UNITED STATES PATTERNS OF
OWNERSHIP AND CONTROL:
THE EMERGENCE OF FIDUCIARY
CAPITALISM
The twentieth century has seen several sea changes in corporate ownership. At the end of the last century and into the beginning of this century corporations were dominated by 'captains of industry.' Such wealthy individuals as Morgan, Rockefeller, Carnegie and du Pont not only owned large blocks of stock in companies such as Standard Oil and United States Steel, but they exercised their rights as owners to control these companies. Typical of this era of ownership was the role Pierre S. du Pont played at General Motors during the 1920's. When the company fell on difficult times he, as the major shareholder, moved into the executive suite and personally guided the company back to financial health.
By the 1930's the pattern of US ownership of corporate equities had changed so much that Adolph Berle and Gardiner Means could conclude in their seminal work on the modern corporation that US capitalism had passed from the age of the entrepreneurial owner to an age in which ownership had become atomized. This was an age in which the effective control over the corporation was typically no longer exercised by the legal owners of equity-the shareholders-but an age in which effective control of corporate America was exercised by hired, professional managers. US capitalism had become, in Chandler's terms, 'managerial capitalism.'
The phenomenon which Berle and Means identified in 1932 -- the divorce of ownership from control -- would come to dominate most thinking about issues of corporate governance for much of the rest of the century. It would also come to dominate most policy on the federal and state level. In its modern form the ownership-control problem is part of a larger 'principle-agent' problem. "Agency problems arise when a principal hires an agent to perform certain tasks, yet the agent does not share the principal's objective. To align the agent's incentives with his own, the principle may use a variety of instruments, including cash bonuses, equity shares, promotions, and dismissals. Common examples of principal-agent relations include those between shareholders and CEOs..." As Gilson put it: "...the central corporate governance inquiry in the United States took the form of the academic equivalent of the search for the holy grail -- the quest for a technique that minimized agency costs by bridging the separation of ownership and control." The quest is vitally important as Richard Koppes, General Counsel for the largest public employee retirement pension fund in the Untied States, notes when he says, "The gulf between ownership and control is widening, and is now recognized as a true flaw in the competitivenses within the US economy."
In his 1979 book, The Unseen Revolution: How Pension Fund Socialism Came to America, Peter Drucker noted that forces were underway that would again remake the landscape of corporate ownership. This time the responsibly of ownership was being concentrated in the hands of a relatively small number of institutional investors -- primarily public and private pension funds -- acting on behalf of a large, almost universal, group of individual beneficiaries. Drucker proclaimed, "If 'socialism' is defined as 'ownership of the means of production by the workers' -- and this is both the orthodox and the only rigorous definition -- then the United States is the first truly 'Socialist' country." While we read Drucker's point about socialism as primarily a rhetorical one, he does raise important issues about the decline of traditional, personally held private property in equity form. Some potential implications regarding the nature of property and ownership are discussed later in this paper concerning what the authors of Lifting All Boats refer to as the 'institutionalization of equity' (an emerging organizational-bureaucratic, or trustee, form of property) where agents watch other fiduciary agents.
As noted above, one of the most important implications of the institutionalization of equity has been the rapid growth in the size and importance of the financial institutions that have evolved to administer this growing pool of pension fund capital. Figure 1 traces the growth of institutional investor asset growth from 1970 to 1994 by major institutional entity's holdings. Striking is the massive growth of both pension funds, over 2000%, and investment companies, mainly mutual funds, which grew over 3000%. Figure 2 shows that by 1990 the direct ownership of equities by households had fallen below 50%. In this same period private pension fund ownership rose from 0.8% of all US equities to 17.3% in 1994 and state-local government retirement fund ownership went from virtually nothing in 1950 to 8.6% in 1994. In addition to this rapid growth of pension funds, open-end mutual fund ownership of equities grew from 2% in 1950 to 12.2% in 1994. Taken together, pension funds and mutual funds increased their share of equity ownership more than ten fold in forty years from 2.8% of total US equities in 1950 to 38.1% in 1994. At the same time all other major forms of equity ownership -- private households, bank trust departments, and insurance companies -- experienced a precipitous declined in relative importance from 94.8% of US equities in 1950 to 55.2% in 1994.
(See the Appendix for data on pension fund growth: compound annual growth rates by major type of financial institution from 1980 through 1992-93; investment allocation of pension fund assets in the same period ; and pension fund equity holding growth by type of pension fund, 1980-94 (Figure 3)
Before turning to the governance implications of this most recent sea change in the ownership, it will be worthwhile to briefly describe the nature of these financial institutions since it will turn out that because of their structure and their position in the economy some are much more likely than others to actively engage the issues raised by the corporate governance debate at the end of the twentieth century.
The US financial institutions that play a major role in the ownership of equity capital are bank trust departments, private pension plans including labor union pension plans, public employee pension plans, not for profit/cooperative pension funds (mainly TIAA-CREF) and mutual funds. Each of these institutions is subject to the highest standard of care and prudence the US legal system has developed, the fiduciary standard. This standard requires, among other things, that the fiduciary take only those actions a 'prudent person' would take with respect to the management of the resources entrusted to the fiduciary. In discharging their fiduciary duty they purchase equities and vote proxies. In effect, they exercise the ownership rights -- though on behalf of their beneficiaries.
Bank trust departments are a large category of institutional investors who act as trustees and managers for everyone from wealthy individuals to pension plans. In their fiduciary capacity they make investments and vote proxies. Because of the industry's important commercial relationship to corporate clients, bank trust departments are generally considered to be conservative in nature and pro-management in out look. In any case, as Figures 1 and 2 illustrate, since 1980, the faction of equity accounted for by bank-managed personal trusts has declined by two thirds, although available data indicates it increased for institutional holdings in the top 25 largest firms and banks continue to be important fiduciaries.
The Investment Company Act of 1940 established mutual funds as trusts, but the fact that investors can take they money out at any time separates them dramatically from other institutional investors. Operationally this requires a commitment to liquidity that is generally though to impel mutual fund managers to seek to maximize short term returns at the expense of longer term responsibilities of ownership. During the takeover boom of the 1980s this generally meant tendering shares whenever an offer was made at a premium to the current market price. However, this commitment to liquidity may be 'illusory' since it may aggravate fluctuations in the stock market where redemption orders get quickly translated into sell orders. Friedman attributes some of the excess market volatility in the 1987 stock market crash to this source and worries that the illusion of liquidity may, in certain circumstances, have a destabilizing effect of financial markets. In any case, the convenience, diversification, and professional management offered by mutual funds probably accounts for a substantial portion of the decline in individual ownership of common stock shown in Figure 2.
Though the majority of the pension fund assets are accounted for by the next two categories, a growing fraction of mutual fund assets are in individual retirement accounts (IRAs) and 401(k) retirement plans. In these cases, the mutual fund offering the account acts much like a money manager acts vis a vis a public or private pension fund administrator. By their nature and because of substantial tax penalties for early withdrawals, these funds are invested for long periods of time and the high liquidity preference aspect attributed to other mutual fund investments is reduced or eliminated. While mutual funds have not been publicly active as 'shareholder activists', recently they have been increasingly active informally, working with the more public activists as well as on their own.
Private pension funds are far and away the largest category of institutional investors. In 1994 they accounted for more than 17% of all equity ownership in the US and their growth rate has been the fastest of any category in Tables 1 and 2. These pension funds are governed by the Employees' Retirement Income Security Act of 1974, commonly referred to as ERISA. Their growth has been driven by a number of factors: the favorable tax treatment of compensation given and received in the form of pension benefits, demographic and work preference trends, and the growth in the stock market are the most important. Roe summarizes:
The rise of huge stock-owning pensions was not primarily due to corporate governance issues or public choice decisions. Pension funds became important because of changing social circumstances: Employees' life-spans lengthened, their wealth rose and they took some of it in earlier retirement. Public choice plays a background role: private pension became important because America has just about the lowest publicly-funded old age pensions....in the industrialized world...once American politics took out the big institutional players--banks and insurers--from playing an active boardroom role or from even owning stock, pensions were the only players left.
Private pension funds are further divided into two groups: employer sponsored pensions and 'Taft-Hartley' funds. The former are closely aligned with their sponsoring corporation which acts as the plan fiduciary or who delegates this responsibility to pension fund administrators appointed by management. The latter are labor union pension funds covering workers in a given industry (teamsters, carpenters, etc.) who may work for multiple employers. Because of the nature of the incentive systems surrounding employer sponsored plans they are thought to be particularly passive and particularly inclined to side with management whenever circumstances or policy forces them to act. However, the Department of Labor which administers ERISA and therefore has substantial influence over what constitutes prudent behavior for these fiduciaries has since 1988 made rulings that are seen as requiring more aggressive action to discharge their prudent person responsibilities. Some Taft-Hartly funds have been active on corporate governance issues, but they are viewed with suspicion by management who feel they may mix pure ownership issues with the larger labor agenda.
Recently, some erosion in the power of private pension funds is observed to be taking place as defined-benefit plans are being replaced by defined-contribution plans in the form of 401(k)s. As Figure 4 makes clear, defined benefit plans fell from just over 60% of private trusteed pension assets in 1983 to just over 45% in 1993, while defined contribution plans have grown from just under 30% in 1983 to just over 42% in 1993. Under defined-contribution plans employers undertake to pay a specified pension benefit. Corporations make contributions to the plan and then the plan administrator, usually through professional money managers, is charged with investing the pooled assets. Under defined-contribution plans a given amount is contributed with the actual value of the pension depending upon the investments chosen by the individual beneficiary from a list of vehicles, typically mutual funds, provided by the employer. Many observers have noted that individuals tend to make more conservative investments than institutional money managers, partly because they may be less astute at choosing long term investments and partly because individuals may be justifiably more risk adverse that would a manager of a larger, pooled fund. As Margaret Blair notes, "Most individuals with assets in 401(k) plans make conservative investments in, for example, high-grade bonds or mutual funds. The latter, of course, face the same impediments to shareholder activism that mutual funds face."
The final category of institutional owners are the pension funds of the public employees of state and local governments. As Figure 5 shows, employment growth at the state and local level has considerably outpaced employment growth at the federal level. The growth of public employee pension fund assets has been equally dramatic. In 1950 public pension funds were almost entirely invested in bonds. By 1994 they owned 8.6% of all US equities (Figure 2). Some of the funds are among the largest equity owners in the world. For example, "The California Public Employees' Retirement System (CalPERS) grows about $1 billion every two months -- 'in a year more than four times the median market value of a Fortune 500 industrial company; in a year, enough to buy all the common stock of General Motors with enough left to buy five tankfuls of gasoline for each vehicle it makes.'" Currently, CalPERS assets stand at almost $100 billion dollars. The public pension fund category also includes the largest pension fund in the United States, TIAA-CREF, which provides pensions and annuities to college professors.
Unlike other institutional owners, public pension funds do not have close commercial ties -- and hence potential conflicts of interest -- with the business community. At least partially for this reason, many of the largest of these institutions have been among the most active institutions in the area of corporate governance. "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 [New York state] and Wisconsin, Pennsylvania and to some extent Florida, you might have very little activism at all." While they are independent of direct pressure from the business community, the state pension funds function in a political atmosphere that makes them particularly susceptible to pressure to make certain types of investments to aid the local state economy (these are called 'economically targeted investments' or ETIs) or to refrain from others such as, in the 1980's, investments in companies doing business in South Africa. Nonetheless, as the quotation indicates, public pension funds have been notable for their leadership on issues of corporate governance.
In addition to the state and local employees' pension funds, the Federal Employment Retirement System Act of 1986 (FERSA) established what is in effect 401(k) plans for federal employees. Overtime this fund is expected to become the largest institutional investor in the world. However, in order to avoid what was characterized during congressional hearings as 'back door socialism,' FERSA placed severe restrictions on the types of investments the fund could make (an index fund representing the S&P 500 stock index) and provided that "The Board, other government agencies, the Executive Director, and employee, a member, a former employee, and a former member may not exercise voting rights associated with the ownership of securities by the Thrift Savings Fund." Thus the voting power -- the very exercise of ownership rights -- was delegated by law to the administrator appointed by the trustees of the fund.
Black concludes that among all institutional investors there are various types of conflicts of interests so that, "no institution is completely beholden to corporate managers; no institution is conflict-free." But that public pension funds have weaker pro-manager conflicts than other types of institutions. "All major institutions have significant conflicts of interests; all but public pension funds have incentives to keep corporate managers happy....only public pension funds, and perhaps mutual funds, are potential shareholder proponents."
At the end of the twentieth century the rise of institutional
ownership -- particularly through private and public pension
funds and mutual funds -- has led to a period we have
characterized as fiduciary capitalism, a re-concentration of
ownership in the hands of a relatively small number of decision
makers. Even though, in fact, legal ownership is still widely
dispersed, the fiduciary duty of these institutions potentially
gives them a responsibility to exercise the power of ownership.
However, they now have a new problem. Because the institutions
are so large collectively they effectively own a large fraction
of most major companies. (See Figures 7 to 10 for data on the
concentration of ownership across institutions.) Institutional
ownership of the top 1000 firms was 57% in 1994, up from 46.6% in
1987, while institutional ownership of the second 50 largest
firms was 64.3%. Concentration by size of the institution is
greater than by size of the firm. Data is available for the
largest 25 institutional holders in the largest 25 firms. As
Figure 9 shows, the top five institutional holders held fully
10.8% of all shares in the top 25 largest firms, while the top 25
institutional holders held 24.5% of the shares. This ownership
structure is consistent across all major sectors and creates the
potential for a very small group of very large institutional
holders to have extraordinary leverage with most publicly traded
large firms in the U.S.
Because of this concentration of ownership and because the pension funds have very long term liabilities, they find their ability to trade in the market is severely limited. This is especially true for those funds which are indexed and are therefore, by definition, 'passive' traders. Figure 11 presents the evidence that public funds (and TIAA-CREF) are the most heavily index of pension funds, although banks and corporate funds also rely on indexation for just over a third of their equity holdings. Consequently, some of these institutions have been driven to take a monitoring role vis a vis their portfolio companies since their liquidity is severely restricted. Monitoring and all that implies for corporate governance is the only avenue left through which institutions can excised their fiduciary role as 'owners.' This is discussed in part IV.
Appendix: Statistical Tables
Figure 1: Institutional Investor Asset Growth by Category: 1970-1994
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), January 1995, (vol. 2, ed. 1), p. 15 and 19, tables 2 and 4.
Table 1. Institutional Investor Asset Growth by Category 1970-1994, in billions of dollars
Figure 2: Percentage Ownership of US Equities: 1950 - 1994
Source: Benjamin M. Friedman, "Economic Implications of Changing Share Ownership, Working Paper no. 5141, National Bureau of Econoimc Research, Inc., Cambridge, MA, June 1995, p. 3.
Figure 3: Pension Fund Equity Holdings: 1980, 1988, 1993 and 1994
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), January 1995, (vol. 2., ed. 1), p. 33.
Figure 4: Private Trusteed Pensions-Defined Benefit vs. Defined Contributions
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), January 1995, (vol. 2., ed. 1), p. 48.
Figure 5: Civilian Employment by Level of Government: 1940 - 1982
Sources: 1940-1970: US Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Bicentenial Edition, Part 1, Washington, D.C., 1975; and, 1980-1992: US Bureau of the Census, Statistical Abstract of the United States, 1995, (115th edition), Washington, D.C., 1995
Figure 6: Economically Targeted Investments As a Proportion of Total Assets, Largest 20 Public Funds
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), May 1995 (vol. 2, no. 2), p. 53.
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), September 1995, (vol. 2., ed. 3), p. 11.
Figure 8: Relative Growth in Market Value, all Domestic Corporations vs. Top 1000: 1990-1994
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), September 1995, (vol. 2., ed. 3), p. 13.
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), September 1995, (vol. 2., ed. 3), p. 31.
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia), September 1994, (vol. 1., ed. 3), p. 32.
Figure 11: The 25 Pension Funds with the Largest Indexed Equities: 1994
(Source: The Brancato Report on Institutional Investment (The Victoria Group, Fairfax, Virginia),May 1995, (vol. 2., ed. 2), p. 28.