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December 5, 1991
By inveterate tradition and unchanging law, fund managers are accountable exclusively to the beneficiaries for whom they act as trustee. In their role as "owners" of portfolio companies, however, institutional investors have a substantial disincentive to "monitor" managements. They do not get extra pay for doing so and enthusiastic oversight runs the risk of creating commercially threatening resentment. To date, shareholder success has largely been limited to "raising consciousness" as to their potential power and role. Now that there is general recognition of the size and responsibilities of institutional investors, it is possible to understand what are the necessary ingredients for fund managers to be able to exercise an effective role as shareholders.
A critical question must be asked at the outset - is this wanted? Or is it preferred to continue with the appearance of accountability and the reality of autocracy? This paper will consider the present situation of institutional investors and will proceed to describe two models for effective ownership involvement in monitoring American corporate managements.
#1 -SIZE Institutional Holdings in America, as a percentage of total holdings, - 50% - are a bit smaller than in the UK. As of 1990 - Total Institutional Holdings are $6.52 Trillion* [*An American Trillion is a Thousand Billion, as a Billion is a Thousand Million], of which $2.491 T. (38.2%) are pension funds, $1.935 T. (29.7%) are insurance companies, $1.121 T. (17.2%) are Investment Companies, $786 Billion are in Bank Trusts (12. %), and $187 billion in Foundations and Endowments (2.9%). Institutional Investors' ownership has steadily increased over the last several decades and up to the present just over half of the total outstanding stock of the top 1000 companies.
#2 - CONFLICTS OF INTEREST - Generally speaking, all institutional investors have conflicts of interest as they contemplate and exercise ownership responsibilities with respect to securities held in their portfolios. To the extent that institutions diligently function as owners, they run the risk of antagonizing managers to whom they look as potential customers. (There are more effective selling strategies than to deliberately antagonize the prospects!) This creates a virtually insuperable problem for banks and insurance companies whose business is essentially based on selling products to large companies. Universities unsurprisingly (if a bit disappointingly for the teachers of ethics) are loath to antagonize potential corporate donors. Even investment companies that fundamentally are comprised of millions of individual customers want neither to offend the companies on whom they call for information nor to lower their chances of being considered for lucrative pension management business. The surprising thing is not so much that commercial institutions can be predicted to act in aid of their pocket books, but rather that everyone full well understands that "trusteeship" is fatally undercut and, nonetheless, proceeds unconcerned. Under existing practice, it is virtually impossible for the beneficial owners even to find out how their trustees vote. It is not possible to conclude whether the present illusion of accountability is actually preferred in lieu of the system to which we nominally adhere, or whether it just happened this way.
#3 - PENSION SYSTEMS - The only institutions who have a modicum of independence are the pension funds - public and private. The Pension and Welfare Benefits Administration of the U.S. Department of Labor ("PWBA" and "DOL", respectively) has jurisdiction of all non-governmental employee benefit plans, the individual states have authority over the public employee systems. PWBA has taken the lead [Avon, Polaroid, Monks and other letters ] in making clear that ownership responsibilities, including voting, are "plan assets". Managers are, therefore, held to the same fiduciary standards of care and loyalty in functioning as owners as in the more conventional buy, sell and hold decisions.
The irony is that private plans, who are unmistakably subject to PWBA jurisdiction, have only grudgingly followed its directives, while the public system has treated its utterances as gospel. Private plan sponsors who take ownership rights seriously would find themselves voting proxies and evaluating shareholder lawsuits for companies they are used to thinking of as competitors, suppliers, customers, possible takeover targets and even possible hostile acquirors. While large private plans, through organizations such as CIEBA, have occasionally acted as fiduciaries and taken positions apart from their corporate parents, the pattern is of top management deciding that shareholder involvement - even by themselves, as the largest owner - is undesirable. So long as the option appears to exist of being accountable to no one, corporate America prefers not to be involved in a system of ownership based accountability.
This leaves the public pension system, out of all the institutional investors, as the one who can act as owner. One should not fail to point out that public pension fund trustees are part of a political system. The political power of large corporations in the states where they have significant business enterprises is epitomized by the capacity of Pennsylvania based Armstrong and Massachusetts chartered Norton to succeed in 1990 in having their respective legislatures make their takeover virtually impossible. Public fund trustees and officials, by experience and background, have little experience with large corporations; their framework is that of the public servant; they are not the ideal monitor of corporate behavior.
#4 - Shareholder Activism - Over the last half dozen years, individual shareholders and public plans have introduced several dozen resolutions for consideration by corporations at their Annual Meetings. Pursuant to SEC regulation, well crafted proposals must be included by the company in its own proxy statement. This assures circulation among all the shareholders at no incremental cost to the proposer. A not insignificant number of these proposals have received the support of a majority of the shareholders. The proposals have been precatory in nature and focus on the simplest of governance principles. None of them have actually required a management to do anything. Former SEC Commissioner Bevis Longstreth has said: "IF CalPERS (the leading shareholder activist in the US) didn't exist, the Business Roundtable would have had to invent them." What he meant was that CalPERS' highly publicized governance activities in no way inhibited the exercise of power by corporate America, but it gave the impression of there existing an effective governance system.
This is a field in which everyone knowingly uses words in a manner far removed from their common meaning. Thus, in the context of directors - "nominate", "elect" and "vote", words with a legitimating aura, are used to describe a process that everyone knows is more accurately characterized by "invite", "ratify" and " 'bullet' a single slate ballot". "Owners" are desperately trying to avoid any of the responsibility of that status."Trustees" are preoccupied with finding justification why they need not do what they don't want to do.
#5 - Status of Monitoring to date
Corporate Governance has arrived in America to the end of the first Act. No one today knows whether there will be an Act II, or, if so, what its denouement will be. To recapitulate the present situation, none of the existing "institutional investors" are well suited to perform the monitoring function of the "legendary shareholder" or to incarnate that self-interestedness that according to Smithian theology uniquely assures the public good. Nor, as we note in section 6, below, can any shareholder easily overcome the problems of "collective action" and regulatory restraint that persist. Why, one might well ask, is there continuing discussion about "governance" and the responsibility of "institutional investors" in the face not only of lack of accomplishment but also of seeming structural impossibility of such. One answer is that everyone feels that "accountability" of corporate power to someone is essential to its congeniality with a democratic society.
#6 - Steps necessary for the development of an effective monitoring system
We proceed to the design of a potentially effective system relying on three premises: (i) effective shareholder oversight creates value. (ii) What we are really talking about is changing a system of power. Management has this power at present and resists change. (iii) Institutional investors can be induced to function as efficient monitors only if there is clear business incentive (in addition to undoubted legal obligation) for them so to do.
There is substantial evidence that the market values more highly a company with a credible monitoring shareholder than one without. Public announcement of the involvement of Warren Buffet, for example, has consistently been associated with rise in value of the company stock. (See Columbia Professor Bernie Black, Agents Watching Agents: The Promise and Limits of Shareholder Voice , and particularly pages 36-58 - "Evidence on the Value of Shareholder Oversight" - [To be published in 1992]) His taking up executive responsibility for Salomon Brothers in extremis during the summer of 1991 corroborates the extra value in having a responsible shareholder involved in a particular corporation. A way of expressing the way in which this value is achieved is through the alignment of manager and ownership interests.
It is in the alignment of interests that the question of who should get the benefit of increased value can be answered. Should management get the full benefit through effecting a Management Buyout? Warren Buffet usually comes into a situation at the invitation of management and he takes his price in advance in the form of a preferred class of security. At the same time, the corporation increases in value and the other shareholders - in theory - may not be hurt. They may even benefit if the increase in corporate value exceeds the price extracted by Buffet. There can be general agreement that the increase in value should be the property of the shareholders, but no one has been able to figure out a structure within which some competent and effective party has incentive to undertake monitoring for the benefit of the shareholder class as a whole.
Notwithstanding the niceties of legal, economic and managerial debate, the reality is power. The present system, howsoever it is described and legitimated, is satisfactory to those in executive charge of America's corporations. Management dominates the process utterly and creates an illusion of accountability and involvement so as to meet public expectations of legitimacy. (Lynne Dallas, Two Models of Corporate Governance - beyond Berle and Means , 22 MichLR 1, 1988)
Any change represents a diminution in the ideal, and therefore must be resisted. This is the only explanation for the Business Roundtable objecting so vociferously to the mildest of reforms in the proxy rules as suggested by the SEC.
Many scholars have written of the desirability of empowering shareholders. Several recent proposals - preeminent that of Martin Lipton, U.Va.L.R.- have proposed that corporations reimburse shareholders for the expenses of their proxy efforts. This removes an existing disincentive, but that is not the same thing as creating an incentive. For trustees, the "collective action" problem is disabling. Although it is easy to understand that particular activity is in the economic benefit of a class taken as a whole, that it is disadvantageous to individual members raises the most grave questions of breach of trust for fiduciaries. How can even the most conscientious trustee holding 1% of a large corporation justify the costs and exposure of a proxy contest in which they bear all the costs, but only stand to benefit by 1% of the gains. There has been no administrative or judicial validation of institutional investors' incurring the costs of active shareholding.
#7 - TWO SUGGESTIONS FOR EMPOWERING INSTITUTIONAL INVESTORS
A. Shareholders can amend a corporation's by-laws to create a new category, the "monitoring shareholder". The Buffett role should be made available to all long term shareholders; selection should be open; the program and compensation should be competitive, based on information reviewed by the SEC and contained in the company's own proxy statement. By amending the by-laws of the corporation, shareholders can provide for the election every fifth year of a "monitoring shareholder" who will be elected at the Annual Meeting based on the vote of a plurality of shareholders. In order to assure that the "monitor" represents the long term interests of other shareholders and the corporation itself, eligibility might well be limited to shareholders holding a minimum percentage of the outstanding shares for a minimum period.
There follows the actual proposal that I have made to EXXON corporation for consideration at its 1992 Annual Meeting, all within the 500 word limit imposed by the SEC.
SHAREHOLDER PROPOSALRESOLVED:(1) The shareholders of Exxon Corporation (the "Corporation") adopt the following amendment to the Corporation's by-laws:
(a) The Corporation shall have a Policy Auditing Committee, consisting of three members. The Policy Auditing Committee shall have the responsibility of monitoring the policies and objectives of the Corporation and advising the Board of Directors with respect to shareholders' concerns. The Committee may engage reasonable expert assistance at the Corporation's expense. The Committee shall be provided with at least 2,500 words in the Corporation's proxy materials or annual shareholders' report to report to the shareholders each year on its activities and its evaluation of the Corporation and the Board of Directors, and to comment and make recommendations on any matters proposed for action by shareholders.
(b) The Members of the Policy Auditing Committee shall be shareholders (including individuals, designated by institutional shareholders) of the Corporation and shall be elected for a five year term, by a plurality shareholder vote. Each member of the Committee shall be paid a fee equal to 50% of the Corporation's directors' fee for the relevant year.
(c) The Corporation shall permit any Qualified Proponent to include in the Corporation's proxy materials nominations of and nominating statements for members of the Policy Auditing Committee and shall reimburse all expenses reasonably related thereto. Nominations must be received by the Corporation at least 90 days prior to the date set for the Corporation's annual meeting of shareholders. Nominating statements may not exceed 2,500 words and may include information on (but not limited to) the following matters: (1) qualifications of the nominee; (2) the nominee's plans for carrying out his or her duties as a member of the Committee; and (3) the nature and scope of expert assistance the member intends the Committee to utilize. Expert assistance of a nature and scope described in nominating statements of all nominees elected to the Committee shall be presumed to be reasonable under Subsection (a).
(d) As used herein, the term Qualified Proponent means any shareholder or group of shareholders which has held, beneficially or of record, at least one tenth of one percent of the outstanding voting securities of the Corporation for the five years prior to the date of the nomination.
(e) The Policy Auditing Committee shall have no authority to bind or to act on behalf of the Corporation. Positions taken by the Policy Auditing Committee shall not restrict the power of the Board of Directors to manage the Corporation as it deems fit and to otherwise exercise its fiduciary duties and act in the best interests of the Corporation.
(f) This provision of the by-laws shall not be altered or repealed without approval by stockholders.
(2) The first members of the Policy Auditing Committee shall be nominated in the Corporation's 1993 proxy statement and elected for a term beginning immediately following the Corporation's 1993 annual meeting.
ACCOMPANYING STATEMENT
The proposed by-law intends to eliminate certain of the existing legal and economic obstacles to efficient shareholder involvement in the governance of the Corporation.
The definition of "qualified proponent" yields an eligible class of a few dozen leading institutions. It is not yet clear whether the SEC, in its interpretation of the various applicable statutes, will require this resolution to be included in the company's proxy statement.
The resolution squarely presents the issue as to whether an on-going, effective, well financed, monitoring capability is wanted as part of the governance structure for modern corporations. There can no realistic concern that the "monitoring shareholder" will abet the takeover of EXXON. There should be no thought that corporate assets are being wasted by yet another redundant control device. We have already demonstrated that the presence of an effective monitoring shareholder enlarges the value of the corporation in the minds of the market.
B. Columbia's Professor Mark J. Roe in a recent magisterial review of institutional history - A Political Theory of American Corporate Finance , 91 Columbia LR 1, (January 1991) - reviews the persistent suspicion of concentrated financial power in the United States. He concludes: "Post-World War II corporate history can be seen as an effort to find substitutes for the direct monitoring that politics disallowed. The failed proxy system gave way to the conglomerate. The conglomerate gave over to the takeover. And at the end of the 1980s, the takeover began to share center stage with the leveraged buyout. 1. Emergence of Monitoring Intermediaries Despite the Prohibitions on Financial Institutions. How would a monitoring intermediary emerge? And how would the body politic allow emergence? Repeal of the prohibitions on financial institutions holding equity control is one way, the most direct. Or an unregulated firm might somehow acquire monitoring expertise and obtain financing from the regulated and disabled financial institutions."
This suggests the creation of a new investment vehicle, in which management power is conferred on to some individual or firm which is not regulated by government and in which institutions are the investors. Plainly, investment in such a vehicle, if it is well designed and managed, would be prudent. Institutions clearly have the power to make "prudent" investments. The best way for them to assure the existence of a desired presence of "monitoring" may well be through empowering new actors. Such a fund should be profitable in itself, following the lead of Buffet; it should be able to afford the proxy costs that are so inhibiting to institutions acting directly; and its managers should be "incented" through profit sharing arrangements that will assure the availability of the highest level of talent.
I am in the process of organizing such a Fund - The Lens Fund - and would be glad to forward a copy of the Prospectus to anyone desiring one.
#8 - CONCLUSION - The present corporate "governance" system represents the classic oxymoron. The existing equilibrium is pleasing to corporate management. All change is vigorously resisted. There is no abstract set of principles to which a governance structure must conform in order to be effective. We have to think of governance in very practical terms. Do we need it? Corporations must be understood as commercial enterprises. To what extent do they succeed in their mission of providing competitive quality goods and services at acceptable societal costs? In the United States, the answer is plain - we are not succeeding. This means that we must change.
By focusing clearly on the problems of language, power, collective action and incentive, it is possible to design systems that will result in effective "monitoring shareholders". It is clear who will not welcome such a development. What is less clear is whether those who do will have sufficient tenacity and commitment.