October 2005

Grade Inflation or Truly Outstanding?

Business Week carries an article, Stars of the Boards, outlining recent awards by the Outstanding Directors Institute. “The group presents a list of candidates — nominated by fellow directors — to an advisory board composed of sitting corporate directors and chief executives. They help determine the final list. To make the cut, directors have to be clearly aligned with shareholders’ interest, devote significant time to their jobs, be deemed a key player by fellow board.”

Former U.S. Senator Bill Bradley makes the cut for may be best known for giving Starbucks guidance and contacts for expanding globally, as well as for helping to design a health-care plan for employees. Former Smith College President Jill Conway, pioneered a plan to tie stock option exercise prices to executive performance on the Colgate-Palmolive board. Inter-Con Security Systems CEO Rick Hernandez, Jr., wins accolades for helping turn around Nordstrom as a director, in part from his own experience in running a family business.

The article lists several more and their achievements. Les Greenberg, of the Committee of Concerned Shareholders, asks if getting awards for doing what all directors should be doing isn’t a bit like grade inflation in our schools. I wonder why directors are grading other directors for “being clearly aligned with shareholders’ interest.” Shouldn’t a panel deciding that be made up of shareholders? I suspect a list drawn up by shareholders might include Ralph V. Whitworth, Herbert Denton, and Andrew Shapiro who are well known for turning companies around and adding shareholder value. (for additional examples, see The Turnaround Tactician)

Public Funds Move From Hedge Funds

When the ratio of assets to liabilities plunged from 95% in 2001 to 80% in 2002, public pension plans scrambled into hedge funds, hoping to increase yields. Now that funding ratios have improved to 88%, fewer are showing such interest, according to recent Wilshire Consulting study of assets and liabilities of 104 city and county retirement systems. Steven Foresti, managing director at Wilshire, commented: “Now institutions that are moving to hedge funds are thinking about it and moving in a more strategic way.” Foresti predicts that hedge funds will not exceed 10% of a city or county pension fund portfolio. (Pension Trustees’ Interest in Hedge Funds Wanes, MMExecutive, 10/12/05)

Still, Wilshire forecasts a long-term median return on city and county pension assets equal to 7.2% per annum, which is 0.8 percentage points below the median actuarial interest rate assumption of 8.0%, so some pressure continues. Additionally, demand for hedge funds as a tool for activists could grow. Cash at S&P 500 industrials recently stood at $613 billion. As a percentage of stock-market value that’s higher than at any time since the early 1980s. Shareholder’s want it put to productive use. If the company won’t use it, shareholders will want it back. Jesse Eisinger argues the need for hedge funds with a long-term approach. (Hedge-Fund Activism Wins Plaudits, But the Focus Is Really on Firms’ Cash, WSJ, 10/12/05)


Option Grants Decline

The economic value of stock option grants at the nation’s largest corporations declined by almost 60% over the last three years from a total of $118 billion to $51 billion, according to a new Watson Wyatt survey. The survey also found that, using the Black-Scholes formula, the economic value of stock options granted at the typical company declined 64% from $103 million in 2001 to $37 million in 2004, according to a Watson Wyatt press release. The decline occurred in all industry sectors in spite of stock market increases, and was attributed to fewer stock options being granted and a decrease in the size of grants that are offered. Significantly, companies that provided higher total long-term incentive opportunities to their CEOs over the last five years did not outperform those that provided lower award opportunities.  (PlanSponsor.com, 10/12/05)

FTSE Companies Need Improvement

Less than half of the UK’s top 100 companies are complying with the Combined Code, according to the Association of British Insurers. However, 96% are meeting performance evaluation and independent directors guidelines. which are both met by 96 pct of the FTSE 100. (Less than half FTSE 100 companies meeting corporate governance standards – ABI, Forbes.com, 10/12/05)

Home Depot Cuts Through Bureaucracy

“In 1991, Home Depot became one of the first U.S. companies to mandate store visits by outside directors so they could spot trends and better advise senior management. Now, many boards rub shoulders with workers through site visits. Experts say the Atlanta-based retailer has broken ground again with the addition of “functional” visits to areas such as finance, human resources, operations and information technology…”

“Governance watchdogs agree. ‘It’s a great idea,’ because functional expertise bolsters boards’ monitoring of management, says Roger Raber, president of the National Association of Directors in Washington. A functional visit ‘demystifies’ the directors, says Paul Lapides, director of the Corporate Governance Center at Kennesaw State University in Kennesaw, Ga. “I’m not aware of anybody else who does [functional visits] in a formal way.” (Home Depot Board Gains Insight From Trenches, WSJ, 10/10/05)

Critics charge that such visits encourage directors to rely to heavily on insiders. However, if directors continue to monitor outside sources, such visits are entirely a plus. They allow dissenting opinions to filter up much more quickly in the organization and the information gathered prompts directors to ask more difficult questions of management. Store visits and functional visits set Home Depot ahead of most in this one area of communications. To improve communications even further, they could also begin a dialogue with shareholders. Morningstar holds monthly “forums” to answer questions 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.

Back to the top

Cox Calls for Democracy

Hedge fund operator Phillip Goldstein sent the following e-mail to Phyllis Plitch, a frequent writer for the Dow Jones Newswire and Wall Street Journal. I was copied on the message and believe readers will find it interesting.

We have spoken once or twice in the past about proxy matters.  Perhaps you may recall that I manage a few hedge funds and use an activist approach to unlock value from our investments which include closed-end funds.  Our website is www.bulldoginvestors.com

I am writing to you because you cover shareholder rights issues.  I just read Chairman Cox’s very fine speech which he gave today at the National Endowment for Democracy.  See http://www.sec.gov/news/speech/spch100605cc.htm

I will give Mr. Cox the benefit of the doubt and assume he is not aware of the irony of passionately promoting democracy around the world while shareholders right here in America live under a one-party electoral system that Fidel Castro would envy.  Forget about Donaldson’s lame highly conditional proxy access proposal.  Even when shareholders are willing to incur the cost of conducting a proxy contest, it is not uncommon for management to freely use corporate assets to pay lawyers to frustrate their efforts to elect a competing slate.  (We have made demand on The New Germany Fund to sue Sullivan & Cromwell for malpractice in promoting an anti-shareholder preclusive director qualification bylaw.  Let me know if you want to see the documents on that.)  When we asked the SEC staff if the board of directors of a closed-end fund, which under the 1940 Investment Company Act (ICA) is required to be elected by shareholders, could avoid a challenge by imposing burdensome qualifications on shareholder nominees, the staff’s response was that was OK because “the right to vote is not totally meaningless . . . when shareholders can reject nominees but cannot influence nominations.”  I am not making this up as you will see in the attachment.

Perhaps you can ask Mr. Cox if he shares the staff’s view as to what the standard should be for an election required by the ICA, a law that was passed to address abuses of investors by management (see section 1 of the ICA athttp://www.law.uc.edu/CCL/InvCoAct/sec1.html).

I would add, it is ironic that Cox would tell those gathered at the National Endowment for Democracy that “democracy is like oxygen. You might not think of it at all … until you’re deprived of it.” Shareholders have been deprived of democracy for a long time. I would be pleased if Mr. Cox would take up the issue of democracy in corporate governance. I say to you Mr. Cox, tear down the wall that prohibits shareholders from using the proxy of the corporations they own to nominate and elect truly independent directors.

You say “the Soviet Union fell because America and its leaders instinctively trusted the power of freedom.” I ask you to trust that power as well. Give shareholders the freedom to hold our directors and our companies accountable. Don’t let them hide behind a wall of no action letters from the SEC. You say, “democracy requires open debate, civility, and a solid understanding of your opponent’s point of view-if only to defeat him or her through the force of reason.” Without access to the proxy, there is no open debate, no exchange of ideas, not understanding of the other’s point of view.

You say “the challenge of preserving liberty in America, and the challenge of extending liberty throughout the world, are as one.” How about using your powers at the SEC to extend democracy to some of the most dynamic organizations ever conceived by the human mind, the corporation?

As Gourevitch and Shinn note in their book Political Power and Corporate Control, the corporate governance framework “creates the temptations for cheating and the rewards for honesty, inside the firm and more generally in the body politic.” With billions of dollars spent by oligarchic corporations on political contributions and lobbying, many would question if our current political system is actually democratic.

The growing power of corporations is a concern of many, both here and abroad. In fact, resolutions introduced by US shareholders requesting disclosure of corporate political contributions gained ground in 2005. As reported by Institutional Shareholder Services, “advocates of this type of reporting have suggested that companies use a series of organizations to filter money through to local, state and federal political entities without adequate disclosure to shareholders or appropriate internal controls…the resolution at Plum Creek Timber Co. received support from a notable 56.18 percent of shareholders.” (The Friday Report, 10/7/05)

Wouldn’t we be on firmer ground in our attempt to convert other countries and other peoples (including potential terrorists) to democracy if we instilled some democratic values into what many believe is our dominant institution? Mr. Cox, tear down that wall. Don’t let incompetent, ineffective, or even simply unpopular directors hide behind a wall of SEC rules that deny us the equivalent of oxygen, access to the corporate proxy. Let shareholders breathe!

Political Power and Corporate Control

According to Gourevitch and Shinn, “corporate governance – the authority structure of a firm – lies at the heart of the most important issues of society”… such as “who has claim to the cash flow of the firm, who has a say in its strategy and its allocation of resources.”

The corporate governance framework shapes corporate efficiency, employment stability, retirement security, and the endowments of orphanages, hospitals, and universities. “It creates the temptations for cheating and the rewards for honesty, inside the firm and more generally in the body politic.” It “influences social mobility, stability and fluidity… It is no wonder then, that corporate governance provokes conflict. Anything so important will be fought over… like other decisions about authority, corporate governance structures are fundamentally the result of political decisions.” If the authors haven’t hooked you on the importance of corporate governance by these statements on page 3, you aren’t breathing.

I have long argued that creating sustainable wealth and maintaining a free society both require that institutional investors act as mediating structures between the individual and the dominant institutions of our time, the modern corporation. Democratic corporate governance will reduce the corrupting influence of unaccountable power on government and society. At the same time, by transforming corporations into more democratic institutions, institutional investors will instill them with their own values and will unleash the wealth-generating capacity of “human capital.”

The model Gourevitch and Shinn set forth in Political Power and Corporate Control: The New Global Politics of Corporate Governance uses corporate governance as the dependent variable. “The arrow of causation flows from preferences to political institutions to corporate governance outcomes.”

Whose preferences? Key, are those of owners, managers, and workers. How? “To obtain their preferred corporate governance outcome, they have to win in politics” by mobilizing allies outside the firm in systems the authors categorize as largely majoritarian or consensus. A dynamic feedback loop is thus created: “institutions shape policies that influence preferences. At the same time preferences induce institutional arrangements that increase the chances of preserving the policies desired by the preferences.”

Treating the categories of owners, managers, managers and workers as homogeneous blinds us to coalitions. Through an analysis of available datasets, the authors demonstrate that outside owners are more likely to ally with workers to support transparency. Workers seeking to preserve their jobs are more likely to ally with managers; whereas, concern for pension funds motivates transparency and ability to exercise shareholder voice. Firm-centered managers prefer blockholding owners; those seeking maximum pay tend to support minority shareholder protections and vigorous labor markets.

Variation in corporate governance is not necessarily a function of economic stages, technology, or legal framework. Instead, Gourevitch and Shinn provide substantial support for the argument that “corporate governance arises from incentives created by rules and regulations that emerge from a public policy process, reflecting the power of alternative coalitions.”

Although most academic writers and the press emphasize minority shareholder protections, Gourevitch and Shinn emphasize the need to also account for “degrees of coordination,” which shape incentives to concentrate shareholding or sell down to a more diffuse market. These include product-market competition, price and wage mechanisms, labor relations, and social welfare systems. Each coalition seeks to persuade society-at-large to provide public policies in corporate governance that favor their own interests.

Systems shift when economic conditions change in big way. One of their most interesting discussions concerns their assertion that pension funds, which they define to include all forms of deferred compensation plans, may be most important as the next phase unfolds. “To understand the future politics of corporate governance debates, we will have to track fights about pension reform.” “Pension plan regulations may turn out to be the tail that wags the corporate governance dog.”

Defined benefit plans held 27% of all U.S. equities in 1989-95 but fell to 21% more recently. Mutual fund ownership, on the other hand, has climbed from 8% in 1990 to 28%. As more defined benefit plans (often jointly administered with employee or union representatives) are dropped, the future of corporate governance reform may lie with mutual funds. That tail, using the above analogy, seems to wag whenever management speaks.

They are required by law, as fiduciaries, to represent the interests of the investors whose money they oversee, not their own business interests, which may including landing contracts to administer 401(k) plans. Recently, Vanguard, Putnam, and Fidelity voted against shareholder proposals that would require directors standing for election to stay on only if a majority of votes are ”yes.” Clearly, these funds were not voting in the best interest of owners. Mutual funds used to turn over 17% of their portfolio each year (1950-1965) but averaged 91% per year in 1990-2005, prompting John Bogle to remark the “rent-a-stock industry has little reason to care” about good corporate governance.

Gourevitch and Shinn find that “as worker-citizens acquire assets, they develop preferences for shareholder protections, thus adding pressure to the potential for a transparency coalition” and “assets in the hands of institutions that are accountable to their owners are likely to pay more attention to governance than are assets in the hands of autonomous managers.” Perhaps an actual power shift will follow as mutual fund investors demand a role in mutual fund governance and those funds begin to represent their true preferences with corporations. If that happens, we might see a book that looks in reverse, tracing the effects of corporate governance outcomes on political institutions. “Socially responsible investment” will then take on new meaning and dimension.

In the meantime, Gourevitch and Shinn, note enough interesting correlations and observations to make the book must reading for any corporate governance policy analyst, especially those with global concerns. Here is a small sample:

  • Blockholding and minority shareholder protections are negatively correlated.
  • Minority shareholder protections and share price are positively correlated.
  • Blockholding dips after increased minority shareholder protections are likely the result of sales by “new money” entrepreneurs, rather than old money blockholders (who may fear the tax collector).
  • Blockholding may be preferred when uncertainty is high.
  • State-owned enterprises are the most aggressive users of ADRs.
  • Money flows toward firms and countries that provide shareholder protections. “No other group can have quite this direct an effect on the economy…the economic vote of investors counts greatly against the mass of votes in elections.”
  • Where job security is strong, diffusion is weak, and minority shareholder protections are weak.
  • Weak intermediate institutions of finance, investment, pensions and stockmarkets are correlated with little voice for shareholder rights.
  • “The U.S. Securities regulation system assumes that institutional investors and reputational intermediaries are the agents of investors.” “Yet it has become increasingly clear to many observers that these private actors have multiple, complex incentives…”
  • “As much as 10 percent of the total ownership of U.S. public firms was transferred from the existing stockholders to senior managers through stock option grants between 1990 and 2000.”

Their treatment of the definition of corporate governance from various perspectives is also an eye opener. Here’s a flavor of that discussion:

  • Where the political scene is capital versus labor, “the investor coalition defined corporate governance in terms of ‘meeting the challenge of financial globalization,’ adherence to the OECD Principles, fulfilling ‘international standards of governance in the global competition for capital.'”
  • From a labor power position, “blockholders and foreign portfolio investors were castigated as selfish oligarch in league with the heartless IMF and the faceless gnomes of Zurich.”
  • Those favoring the corporatist compromise made much of managers and workers “being in the ‘same boat’ together, of corporate governance choices that ensured that firms ‘served the nation’ in a ‘stable’ economy – with owners dismissed as oligarchs or ‘speculators.'”
  • Countries shifting transparency coalitions and managerism alignment “witnessed predictable invocations of corporate governance that protected ‘the little guy, ‘ the individual investor,’ the widow and orphans,” such as speeches by U.S. SEC commissioners.
  • “Meanwhile across the alignment divide, managers compete to hijack the notion of corporate governance for their own purpose…’building shareholder value.”

Shareholder value is partly about efficiency. But Gourevitch and Shinn raise serious issues of distribution, job security, income inequality, social welfare. Will firms of the future be efficient at creating a healthy environment and general prosperity or efficient at putting money into the pockets of CEOs?Political Power and Corporate Control provides a groundbreaking guide, based on empirical evidence, for anyone concerned with the direction of corporate governance and society.

Call to Action By New York Times

The New York Times (Who’s Afraid Of Shareholder Democracy?, 10/2/2005) carried an article by Gretchen Morgenson who questions how mutual funds, such as Vanguard, Putnam, and Fidelity, can justify voting against shareholder proposals that would require directors standing for election to stay on only if a majority of votes are ”yes.”

They are required by law, as fiduciaries, to represent the interests of the investors whose money they oversee, not their own business interests, which may including landing contracts to administer 401(k) plans. Morgenson quotes Glenn Booraem, a principal at Vanguard Funds, twisted attempt to justify their vote in opposition:

Generally, we did vote against those types of proposals from the general perspective that we were concerned with some of the practical applications about the standards that were proposed, such as how the majority standard would work from a corporate law perspective if a full board wasn’t elected, if there weren’t sufficient directors that got a majority vote to enable the board to continue to operate.

John Hill, chairman of Putnam Funds, says they have been focusing on executive compensation and dilutive stock awards. Majority votes for directors are on its agenda now. “My board has got to vet it, but I think there will be sentiment to support majority voting going forward,” he said. However, the law doesn’t say fiduciaries can vote with management until they get around to analyzing the impact on investors. They have a fiduciary duty to do that analysis before they vote and frankly I don’t see how any fund can justify a vote in opposition.

Morgenson suggests that her readers write to David C. McBride, a partner at Young Conaway Stargatt & Taylor LLP, who is chairman of the corporate law section of the Delaware State Bar Association that will recommend amendments to the state laws relating to corporations, perhaps are early as next April or May. For an example, see a 6/15/2005 letter from the Council of Institutional Investors.

Morgenson also reminds her readers “who own mutual funds that vote against these proposals should also let those companies know if they are displeased with their stances.” She notes that “some 36 companies have changed bylaws to require majority votes for directors…but at most companies, shareholder democracy remains an oxymoron. Investors have the tools to change that. Let’s see if they do.”

I’m delighted to see Ms. Morgenson informing her NYTimes readers on this issue. I only wish she had included contact information. Without it, most of her readers are unlikely to take action and, unfortunately, our readership is not nearly as extensive. For Vanguard FundsPutnam Investments, orFidelity click “contact us” in the upper right and fill out the form.

As far as democracy goes, requiring those who win to get more than 50% of the vote seems so rational. Yet, even this nominal reform often takes far too long. CalPERS, long known as a corporate watchdog, finally adopted similar regulations governing their own board elections that apply for the first time to their current elections. (Nine seek seats on CalPERS board, SacBee, 10/1/2005) Unfortunately, CalPERS opted for an expensive runoff process, instead of the much more economical instant runoff form I urged them to adopt in 1998-99 (comments to CalPERS).

September 2005

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