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Draft, October 19941
Carl Ichan's 1988 proxy contest at Texaco was a tough call. Both sides made presentations to the then-new Council of Institutional Investors, each making a strong case. Some of the institutions voted for Ichan, some for Texaco management. But at least one voted for both -- T. Rowe Price voted the shares of one of its funds for management, and the shares of another for Ichan. They explained that this was consistent with the funds' announced strategies. The short-term fund proxies were voted for Ichan, and the long-term fund proxies were voted for management.
We are all familiar with, and even comfortable with, the notion that these same two funds might have contrary approaches to buying and selling stock. A short-term fund might be selling Texaco while a long-term fund managed by the same firm was buying it. But I submit that the justification for these opposite transactions does not apply to the case of proxy voting and other share ownership rights. While in some macro sense selling a stock with one hand and buying it with the other may be a zero sum transaction, from the perspective of the funds' investors, both funds (and their investors) are left with value, indeed, the value they intended to acquire. But in the case of proxy voting, contrary votes cancel each other out in a way that benefits no one.
It is important to emphasize that I am defining shareholder activism, from strategic use of proxy voting to more affirmative initiatives, as an investment strategy. In other words, I mean that the exercise of ownership rights is as much a financial decision as the decision to buy, sell, or hold. In the institutional investor context, that means it is as much a fiduciary decision, too, and as subject to the requirements of care, skill, prudence and diligence. Everything I am advocating here is based on the showings by empirical evidence that shareholder activism consistently adds value and is a highly competitive an investment strategy, and increasingly so as markets become increasingly institutionalized.
As Charles D. Ellis, one time President of the Institute of Chartered Financial Analysts, noted: "Investment management, as traditionally practiced, is based on a single basic belief: Professional investment managers can beat the market. That premise appears to be false, particularly for the very large institutions that manage most of the assets of most trusts, pension funds, and endowments, because their institutions have effectively become the market."
William Fouse, chairman of Mellon Capital Management, says that pension fund management is "like monkeys trading bananas in trees." As he observed in an interview with Forbes writer Dyan Machan, "The money managers end up with a lot of the bananas." The efforts by pension fund fiduciaries to find active money managers who can beat the market over time have been unsuccessful. Most pension funds give their money to whichever manager did well the previous year, and given the statistical "regression to the mean," the odds are that manager will not do as well in the future.
An alternative strategy is "indexing," in which a fund buys every stock in a given index, such as the S&P 500. The holdings are held, not traded, so the fund neither beats the market nor underperforms it -- but replicates it. Forbes described an index strategy in simple terms: "Don't Just Do Something, Sit There."
Decisions are often based on recommendations by consultants. But consultants rarely recommend indexing. "[I]t would put them out of business if everyone did it. Pension funds pay consultants for objective advice on which funds to hire, but the same consultants charge managers fees for measuring the managers' performance...There are plenty of stories about managers who are recommended by the consultants on the grounds that the managers pay the consultants the biggest fees."
A rare contrarian exception is the General Mills pension fund, which has dared to "break entirely out of the cycle ... Instead of firing the stock picker who happens to be performing below the mean in a given year, General Mills gives him more money, taking from highest ranked performer. As a result, General Mills has produced one of the best long-term records with 17 percent annualized equity return over the 15 years ending in 1992. It is therefore not surprising that a study of 135 funds with $700 billion in assets, concluded that "There was no positive correlation between performance and money spent on staff, managers, and other high-priced advice to get it."
Every investor, whether individual or institutional, hopes that it can be the exception and can beat the averages. This is reminiscent of the line about the poker game, "If we all play well, we can all make money." This hope, rather than any statistical evidence, accounts in part for the change in the way shareholders see themselves today: no longer as an owner but as a speculator.
Of course another of the incentives for a minimal sense of ownership by money managers is short term self-interest. Active trading produces immediate transaction costs. Monitoring involves the commitment of resources for gains that are not immediately quantifiable, with the possible exception of shareholders who are large enough and aggressive enough to underwrite contests for control. In the longer term, this has involved a high price for the business system as whole.
Transferability has had consequences for corporations as well. It means that the interests of shareholder and managers are based on incompatible premises. The investor will want to sell at the first sign that the stock may have reached its trading peak, whereas the manager wants stable, long-term investors. The American corporate system was initially based on the permanence of investor capital. But while the capital may have remained in place, the owners kept changing. Unintentionally, the growth of the institutional investors may have served to reintroduce stability in stock ownership. But that could not happen until the institutional investors were shocked into activism by the abuses of the takeover era.
An essential part of the theoretical underpinning for the market was the notion that shareholders should sell to each other, and as often as possible to keep the markets "efficient ." During the takeover era, it became clear that, though the system was designed to promote transferability above all, there was one kind of transfer that the system would not tolerate: the transfer of power from one group to another. Despite a strong theoretical commitment to "the market for corporate control," as soon as the means create a genuine market were developed, corporations, lawyers, and legislators, even judges, worked quickly to obliterate it.
The shareholder has the exclusive control of the stock itself. But as a condition of the shareholder's limited liability, the shareholder gives up the right to control use of the corporation's property by others. That right is delegated to the management of the corporation. Indeed, it is one of the benefits of the corporate organization to the investor; he can entrust his money to people who have expertise and time that he does not. But it is also one of the drawbacks. Thus, it is this separation between ownership and control that has been the focus of the struggles over corporate governance.
Professor Melvin Aron Eisenberg writes of the "limits of shareholder consent,"noting that "under current law and practice, shareholder consent to rules proposed by top managers in publicly held corporations may be either nominal, tainted by a conflict of interest, coerced, or impoverished." In Eisenberg's view, shareholder consent is "nominal" when (as permitted under proxy rules) the shareholder does not vote at all and management votes on his behalf, or shares held by the broker or broker's depository are voted with no direction from the beneficial owner. Shareholder consent is "tainted" by a conflict of interest when an institutional investor votes in favor of a management proposal it would otherwise oppose, due to commercial ties to the company management (see below).
Shareholder consent is "coerced" when, for example, management ties an action that is attractive to shareholders, like a special dividend, to passage of a provision that may be contrary to their interests. For instance, in 1989, shareholders of Ramada Inc. were asked to approve a package of antitakeover measures, bundled with a generous cash payment. And shareholder consent is "impoverished" when "for example, shareholders may vote for a rule proposed by management even though they would prefer a different rule, because the proposed rule is better than the rule it replaces and management's control over the agenda effectively limits the shareholders' choice to the existing rule or the proposed rule." This is a reflection of management's vastly superior access to the proxy, both procedurally (in terms of resources) and substantively (in terms of appropriate subject matter). Eisenberg has described shareholders as "disenfranchised."
The disenfranchisement of the modern shareholder has been developing for over a century, but it took the events of the last decade to bring them to public attention. In the 1980s, the takeover era itself was a symptom of the problems created by the failure to link ownership and control. As we describe below in more detail, 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, as noted above, 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 a system which was working very well from their perspective.
As a result, Harvard Professor Michael Jensen predicted in The End of the Public Corporation that the "ownerless" modern venture without the discipline of accountability would inevitably be unable to compete. He saw that the leveraged buyouts that had reconnected management and ownership at the end of the 1980s as the model for the future.
Shareholders are often referred to as the "owners" of the corporation, but the corporation's "legal personality" raises questions about whether it can be "owned" in any meaningful and effective way. 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 be an open process between entities that are informed, motivated and empowered.
The regulatory framework governing the issuance and trading of public securities and the functioning of exchanges was almost entirely set up by two landmark statutes of the New Deal era. Congress passed the 1933 Securities Act and 1934 Securities and Exchange Act after exhaustive debate and in response to overwhelming evidence of mismanagement, deception and outright fraud during the stock market boom of the late twenties. In the Public Utility Holding Company Act of 1935 and the Investment Company Act of 1940, multiple classes of common stock with differing voting characteristics were flatly prohibited for the affected companies. Rather than attempt with industrial companies to remedy specific mistakes or abuses, lawmakers attempted a far more difficult task; they tried to set up a process of corporate accountability--an impartial set of rules preserving the widest possible latitude for shareholders to protect their financial interests. In searching for a reliable and familiar model, they turned to America's own traditions of political accountability.
Shareholders were seen as voters, boards of directors as elected representatives, proxy solicitations as election campaigns, corporate charters and by-laws as constitutions and amendments. Just as political democracy acted to guarantee the legitimacy of governmental or public power, the theory went, so corporate democracy would control--and therefore legitimate--the otherwise uncontrollable growth of power in the hands of private individuals. Underpinning that corporate democracy, as universal franchise underpinned its political counterpart, was the principle of one share, one vote.
It is not difficult, in this context, to establish a standard for the prudent exercise of ownership rights for pension fiduciaries. Their commitment to the long term makes them good, if not perfect, corporate citizens. It is much more difficult to argue that effective monitoring is cost-effective for investors whose profit is principally derived from buying and selling in the short term. Robert Monks and I refer to these investors as the "one-night-stands." For institutions whose commitment is to liquidity, rather than long-term security, the prospect of buying low and selling high is so beguiling that a lucrative industry of "active money management" has flourished. This is, notwithstanding the reality that from a macro perspective institutional investors are the market and, therefore, cannot hope to beat its performance.
Mutual funds are trusts, according to the terms of the Investment Company Act of 1940, which governs them. Otherwise, they bear little resemblance to the other institutional investors because of one important difference: they are designed for total liquidity. The "one-night stands" of institutional investment, they are designed for investors who come in and out on a daily basis, or at least those who want the flexibility to do so.
The investors are entitled to take their money out at any time, at whatever the price is that day. The investment manager has no control over what he will have to pay out or when he will be forced to liquidate a holding. So he views his investments as collateral; they are simply there to make good on the promise to shareholders to redeem their shares at any time. This is not the kind of relationship to encourage a long-term attitude toward any particular company the fund happens to invest in, and if there is a tender offer at any premium over the trading price, mutual fund investment managers have to grab it.
In the face of the real need to attract new money and to retain the investors he has in a world of perpetual and precise competition, the mutual fund manager cannot concern himself with the long term, because his investors may all show up today, and he must be prepared to stand and deliver. For the effect of this difference, compare the T. Rowe Price votes at Texaco to the 1993 announcement of the proxy voting policies of the Campbell's Soup pension fund.
In July of 1993, Campbell Soup Company's $1 billion pension fund became the first major ERISA plan to make a commitment to "investing" in shareholder activism. Until that point, institutional shareholder activism had been largely the province of public pension funds. Proud of its own corporate governance structure and record, Campbell's pension fund announced that it would direct the firms managing their pension fund's equity investments to vote their proxies against companies that elect more than three inside directors or re-price stock options after falling stock prices leave them with little value. Campbell's also said it would direct its money managers to vote their proxies to emphasize linking executive pay to performance.
But Campbell's is an exception. Despite undeniable evidence of the value of share ownership rights, many institutional investors continue to ignore them. The two primary obstacles are the two classic justifications for government intervention: collective choice problems and conflicts of interest.
1. Collective choice
The incentives driving shareholder actions can be compared to the famous logical problem called "the prisoner's dilemma." Two co-conspirators are captured and placed in separate cells by the police. They are each told that if neither confesses, there will not be enough evidence , and both will go free. If one confesses, only that prisoner will get a reduced sentence. If both confess, both go to jail for a reduced term. Each must sit, unable to communicate with the other, and decide what to do. The dilemma is that an action that may benefit the individual making the choice (whether silence or confession) may have adverse consequences for the group (prison), whereas an action that benefits the group (silence) may have adverse consequences for the individual (prison, if the other confesses). This is also referred to as the problem of "collective choice" and the "free rider" problem. Any shareholder who wants to exercise ownership rights to influence a company must undertake all of the expenses, for only a pro rata share of the gains, if there are any. This problem has also produced one of this field's better oxymorons, by giving rise to the term for shareholders who deem it uneconomic to become involved in governance: "rational ignorance."
2. Conflicts of interest
Money managers have commercial relationships with corporations. They also vote proxies on behalf of the beneficial holders. The beneficial holders do not know how the votes are cast on their behalf. In almost all cases, the companies who are or might be doing business with the money managers do know how their votes are cast. Thus, the money managers have every incentive to vote with management, even when it may not be in the interests of the beneficial holders. The results of this conflict of interest have been discussed in detail (see, for example, Conflicts of Interest in the Proxy Voting System , by James E. Heard and Howard D. Sherman).
The Labor Department, responding to just these two obstacles to effective exercise of ownership rights by institutional shareholders, has issued a series of letters, enforcement surveys, and, most recently, a formal interpretive bulletin, determining that exercise of share ownership rights is a fiduciary obligation. They did not proscribe any particular action, and do not even require written proxy policies. They merely said that these decisions must be done prudently, based on thoughtful and reasonable analysis. The impact on the ERISA community has been dramatic. A similar ruling by the SEC seems at least equally justified, and equally likely to produce meaningful results. My own recommendation would be to go further than the DOL, and require disclosure of proxy policies (or even of the existence of proxy policies), but that may not be practical.
Ultimately, all institutional investors, including 40 Act managers, should consider share ownership rights a valuable asset that can and should be exercised to preserve and enhance value.
They should do it because it makes money, as shown by empirical evidence.
They should do it because they are required to, as a fiduciary, whether the SEC says so explicitly or not.
They should do it because they need to, to be competitive, as investors become more aware of the benefits of effective exercise of share ownership rights.
They should do it because if they don't, someone else will, and they won't like the results. The problem with being a free rider is that you can't control the direction of the ride.