Corporate Governance: Past, Present, & Future

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Editor’s Note: Robert Monks is the founder of Lens Governance Advisors, a law firm that advises on corporate governance in the settlement of shareholder litigation.

The Vision

The modern business corporation emerged as the first institutional claimant of significant unregulated power since the nation state established its title in the sixteenth and seventeenth centuries.
—Abe Chayes [1]

Abe Chayes, a former Kennedy administration official and long-time Harvard Law professor, wrote those words at the outset of what might be thought of as America’s own “Thirty Glorious Years” — that three-decade span from the late seventies through 2008 when it seemed possible that private enterprise could operate on a global stage, free from the constraints of governmental regulation and oversight. The vision was simple and stirring, and in many ways irresistible: Corporate efficiency could co-exist with democracy.

Writing in the Stanford Law Review, another professor, David Engel, [2] precisely articulated the standards to which corporations would need to subscribe in order to legitimate this unregulated power within a democratic society:

  • Disclose fully the impact of their operations on society
  • Obey the law
  • Restrain their impact on government– both elections and administration

Today, we are surrounded by the wreckage of this seemingly noble experiment. ”Self-restraint” proved largely to be no restraint. Rather than legitimatize the power handed them, corporations have insured the ultimate need for involvement of government and the end of the dream.

There is, however, a silver lining in all this. The financial crisis of 2007-2010 has created the rare political climate in which one can realistically suggest preemptive federal action, particularly to redress the unintended consequences of earlier actions. And the Supreme Court’s recent decision in the Citizens United case has created not only a compelling need to do so but an inherent logic in how to proceed. First, though, some background.

The History

Government and the Corporation

The Constitution does not mention the word corporation, but suspicion of centralized corporate power was an early part of the American political landscape, culminating in President Jackson’s refusal to recharter the Second Bank of the United States. By the middle of the 19th century, corporate charters were available as of right, but corporations were limited as to size, purpose, and tenure. Power, though, was beginning to drift the corporation’s way. By insuring that states would always compete for charters through ever-more diluted restrictions, the federal system resulted in unrestricted chartering of corporations by the end of the nineteenth century. In 1886, in an important aside, the Supreme Court concluded that corporations were “persons” entitled to the protections of the Fourteenth Amendment to the constitution and, therefore, legal participants in the political life of the country.

Corporate power continued to be a critical element of disagreement between the political parties in the presidential elections of the early 20th century. In general, Republicans backed Wall Street and big business, while Democrats sought to outlaw monopolies and unfair practices. But Theodore Roosevelt consistently battled the “trusts,” and in his 1912 campaign (running now under the banner of the Progressive Party, rather than as a Republican), Roosevelt recommended strong federal regulation to offset corporate power. Justice Louis Brandies concurred. Large corporate power cannot be controlled from without, Brandeis argued: “We believe that no methods of regulation ever have been or can be devised to remove the menace inherent in private monopoly and overweening commercial power.” [3]

As ownership of the great enterprises passed from the “robber barons” to their heirs and the general public, Wall Street and financialization became the critical factors in corporate governance. Transactions affecting corporate capital and control generated fees, which became the informing energy of the American capitalist system, a situation that has prevailed into the 21st century.

In the earliest days of financialization, control over corporations was largely exercised by the respected leaders of the banking houses, epitomized by J.P. Morgan, but this soon became “control” only in the loosest sense. In 1932, Adolph Berle and Gardiner Means vivisected the modern corporation and found a virtually omnipotent management and an impotent shareholdership. A quarter century of unparalleled corporate law reform followed, and the American business corporation emerged from World War II still bearing the stains of fifteen years of Depression and disgrace.

For corporations, what might have been the worst of times proved instead to be the beginning of the best of them. Industrial production, which had built up to historically high levels in order to “win the war,” barely missed a beat as the “industrial military complex” expanded to win the peace, consumer appetites swelled after years of price controls and rationing, and foreign competition lay either destroyed or dormant. Thus, US global hegemony coupled with domestic oligopoly allowed the rarity of shared prosperity to the extent that corporate CEOs could be thought of as “philosopher kings.” This dimmed any serious analysis of the governance of corporations.

Who Owns Corporations?

In 1958, Joseph Livingston surveyed the lot of the shareholder in this reformed world — a world of SEC regulation, extensive disclosure requirements, elaborate proxy machinery, Stock Exchange self-discipline, corporate Good Citizenship, People’s Capitalism, and Corporate Democracy. His finding? Exactly what Berle and Means had discovered a quarter century earlier: A virtually omnipotent management and an impotent shareholdership.

These findings, of course, will not surprise today’s readers. Over the succeeding decades, corporate failures – both to learn and to conform with societal standards – have repeated themselves with almost metronomic regularity. Every decade, it seems, government predictably considers and often passes legislation: in the late seventies, the Foreign Corrupt Practices Act; in the eighties, the Corporate Democracy Act (which, in fact, did not pass); in the early years of this century, Sarbanes Oxley; and most recently, Barney Frank and Chris Dodd’s almost Quixotic struggle to produce a pre-election reform bill.

Whatever the supposed cure-of-the-moment, the result is highly predictable: Public concern diminishes, the lobbies flourish, and the cycle starts again. Criminal malefactions dot almost every decade – General Electric and Westinghouse in the electric company conspiracies; Armand Hammer and George Steinbrenner for violation of election contribution laws, Charles Keating and the S&L crisis, Ivan Boesky and Michael Milkin in the eighties, WorldCom and Enron in the early years of this decade, and the finance sector as a whole in the new century. Outrage invariably follows. The talking heads become screaming ones, but in the end, human nature appears to triumph over all manner of controls.

A Fundamental Flaw

The various reform efforts chronicled above were informed by a belief that shareholders elect directors, that directors have a fiduciary duty to protect the shareholders’ interest, and that management is accountable to the board. It has long been clear — and now it is demonstrably so — that each of these premises is probably false. John J. Flynn stated the matter clearly in his book Corporate Democracy:

Our corporate statutes assume that shareholders own the corporation, that the rights and powers of shareholders flow from their providing ”risk capital,” that directors shall manage the business, and that officers are agents of the corporation under the direction and control of the board, with a duty to manage the corporation for the benefit of all the shareholders. None of these claims is true. [4]

By extension, then, it follows that the American-style “trente glorieuses” — as the 30-year, post-war rise of the French economy became known — was also fundamentally flawed. It took as its assumption, as we have seen, that a corporation unfettered by any regulation — governmental or ownership — was the best corporation. The reality, as we have also seen, is that self-restraint in the corporate mind frame yields no restraint. So how did we get there? Incrementally, it turns out, and often with the best of intentions. To cite only a few of the highlights:

  • In 1971, while Lewis Powell was still a prominent lawyer advising the US Chamber of Commerce of the need to organize a business response to its diminished state, he was appointed and confirmed a Justice of the Supreme Court of the United States. From that “bully pulpit,” he effectively and discretely continued to provide the informing core for the emerging corporate hegemony.
  • Inspired by Powell’s appointment and advocacy, conservatives organized the Federalist Society to screen, educate and ultimately to approve of appointments to the Federal bench. The new corporate energy also created the Heritage Foundation and revived the American Enterprise Institute, assuring a consistent and continuing conservative voice.
  • This wasn’t just a Conservative revolution, however. A pervasive sense of frustration with federal involvement in business — a belief that government is the problem, not the solution— led Democratic President Jimmy Carter to deregulate the airlines, and more deregulation quickly followed.
  • In the UK, Margaret Thatcher denationalized every business she could get her hands on and sent a message to continental Europe.
  • Back in the U.S. and with momentum on his side, new president Ronald Reagan fired the air traffic controllers, confirming the irrelevance of organized labor, and the rout was on. Reagan handed the ball off to George H.W. Bush, who had served as the deregulation point man while Vice President. Bush passed it on (reluctantly) to Bill Clinton, who had no stomach for a populist crusade against Big Business; and Clinton yielded to George W. Bush, who had not fallen far from his father’s tree.

Regulation didn’t cease and desist during these years. The administration of Richard Nixon, for example, imposed multiple new standards affecting particular aspects of corporate impact on society – the environment and product safety. Under Reagan and others, Big Business even showed that it was not against all regulation. Indeed, many of the most expensive and daunting licensing practices have been quietly supported by the major companies since the existence of these regulations effectively blocks the emergence of new competition. And in fact the
single consistent element of US government involvement in business over the entire past has been just that: the enforcement of anti-competitive or anti-trust laws.

During Reagan’s administration, enforcement was so slender that major private law firms specializing in anti-trust shut their doors. Major anti-trust cases – those against IBM and Microsoft – ultimately were decided in favor of the defendants because of deep pockets, skillful counsel, and the patience to await a forgiving new Presidential administration.

Even when the financial crisis of 2007-2010 appeared to require aggressive entry by government into failing sectors of the economy, the intrusion was done largely on corporate terms. Both political parties participated in “bailouts” of financial institutions, automobile companies, and GSEs (government sponsored enterprises), especially Fannie Mae and Freddie Mac. Rather than simply “nationalizing” target companies, the government selectively chose tools deemed appropriate for expressing the public interest in the operation of these companies without, in many instances, making any serious effort to tether the corporate leadership that had helped bring on the crisis.

The government’s “cuckoo egg” like presence in various companies might have humbled some of them, but on the whole, it did little to alter the situation Flynn, Chayes, and others had described. Ownership was still effectively internal in most publicly held corporations, with the greatest share in the hands of the corporation’s own reigning monarch.

The CEO as Philosopher King

There never has been a strong intellectual justification for the notion of the corporate Chief Executive Officer as a dispenser of public good. Berle, for example, engaged in a spirited public dialogue with Professor Merrick Dodd in the later 1940s and concluded that the CEO as public fiduciary probably was the prevailing reality of the time although he continued to feel that a chief executive’s focus should be on optimizing the corporation’s value.

In recent decades, the debate over the role of CEO’s has broadened to include executive pay, but here again, we are without any persuasive explanation as to why top executives should suddenly earn ten or twenty times more – by all measures of comparison – than they ever did before. I confronted the formidable Lee Raymond at the 2006 ExxonMobil Annual Meeting with this simple question: “What is the justification for paying yourself 16 times more than your predecessor received?” No answer was forthcoming, in large part because no answer was required. Like all annual meetings, at this one all the cards were held by management, and thus shareholder-owners such as myself were supplicants at best, and in reality mostly stage props.

Executive pay, in short, is the symptom. The disease is an executive power that is accountable to no one. No legitimate governance system can be based on the unaccountable power of senior executives, and in the U.S., no existing governance system seems capable of reigning them in, least of all the ones appointed to do the task.

Boards of Directors

Peter Drucker has long raised the question as to whether the current standard of board functioning is so unsatisfactory as to require structural change. Nearly 30 years ago, in The Bored Board, he wrote: “Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years, it is futile to blame men. It is the institution that malfunctions.” [5] In the years since, the inability of any portion of the corporate governance structure to deal effectively with holding top management to account — see the discussion of executive compensation, just above — compels the conclusion of continuing systemic board failure.

Simply put, if shareholders cannot hold the CEO accountable for his compensation, how can they assume they exercise effective accountability in any other area? One might ask essentially the same question about the board nostrums commonly put forward: ever larger “majorities,” ever more extensive definitions of “independent.” Why have faith in either solution when the problems persist unchecked?

At present the consensus view as to corporate governance best practice is so dominant that it is difficult even to suggest that further empowerment of an independent monitoring board may not be the solution to the current round of corporate scandals and flagrant abuses. Nevertheless, after watching independence and empowerment ratcheted up and up and up for 30 years, our conclusion is that enough is now enough. It is time to recognize that other best practice models of corporate governance need to be evaluated….. The point is that by turning the corporate board into the ”monitor” of corporate management, we do not appear to have been able to stop the scandals and flagrant abuses, and we may well be losing the vision, advice, and competitive perceptiveness that a good board should be providing the CEO. Surely there must be better ways to deal with the consequences of the separation of ownership from control in the modern corporation. The time has come, we believe, to think outside the consensus box. [6]

One definition of madness is repeating the same action and expecting a different result, yet this is madness seemingly without any ready cure. Corporate America has opposed even a scintilla of suggestion that shareholders participate in the nomination of board candidates. Former SEC Chairman Donaldson’s proposal for token shareholder involvement was so plainly unlikely to lead to the election of even a single truly “independent” director that one is bewildered by the violent rhetoric of opposition which persists to this day. The usual reason given is the need to maintain the confidentiality and collegiality of board functioning. Sherlock Holmes would look further, but we need not do so here.

Squaring a Circle

Perhaps, then, it is time to recognize that a fundamental and irreconcilable conflict exists in the perception of what boards should do and how they should be constituted. Our efforts to achieve functionality within the context of the traditional single board can be understood as the metaphoric inability to square a circle. We cannot hope to make progress until — once and for all — we face up to the reality that a self-selecting board cannot ever meet the very real needs for independence at critical points in the governance structure.

To reduce the argument to a philosophical proposition:

  • Independent directors are essential to good governance
  • Directors selected pursuant to a self-selecting process cannot be considered in any meaningful way to be independent
  • Therefore, good governance requires something other than a board of self-selected directors

But how can we see this syllogism into existence? In fact, the United Kingdom offers a very effective model. There, five percent of voting shareholders have the right to call a special meeting at which a majority can remove any or all of the directors with or without cause. This creates in world in which:

  • Major shareholders can, without provoking undue controversy or potential legal exposure, agree that there should be change in a board of directors. [7] Substantially greater commitment and exposure is required to get agreement as to the particular individuals who should be proffered as replacements. [8]
  • Institutional shareholders have no particular competency to select individuals to serve as director in specific situations. [9] They can, however, readily acquire the capacity to evaluate board changes proposed by management.
  • Change does not mortally challenge management who retain the power to nominate directors. [10] This continuing prerogative is importantly balanced when shareholders have non-controversial power to remove directors.
  • Maybe most important, a creative tension exists. Management must ultimately propose nominees satisfactory to the shareholders, and shareholders can effectively express opposition without undue exposure. In sports, this is known as a trade that benefits both clubs.

Achieving the same end in the U.S. would require a federal statute pre-emptive of state laws that almost always bend toward corporate power. In the current political climate that might be possible, but without the serious and dedicated participation of owners in publicly traded companies, the political fight, even if successful, would likely yield a Pyrrhic victory. And that gets us to the central issue of the entire discussion: how to insure the intelligent and effective involvement of owners? [11]


Who Are They?

Shareholder in its modern Anglo-American usage has multiple meanings — so many that Ira Millstein recently described shareholders as being akin to vegetables: They are all of the same species, but there is almost an infinite variety with many dissimilar characteristics. Still, if we are going to seriously address what rights and powers shareholder-owners do and should have and exercise, we need to first understand what we are talking about. Thus, this initial effort at a working definition of the word.

Shareholders are:

  • The flesh-and-blood individuals beneficially entitled to receive distributions with respect to their holdings; sell or transfer those holdings; and participate in corporate governance, including voting, as conferred by statute or charter
  • Trustees with rights and obligations as spelled out under appropriate Federal statutes, in particular the Retirement Income Security Act of 1974 and the Investment Company Act of 1940; as spelled out under the laws of appropriate states, respecting state chartered banks and insurance companies; and as derived from Common Law.
  • Custodians, with rights and obligations as defined in the agreement creating the relationship.
  • Creditors, with rights and obligations the same as if they were custodians.

That breaks the ice, perhaps, but it doesn’t begin to address all the inherent permutations and combinations of the possibilities above. What about nationality, for example? Will policy makers continue to treat corporations as having a single domicile or home, and if so, will shareholders be considered to be nationals of a particular country and will the extent of their involvement by affected by this determination?

How about duration of ownership or even intent of ownership? Should ownership obligations and rights be identical for those who treat their shares as long-term investments vs. those who regard their shares basically as betting slips, and for those who actually think through their selections vs. those whose ownership has been mechanically determined? McKinsey concludes that up to half of shareholdings result from mechanical formulae, be they indexes or computer algorithms. At the extreme, computer-generated shareholdings can last a nano second and shareholdings in standard indexes can be considered as permanent. Meanwhile, contractual provisions can create a situation in which the voting prerogative of shares is exercised in a manner contrary to their economic value – perverse ownership!

Clearly, the modern shareholder, like love, is a many-splendoured thing, but while we can admire such diversity, we also have to ask whether any single class so broadly writ can ever begin to exercise its ownership rights vis a vis entrenched and well-funded corporate power. On that score, the evidence of recent years is overwhelming: The practical effect of having ownership spread so broadly is that shareholders as a group have virtually no effective ownership rights they can exercise. Senior management pays itself, boards sit idly or complacently by, corporations abrogate ever more authority to themselves and gain an ever stronger voice in the political process, and when it comes time for the piper to be paid, the shareholders pony up in lost equity value and increasingly of late taxpayers pick up the final tab. This is a condition that ultimately serves no public good.

Government as Shareholder

As the enforcer of last resort of the inveterate and unchanging obligation of Trustees to manage properties for the exclusive benefit of their beneficiaries, Government has demonstrably failed. In recent times, particularly when fiduciary power is held by financial conglomerates, conflicts of interest are rife, and there is virtually no supervision or enforcement for breach of trust when the trustees favor their own commercial interest. Government innocently created this problem by putting voting control into federally regulated fiduciaries and then failing to provide guidance or enforcement as to how those fiduciaries should function, but in the final analysis, innocence is no excuse. The result has been sterilization of the majority of owners with the result that wildly inappropriate results can be achieved by well-organized minority groups.

Nor has Government made any notable effort to mandate changes in the reward/penalty structure, so as to create an environment within which fiduciaries can act as owners without unacceptable cost to their beneficiaries. To cite one small example, my annual fees of some $50,000 to file a “plain vanilla” §14 (a)(8) resolution with a hostile Exxon Mobil gives some hint as to the administrative complexities and legal costs of effecting a nomination filing under the various access proposals. Who, as a practical matter, is going to incur these expenses?

One might, however, expect that Government would act in its own enlightened self-interest now that it has become a principal shareholder in a number of America’s iconic businesses. Here, too, though, the problem goes back to the very definition of shareholder ownership. The most obvious example is the evident confusion over who actually “owns” the entities the federal government (and taxpayers) have rescued during the current economic near-meltdown: the automobile companies, Fannie and Freddie, AIG, Citigroup, etc.. There appears to be no consistency in the normative mandate in these instances.

Other examples of inconsistencies structural and otherwise:

  • Government involvement in voting shares of equity securities held by the Thrift Investment Board (U.S. federal employees), the largest institutional owner in the country, is specifically prohibited by statute – Section 8438(g). [12]
  • Three designees of the Federal Reserve Bank of New York are the voting trustees for 78% of the common stock of AIG. They are solemnly mandated to vote in the best interest of the shareholders, except to the extent the contrary is indicated by the US Treasury.
  • The Treasury Department – per Assistant Secretary Herb Allison – undertook to provide to the Congressional sub committee chaired by Dennis Kucinich a written expression of Treasury voting policies. On further consideration, the Treasury says that none will be issued.

And so it goes. The prevailing shareholder structure in the United States is the unintended consequence of federal laws whose principal objection was to authorize investment companies and employee benefit plans. While the principal objectives of the legislation seem well enough served, the consequences of having government-regulated entities as the dominant shareholders of publicly traded US companies have not been squarely confronted.

ERISA plans, for example, account for about 30% of total shareholding in publicly traded US companies. Plans under the Investment Company Act cover roughly another 20%, with some duplication for 401(k) plans. What’s more, under “back door ERISA,” tax exemption under the Internal Revenue Code is granted various charities, non-profit organizations and municipalities. In theory, corporate governance considerations are one of the controlling considerations in granting this status, but as with other ERISA holdings and those under the Investment Company Act, the federal government has had a policy of “benign” neglect with respect to voting these shares, even extending to conflicts of interest that inevitably arise with respect to competing fiduciary relationships among companies whose shares are held in the trusts.

One might applaud benign neglect where government is concerned, but here exists a fundamental contradiction in the fiduciary provisions of ERISA – namely that the party setting up the trust can also act as the fiduciary. This means as a practical matter that private pension plans – those subject to ERISA – are likely to be voted not in the interests of the plan participants but in the interests of the employer. [13] Nor has any enforcement been directed at charities, the most prominent of which simply disdain any voting participation on account of their ownership responsibilities. [14] And as ERISA and AIG etc. go, so goes much of the rest of federal oversight and shareholder role.

Proprietors or Punters?

Simply stated, there can be no universal definition of “shareholder” and no possibility of articulating purpose or interest that will apply to all components of this class at all times. This dichotomy was aptly captured twenty years ago in the Economist article captioned “Proprietors or Punters.” For some shareowners, control and direction of the company in which they are invested is critical. Their objective is that portfolio companies should be sustainable, should be able to function in harmony with civil interest indefinitely. For others, ownership is literally a betting slip, and it is mere coincidence that the slip relates to a share of stock, rather than a horse or a football game. Can these seeming contrary energies be combined in a single shareholder?

Half a century ago, Bayless Manning argued persuasively that the underlying theme of shareholder as owner has plainly been proven not to be useful, and therefore, he conjured a fundamentally new corporate configuration:

If our present course of reform toward more Corporate Democracy is misguided, is it possible at this time to project a more satisfactory approach ~ Probably so. But such an approach would have to proceed from the facts of the modern corporate institution and be accommodated to them, rather than to a bucolic and obsolete image. An arbitrary model of a corporate structure may prove helpful in attacking the problem. Assume a large modern corporation similar to its typical commercial counterpart in all respects but two.

First, the model abandons the a priori legal conclusion that the shareholders “own the corporation” and substitutes the more restricted conception that the only thing they “own” is their shares of stock. Second, the shareholder in this model corporation has no voting rights. His position would be quite similar to that of a voting trust certificate holder with all economic right in the deposited stock but no power to elect or replace the trustees by vote.

Given this corporate model, there can be no talk of “corporate democracy” or rejoining “control” and “ownership.” In such a corporate world, how would one go about ensuring the desired degree of management responsibility while permitting corporate officers the necessary discretion to run the business? The problem is difficult but not impossible. Its solution has already been approximated in trust law. [15]

A half century later, Manning’s solution is still relevant and more necessary than ever: Good governance does not require the involvement of all shareholders; it requires only that there exist an informed, effective, and motivated ownership element within the corporate constellation.

Shareholder as Steward

Do we want to have owners? Do owners constitute a unique opportunity for society? Do they provide the possibility of wealth and equity? The answer to all three question is indisputably yes. Equity investment in publicly owned companies is twice blessèd: It blesses the corporate manager who does not need to pay interest to his financiers, and it blesses the investor who – historically – has achieved returns in excess of those obtainable from “safe” investments. It is not only the wealthy who benefit; it is society, most conspicuously in the form of pensioners. Funds invested at a 6% real rate of return over a thirty-year period will provide more than double the resources than if only the historical 2% for debt is obtained.

Do owners perform a uniquely valuable function in the governance of the corporate sector? Can attractive returns and responsible operations be achieved ? Is there any way to rationalize shareholding to create able steward-owners? These questions, in fact, go to the very crux of the matter at hand.

Clearly, the present range of shareholders cannot be rationalized into coherent ownership energy. This suggests that the answer may lie in multiple classes of equity ownership — a pattern that has proven successful in several contexts over many years. There is no need that all participants in the equity strata of corporate capitalization should function as stewards; The need is only that a significant caste of stewards should be effectively present in each public company. But where will that significant caste be drawn from? What criteria will be used to identify potential stewards?

”Activism” itself is not generally attractive because the “carrot” of adding value is not sufficient inducement and the “stick” (discipline or fines for fiduciary failure) is insufficiently daunting. The result is that with a few honorable exceptions —TIAA/CREF in America, Hermes in the UK – activism has been limited to union and public employee pension funds, which despite their many virtues do not appear to have the experience or orientation necessary to act as credible maximizers of shareholder value. Meanwhile, the vast preponderance of shareholders prefers non-action, which effectively leaves the least credible slice of equity owners acting for the class a whole.

This systemic dysfunction necessitates the involvement of an external catalyst: government. Only government can definitively locate the responsibilities of shareholders – shares loaned, shares sold short, shares whose vote is contracted away from the economic beneficiary, etc. What’s more, government is increasingly heavily represented among the shareholding class. Thus it has not only an obligation but a clear, self-interested need to place responsibility for stewardship on one of the parties in the fiduciary chain. The pattern of trustees delegating functions is well established; often the voting responsibility is de facto delegated to a voting service. If active ownership is to serve its intended purpose, there needs be a single responsible body.

Short-term activists – arbitrageurs, “locusts,” hedge funds – need no encouragement to insert themselves as best they can in the fiduciary chain. Their business model rewards thrusts into the market place. What’s needed is a counter-balancing caste of long-term activists, stewards for whom shares are more than betting slips, and that leaves us with two choices: the unthinking index and computer shareholders, or the activist portion of McKinsey’s “intrinsic” holders.

In fact, they have very different characteristics. The index funds are in competition with active managers for the portion of investors funds allocated to equity. One of the principal competitive advantages they have is lower costs. If the index funds are to be an element in the activist shareholder of the future, some economic arrangement will be necessary in order not to prejudice their competitive posture. Their perspective will inevitably be systemic. The intrinsic holders, by contrast, will focus on individual companies. Probably, their incentive structure also needs to be reconsidered. Do we want two kinds of activism? And if not, which one?

Such questions abound, of course, but rather than get lost in theoretical possibilities, allow me to suggest a single group already well-position to take on the role: The shareowners pursuant to ERISA and the Investment Company Act of 1940. These are practiced fiduciaries the scope of whose responsibility can be articulated under existing federal laws. There is a certain fairness, too, in choosing this group – the beneficial owners of employee benefit and investment savings plans probably are in the excess of a hundred million Americans with a long-term holistic interest in the health of the company and the country. Who is better equipped to serve as the proxy for ownership of American business? Whose range of interests – be they long or short term, be they narrow or sustainable focus – is a more appropriate guiding energy for American chartered businesses?

Government’s involvement could take multiple forms:

  • Enforce laws requiring stewardship responsibility and provide that those providing such monitoring competence are entitled to fair pay from the corporation itself.
  • Create a special-purpose corporation along the lines of the UKSIF — the London-based Sustainable Investment and Finance Association.
  • Promulgate a code of best practices along the lines generated by the FSA (Financial Services Authority) in the UK in 2009.
  • Monitor the effectiveness of the stewardship program through a specially created Commission. It may be that a coherent 30% equity interest will accomplish the monitoring necessary to assure optimal corporate functioning. But more may be necessary.
  • And perhaps provide for discrete “stewardship” and “trading” classes of equity holding. At other times and places, dual-class capital has been both prevalent and desirable. It might be in this case, too.

As to why government involvement is necessary, we need only look at government’s own horrendous failures of the past, most notably perhaps its refusal to enforce existing trust laws in the aftermath of the Hewlett Packard – Compaq merger of eight years ago. That merger, recall, had cast Deutsche Bank in a dual and conflicting role: on the one hand, as the holder of fiduciary votes; on the other, as a paid agent of HP to expedite the merger. At first, the Deutsche Bank fiduciaries had opposed the merger as ill serving shareholders. Then, on the eve of the vote and as a result of a well-documented call, the fiduciaries yielded to internal pressures and voted in favor of the merger. This was, of course, a per se violation of ERISA’s fiduciary requirements. Far worse, was the Department of Labor’s refusal, despite repeated entreaties, to take any action against Deutsche Bank [16] even after the SEC had aired the abuse and settled with the malefactors.

Will the next time be different? Perhaps. Administrations change; new emphases arrive. But the critical point is this: In the final analysis, nothing can be expected of CEOs or of boards or, witness the HP-Compaq case, even of direct government regulation. Those who have day-to-day charge of the corporations will always to act in their own self-interest, while those who have day-to-day charge of regulating corporations are for the most part insufficiently motivated to enforce regulations and often sufficiently over-motivated to turn to a blind eye to malefactions. In the end, if corporations are to be effectively restrained and management monitored, it’s shareholders or nothing. And only the federal government has the capacity and authority to make that happen.

The Vision Revisited

The failure of the private sector to capitalize on the opportunities afforded it over the past three decades — a polite way of describing the disgrace of corporate leadership during the trente glorieuses — has assured that a measure of government involvement in business will be considered politically necessary for the foreseeable future. Yet virtually everyone also agrees that role should be as limited as possible. Risk-taking, what markets best reward, is what governments do worst. Simultaneously, the Supreme Court’s Citizens United decision, further extending the “personhood” of corporations, all but guarantees that once recovery takes hold, the political scales will tilt even more toward corporate power. What the Court grants, of course, Congress can take back with legislation limiting or excluding corporate political involvement, which could then be overturned in the courts, which could then be re-legislated on Capitol Hill ad infinitum. Too much is at stake to get caught on the checks-and-balances seesaw. What’s needed is a solution that approaches permanency.

That leaves government with little choice if we are not to repeat this history, almost certainly in ever-tighter cycles. First, the role of government as shareowner, with the rights and responsibilities attendant thereto as conferred by state law, needs to be codified. Owners of ventures expecting traditional value enhancement cannot be government bureaucrats. Second, and more important in the long term, a legal environment must be fashioned within which the previously mentioned fiduciaries, acting under existing laws, are both protected from peer-group unfair competition and are required by the prospect of government oversight and enforcement to be effective stewards of equity ownership.

Stiffened by such encouragement and oversight, this cadre is entirely capable of deciding how it will function as dominant owner of publicly traded companies. The trustees are the appropriate group to determine how “activist owners” are to be compensated for the value they contribute to the over-all enterprise. They can decide the correct means by which “passive owners” – particularly those selected by formula and algorithm – can best function. Also, they can decide whether classes of stock provide a useful mode for functioning.

Having a functioning ownership class permits many difficult questions to be addressed. The most difficult of these is the power of corporations to influence and to dominate the government process by which they are regulated. The power of lobbyists appears to be enshrined by the Supreme Court with its repeated insistence on “freedom of speech – that is to say “money” — of corporations in the law making and enforcing process. This license seriously erodes the legitimacy of corporate power.

A functioning ownership group can follow David Engel’s advice: restraint in dealing with government. The owners of a corporation can limit its lobbying and campaigning presence. Once this basic discipline is established, we can move on to the essential elements of legitimacy. How do corporations deal with the social consequences of their functioning? Again, Engel provides the answer: furnish all information to law makers, be respectful of the law-making process and obey the law. Clearly, progress can and should be made in the direction of developing a more holistic accounting system, which would provide uniform requirements for taking into account “externality” costs. This is a project that the ownership cadre should address.

Punters and Proprietors

I cited earlier the “Punters or Proprietors” article in The Economist of twenty years ago. It may be that the passage of two decades has changed the conjunction and today the answer is Punters and Proprietors. It must be clear that amidst the panoply of stock ownership, there is a difference of kind between those who invest through impersonal mechanism and those whose investments are a matter of sentient choice.

A further dichotomy might be drawn between those shareholders – passive and active – who chose to function as stewards and those who do not. Again, dual classes of stock might be appropriate. It is well to remember that when Warren Buffett invests in marketable securities, he is usually able to secure a special classification that reflects the value added by his involvement. Nor has the dual class prevalent in Scandinavia lowered long term equity returns. Even American scholars such as Martin Lipton and Jay Lorsch comment favorably on such a notion: “Providing long-term shareholders a greater number of votes per share should become a permissible option.” [17]

Further improvement would result from the determination that stewardship, being in the interest both of the corporation and of society, is appropriately an expense of the corporation. Making a sum available for those willing to undertake the costs and exposure of stewardship would help enlist the index funds to perform this key long-term role — a vital element since what is wanted is both long term stewardship and a perspective for the investment world as a whole, in contrast to individual companies.

In Summation…

This paper is based on two assumptions:

  • A self-governing corporate structure is optimal if it can be made to work.
  • The history of the last 30 years of supposed corporate “self-restraint” coupled with the economic debacle of the last two years offers compelling evidence that current efforts at corporate governance are not working.

Who, then, will step into the breach? This time, three assumptions are at play:

  • Involved owners (i.e. shareholders) are the “last best chance” for an internally governed corporate structure.
  • Ownership as presently construed is so diffuse and often so transient that even the most committed owners have virtually no say in corporate governance and often must endure onerous expenses even to be actively ignored.
  • Therefore, two classes of ownership are both desired and needed: passive shareholders, who choose not to exercise ownership rights, and stewardship shareholders, who already bear a fiduciary responsibility for funds under their management.

Clearly, realizing this vision of empowered owner-stewards will entail federal action:

  • First, only the federal government can create a framework of legally enforceable responsibility.
  • Second, government enforcement will be central to creating an environment within which leaders of the fiduciary community can develop practices for selecting fiduciaries and for monitoring portfolio companies.
  • Third, enlightened governmental guidance can also assure that this new cadre of corporate stewards equally represents (a) computer-selected shareholders – i.e., through index funds – with their wide perspective and (b) long-term owners of carefully chosen equities with their narrower focus on specific corporate performance.
  • Fourth and finally, government action will be needed to create a mechanism for compensating these corporate owner-stewards — a practical recognition of the asymmetry of responsibility between their duties and the non-participation of the passive owners for whom this cadre will serve as proxy.


[1] Nader, Corporate Power in America, Foreword (1973)
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[2] Engel, David, 32 Stanford Law Review 1 (1979)
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[3] Urofsky, Melvin I, Louis D. Brandeis, (Pantheon, 2009) at p. 346
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[4] Nader and Green, Taming the Giant Corporation (1976), Flynn, John J., Corporate Democracy. Nice Work if you can get it. 94,96.
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[5] Drucker, Peter, “The Bored Board,” Towards the New Economy and Other Essays, (Harper & Roe, New York 1981), 110
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[6] Harris, Alton B and Andrea S., Corporate Governance Pre Enron, Post Enron, Corporate Aftershock. The Public Policy Lessons from the Collapse of Enron and other Major Corporations, Ed. By Christopher Culp and William A. Niskanen (John Wiley & Sons, 2003) 49,71
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[7] Institutional investors would as a matter of “due diligence” have an opinion as to whether change is necessary in a particular company; the process of identifying particular individuals to take the place of particular directors involves substantial time, legal exposure and expense.
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[8] My annual fees of some $50,000 to file a “plain vanilla” §14 (a)(8) resolution with a hostile Exxon Mobil gives some hint as to the administrative complexities and legal costs of effecting a nomination filing under the various access proposals. Who, as a practical matter, is going to incur these expenses?
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[9] As special counsel in the settlement of many shareholder litigations, I have had experience in selecting new directors. I have a lot of humility about my role. In the UK, over ten years with Hermes Lens Focus Fund and Governance for Owners, I witnessed the creative tension that exists between a credible shareholder and management in the selection of particular directors.
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[10] Outsiders cannot have the necessary knowledge of the chemistry and experience of the board, so as to be able to make optimal suggestion as to desirable changes in the composition of a board. Empowered shareholders can require management to justify their recommendations.
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[11] Pozen, Robert, Too Big to Save, (John Wiley, 2010), 293,294
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[12] Public Law 99-335 – June 6, 1986
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[13] Gillespie, John and Zweig, David, Money for Nothing, (Simon and Schuster, 2010) at 217
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[14] Lipman, Harvey, Meshing Proxy with Mission, (The Chronicle of Philanthropy, 5/4/2006)
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[15] Manning, Bayless, The American Shareholder, 67Yale Law Journal 1477, 1490 (1958)
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[16] This was the subject of extensive and critical review by the Government Accountability Office – GAO-04-749
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[17] Lipton, Martin and Lorsch, Jay, Schumer’s Shareholder Bill Misses the Mark, Wall Street Journal , May 12, 2009
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One Comment

  1. Jose
    Posted Saturday, March 13, 2010 at 9:03 pm | Permalink

    Great article

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