In this complicated world, we delegate authority to make many critical decisions about our lives and society. Increasingly, we are delegating those decisions to private entities, now eclipsing government in reach and power. Traditionally, countries have been able to assure that private power was exercised in the public interest through law. As private enterprises become preponderantly multinational in character, any one country's capacity to affect the impact of commerce on its citizens through laws is vastly diminished. This has been the pattern in the United States with the interplay between state and federal laws, and this is what I see in Europe with the emergence of the European Community corporate laws.

Experience in the US has shown that the current governance system is no governance system at all. This is despite clear evidence, as demonstrated by the Honeywell example, that good governance is good value, and the incentives that should provide for participation in governance. My conclusion is that we must have an effective multi-national organization of institutional owners and that the NAPF, as the premier national institution of this kind in the world today, is in the best position to begin.

I. World dynamics: The evolution from political and military to economic and business

Our grandchildren will find that their affiliation with an industrial group is far more important than their citizenship in a particular country.

While the post-World War II international system really could be modeled as a two party game, this is clearly no longer the case. First, economic developments have diminished the relative power of the U.S. and U.S.S.R. within their respective blocs. The soaring wealth of Japan and the economic integration of the EC has created two more superpowers of sorts. Second, the very rationale for the existence of two superpowers has been thrown into question by the Gorbachev initiatives and the eagerness with which they are being embraced by the West.

In some ways, World War II is ending at last. We must be very sensitive to the kinds of change that brings. First, the dominant mode of the expression of power in the world will be decreasingly political and increasingly economic, less military and more corporate. Second, an escalating percentage of corporate activity will be conducted by companies having operations across national boundaries. Third, the effective combination of culture, public opinion and law that, in the past, has assured the compatibility of corporate power to the public interest will be insufficient for that purpose in the future. Fourth, restraints on corporate power based on the law of their domicile will follow the pattern in the U.S. of a "race to the bottom" and will have little impact. Fifth, we must therefore ensure a structure adequate to compel accountability of those in charge of corporations to some source outside of their organizations--and we have to accept that it cannot be left to individual country's political systems. Sixth, in law, tradition and common sense, the best place to start is with owners.

Attempting to predict who the players will be in this new game forces us to confront the perhaps most important reason to expect heightened instability in the future; the likelihood that the typical "player" will consist of nations and/or organizations lacking any aligned set of public policy objectives. Indeed, it is almost a certainty that the nations comprising each bloc will have differing economic and security concerns. For example, we would hardly expect the concerns of the British to parallel those of a reunified Germany. This lack of internally cohesive objectives within a geopolitical bloc reflects a deeper problem, namely the reduced importance of classical territorial imperatives and the increased significance of technology-based economic imperatives. These have little to do with geographical boundaries of any kind.

For example, what if the U.S., Canada and Mexico decided to form a North American Alliance, and erect protectionist tariffs? Will the existence of this trading bloc be good news for the Boeing Corporation? Will Boeing use its considerable political clout to champion barriers to trade with Japan--potentially its largest customer? Boeing would not, but the National Semi Conductor Company might. And yet, its suppliers probably would not. And so on. In such an environment, can we really expect anyone to have a clear idea of national priorities? Most probably not, because there won't be any.

II. The increased need for a system of effective governance of corporations, particularly in light of 1992.

Corporations appear to be a straightforward proposition. They are artificial creatures of the state, authorized to permit the most efficient combination of capital, labor and management. Governments should have the capacity to make sure that they act in the public interest. But we have been shown in the most compelling terms that they do not. Factors other than law - national culture (as in Japan), concentrated stock ownership (Germany), national ownership (Italy) have been moderately successful in assuring corporate "good citizenship." In the US, where these factors do not exist, we do not even have that. But the failure by any government to assure effective corporate governance, already a problem, seems certain to get worse, as a result of two emerging trends: multi-national enterprises who are virtually free to charter and to operate their business from any national base(s) and the creation in Europe of a new legal authority having jurisdiction over the entire community.

It is in this climate that we must look at the questions of corporate governance. Corporations will be able to formulate and promote their self-interest more confidently than nations can. There are two reasons: first, the issues tend to be one dimensional; and, second, corporations are free to walk away from both internal and external liabilities. If companies are then not going to be accountable to citizens through the power of the laws enacted by governments, we must determine what power will be able to hold them accountable. After all, it is only accountability that legitimizes the exercise of any power; because it is the only way to ensure that the power which has been delegated is not abused--that any conflicts of interest that arise between those who delegate the power and those who exercise it are properly resolved.

The American legal system developed at a time when the greatest threat to individual freedom was the power of the state; this system has proven to be inadequate now that the threat is from private, largely corporate, power. Restraint through enactment of laws has been less and less successful. Keep in mind that in the United States, state, in contrast to federal, law has primary authority over corporate chartering and functioning. The result has been called "the race to the bottom"--states (both legislatures and courts) design their laws to be as inviting as possible to corporate management, so that they may have the benefit of the tax revenues. And why not? They are not the ones who pay the price. As the supra national European Community takes shape, I hope it will avoid the problems caused by our melange of state and federal authority.

III. American Governance in 1989: The Difference between what is right and what is legal (MBOs, GAF, UAL, Time/Warner and Loral)

The Wall Street Journal , in an editorial comparing the takeover battles of Time in America and B.A.T. in Britain concluded: "It's better to be a shareholder in Britain. It's better to be a lawyer in America."¹

Corporate governance in the United States is largely a tale of the difference between what is legal and what is right. For example, even a legally correct MBO cannot be fair to shareholders. Sam Heyman, whose MBO at GAF stands as an example, showed how little real value matters when he revised his bid, following the 1987 stock market crash. Heyman originally offered $66.50 for each share of GAF common stock in September 1987. That offer was rejected by a special committee of GAF's independent directors then withdrawn by Heyman himself after the October stock market crash. Some months later, he offered bids of $48.50 and $51, which were also rejected by the special committee. The final bid of $53 -- $46 in cash and subordinated debt with a face value of $7 -- was ultimately accepted by the committee. To operating management, a company's asset value does not change with a sudden drop in the entire stock market, yet to the management trying to purchase those assets, it does.

How can management possibly mediate fairly between its shareholders' interest in the highest price and its own interests in the lowest price? It cannot. Inevitably, the interests of management, which controls the information and timing--and the board--will prevail. This is why the law of trusts inveterately and unchangingly does not permit a trustee to profit personally from dealings with the trust estate. Yet a corporate manager or director, in a similar position as a fiduciary, has no such strictures.

It is almost tautological that recent MBOs have served, first and foremost, the personal pocket book interest of management. Consider the massive sums management awards itself: Stephen Wolf, CEO of UAL, proposed personal profit approximating $75 million in the failed UAL MBO. This actually pales in comparison to the deals made in the management-led Time-Warner merger. Steve Ross of Warner acquired a salary/compensation/bonus package worth an estimated $300 million dollars. And the CEO of Loral, Bernard L. Schwartz, sold himself two divisions of his own company, despite a higher bid from Banner Industries, and billed himself about $4000 an hour to run them, still drawing full salary from Loral.

The UAL transaction in particular represents a crescendo of many unsavory themes in management-led buyouts. The company--make that the shareholders--are now paying more than $58 million in legal and financing fees for the deal which did not go through. The attempted MBO was designed to protect management from a takeover. If it had been successful, management would have been rewarded on a scale beyond opulence. Why should shareholders bear the downside risk and pay the costs for a venture so blatantly in the principal interest of management?

IV. The Ascent of Directors--the corruption of "pre-emptive rights" and the business judgment rule

I follow with great respect (and, I hope, politely concealed envy) the effectiveness that NAPF and sister organizations have had in the area of preemptive rights. Arising out of the chaos of our multiple state jurisdiction over hostile takeovers, management's latest means for protecting itself is the creation of a new class of stock with particularly attractive characteristics, to be issued to a friendly "white squire." (There can be, however, a bit of a problem when a squire gets less friendly, as with Lawrence Tisch, who decided that he wanted the CBS throne for himself.)

Let me describe a recent example. In its struggle with Roy Disney, Polaroid developed two vehicles. The first, a so-called ESOP (Employee Stock Ownership Plan) was created by the Board literally while Mr. Disney was in the air coming to Boston from California to talk with Polaroid's management. The ESOP contained fifteen percent of the total outstanding shares, a determinative amount under the friendly law of Delaware, where Polaroid, like most large American companies, is incorporated. The Delaware Court, always aware of the importance of chartering revenue to that state (20% of total tax receipts), upheld the validity of the directors' action. Not satisfied with this standoff, the Polaroid corporation proceeded to issue to an affiliate of Lazard Freres a new class of security with a guaranteed minimum rate of return over ten years, board representation and voting rights over some twenty percent of the total. At no point was the approval of the shareholders sought or received, notwithstanding the existence of at least one alternative offer--and notwithstanding the fact that the obligation to the holders of the new shares put the old shareholders in a significantly poorer position. This began a significant new trend; the most recent example is the deal Warren Buffett made with Champion International.

V. Corporate Management - the "new philosopher king" -Pennsylvania Bill #1310

Another deal that left shareholders in a significantly poorer position was the Time-Warner merger. The Delaware Court upheld the Time directors' decision to sell, despite uncontradicted evidence that (1) Paramount was offering more money, (2) the transaction, designed over a two-year period as an equity deal, was restructured in a few days as a debt deal, just to take the decision away from the shareholders. The court held that the Board's consideration of the merger for two years was entitled to deference, despite the fact that the deal that went through was not the one they had planned. Indeed, during that two-year period, it had been explicitly considered and rejected. The court held that Time was not for sale, despite the fact that 60 percent of the stock was changing hands.

This gives some indication of the Through the Looking Glass aspect of Delaware law; like Humpty Dumpty, they decide what they want the words to mean. The courts and state legislatures have bent so far backwards to defer to the "business judgment" of directors--some have even gone so far as to eliminate liability not just for acts committed in good faith, but for negligent acts as well.

A recent proposal to amend Pennsylvania law, designed to give corporate officers and directors the maximum protection from any accountability to shareholders, goes further than anything I have seen in granting sovereign power to establish public policy to the corporation.

The proposed amendments provide:

In discharging the duties of their.. respective positions, the board of directors...may, in considering the best interests of the corporation, consider the effects of any actions upon employees, upon suppliers and customers of the corporation and all other pertinent factors ...The consideration of those factors shall not constitute a violation of subsection (b)" (emphasis added).

Subsection (b) sets forth the standards for director liability. The effect of this language is that directors may consider any factor they chose to, without any risk of liability for breach of their duty as fiduciaries. Directors can not be held liable, without direct self-dealing or fraud. It should be kept in mind that in the United States, the theoretical legal liability of management for breaches of duty to ownership is the instrument through which governance is enforced. Accountability is thus eliminated under the proposed Pennsylvania statute.

It is not hyperbole to say that this is corpocracy. Our current system is based on Adam Smith's theory that the pursuit of profit would provide the best assurance that what corporations did was in fact congenial to the citizens' interests. Pennsylvania SB 1310 would permit decisions to be made on another basis, based on their own evaluation of the trade-offs, and therefore grants to corporations the power to establish public policy. By doing so, it repudiates the entire basis for corporate legitimacy. All power is delegated in exchange for some accountability, whether in the political context or the corporate context. By delegating additional authority to corporations, just as accountability is being diminished, this proposal undermines both political and private systems.

VI. No set of laws can ensure an adequate system of corporate governance, without a supporting culture and institutional structure. The informed and active involvement by owners is essential .

The solution may be found within the structure of the corporation itself. Owners are increasingly institutional, with little need for day-to-day liquidity and with a long term interest in value enhancement that is compatible with those of the enterprise and its management, as well as with the overall society and the world economy. Both shareholders and management must realize that the tension in their relationship provides checks and balances that are creative, constructive and cooperative. This brings corporate power almost back to where it began, before the stress on instant liquidity sundered the common interests of manager and owner.

To quote Sir John Hicks: "there is something to be said for the system which seems to be evolving under the pressure of taxation, in which the shares of large companies are held, in large blocks, by institutions - banks, pension funds and so on - which have a sufficient stake in the company to have an incentive to keep in close touch with its affairs, just as the holder of a non-transferable share has an incentive to do. Such a system could indeed be regarded as that of the private company writ large. It would indeed lose something, perhaps much, in flexibility; but it could offer gains in other ways."²

The conventional wisdom is that corporate management is accountable to ownership, that the directors and officers work for the shareholders and that this accountability sufficiently limits corporate power so as to make it tolerable in a free society. During the last several decades, it has been convenient for all parties to maintain lip service to this fiction, for government, because of a wish to avoid confrontation from which it was uncertain to emerge successful; for management, because of the convenience of actually being accountable to no one while having an absolute defense against charges of excessive power; for shareholders, because of the excuse from expending resources with only vague possibility of returns. There should be no doubt, however, that accountability to ownership in the United States is only a polite fiction.

VII. "Rational Ignorance" and "Rational Involvement" by shareholders - Honeywell

Commentors have used the oxymoronic term "rational ignorance" to explain one of the reasons for this fiction. The problem is one of collective choice, often called "the prisoner's dilemma." Any shareholder, even a large institutional shareholder, who wants to take action to hold management accountable must pay all of the costs, for only a pro rata share of the returns, if there are any. A fiduciary shareholder can barely justify the costs of educating himself about governance, much less participating in it.

But last year gave us an example of "rational involvement," of collective action that was not only prudent, it was one of the best investments of the year. It was the first ever full-scale proxy fight³ that was not about control of the corporation; it was also the first time that shareholders defeated a management proposal, without a contest for control to provide the fuel.

The company was Honeywell.

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

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

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

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

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

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

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

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

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

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

Over the threemonth period, Honeywell common stock moved 22%, from $73 to over $89 per share. We do not claim to be responsible for all of the gain takeover rumors had been circulating throughout the entire period, and perhaps Honeywell management would have announced its restructuring even without external pressure. But we believe our demonstration of shareholder concern and power played a substantial part in the gains realized.

The 1989 Honeywell proxy solicitation was an historic achievement for several reasons:

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

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

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

VIII. Multi-national ownership groups

At the end of the day, the proposition is simply stated. There will be an increasing need for the effective governance of large corporations as the traditional capacity of law is diluted with the eradication of national boundaries. Law and tradition have inveterately and unchangingly based the legitimacy of corporate power on the self-interest of owners to assure that management pursues objectives that are compatible with societal interest. The recent American experience demonstrates on the one hand that there is no limit to the extent of potential deterioration of protection from law and on the other that involvement in governance is value enhancing.

NAPF is unquestionably the premier institutional ownership organization. There is no group better situated than yourselves to begin to develop a multi-national capability that can effectively assert ownership interest, and there is no time better than the present. Or as Maimonedes used to put it: "If not you, who? If not now, when?"

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