"In our free-market system, investors in corporate equity assume substantial investment risks in exchange for unlimited potential reward. Protection of the fundamental voting rights associated with equity ownership, which provide shareholders with their sole means of monitoring the performance of corporate managers, is essential to the continued stability and soundness of this system. Unless assured that management can be held accountable directly to shareholders through the exercise of the voting franchise, institutions and other investors could well shift their much-needed capital from equity to debt securities, or to other types of domestic or foreign investments." Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, U.S. Equity Markets in the 1990s: Institutions and Corporate Governance , 4/2/90 (emphasis added).

"I believe that, as institutional shareholders own an ever greater portion of corporate America, it is inevitable that those responsible for the management of plan assets . . . will have to become more activist as shareholders. To paraphrase Walt Kelly's immortal words in the Pogo Comic Strip, 'We have met the marketplace and they is us.' If you are unhappy with the way management of a major corporation is performing, you have three choices: either persuade management to change those things which it is doing which is leading the company to underperform, or attempt to change management, or sell the stock. Since institutions now dominate the market, stampedes out of a stock increasingly result in losses of five to fifteen percent in a stock's price in one day. It would seem, therefore, that institutional investors have a duty to carefully examine proxy proposals and to reject those which would benefit management as opposed to benefiting the company." David G. Ball, Assistant Secretary of Labor ("ERISA"), Speech before the Financial Executives Institute, 1/23/90 (emphasis added).

"I accept the fact that shareholders with the credibility and avowedly long-term view of the California fund have a place in the corporate governance process. With an enlightened approach -- and why assume otherwise? -- both shareholders and corporate executives have more in common than anything that divides them . . . . There is a gap that can only be filled by the owners of the business -- at least if like the California pension fund, the owners are no in-and-outers and if they own a substantial block of stock. The converse is politically and economically absurd. The managers of the nation's resources would be accountable to no one but themselves and their hand picked boards." Louis Lowenstein, Washington Post , "B" Section, page 1, 1/14/90 (emphasis added).

"Envy and suspicion of unchecked power will have to find new targets. Our guess is that the corporate chieftains had better stop to think. Now even more insulated from shareholders, they had better be prepared to explain to whom they're accountable. Otherwise they may end up accountable to John Dingell. The first warning sign: General Motors received (though politely rebuffed) letters from California and New York state pension funds inquiring about its procedures for selecting a successor to Roger Smith." Wall Street Journal , Review & Outlook, "Closing an Era," p. A24, 4/26/90.

The proxy contest must be the least desirable mode for communication between corporate owners and managers -- save one, no communication at all.¹ From the point of view of shareholders, the annual meeting has about it the aura of communicating with one's spouse in a divorce court; the language is stilted and, if any conclusion is reached, subsequent compliance is grudging in the extreme. This paper proposes that the essentials of shareholder involvement can be accommodated relatively simply within the scope of existing law so as to assure an ongoing "creative tension."² Essentially this includes two related elements: (i) a disciplined agenda of items appropriate for shareholder consideration ("ownership agenda") and (ii) the assurance that the ownership agenda will be routinely considered at shareholder meetings under procedures that permit "rational" involvement.

I. Ownership Agenda

There are areas -- apart from those specifically proscribed by statute -- where ownership involvement is essential under the corporate form of organization. These are: (i) the maintenance of those characteristics of common stock essential to its continuing value; (ii) those contexts in which conflict of interest is inevitable, and ownership review and approval is necessary; and (iii) the selection of directors.

A. Common Stock

We have received the concept of common stock -- a mode of investment that entitles entirely passive investors to share the results of corporate operations after all other claims have been settled. Over the last century in the United States, common stocks have provided an indispensable opportunity to share in the growth of the economy and to protect against inflation. In recent times, however, certain components, essential to the attractiveness of common stock as a mode of investment, have been seriously diluted. We are approaching the point where it may be more appropriate to style the investment as "junk stock" rather than "common stock."

The inveterate and unchanging promise of law and tradition to common stockholders is that management is obligated loyally and competently to conduct the corporation's affairs so as to enhance long term values. In the recent face of threat of hostile takeovers, however, legislatures and courts have increasingly authorized and permitted alteration, and even elimination, of this fundamental obligation owed to ownership. Written instruments protect the entitlements of bond and senior security holders; the rights of common stockholders are a function of (i) the law of the state of incorporation and (ii) the provisions of the charter and bylaws. The only way for institutional investors to protect the value of their investments in junior equity is by becoming informed and involved in the governance of corporations. In the absence of "legal" protection of the historical attributes of common stock, institutional investors must learn to work together in order to protect those elements of common stock that make it an attractive mode of investment. The situation has become so attenuated that a failure to do so might be considered imprudent.

By way of brief summary, we will simply mention the actions of the governments of the Commonwealths of Massachusetts and Pennsylvania during the month of April 1990. Pennsylvania enacted a new corporation law which made clear, among other things, that directors are no longer obligated to run a corporation for profit. Massachusetts legislated that owners could be made to wait up to two years to take control over a corporation, no matter how large a percentage of ownership they have -- right up to 100%; no matter how seriously negligent the board of directors; and no matter how irreversible the damage being done to corporate values. Holders of what is called "common stock" in Massachusetts and Pennsylvania corporations plainly own something different from what has been the traditional meaning of that classification.

The courts of several states (including Delaware) have refused to accord owners: (i) the right to be consulted on the most fundamental changes in a corporation's business; (ii) the right to approve the leveraging of a corporation to the point of threatening its viability; (iii) the right to review or approve the compensation of managers, even when such is a material portion of total value; (iv) any authority to limit management's capacity to expend resources to change governance provisions to secure their own entrenchment; or (v) any protection against the blatant conflicts of interest inherent in management buyouts.

In contemplating today's share value of $94 for Time/Warner against the $200/share cash offer of a year ago, we must recognize that certain fundamental rights of owners, such as the transferability of shares, have been lost without much notice.

We are in a situation where the gradual erosion of traditional entitlements has not provoked the awareness or the outrage that are appropriate in view of the cumulative scope of the losses.

The difficulties for even the largest shareholders to justify expending resources to achieve objectives that are concededly in the interest of ownership as a whole have been widely described under the rubric of the "collective action" or "free rider" problem. One of the consequences of this non-action is the widespread elimination of essential ownership rights through amendments to bylaw and charter. An essential element of value in a share of stock of a publicly held company is the capacity to transfer it to a willing buyer at a mutually agreeable price. This is a right that is abrogated through the "poison pills," which are now commonly in effect in American companies. Another right absolutely central to ownership's capacity to enforce satisfactory management is change of the board of directors. By the staggering of terms of election over three years, shareholders have been deprived of the capacity at any given time to change management.

If an institutional investor wants to have available a medium for investment that accords with traditional common stock, there is no choice but to commit resources to effective exercise of ownership rights and responsibilities. Corporate governance is a matter of requiring that managements be accountable for directing the venture so as to maximize long term values; the only way that this can be achieved is through a process of increasing shareholder involvement. It starts with shareholder understanding of what has been done to their traditional entitlements by the various legislatures, courts and managements; it continues to the point where shareholders understand that they will have to devote attention, professional competency and monetary and personnel resources to being informed on governance issues; it goes on to recognition that being responsive to the proposals made by managements on the annual meeting proxy is necessary but inadequate; it culminates in the understanding that ownership of common stock, as a concept, needs vigorous and effective assertion in order to survive.

Concern with governance, thus, is not simply a matter of proxy voting; it is a question of the effective assertion of the rights of owners in competition with other interests in a pluralist world. Nor is that competition being conducted on a "level playing field"; institutional investors must recognize their present disadvantage arising out of years of inattention and neglect and the according need to take appropriate remedial action.

B. Conflict of Interest

Graham and Dodd, in their first edition of Security Analysis (1934) said: "The choice of a common stock is a single act, its ownership is a continuing process." In their view, it was inevitable that the interests of stockholders and officers would conflict at certain points and that shareholders should expect to be involved to protect their values. The agenda was defined by this inevitable conflict, which would keep it a creative tension, a system of checks and balances in which the interest of the officer and the stockholders may be in conflict. This field includes the following:

1. Compensation to Officers -- comprising salaries, bonuses, options to buy stock.

2. Expansion of the business -- involving the right to larger salaries, and the acquisition of more power and prestige by the officers.

3. Payment of dividends -- should the money earned remain under the control of the management, or pass into the hands of the stockholders?

4. Continuance of the stockholders' investment in the Company. Should the business continue as before, although unprofitable or should part of the capital be withdrawn, or should it be wound up completely? (Securities Analysis at pp. 510, 511)

The third element of an ownership agenda, along with the protection of the essential characteristics of stock itself and the need for a process to review conflicts of interest endemic to the form of organization, is in the selection of members of boards of directors. Professor Lowenstein, in the quotation at the beginning of this paper, describes "their hand picked boards" referring to management. While the theory of corporations unchangingly insists that owners elect directors who choose officers, the reality is exactly contrary. This, in turn, has created a situation in which shareholders, management and government alike have for over half a century found it convenient to discuss corporate governance as if the traditional model were operative, all the time knowing that such is not the case. Shareholders have not been able to find a means of effective collective action and, therefore, have been content to remain "rationally ignorant," while accepting the conventional wisdom that they have fundamental power; managements, who have all the power, have been glad to be able to defend against charges of possessing excessive power -- mantra like -- that their only power is that which the owners confer on them; government has not wanted to face up to the issue of the legitimacy of corporate power and "shareholder participation has thus provided the ideological justification for managerial power."³ The continuing key to the inversion of the traditional legal governance model is the chief executive officer's practical power to select and control the board, which then can easily dominate the proxy process through its control over the corporate resources. Unhappily, the determination to continue this pattern of CEO hegemony remains firm. The Business Roundtable's March 1990 Corporate Governance and American Competitiveness (p.14) continues to insist that the CEO also act as presiding officer over the board and that " . . . the items on the agenda are determined by the chairman , in consultation with the board (emphasis added)." It is unmistakable that the BRT does not consider the board to be an independently significant organ of governance deriving its authority from the shareholders, but rather as another department in a vertical corporate structure to be administered by the CEO " . . . the CEO can periodically ask the directors for their evaluation of the general agenda items for board meetings and any suggestions that they may have for improvement."

The tasks confronting owners to restore board selection and functioning to its traditional and legitimate role involve developing a register of independent qualified director candidates, participation in a nominating process not dominated by management and its "hand picked boards," including so-called outside directors , and effective use of voting power. The problem with the composition of boards in the United States is not the personnel, but rather the process by which they are selected for membership. The old refrain rings true: "You go home from the dance with the guy that brought you." Central to the ethical system of present day Americans is an abiding loyalty to the person and the process that selected them. There is, therefore, no way for a board of directors, itself, or of a "nominating committee" consisting of members of that board, to provide the essential independence to their nominee for board selection. Such a nominee will be a product of the existing board; the temptation will be overwhelming for his most fundamental loyalty to run to that board; and the appearance is unmistakable that he will not be able to view himself as a fiduciary exclusively for the benefit of the corporation's shareholders. The best way to break this chain is through the establishment of a registry -- along the lines of the British Pro-Ned -- of qualified and independent directors. These individuals may, and probably will, resemble the incumbent board members, but they will possess the indispensable extra quality of having been introduced by an external nominating process and, therefore, will be able credibly to have primary loyalty to shareholders rather than to the incumbent management.

Owners should not be involved in operational matters. But the informed involvement by owners in appropriate areas not only is essential to the proper functioning of corporations, it is essential for the long term enhancement of values. The improved performance of Honeywell following the unprecedented defeat of "management entrenchment" proposals at the 1989 annual meeting provides compelling evidence that good governance is good value.

It is essential that the SEC rules respecting proxy solicitation unmistakably permit "freedom of speech" in contacts with sophisticated institutional investors. Further, there is need to clarify the propriety of institutions making common cause with respect to the ownership agenda.

II. Periodic Consideration of Shareholder Agenda at Routine Meetings

Once there is recognition of a range of subjects that are undoubtedly appropriate for consideration by shareholders, it is sensible to conclude that such items be periodically (maybe not every year, but certainly within a five year period) placed on the agenda of shareholder meetings, that appropriate materials addressing the item be prepared and distributed timely to the owners, and that shareholders have the opportunity, both in the corporation's proxy and at the meeting, to present supplementary or even contradictory material, and, where appropriate, to vote on the matter. Almost half of the stock ownership of the publicly traded companies in America is held by institutions, the scope of whose fiduciary responsibilities as owner is subject to definition by federal agencies under existing laws.⁴ It should be possible for the appropriate regulatory agencies, as a matter of defining a "federal law of ownership" or the SEC pursuant to its powers under Section 14 of the Securities and Exchange Act of 1934 to proscribe the subjects and the periodicity of their inclusion in shareholder meeting agendas. By requiring that such matters be included in the company's proxy, in the manner presently used with Section 14A-8 questions, solicitation can be effected by both shareholders and management in the most cost effective manner. It may be desirable to provide for company funding of both sides of this "governance agenda."

Thus, a comprehensive view of executive compensation, an analysis of the relative values of conglomerate organization (in the style of Carl Icahn's 1990 proposal to USX), and a consideration of the whole panoply of bylaw and charter antitakeover provisions are examples of items that ought to be routinely placed on an agenda for approval by shareholders.

What is suggested is recognition and structural accommodation of the reality that owners and managers are both best served by squarely facing their interdependency. As has been set forth in the section "Ownership Agenda" above, there are categories where the appropriateness of ownership involvement is indisputable. At present, the "proxy system" and the "collective action" problem together inhibit an economical, indeed "rational," shareholder role. This means that owners have to resort to a hostile "proxy contest" in order to get consideration of items that should not be confrontational, but that should, on the other hand, receive shareholder attention.

A current example of how this might work in practice is presented by the spate of laws recently passed by state legislatures⁵ in response to a perceived threat to a particular company, laws threaten to make a mockery out of corporate governance in America. There is a relatively straightforward solution to this problem within the context of this paper -- shareholders need be assured of the right periodically to vote on the question of their preferred state of incorporation. At present, while some laws may appear to confer this right on owners, the practicality is that the domicile decision is made by management. By requiring that the issue appear periodically on the ballot, there could well result a "race to the top" in which owners make the decision on the basis of which state's corporation laws are most encouraging of long term values.

We are not making here argument for massive change in existing state laws, nor for a new federal presence. We are suggesting rather a new concept -- the development of categories of corporate activity for routine review by shareholders at appropriate intervals. The onus of marshalling dissenting votes remains with the institutional investors, who collectively own control of the large American corporations and who are increasingly being made aware by federal regulators of their responsibilities. They will need copy the British model and develop structure for collective agenda setting, cost sharing and ownership action along the line of the National Association of Pension Funds and the Association of British Insurers.

The keys to a value adding governance process are not in "proxy contests" but rather in:

1. Development of an "ownership agenda," the components of which will be considered as a right at shareholder meetings;

2. The ownership agenda will include reconsideration of the corporation's domicile at least once every five years; and

3. Development of a registry of suitable director candidates who are entirely "independent" of all existing corporate constituencies.

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