July 2005

Wyser-Pratte to Launch Fund

The hard charging ex-marine with the German-sounding French name, Guy Wyser-Pratte, is plunging his investment activism full throttle into the limited arena of corporate governance-dedicated investment funds. Wyser-Pratte plans to launch the publicly listed Wyser-Pratte Euro Value Fund this September.

Everyone wants to see investors get rewarded for backing companies striving to improve corporate governance. Now here’s your chance, if you have the $2 million minimum investment. Learn of this and other opportunities by signing up now for the TurnaroundTactician now to get subscribe at their charter rate.

The False Promise of Pay for Performance
Many, including this reviewer, called Bebchuk and Fried’s Pay without Performance: The Unfulfilled Promise of Executive Compensation the best corporate governance book of 2004. James McConvill’s The False Promise of Pay for Performance: Embracing a Postive Model of the Company Executive, largely a critique of Pay Without Performance, deserves similar attention.

Bebchuk and Fried clearly demonstrated that many features of executive pay are better explained as a result of shear managerial power, rather than arm’s-length bargaining by boards of directors. Their recommendations on improving executive compensation are aimed at eliminating or reducing some of the most egregious problems and are written to shareholders, since such reforms are not likely to be raised by “independent” directors, as independence is currently defined. One of their major points is that board members should not only be independent of CEOs, they should also be dependent on shareholders.

McConvill does not dispute that managerial power has led to the decoupling of pay from performance but he takes issue with Bebchuk and Fried’s failure to clearly reject agency theory, which “derives from a narrow – and ultimately false – understanding of human motivation and behavior.” McConvill contends “the managerial power thesis assumes that only economic factors (based on agency theory) influence executives in their attitude towards remuneration…” He further writes that Bebchuk and Fried “suggest that managerial power provides a complete explanation” for the decoupling of pay and performance. (my emphasis)

Despite what I believe is exaggerated rhetoric, since I did not read such assertions of certainty into the work of Bebchuk and Fried, McConvill’s book is critically important as one of too few works that begin to explore alternatives to homo economicus in corporate governance.

The book should find immediate appeal among the mostly liberal proponents of socially responsible investing, who also embrace the notion that we are not driven by money alone, and among conservative pro-management organizations like the Business Roundtable because of McConvill’s assertion that “positive corporate governance” will do away with the need for external regulations. However, the book should also be read by anyone open to at least to thinking about alternative avenues of motivation.

McConvill’s main point is that it is not money that motivates CEOs but company performance, trustworthiness, job satisfaction, ego, and status. Unfortunately, too many tend to take pay as a proxy measure of these motivating factors. I like the starting point though. Acknowledging that statistics show a very weak link, if any, between pay for performance, Bebchuk and Fried ask how we can improve that link, while McConvill is more focused on increasing executive productivity through other means. Both areas warrant attention.

There is something to the argument that economists have convinced many in business and law that their discipline is more rigorously scientific than psychology, sociology, and management studies. Equating rationality with being driven by self-interest may actually contribute to a self-fulfilling prophecy whereby managers do, indeed, turn out to be cheats and devious idlers.

Most people conform to trends. As McConvill notes, “informational cascades” prompt us to base our beliefs not on what we know but on what people do or say. Even though we know a decision may be wrong, we tend to go along with the majority to stay in their good graces, resulting in a “reputational cascade.” How we are socialized and the words we use have real world impacts. Do we really want to reinforce the notion that CEOs should be primarily driven by the acquisition of personal wealth?

McConvill goes on to describe differences between the predominant “law and economics” movement and the “behaviorial law and economics” movement, which seeks to better understand how human beings truly behave – frequently in unselfish ways. He cites lessons from game theory to support the notion that cooperation and trust are vital to personal well-being and the well-being of society. Placing too much emphasis on external rewards, such as pay, may have the effect of diminishing internal incentives to do our best.

McConvill’s research finds a stronger correlation between democracy and happiness than wealth and happiness. He might have cited studies by the National Center for Employee Ownership that more democratic companies are also more productive. He does note that relative wealth is more important than absolute wealth. So as long as CEOs measure their own self-worth by how much they earn in comparison with others, boards will face inflationary pressure. “Pay for performance is flawed in the sense that it accentuates, and to a large extent depends upon, the continuation of the social comparison treadmill – with executives always keeping their eyes and ears alert to who is earning more than them.”

McConvill calls for what he terms “positive corporate governance,” borrowing from positive psychologywhich sees beyond what have become traditional concerns with treating the sick to also using social science to build what is right – strength, virtue and the highest qualities of civil and personal life. With most material wealth needs met, more people are focusing on meeting their need for meaning in life. Happy people don’t follow the money; they follow their passions. We need CEOs who are passionate about making the best products, having the most creative or satisfied employees, and creating sustainable companies.

He admits that his critics “will consider much of the argument underlying positive corporate governance as being not only counterintuitive but pure fantasy.” Such criticism would not be without reason. McConvill should give us pause when he writes, “If we can be confident that executives are naturallyinclined to pursue what is best for the company, and doing so is an incentive in itself, external regulation can be dispensed with.” (my emphasis) Even if we could do that by checking their DNA, I’m not sure having a CEO who is inclined to do what is best for the company would warrant dropping all external controls.

While such statements and his attacks on Bebchuk and Fried are liable to win support among BRT members, his notions could also be used to promote a path toward sustainability.

In the end, he appears to want to ground management in positive professional norms. “Education is the key to positive corporate governance working, in terms of promoting the virtues of adhering to a professional ideal, and the rewards which flow on from this, as opposed to emphasizing the need for external incentives and sanctions to influence certain outcomes.”

He has a point but I wouldn’t throw out agency theory altogether. We need to align pay with performance but we also need to promote sustainable norms into our business model, not just by requiring business ethics courses for all MBA candidates.

The key for the success of “positive corporate governance,” as envisioned by McConvill might be for organizations such as the Business Roundtable to hold up as an ideal for executive pay CEOs like Costco’s Jim Sinegal. Last year he earned a salary is just $350,000, plus a $200,000 bonus. Costco’s average pay for employees is $17 an hour; 42% higher than its rival Sam’s Club. By many measures, including its health plan, Costco’s model is more sustainable, in terms of treating its employees, host communities and even its shareholders better in the long run than Wal-Mart. [(How Costco Became the Anti-Wal-Mart, NYTimes, 7/17/2005) (Disclosure: The reviewer is a Costco shareholder)]

McConvill says he does not attempt to construct a new pay-setting approach, although he suggests “best practice” might tie executive compensation to “15-20 times average weekly earnings” of employees. He also cites a study in New South Wales that found excessively high pay levels for CEOs coincide with lower corporate earnings. Christopher Mann of Moody’s recently authored a report that found businesses that offer their CEOs unusually large bonuses or option plans have higher bond-default rates and more frequent and deeper rating downgrades than their peers, (Report Links Defaults, Excessive CEO Pay, CFO.com)

The False Promise of Pay for Performance will get you thinking. If widely read, it could help move us from a narcissistic model of corporate governance, that “greed is good,” to one that encourages all employees, including the CEO, to be more fully human at work.CalPERS Earnings

The California Public Employees’ Retirement System earned a 12.7% return on the nation’s largest public pension plan portfolio for the one-year period ended June 30, 2005, raising its portfolio’s market value to a record $189.8 billion. Investments in real estate, private equity, and international stocks were the main performance drivers, with the real estate gaining nearly 38%, and the fund’s Alternative Investment Management Program, which specializes in private equity and venture capital holdings, generating the second highest rate of return at 22.8%. Investments in corporate governance funds that target ailing public companies posted a 20.8% return, while its international stock portfolio rose 17.3%. Global fixed-income investments returned 10.8%, and domestic stocks earned 7.5%. (PlanSponsor, 7/25/2005)

PERA Shortfall Widens

The Colorado Public Employees’ Retirement Association plans to report a widening shortfall to the state’s Legislative Audit Committee. The funding gap in the pension plan grew by about $3 billion last year in spite of the fund posting a 14% return, beating its target 8.5%.  The plan has a deficit of $12.8 billion and only has about 70% of assets needed to meet its obligations. Market losses and increased benefits, along with pension accounting rules were cited as the reasons for the shortfall.  Colorado PERA has considered increasing the amount of contributions employers make to the plan and have made efforts to reduce benefits, but those reductions were limited to future hires. Colorado PERA manages about $32 billion and has more than 361,000 members.

Similar problems were reported by Minnesota’s PERA recently as legislation was passed to increase contributions by employers to its plans over the course of several years. (PlanSponsor, 7/25/2005) 

Call for Investigation of SEC Nominee Cox

President Bush’s nominee to head the SEC, Congressman Chris Cox, has among the worst anti-consumer records in Congress. As a private attorney, Cox helped a swindler, William Cooper, peddle his Ponzi scheme to the public, costing small investors as much as $130 million. The US Senate Banking Committee is holding a 7/26/05 confirmation hearings on Cox. Listen to or read Foundation for Taxpayer and Consumer Rights President Jamie Court’s commentary against the Cox nomination on public radio’s Marketplace. Stop Cox by faxing your Senator TODAY!

Cooper went to jail; Cox went to Congress. Ask your Senator to subpoena Cooper and Cox’s billing records to find out what Cox really did or didn’t do for Cooper.

Also up for confirmation are President Bush’s nominees Roel C. Campos and Annette Nazareth to fill the two Democratic seats. Mr. Campos, a Texas businessman and a former federal prosecutor, has been serving as a member of the commission since 2002. Ms. Nazareth, the head of the commission’s division of market regulation, would succeed Harvey J. Goldschmid, who is leaving the agency soon to return to teaching at Columbia University School of Law. Published reports point out that the nominations could help clear the path for the confirmation of Rep. Christopher Cox, the conservative Republican from California who has nominated for SEC chairman

Air Alaska Reject Binding Proposal that Passed

According to a 7/19/05 letter to shareholder activist Jim Roberts, Alaska Air Group will not be adopting a binding bylaws proposal to elect each board director annually since that “could violate Delaware corporateion law.” “In order to elminate the Company’s classified board, it would be necessary to the certificate of incorporation.” They don’t have to dit and they won’t.

DOL to Enforce 1959 Law

The Department of Labor is reportedly about to start enforcing a 1959 law which requires disclosure of gifts, ratuities and entertainment used by employers, service providers, labor union officials, and plan trustees to influence each other. “Just because you parked your car beside a fire hydrant for 35 years (and didn’t get a ticket) doesn’t mean you won’t get a ticket tomorrow,” Don Todd, deputy secretary, said at a July 7th meeting where a reporting extension was announced.

In the interest of achieving greater compliance with the reporting requirements of the Labor-Management Reporting and Disclosure Act of 1959, the Office of Labor-Management Standards (OLMS) announced new compliance assistance efforts and enforcement guidelines for filers of Form LM-30 (Union Officer and Employee Reports). Under a cooperative agreement concluded with the AFL-CIO, OLMS is not requiring new filers who submit their Form LM-30 reports by August 15, 2005, to submit reports covering the same financial interests for any prior years, absent extraordinary circumstances.

ULLICO, a money manager for Taft-Hartly penison dunds had been planning to increase marketing expenses for entertaining clients but with DOL’s announceint of a $25 limit for exclusions, virtually all entertainment is not excluded so they will shift resources to less effective areas, such as direct mail. The same issue of P&I carries an editorial warning the 2/3 of institutional investors which aren’t claiming their share of settlements in securities class action suits are likely breaching their fiduciary duty. It also includes a guest editorial by Jeffrey DuFour calling on the government to require education and oversight requirements for all retirement plan trustees. [(Union Fund Officials Lose Some Perks, Pensions & Invemsntments, 7/11/05) (Form LM-10 (Employer Reports) Advisory, 7/15/05) ]

TIAA-CREF Told to Practice What it Preaches

Shareholders press TIAA-CREF officers to explain several governance scandals and its investments in socially irresponsible companies. At is annual meeting, the nation’s largest pension fund once again will come under fire from the Make TIAA-CREF Ethical coalition. On July 19, advocacy groups are joining shareholders to demand greater accountability from TIAA-CREF, the $350 billion pension fund for educators and researchers. After SEC complaints, two trustees had to be removed because of financial conflicts of interest. Additionally, their CFO, now on a leave of absence, is under investigation by the SEC and DOJ for practices in her previous job. Finally, after doing an insufficient background check, they reportedly hired a criminal, resulting in a breech in security and a subsequent lack of candor about events surrounding her removal.

Says activist and coalition representative Jaime Lagunez, of frente civico por la defensa del Casino de la Selva, “For a group claming leadership in governance and social responsibility, they need to look in the mirror and recognize their own shortcomings in these areas. They need to be more vigilant in their own corporate governance and they need to divest from corporations involved in human rights violations and in public health, community, and environmental degradation. Instead they need to be investing in socially responsible ventures.”

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CII on Majority Vote

As we reported last month, the American Bar Association (ABA) Committee of Corporate Laws has issued a discussion paper on majority elections for corporate directors and invites public comment by Aug. 15 to: E. Norman Veasey. Resolutions have been voted at more than 50 companies so far this year. The Council of Institutional Investors posted its June 15th letter to Veasey on their website.

CII supports changes that would that would “presumptively provide for the election of directors by a majority of votes cast for and against, unless otherwise provided in the certificate of incorporation or the bylaws.” “The benefits of this change are many: it democratizes the corporate electoral process; it puts real voting power in hands of investors; and it results in minimal disruption to corporate affairs—it simply makes boards representative of shareowners.”

llustrating the impressive level of shareowner support for the reform, shareowner proposals requesting majority voting have passed by a majority of the votes cast for and against at Altera (59.0 percent), Advanced Micro Devices (58.9 percent), Raytheon (57.0 percent), NiSource (55.0 percent), UnumProvident (53.0 percent), Marathon Oil (52.3 percent), Freeport-McMoRan Copper & Gold (51.9 percent), Federal Realty Investment Trust (51.0 percent) and Pulte Homes (50.2 percent). Similar proposals tracked by IRRC have received substantial support at MeadWestvaco (49.5 percent), Shurgard Storage Centers (49.4 percent), Gannett (48.0 percent), Motorola (48.0 percent), Albertson’s (47.5 percent), Bristol-Myers Squibb (46.2 percent), Waste Management (45.0 percent), Boston Scientific (44.0 percent), Thermo Electron (43.5 percent), Capital One Financial (43.0 percent), Verizon Communications (43.0 percent), Citigroup (42.9 percent), General Growth Properties (42.0 percent), Illinois Tool Works (41.0 percent) and Entergy (40.7 percent)….

Majority voting for directors already is standard practice in United Kingdom, France, Germany and other European nations. And a few U.S. companies—Best Buy, Hercules, Lockheed Martin, Potlatch and U.S. Bancorp—currently provide for director elections by majority vote.

In May, CII sent letters to about 1,500 heads of major US corporations requesting they adopt CII’s policy: “When permissible under state law, companies’ charters and by-laws should provide that directors are to be elected by a majority of the votes cast. If state law requires plurality voting (or prohibits majority voting) for directors, boards should adopt policies asking that directors tender their resignations if the number of votes withheld from the candidate exceeds the votes for the candidate, and providing that such directors will not be re-nominated after expiration of their current term in the event they fail to tender such resignation.”

Subscribers to TheCorporateCounsel.net can listen to an interesting interview by Broc Romanek of Ann Yerger on CII’s Majority Vote Policy. During the interview she says that most of the companies that have responded appear to be at least studying the issue. CII posts responses on the members onlyportion of their site.

SEC Guidance on Independent Chair & Environmental Proposals

The SEC has given activist shareholders guidance in the form of a staff legal bulletin on writing shareholder resolutions requesting that companies name an independent director as the board chair. The heart of the advice is as follows:

When a proposal is drafted in a manner that would require a director to maintain his or her independence at all times, we permit the company to exclude the proposal under rule 14a-8(i)(6) on the basis that the proposal does not provide the board with an opportunity or mechanism to cure a violation of the standard requested in the proposal. In contrast, if the proposal does not require a director to maintain independence at all times or contains language permitting the company to cure a director’s loss of independence, any such loss of independence would not result in an automatic violation of the standard in the proposal and we, therefore, do not permit the company to exclude the proposal under rule 14a-8(i)(6).

“The guidance also follows a battle earlier this proxy season over the director independence issue between pioneering shareholder activist Bob Monks and ExxonMobil Corp. (XOM). Monks’ proposal suffered the fatal flaw because there was no explicit out for the company if a chairman lost his or her status as an independent director, for whatever reason.” (SEC Enters New Territory With Holder Proposal Guidance, Dow Jones Newswires, 7/13/2005) The bulletin also lays out how environmental and public health proposals need to be crafted to avoid a no action letter.

To the extent that a proposal and supporting statement focus on the company minimizing or eliminating operations that may adversely affect the environment or the public’s health, we do not concur with the company’s view that there is a basis for it to exclude the proposal under rule 14a-8(i)(7).


Institutional Shareholder Services, the nation’s largest proxy advisory firm, has reportedly agreed to pay more than $10 million to acquire the Investor Responsibility Research Center, which was founded in 1972, has been struggling to compete since becoming a for-profit entity four years ago.

Though most IRRC staff will be offered jobs at ISS in Rockville, MD, all the proceeds of the sale will go to create the a new IRRC Institute for Corporate Responsibility, a new independent nonprofit think-tank. The institute will be started with existing IRRC board members, who will search for an executive director. ISS asked for one board seat, but no decision has been made on the size of the board. (Institutional Shareholder Services buys IRRC, Pensions & Investments, 7/13/2005)

The combined company, with almost 500 employees across 11 global offices, will be able to offer a broader range of products and services, an improved set of solutions and an expanded research universe of 33,000 companies across 115 markets. (PRNewswire, 7/13/2005)

Generally, I hate to see reduced competition in any industry. In the last few years, even with the rise of several other proxy advisory services, it has become apparent that ISS is dominant in the US and is quickly becoming so worldwide. Their opinion can make or break proposed mergers and other corporate governance decisions involving the votes of institutional investors.

The absorption of IRRC will further solidify that dominance. I expect to see more pilgramages to Bethesda as executives, investment bankers, union officials, enviornmentalists and other activists argue their cases. ISS analysts increasingly take on the role of a corporate governance priesthood, weighing an ever increasing multitude of factors to render advice on how to vote. Who holds them accountable? However, since I agree with ISS more often than not, it is difficult for me to view the merger negatively. If ISS directly abuses the trust of fiduciaries, the faith investors place in their advice should quickly erode.

A more likely danger at ISS could be such market segmentation within the firm that clients get the advice they want but users of the service begin to cancel out each other’s votes.

For IRRC, the merger appears like a real win. They get an honorable exit from the day-to-day proxy advice business and $10 million to fund a return to their original roots. I am excited about the prospects of their new Institute for Corporate Responsibility looking at major social and corporate governance issues from a wider long-term prospective. I sincerely hope they get some additional large grants to endow this important endeavor for the long-term.

Arbitration Award Explainations Proposed

NASD has filed a proposed rule change34-52009, with the SEC to provide written explanations in arbitration awards upon the request of customers, or of associated persons in industry controversies. For an example of thoughtful comments, see Les Greenberg’s letter.

The Public Investors Arbitration Bar Association supports getting rid of the industry arbitrator. So does Les Greenberg. His Request for rulemaking under the Securities Exchange Act of 1934 concerning arbitration sponsored by NASD Dispute Resolution submitted to the SEC in May would:

TIAA-CREF Meeting to Draw Controversy

The “Make TIAA-CREF Ethical” coalition will be there. Join them and influence how $350 billion is invested. Raise your voice inside the annual meeting in New York City on July 19th. For participants and sympathetic others: Demonstrate outside the corporate office in New York

If you can’t be there, call and email the CEO. The coalition calls on TIAA-CREF to:

  • invest positively (such as in low-income housing and start-up companies promoting environmental protection);
  • divest from Costco, Nike, Wal-Mart, Philip-Morris/Altria, Coke, and Unocal (or Unocal leave Burma); and
  • pledge not to buy World Bank bonds.

The coalition asks you to “make your plans now.” The meeting begins 9:00 a.m., Tuesday, July 19 (participants must call 1-877-535-3910, ext. 2440 for a pass to attend). Demonstration runs 8-10:00 a.m., 730 Third Ave. (between 45th and 46th Streets).

Anyone can raise a voice from their hometown during the week before the meeting (July 11-19). Call CEO Herbert Allison at 800-842-2733 or 212-490-9000. Ask for Mr. Allison and speak to his assistant. Calls are best, but you can also email HAllison@tiaa-cref.org For background, see makeTIAA-CREFethical.org (and sign-up at web site for campaign updates). For further details, contactNJWollman@manchester.edu

The coalition summarizes their requests regarding particular companies as the following:

  1. Philip Morris/Altria has been legally proven to be responsible for thousands of tobacco related deaths world wide. It should not be in any TIAA-CREF portfolio.
  2. TIAA-CREF should request that Costco close its warehouse in Cuernavava, Mexico. The company is responsible for hurting the quality of life in that city, severely damaging an archeological site, and abusing human rights. This was concluded by the Office of the High Commission for Human rights of the United Nations.
  3. TIAA-CREF should request that Wal-Mart close its Aurrera warehouse in Teotihuacan, Mexico. Like Costco, the company is responsible for destroying world heritage and violating human rights and civil liberties.
  4. The fund should urge Wal-Mart to implement ways to lessen its destructive impact on local economies; while both Nike and Wal-Mart must stop benefiting from abusive sweatshops world-wide.
  5. TIAA-CREF should pressure Unocal to stop financially supporting a Burmese government that has one of the world’s worst human rights records. Unocal recently lost a U.S. court case that found them liable for such abuses.
  6. We thank TIAA-CREF for divesting from World Bank bonds. We ask that it publicly pledge to buy no new bonds as long as WB policies contribute to economic hardship globally.
  7. Since our November meeting, we have added Coca-Cola to our list of companies we wish TIAA-CREF to act on. At home, Coca-Cola’s marketing practices have helped contribute to an epidemic of childhood obesity; abroad, Coca-Cola is responsible for serious human rights violations at its bottling plants in Colombia. TIAFF-CREF should pressure Coke to end all marketing to children and agree to an independent investigation of the human rights abuses at its Colombian bottling plants.

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Gompers/Bebchuk Updated

Corporate Governance and Firm Valuation by Lawrence D. Brown and Marcus L. Caylor of Georgia State University create Gov-Score, a summary measure of corporate governance based on 51 Institutional Shareholder Services factors, representing both external and internal governance. After showing that Gov-Score is positively related to firm valuationGov-7, they create a parsimonious index based on seven of the 51 factors underlying Gov-Score, and show that Gov-7 fully drives the relation between corporate governance and firm valuation. The seven factors are as follows:

  1. absence of a staggered board;
  2. absence of a poison pill;
  3. all directors attend at least 75% of board meetings or had a valid excuse for non-attendance;
  4. nominating committee comprised solely of independent outside directors;
  5. board guidelines are in each proxy statement;
  6. option re-pricing did not occur within the last three years; and
  7. average options granted in the past three years as a percent of basic shares outstanding did not exceed 3%.

Quack Corporate Governance

In The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, Roberta Romano evaluates the substantive corporate governance mandates of the Sarbanes-Oxley Act (SOX) and of the political dynamics that produced the mandates. The Article concludes that SOX’s corporate governance provisions should be stripped of their mandatory force and rendered optional. To mitigate future policy blunders on the scale of SOX, it also suggests that emergency or crisis-mode legislation provide for reevaluation at a later date when more deliberative reflection is possible.

Tax-Abuse Settlements

Dozens of US corporate executives and 33 companies have admitted using abusive tax shelters to under-report hundreds of millions of dollars in compensation as part of a settlement with the Internal Revenue Service.

The IRS said 80 out of 114 executives accused by the tax regulator of using the scheme involving the transfer of stock options to family-controlled partnerships have agreed to pay taxes on $500m in under-reported income plus a 10% penalty. Another 19 executives who under-reported $400m in income have refused to settle and are under audit or face criminal investigation. (US executives to pay up for using ‘abusive’ tax shelters, FT.com, 7/11/2005)

Executives had until May 23 to report their involvement in the shelter and participate in the settlement program, which requires them to pay a 10% penalty — half the 20% penalty that could have been applied. In the typical tax shelter, a corporation grants an executive stock options. The executive transfers the options to a family partnership established solely for receiving the options, usually owned by the executive, spouse and children. The executive takes a 15- to 30-year promissory note as payment for the options. The partnership sells the options and takes the position that taxes aren’t due for 15 to 30 years.

Tax laws say that executives owe tax when they exercise stock options. (Execs, Corporations Get Reduced Tax Penaltiesnbc4.tv, 7/11/2005)

Shooting Blanks

Steven M.H. Wallman, founder of FOLIOfn and a prior SEC commissioner, writes that the definition of “good” corporate governance has been decided by a small number of proxy advisory firms based on proscriptive, one-size-fits-all formulas. (A New Approach to building Shareholder Value, The Corporate Board, 7-8/2005)

Wallman cites a study (How Important is Corporate Governance?) by David F. Larcker of the University of Pennsylvania, which evaluated 39 corporate governance indicators (e.g., board characteristics, stock ownership, institutional ownership, activist stock ownership, existence of debt-holders, mix of executive compensation, and anti-takeover variables) refined into 14 governance constructs using principal components analysis. We find that these 14 constructs are related to operating performance, have a somewhat mixed association with abnormal accruals, Tobin’s Q, and excess stock returns, and little relation to class action lawsuits and accounting restatements. Wallman points to the overall conclusion that the typical structural indicators have “limited ability to explain managerial decisions and firm valuation.” One limitation he doesn’t acknowledge, unless I missed it, is that the study only analyzes a single year of data, not exactly a long-term approach.

Wallman says that his firm, PROXY Governance, doesn’t believe in the one-size-fits-all approach, nor do they believe corporate governance is a zero-sum game between managers and shareholders. The goal must be on creating long-term shareholder value, not on gaining power for shareholders or management. Company-specific evaluation should be relative to peer companies in its industry over some reasonable period. Is the company improving or deteriorating?

CEO and director pay should promote long-term wealth, rather than schemes that temporarily boost stock price. He argues that a staggered board can foster more open and frank boardroom discussion. On majority voting, Wallman indicates shooting “real bullets,” instead of “blanks,” doesn’t allow shareholders to send a message without actually putting them out of office. On socially responsible investing, Wallman argues the “legitimate goal of shareholders is to see the value of their investments increase,” a goal “not enhanced by arbitrary, flavor-of-the-month approaches to proxy voting recommendations.”

Shareholders serve they interests best “when they zealously oversee boards with the goal of eliminating self-dealing and excessive pay, and replace boards and managements that are unable to increase value for shareholders over the long term.”

No one can reasonably argue against the need to be vigilant in eliminating self-dealing or to build trust between the shareholder-management-team. I also agree that corporate governance must be tailored to the specific firm and its point in development. However, in attempting to decrease “the shrillness of discourse” and increase trust, we should not ignore the fact that shareholders must be able to hold directors accountable. We can only “replace boards and managements” if we have “real bullets.”

Big Box Standards

Investors representing $33 billion backed issued a set of nine guidelines for major retailers to use in making decisions about store site locations, land procurement and leasing. The guidelines developed by Christian Brothers Investment Services, Inc. and Domini Social Investments urge major retailers to embrace environmental stewardship; public disclosure of siting policies; advance consultation with affected communities; respect for Indigenous cultures; protection of cultural heritage; and adherence to “smart growth” practices. 

While companies are encouraged to adapt the guidelines to suit their unique business models, the report strongly recommends that all retailers should have a clearly formulated, well-monitored and effective policy for assessing and mitigating social and environmental risks associated with store siting. See Guidelines To Curb Controversies Over “Big Box” Store Locations Issued By Christian Brothers Investment Services, Domini Social Investments for the guidelines and endorsing funds. Adoption of the policies would go a long way toward reducing conflicts with communities and would reduce the risk of lawsuits, political action, and boycotts.

Unocal Deal Reveals Weakness

The fact that directors of the China National Offshore Oil Corp. (CNOOC) were not brought into the deal until late in the game may reveal a troublesome weakness in Chinese corporate governance practices. According to a report in Time magazine, the subject of buying Unocal had never before been discussed at a board meeting until 3/29. “The ship was about to leave the port, and the [directors] hadn’t even known there was a ship,” said one adviser to CNOOC.

According to SEC documents, as far back as December, CNOOC’s CEO Fu Chengyu had directly discussed the possibility of acquiring Unocal with the California firm’s CEO, Charles Williamson. “He was treating his own board as an afterthought,” says one source close to outside board members. “It was very much the China of 20 years ago in the way the directors were treated initially—where the boss decides and the board just rubber-stamps everything. Why were they treated that way? I don’t have a clue.”

Three key outside directors—former Shell Chemicals CEO Evert Henkes, former Swiss ambassador Schurtenberger, and Courtis of Goldman Sachs—all raised pointed questions at the 3/29 meeting, according to the report in Time. They questioned whether the company was prepared for a hostile U.S. political reaction wondered about the debt load that CNOOC would have to take on to finance the transaction.

Had the board been consulted in advance, CNOOC would have been more likely to have initially offered to shed some of Unocal’s American assets to address concerns about the loss of domestic U.S. reserves. They might have also brought in a US partner to absorb some of the risk and political flak, as Haier did in its bid for Maytag last month. (Uncharted Waters, Time, 7/11/2005)

In contrast with last year, only two Chinese firms that have gone public so far this year have listed their shares in the United States, in part because of concerns over more stringent corporate governance requirements. “Companies are coming to the United States to raise capital, they are just doing it through 144A offerings in the institutional market as opposed to SEC-registered public offerings,” according to one quoted source. (Chinese IPOs sticking close to home, China Daily, 7/11/2005)

Maybe Chinese companies are so attractive that investors are willing to forego good corporate governance practices. That seems more like gambling than investing to me. China doesn’t need to ape US corporate governance practices, they’re not that good. But if they’re going to imitate anything, it shouldn’t be the royal CEO and rubber stamp board. I hope lessons are learned from the Unocal mess. More democracy in corporate governance could make a great contribution to continued economic growth on a more sound footing — advice that applies to those on both sides of the Pacific..

Oxley at ICN

US congressman Michael Oxley, co-author of the US Sarbanes-Oxley corporate governance legislation, attended the International Corporate Governance Network conference. Oxley told delegates that he had “mixed views” on Europe, referring to issues like “hostility to cross-border mergers in the banking sector.” He said investors “have enormous influence and I think they are finding their voices that here to fore have not been so strong.

Oxley also said auditors should not have “cosy relationships” with company management. “If there is an area where that needs separation and this independence, it is this particular area.” (US’s Oxley on corporate governance, ipe.com, 7/8/05)

Strine at European Policy Forum

Judge Leo Strine, a vice-chancellor of the Delaware Court of Chancery, warned federal legislators to “stay in [their] lane” and leave corporation law to individual states. In a speech to the European Policy Forum, Strine noted that following the Enron and WorldCom scandals “the sour scent of hypocrisy wafted from some important congressional chambers” as federal legislators who had previously helped to block efforts began to support rapid action. He described the Sarbanes-Oxley legislation as a “strange stew” that coupled sensible ideas with “narrow provisions of dubious value.” (US judge attacks corporate governance legislation, MSN, 7/5/05)

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Unmasking Ritual

Gerald F. Davis critiques the functionalist view of the nexus-of contracts (or contractarian) theory of the corporation, where financial markets render continuous judgments on corporate performance. Sociology, he writes in New Directions in Corporate Governance, provides an alternative perspective that lends insight into networks, power, and culture.

Functionalism in sociology is a consensus theory that arose largely as a response to the French revolution, with its increased emphasis on individual freedoms, and the emergence of a new industrial society, with its loss of community. It is a conservative theory, which best explains stabile environments. One of its founders, Emile Durkheim, drew an analogy between biological organisms and society. Various organs work together to maintain a healthy individual, just as institutions work together to produce the social order.

Although functionalism is the dominant theory in sociology, it is often criticized for being teleological, explaining things in terms of what happened afterward, not what the motivations were when events occurred. Conflict theorists, such as Machiavelli, Hobbes, Marx, and Weber attempted to explain behavior in terms of self-interests. They remind us that ideas and morals are socially created and serve the parties to the conflict. It is this sociological tradition that Davis appears to draw from.

The foundation of the functionalist view in corporate governance, according to Davis, is the efficient market hypothesis (EMH), the claim that financial markets are “informationally efficient”-that is, that they value capital assets (such as shares of stock) according to all available public information about their expected future ability to generate value. Davis cites faith in EMH as the “bedrock” of the contractarian approach: According to Jensen (1988, p. 26), “no proposition in any of the sciences is better documented” than the EMH.

To survive, public corporations must demonstrate their fitness to financial markets by showing that they are oriented toward shareholder value. The institutions of corporate governance could thus be seen as a sort of financial global positioning system, a set of devices that mesh to guide corporate executives toward the North Star of shareholder value.

EMH does not have to be true to be useful, it only needs to be the best available option. William Allen, for years the most influential jurist in Delaware, asserted that the contractarians/shareholder value approach “is not premised on the conclusion that shareholders do ‘own’ the corporation in any ultimate sense, only on the view that it can be better for all of us if we act as if they do.”

Davis notes that under the contractarian approach, shareholders are simply placeholders; the stock market value is what is essential. Readers of our newspage will note, this conforms with the function of US audits, which are designed to keep markets efficient, rather than to inform shareholders of corporate inefficiencies.

According to Davis, power theory proposes a very different agenda for research: Who made the decisions that created large industrial corporations? What were the alternative choices they faced? To what extent did rationality, social influence, or other decision-making logics shape their decisions?

Neil Fligstein, whose work we have reviewed elsewhere, provides a four-part periodization of the history of the large American corporation, largely dependent on adaptation around state intervention.

  1. The first corporate strategy consisted of predatory competition. With the rise of antitrust suits, cartelization and then monopolies developed.
  2. The manufacturing conception of control was developed by absorbing suppliers and marketing functions into their organization in an attempt to stabilize the production process through oligopolistic pricing.
  3. A sales and marketing conception of the firm next evolved in the 1920s.
  4. Finally, the currently dominant conception of the corporation emphasizes the use of financial tools, which measure performance according to profit rates.

Rather than accepting contemporary structures as self-evident, inferring an “efficient history,” conflict theorists document the critical historical junctures that shaped the developmental trajectory of the corporation.

Other instances of such an approach cited by Davis include:

Boards with relatively powerful CEOs are more prone to choosing new directors from relatively weak outside boards, while boards that are relatively more powerful than their CEO evidently do the opposite (Zajac & Westphal, 1996).

Reputation ratings of established firms go up when they appoint well-connected directors to their boards, even though this has no discernible impact on corporate performance (Davis & Robbins 2004).

Firms announcing stock repurchase plans that they never implement nonetheless receive an uptick in share price (Westphal & Zajac 2001).

Davis says “these studies suggest a useful new direction for sociological studies of governance, organized around performance and rhetoric in the context of financial markets.” He cites one entry point for a sociology of corporate governance in the work of La Porta, Lopez-de-Silanes, Shleifer, and Vishnyconcerned with how well investors are protected by law from expropriation by the managers and controlling shareholders of firms, an important factor in explaining both the growth of financial markets and the relative dispersion of shareholdings within companies.

A sociology of corporate governance, which maps out players and motivations, is more “self-conscious about the limits of functionalist explanation” and can better “provide an understanding of their origins and trajectories that brackets the assumptions of financial economics.”

The potential influence of research in restructuring reality can be seen in the “market for corporate control,” which Davis notes was of relatively trivial importance when Manne (Henry G. Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy 73, April 1965) named it. It didn’t take on major importance until the 1980s, when sympathetic scholars gained influential policy positions in the Reagan administration and enacted the theory.

In short, economic and legal theorists have had substantial influence in formatting the institutions that grew up around the shareholder value system of corporate governance, and tracing their impact and pointing to options are apt topics for sociological analysis.

We need to guard against corporate governance reforms that are simply ritualistic token practices and structures intended to convey compliance but decoupled from actual practice. “Enron famously set up a Potemkin trading floor to impress visiting analysts with the volume of their business, while simultaneously hiding much of their real business in off-shore accounting entities invisible to investors.”

Conflict theory, symbolic interactionism, which emphasizes the subjective meaning of human behavior, and other sociological theories can unmask such rituals and provide new insight into how we are continually readjusting corporate governance and negotiating a continuously unfolding process. Davis certainly makes a contribution with New Directions in Corporate Governance.

Feckner on the Cover

The June issue of Institutional Investor magazine carries a cover story on Rob Feckner, calling him low-key and little known. (A truly civil servant) “Rob Feckner, the new CalPERS president, is toning down the activist rhetoric. But he vows to fiercely defend the pension fund from its powerful critics — including California Governor Arnold Schwarzenegger.”

Schwarzenegger has vowed to put a measure on the ballot next year to outlaw defined benefit plans for all new public employees argues that government can no longer afford the risk. CalPERS’ portfolio grew 13.3% last year, compared to a median of 11.8% for public pension funds with assets greater than $1 billion. (8.1% vs 7.5% over the last 3 years)

A sidebar article notes that where states have given employees an option, few employees have opted for it. Florida has offered the option since 2002 but only 6.6% have opted in. Ohio’s plan attracted 1% and Montana’s 3%. “Defined contribution plans offer less diversification than defined benefit plans at a higher cost,” says CalPERS chief investment officer Mark Anson. “There’s not a lot to like.” Anson is right. If Schwarzenegger’s plan takes effect, I estimate the yield to money managers will be an extra $5.65 billion every year while earning $10.2 billion less for public employee retirements every year.

The article goes on to briefly describe Feckner’s coming of age, a tale of hard breaks and dogged persistence. One who has been on the opposite side of bargaining with Feckner says, “Rob is neither vindictive nor power-oriented. He’s a down-to-earth leader who understands politics and is a very effective advocate. That’s why he has gotten where he has.” Most see his leadership as quieter, but probably more effective than Harrigan’s.

Beginnings of Communication

In June we reported that Morningstar began holding monthly “forums” to answer questions about its business from any investor or prospective investor. Investors submit written questions by email. Morningstar’s director of investor relations digs up the answers and reports to shareholders and the SEC. I said that although the “forum’s” are an innovation in reporting, Morningstar should take measures which actually allow shareholder to act like owners. So I asked them:

Corpgov: Will Morningstar allow shareholders a greater role in nominating directors?  For example, Ashland agreed to solicit director candidates from major shareholders and to nominate a qualified candidate for election to the board. Shareholders of Microtune can nominate one director beginning in 2005 at the annual meeting and a second director at the annual meeting in 2006. See also Apria Healthcare’s innovative policy allowing shareholder to place nominees on the proxy under limited circumstances at http://media.corporate-ir.net/media_files/irol/11/111451/corpgov/NominationOfDirectors.pdf.

Morningstar: As a newly public company, we’re interested in seeing examples of other practices in corporate governance, and we appreciate the suggestion. We’ll pass this idea along to the nominating and corporate governance committee of our board of directors for their consideration.

Our company by-laws currently provide for annual elections of each member of the board of directors and specify that we will have at least five and no more than 12 directors. (Our board currently consists of six directors, four of whom are independent.) Our nominating and corporate governance committee is responsible for recommending to the board nominees who will be submitted to shareholders for election at each annual shareholder meeting, as well as nominees to fill any vacancies or additional board positions. The by-laws and the nominating and corporate governance committee charter are available in the Investor Relations section of our corporate Web site, global.Morningstar.com.

Amending the nominating and corporate governance committee charter to provide for shareholder nominations would require more research and discussion, but it’s something we’ll consider as we annually review the charter.

Corpgov: Will Morningstar allow shareholders to select the auditor? Would Morningstar embrace a shareholder resolution that provides for auditor selection by shareholder such as the one outlined at http://www.corpmon.com/AudInd-USG.htm?  One of the fundamental problems with audits is that the duty of care for auditors in the U.S. is not to shareholders but is to buyers and sellers in the market. Our audits are better designed for day-traders than long-term owners. Efficient markets and efficient companies are not the same thing. If shareholders could select the auditor, it is likely they would choose one which places a high priority on informing shareholders about corporate inefficiencies.

Morningstar: In accordance with current SEC and NASDAQ rules, the audit committee of our board of directors is responsible for retaining our auditor, as well as providing general oversight of the audit work. The audit committee takes this responsibility seriously and has the goal of providing audited results which clearly reflect the company’s financial performance. These reports are designed to equally inform all shareholders, both short and long-term. The audit committee will continue to monitor the quality of audits performed by our independent registered public accounting firm, which is Deloitte & Touche.

Although Morningstar didn’t exactly embrace our suggested reforms, their reply and filing was much more responsive than we have seen from many other corporations.  For example, in April I sent some questions to Whole Foods Market concerning shareholder proposals appearing in their proxy. The following was their response: “Because of SEC regulations, we are required to limit our substantive comments regarding shareholder proposals to documents that we file with the SEC.  While we would like to do so, we are precluded from separately addressing the points raised in your letter at this time.”

Morningstar’s “forum” represents clear progress; we still have a long way to go.

“True and Fair” Ending in UK

The Financial Times ran an article titled, True and fair view of British audits is in jeopardy, by Keith Jones (7/5/05), which laments that while the “true and fair view” assessment of a company’s state of affairs has been a cornerstone of UK accounting, it is now in jeopardy. “Britain and Europe are moving dangerously close to a weak, narrow and limited US-style audit based on technical compliance.”

Instead of making qualitative judgments about whether a company’s accounts present a true and fair view of a business’ state of affairs, auditors will check arithmetic compliance with accounting standards. This will open us up to more Enron’s, which regularly received a clean bill of health under such restricted standards.

According to Jones, who is the CEO of Morley Fund Management, International Auditing Assurance Standards Board’s US-derived international standards of auditing (ISAs) gives priority to rules at the expense of robust judgment and common sense. Given a legislative footing under the European Union’s proposed eighth company law directive, ISAs could change the application and interpretation of existing auditing principles, reducing the scope and rigor of UK audits.

Jones reminds readers the purpose of the audit is to act as a safeguard and check on “agency problems and costs” that arise from the separation of ownership and control in companies. The risk is that management may not always act in the best interests of the shareholders.

We need to decide whether we want the focus to be on ensuring that they are properly empowered to carry out substantive audits or whether we subordinate them to a US-style, process-based framework…There is no sense in introducing further safe harbour provisions for those who carry out audits when there are serious concerns about the nature of the audit itself. In short, the auditor liability regime should not be changed until the quality of the audit has been ensured. To do otherwise is to put the cart before the horse.

As Ian Richards of the Morley Fund notes, “Time is against us, as the dogged resistance there has been over the last two years to any substantive discussion of issues other than liability reform, ahead of the fast-track adoption of the EU’s 8th Company Law Directive, means we will have gone (if we haven’t already) over the edge of the cliff that we were alluding to in the paper Bringing Audit Back from the Brink” (Feb 2004). Richards continues, “The commoditisation of the audit that really started in the UK with the low-balling of the Prudential audit tender in 1991/1992 (the symptoms were seen repeatedly in the POBA – Audit Inspection Unit’s report last month), will largely be underpinned by a framework that enables the highly diversified, global audit firm to be ‘righteous by process.'” 

Divided by Common Language

We reported on this paper by Tim Bush of Hermes Pensions Management last month under the heading Audit Independence. We suggested that anyone who truly wants to address the issues surrounding audit independence would do well to read Bush’s paper, along with How US and UK Auditing Practices Became Muddled to Muddle Corporate Governance Principles by Shann Turnbull and Mark Latham’s Auditor Independence proposal.

Divided by Common Language, which has now been formally released, highlights difficulties arising from the US 1933 Securities Act. Created as a pragmatic federal solution to bring the US out of depression, the 1933 Act focuses financial reporting and corporate oversight on stock market pricing. By contrast, the British model developed both shareholder rights and financial reporting under a single system of company law. In the US, company law is fragmented because it is set at a State level.

With the globalization of capital, calls for a level playing field in corporate governance to instill market confidence have never been greater. There is a presumption of a convergence towards an Anglo-American model of capital market behavior. Subsequent confusion can arise among policy-makers world-wide because of the superficially ‘common language’ of the UK and the US where legal and regulatory frameworks are different in both intent and effect. Major differences exist between the US and the UK regarding both the preparation of financial statements and the governance aspects thereof.

Tim Bush, author of the report, said: “The impact of legal differences is significant, especially at the margins, and should be recognized in order to prevent inappropriate exchanges between countries with different legal frameworks that don’t support the same basic concepts.”

The report launches the ICAEW’s Dialogue in corporate governance initiative. The first series is entitled ‘Beyond the myth of Anglo-American corporate governance’ and will seek to promote understanding of differences between US and UK systems and possible areas of learning and convergence.

For more information please email corporategovernance@icaew.co.uk.

Links Updated

We spent a several hours on July 4th cleaning up our Links page, weeding out sites that are no longer functional and tracking down where sites have moved to. Please do not hesitate to let us know about broken links by letting us know the link word or words that are broken, as well as the URL of the page where the words were found. E-mail corrections to James McRitchie. We operate with antiquated software and a ten year old site design which depends on the goodwill and participation of our readers. Thanks for your patience.

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