How the Financial System Fails Us and How To Fix It

Stephen Davis is associate director and a senior fellow at the Harvard Law School Program on Corporate Governance. This post is based on the new book by Davis, Jon Lukomnik, and David Pitt-Watson, What They Do With Your Money: How the Financial System Fails Us and How to Fix It (Yale University Press).

“Where were the directors?” is the plea often heard in the wake of corporate failure. [1] Critics will also ask “Where were the shareholders?”, by which they typically mean institutional investors. [2] But observers usually ignore an equally important question: Where were the beneficiaries? Statutes, regulations and codes around the world have sequentially addressed the duties of corporate managers, the responsibilities and structure of boards of directors, and optimum stewardship behavior by institutional investors. But the governance ecosystem includes few parallel efforts to generate guidance, safeguards or incentives to animate retail savers as a force in corporate governance. This would seem perverse since, in the US alone, an estimated 92 million Americans entrust retirement and other capital to investing institutions, and would presumably have a powerful interest in ensuring that their nest eggs are deployed at portfolio companies in ways that promote value over the long term. However, structural barriers have impeded accountability of institutional investors to beneficiaries, making it difficult for retail savers to police the stewardship behavior of their agents in respect of investee companies. Such barriers have roots in law, regulation and commercial practice that have failed to keep pace with market change. But with hostility to Wall Street a recurring theme across political parties in the US presidential campaign, prudent remedial steps may be in sight.

Few studies so far probe whether, to what extent, or in what ways the governance of a fund may affect its conduct as an equity owner. This remains a major research gap. [3] What data there is, however, suggests that there may be a material benefit in financial outcomes to beneficiaries when fund oversight structures incorporate enhanced transparency and accountability features. Conversely, there appears a higher likelihood of a drain on value when such characteristics are missing. [4] Anecdotal evidence from institutions including CalPERS, the UK’s NEST, the Netherlands’ PGGM, the Canada Pension Plan Investment Board, and TIAA further suggests that better fund governance is associated with more assertive fund engagement and voting in support of beneficiaries’ interests.

If beneficiaries do have a stake in a healthy system of corporate governance, why are they so comprehensively omitted from it? One obvious reason is that retail investors number in the tens of millions, and have different interests, perspectives, and timelines. Moreover, there is no collective body in the US that claims to represent them in Washington, when it comes to policy making, or in Wall Street, when it comes to corporate governance frameworks. This could change. ShareAction, a London-based NGO, has gained traction advocating accountability and transparency among investment agents in the UK. [5] It is launching a related initiative—the European Responsible Investment Network—for continental Europe in Berlin in June. [6] The US is ripe for a similar grassroots program. Moreover, technology and social media could prove a force multiplier, just as in the political sphere, in advancing such an effort. [7]

Antiquated regulation is a second reason for the exclusion of beneficiaries from the corporate governance environment. In the US, the mother statute for retirement savings—the Employee Retirement Income Security Act (ERISA) of 1974—is now 42 years old. The world of retirement savings it was written to regulate is long gone. Defined benefit plans with risk shouldered by corporate issuers have given way to defined contribution plans where employees are obliged to assume investment risk. The federal Department of Labor, tasked under ERISA to supervise retirement savings, has for years been stymied by partisan politics and limitations in law in efforts to update rules. Even its most recent bid to reform fiduciary duty as it applies to investment advisors met with rebuff in serial congressional votes. The Securities and Exchange Commission (SEC) is now by default—given the flood of retirement savings into mutual funds—the chief protector of such savings pools. But the SEC is without a mandate to address special characteristics arising when savers are not shareholders by choice but rather “indentured investors” or, as Delaware Supreme Court Chief Justice Leo Strine has put it, “forced capitalists.” [8]

In the absence of robust law and regulation, the accountability of investing institutions to beneficiaries has eroded. Indeed, few asset owners in the US would be able to meet exacting governance standards they expect of portfolio companies. Most retirement savings plans sponsored by issuers feature no board at all, but instead are overseen by a single corporate executive who is the designated fiduciary. Ironically, therefore, even as law, regulation and practice tie institutional investors more closely to corporate governance, cords linking retirement savings arrangements to their capital-providing beneficiaries are largely untended and fraying.

Consequences are significant. We show in our book that a typical American saver using common channels of investment will wind up on retirement from a lifetime of work with a considerably smaller nest egg than he or she should. Estimates show that an individual saving exactly the same amount each year, but living in the Netherlands where rules are different, will end up with 50% more money to live on. [9] The difference may be found in fees in the US that may not appear in disclosures to beneficiaries, thanks to loopholes in current regulation, and that may go unmonitored when oversight is weak.

Other consequences are even less visible. Evidence suggests that institutional investors with feeble governance safeguards may be more likely to put commercial interests ahead of savers. [10] To take one case, in 2012 a large mutual fund spent an estimated $138 million promoting its brand as a champion of clients, but at the same time employed a single person to actually do that advocacy, by managing voting shares at more than 10,000 portfolio companies worldwide. Fund managers are typically incented through bonus triggers to draw more customers to the fund rather than on efforts to press for better returns among companies they invest in.

Together, these faults contribute to the worsening savings crisis, with the typical American nearing retirement with inadequate income to meet basic living expenses. They also contribute to an underpowered market, as capital disproportionately benefits the financial sector compared to the broader economy.

In the next Congress, policies that seek to reconnect beneficiaries with their savings assets could draw bipartisan interest as a way of bringing further accountability to financial institutions that now lack public trust. A reform package could oblige retirement plans to disclose the equivalent of a nutrition statement, so that consumers can learn in plain language whether their agents are configured to act in their best interests. Mutual funds could have to disclose exactly how much money they deduct from client accounts. Legislation could require retirement savings plans to feature skilled, independent boards that police fees, conflicts of interest, and policies of investment funds. Finally, laws could mandate that financial agents abide by fiduciary duties that put the client first. These steps would mark important progress in catalyzing the latent influence of beneficiaries in corporate governance to promote long-term value. The capital market cannot any longer afford them to be missing in action.

Endnotes:

[1] For instance, Where Were the Directors? Guidelines for Improved Corporate Governance in Canada (“Dey Report”) (Toronto: Toronto Stock Exchange, December 1994).
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[2] For instance, Justin Fox and Jay W. Lorsch, “What Good are Shareholders?” Harvard Business Review (July-August 2012).
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[3] Stephen Davis and Ben W. Heineman, Jr., Are Institutional Investors Part of the Problem or Part of the Solution? (Millstein Center-Yale School of Management and Committee for Economic Development, October 2011). Accessible at http://web.law.columbia.edu/sites/default/files/microsites/millstein-center/80235_CED_WEB.pdf.
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[4] Ambachtsheer, K., Capelle, R. and Lum, H. “The Pension Governance Deficit: Still With Us.” SSRN, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1280907, 2008.
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[5] See www.shareaction.org. The author is a nonexecutive trustee.
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[6] https://shareaction.org/event/responsible-investment-in-europe/.
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[7] Stephen Davis, “An App that Could Eat Wall Street,” Huffington Post (May 24 2016), accessible at www.huffingtonpost.com/stephen-davis2/an-app-that-could-eat-wal_b_10110684.html.
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[8] Leo Strine, “Toward Common Sense and Common Ground?”, The Journal of Corporation Law 33, no. 1 (October 2007).
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[9] For UK data, see David Pitt-Watson and Hari Mann, Collective Pensions in the UK (Royal Society of the Arts, July 2012).
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[10] See, for example, Lauren Cohen and Breno Schmidt, “Attracting Flows by Attracting Big Clients: Conflicts of Interest and Mutual Fund Portfolio Choice,” available here; and Jennifer Taub, “Able but Not Willing: The Failure of Mutual Fund Advisers to Advocate for Shareholder Rights,” Journal of Corporation Law 34, no. 3 (2009).
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