. LENS provides a way for indexed investors to achieve diversification from their passive mode through the addition of an "activist" capability.

LENS creates a structure to enable shareholders to realize what was previously available only to others in hostile takeovers. It provides "rational activism," a capability for shareholders to propose value-enhancing change to the management of "focus companies." This is accomplished through alignment of the interests of owners and managers. "More than any other factor, these organizations' resolution of the owner-manager conflict explains how they can motivate the same people, managing the same resources, to perform so much more effectively under private ownership than in the publicly held corporate form."³⁸ This "non-takeover takeover" is designed to capture those values that during the 1980s were the object of hostile takeovers. They are the intrinsic values in a corporation that have been artificially depressed by management's failure to focus on their primary obligation of long-term value enhancement for owners. A motivated shareholder with a large shareholding is in a position to direct attention to those areas where manager and owner attitudes are not aligned, including:

o Compensation

o Dividends

o Retention of Assets in the Business

o Conglomeration

With the resources and credibility of substantial holding and diligent inquiry, LENS will be able to communicate effectively with other similarly placed shareholders, and, if necessary, to secure approval for formal ownership action.

LENS is itself designed to minimize agency costs for its own investors. The General Partner of LENS receives a fee only to the extent that value is added to portfolio companies. This incentive fee arrangement is not legally available for trustees themselves. And the LENS' principals have no affiliations with other commercial enterprises (thus, eliminating conflicting interests).

V. AGENDA

Once the structure has been created, what is the agenda? Empowered shareholders should focus on the board of directors --its composition and its agenda. The job of effectively involved shareholders can be simply described as assuring that the board of directors does its job. This means making sure that the right people are on the board, that they are focusing on the right issues, and that they operate under a structure that enables them to ask the right questions and reach the right answers. This is the answer to the agency cost issue, the most effective way for the ownership to exercise the appropriate level of control.

Whether it is the Exxon Committee or a LENS-like special purpose monitoring organization, ownership needs to assert and exercise control over the selection and ordering of priorities of the board.³⁹

Rational apathy, the typical shareholder's attitude toward corporate governance, will not undermine shareholder committees. First, the committees need not participate in directing the company, they will only nominate directors to do the job. The mere fact that the directors will know that they have been chosen by investors should make them more responsive to shareholder concerns. Second, the committee should have access to corporate resources to obtain and generate information it needs; individual members need not spend much of their own money. Third, where individual expenses are incurred, they will be justified by investors' large holdings in the company and the utility of the expenses in performing the usual portfolio management functions. There are signs that institutions are willing to perform these tasks.⁴⁰

Director "independence" is easy to ask for, but hard to define. Yet it is really the key to the whole system. If the directors are not independent enough to represent the interests of the shareholders, the whole system of accepting capital from one group to finance the operations of another will fail.

While much of the focus on directors centers on whether they have economic or personal ties to the company or the CEO, it is clear that independence is ultimately a question of individual integrity. There are some brothers capable of independence in evaluation of their siblings; there are strangers whose desire to please is so great that they will follow the most improbable leaders. But beyond the quality of the individual directors, the truth is that the culture of the boardroom makes genuine independence difficult. The structural obstacles and social inhibitions to director independence from the CEO are described in detail by the directors surveyed by Harvard Professor Jay Lorsch in his book Pawns or Potentates . As long as the directors are selected by the CEO (who also sets their pay), as long as the quality, quantity, and timing of information are controlled by the CEO, as long as all meetings of the directors are in the presence of the CEO, it is difficult for even the most independent personality to act as anything more than an audience for the CEO's production.

In connection with my proxy contest for one board seat at Sears, Roebuck in 1991, I wrote a piece for the New York Times in which I described the product of the prevailing system of directoral self-perpetuation as being an "oxymoron in the board room."⁴¹ (See Appendix E.) We learned from case studies like Barbarians at the Gate that even directors who appear to be utterly captive can eventually wake up and do the right thing, despite management's efforts to the contrary. The problem is in getting them to wake up earlier. While many people have the personal integrity and judgment to overcome the "dance with the one who brought you" mentality, it seems more sensible as a system to empower the owners with the direct authority to chose those to whom much of their power is, by law, delegated. Possibly the best assurance of independence can be achieved by having board members selected by some group that is not part of the incumbent management. The increasing shareholder focus on independent nominating committees is part of the solution. At Sears, for example, until my proxy contest the Chairman and CEO was also a member of the nominating committee (as well as trustee of the 25 percent of the stock held by the employee stock plan and CEO of the company's largest division).

Who can be the ideal corporate directors? Those familiar with history often point to Pierre S. DuPont,⁴² who served on the board of General Motors at the same time as he was CEO of his family company.⁴³ His involvement in the dismissal of the CEO of General Motors was considered a model of corporate statesmanship. In more recent days, the service of Warren Buffett, CEO of Berkshire Hathaway, brought in to rescue Salomon Brothers, is another example. Michael Jensen welcomes the focused energy of the LBO firm principals on boards of companies in which they invest.⁴⁴ Like DuPont and Buffett, these people are effective advocates for the interests of owners because they themselves are substantially invested in the company.

Yet this same calculus does not apply to institutional investors. The conventional wisdom is that conflicting interests make it not legally permissible for public employee plan trustees or executives to serve on the boards of portfolio companies. Why, one might ask, is Dale Hanson's conflict of interest in serving as a Director of General Motors any more compelling than that of Pierre DuPont? While Mr. Hanson has a fiduciary obligation to the participants and beneficiaries of the California Public Employee Pension plans, so did Mr. DuPont to the shareholders of the DuPont company. Don't Mr. Hanson and Mr. DuPont both have motivation to increase the long-term value of a company in which they are directors? How is this conflicting with the interests of the beneficiaries of their primary fiduciary responsibilities?⁴⁵

Clearly, we need directors who have more than token commitment to their service. The current pattern of "rent-a-name" board service with directors like Henry Kissinger, Alexander Haig, Beverly Sills, and Gerald Ford, with Vernon Jordan serving on 12 boards (in addition to his law firm partnership and position as head of the Clinton transition team), with Frank Carlucci serving on 20 (but, according to Business Week , ready to quit Westinghouse at the first call from an unhappy shareholder) --cannot be the best way to fill the boardroom. Mr. Lipton and Mr.Lorsch recommend that a director serve on no more than three boards. They, and others, like Delaware Chancellor William Allen are recommending smaller, more independent, more focused, and more active boards. But in order for this to happen, we may need legislative (and, possibly, judicial) aid to assure that those who have the largest interest in board quality should not be prevented from, themselves, helping to cure it.

There is no universally applicable formula for the optimal background, skills, or functioning of directors. Different companies will need different energy at different times, and the same company will benefit from focus on different areas at different stages. But there will always be a need for "outside" energy and perspective, particularly in the context of the system in the United States, where the CEO so often is also Chairman of the Board of Directors and therefore controls the agenda and the access to information. Ultimately, responsibility for providing this resource lies in the shareholder/owners. My suggestions for a shareholder committee at Exxon (see Appendix F) and the formation of a special purpose fund through LENS are attempts to provide the structure for the efficient focus of monitoring by owners.

The study by Oxford Analytica provides a useful survey of the generally weak nature of board structure and functioning and describes (in the portion of the quote that is underlined) the characteristics necessary for success.

Given the very limited role of most boards in actually determining the direction of their companies, their ability to oversee management; direction to call it to account for its actions -- preferably before a crisis point is reached -- is a critical element of effective governance. Oversight is also linked to the board's representative function, in so far as the former is far easier to exercise when the board includes a number of outside directors who are backed by major shareholders or other powerful stakeholders . As noted above, however, the presence of powerful stakeholders or their representatives on the board raises conflict of interest problems.

Nevertheless, it is precisely the power and expertise behind many board members which has enabled German supervisory boards to operate as effectively as they have. The two-tier structure contributes to this role by ensuring that the chief executive cannot dominate the supervisory board. Germany is arguably the only one of the seven countries in this study in which the system of corporate governance does indeed result in effective oversight of management by the representatives of other stakeholders.⁴⁶

In other words, the "shareholder victory" has had a simple yet broad impact -- focusing management energy on sticking to business. "[T]he prime power of the proxy vote remains its ability to put pressure on management in a public forum."⁴⁷ The most important achievement of the shareholder movement has been to make the world an uncomfortably embarrassing place for CEOs and directors of underperforming companies. As one commenter noted "When Stempel was hospitalized, he was at a Conference Board meeting. Can you imagine a guy with a $120 Billion problem on his hands giving three hours to the Conference Board?"⁴⁸

No explicit policy has decreed that there must be an unbalanced governance structure. It has been that way because of the momentum that always favors continuance of the status quo; the obstacles to effective shareholder institutions -- government regulations (SEC proxy rules, among others), collective action, and conflict of interest. All of these can be overcome by the undeniable benefits of improving the system. Until then, the system is vacuum evoking the poetic words of Dean Bayliss Manning: "We have nothing left but our great empty corporation statutes--towering skyscrapers of rusted girders, internally welded together and containing nothing but wind."⁴⁹

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