Post-Enron Observations on Corporate Governance

An Address to the Forum on Corporate Governance in Asia, Thirty-Fifth Annual Meeting of the Board of Governors of the Asian Development Bank held in Shanghai, People’s Republic of China, on May 11 2002.

Quite frankly, Enron has left American investors scared and distrustful. The watchdog systems designed to protect us failed and that failure was widespread, extending to investment banking, auditors, regulators and business leaders in general, none of whom acted to prevent the actions that led to Enron’s fall. Take a look at the last two covers of BusinessWeek, our most popular business magazine. One headline reads, “The Crisis in Corporate Governance,” the other “Wall Street: How Corrupt is it?” There is a growing realization that the system is broken. To fix it, we need to reduce conflicts of interest and we need greater democracy both at the top, in the accountability of boards and CEOs, and at the bottom in the form of increased ownership and participation by employees.

There is no question that globalization of capital is on the rise. Countries and companies that seek to attract investors will need to attain ever higher scores by rating systems, such Standard & Poor’s, if they are to obtain low cost financing. Long term investors will seek markets where their legal rights are known and protected and where those using their money can be held accountable.

US investors are even more sensitive to issues such as fraudulent financial reporting, conflicts of interests and lack of auditor and director independence since the demise of Enron, once our 7th largest company. Countries with political stability, transparent accounting practices, shareholder rights, as well as employee protections, will attract long term investors who are willing to pay a premium for shares in well-governed companies.

Let’s examine the recent decision by CalPERS to pull out of several Asian markets. It wasn’t an aberration. I’ll talk about how standards at CalPERS are likely to change over time and I’ll close by noting some of what I see on the horizon.

You’ll have to be the judge of how these developments will impact Asia. The problems we face are different. In the US ownership is widely dispersed. That leaves management in control. Shareholders can loose everything if the CEO is unethical. In Asia, there is usually a dominant shareholder (either the state or a family). The problem is how to guarantee the investments/rights of minority shareholders. US industries are increasingly based on intellectual capital, while yours are more dependent on attracting cash investments. But knowledge work isn’t confined to office workers and even capital intensive industries benefit by putting all the brains of their employees to work. America and the emerging markets of Asia would benefit from something of a convergence and in greater democracy.

The Decision by CalPERS

CalPERS, the California Public Employees Retirement System, has assets of over $150 billion. As was widely reported in February, they announced they would be pulling out of several emerging markets: Indonesia, Malaysia, Thailand and the Philippines on ethical grounds.

Their standards assign a 50% weighting for the following factors:

  • political stability
  • financial transparency
  • labor standards

The other half of the review is based on:

  • market liquidity and volatility
  • market regulation and investor protections
  • capital market openness
  • settlement proficiency
  • transaction costs

Their investments in Asian emerging markets were relatively small to begin with: under $100 million each in Indonesia, the Philippines and Thailand, with a little more in Malaysia. So, was it important?

Yes, without a doubt, CalPERS is a leading indicator of policies that will eventually apply to a larger segment of US investors, and to others around the world well. I understand that each of the affected countries sent delegations to Sacramento, California to plead with CalPERS to reverse their decision. At an April 19th meeting, the Filipino delegation, led by their Secretary of Finance Jose Isidro Camacho, succeeded in convincing CalPERS that it meets their guidelines. They’ll be taken off the blacklist next week.

No Aberration

Pension funds in the US hold a little over 25% of our market. They tend to be long term investors (holding stock for 7-8 years), while most mutual funds turn over their portfolio’s at a rate of 85% a year. CalPERS doesn’t sell when the market goes down or another type of investment comes into fashion. Many pension funds, like CalPERS, are controlled in part by labor unions and their members. At CalPERS, members directly elect almost 1/2 the board. 20-30 years ago union members started waking up to the fact that our pensions were often invested in companies with “unfair” labor practices that were undermining our jobs or, in the case of public funds, the taxbase that pays for our jobs.

At about the same time, our Department of Labor issued a directive that required pension funds to pay attention to how their votes cast in corporate elections. DOL required that proxies be voted in the interest of plan beneficiaries, not the money managers.

During the last ten years, unions and their pension funds have become the leading proponents of shareholder resolutions. Unions know how to organize winning campaigns at shareholders meetings, in the press and with the public. Our pension funds are becoming a more important organizing tool than the threat of a strike.

Typically, large pension funds like CalPERS have used a strategy of buying a little of almost the entire listed market and holding. When company performance lags over a long period, CalPERS doesn’t sell because selling would only drive the price of their large holdings down further. Instead, they work with other investors to target those companies for change. They negotiate with management. If that doesn’t work, they file resolutions to encourage more independent boards and other best corporate governance practices. Sometimes they’ve backed dissident slates … voting out board members and CEOs.

Another fast growing segment of the US market is SRI (socially responsible investment) funds. Religious and other nongovernmental organizations led the way in making corporations and the public more aware of social impacts. Churches began introducing resolutions at shareholders meetings, for example to get Dow Chemical to stop producing napalm when we were at war with Vietnam, and later to get Nike to improve labor conditions at their factories. Mutual funds catering to SRI investors developed screens for whatever they thought was sinful or unethical – tobacco, unfair labor practices pollution, etc. Typically, they don’t buy shares in companies that try to profit from activities they don’t approve.

The U.S. leads the way in “ethical investing” with $2.03 trillion invested in a “socially responsible manner” in 2001, or 10 percent of the $19.9 trillion funds managed. However, Britain and Germany have in the past two years issued laws requiring pension funds to state their position on social, environmental and ethical issues. I understand that France is set to follow suit.

A month or so ago, the Chairman of the Securities and Exchange Commission (Mr. Pitt) clarified in writing that the same policy that applies to pension funds (proxies must be voted in the best interest of shareholders, not money managers) also applies to mutual funds (which hold almost another 25% of the market). This will put some pressure on all funds to examine their voting practices.


Pension funds are becoming more like SRI funds. Members of employee/labor influenced funds, such as CalPERS want them to reflect their values. They are starting to screen out markets and companies that don’t provide minimum protections to investors…of the kind Mr. Dallas has described, and they are doing it first primarily in emerging markets, where risks are perceived to be the greatest. But this trend will probably extend to domestic markets as well.

We’ve already seen evidence of the shift to SRI considerations when CalPERS sold off its tobacco stocks. Sure, they wanted to avoid the risks inherent in tobacco lawsuits but many members of the system are public health workers who want better alignment between their values and the practices of their pension fund. During the day, we’re working to convince kids not to start smoking and to help adults quit. Our pension fund shouldn’t be investing our money to bet against our success at work.

CalPERS should have either sold its investments in Enron much earlier or should have used its corporate governance clout to change their behavior. Enron was a known tax dodger and they helped bring about an energy crisis in California. It is not in the best interest of public employees to invest in companies that avoid taxes or that manipulate markets to defraud consumers. As public employees, we depend on taxes and we spend much of our working lives trying to get companies to obey both the letter and the spirit of the law.

As governments and market forces institute reforms, CalPERS and other funds will get more sophisticated in their approach. Country ratings should be used in tandem with corporate ratings. Combining the country’s score with a given company’s score would more accurately measure risk. CalPERS would still invest substantially more in countries with transparency, political stability and good labor practices. However, exceptional corporations in difficult environments would not be completely out of bounds. CalPERS practices engagement in the US market; many of us believe it should do the same in emerging markets.

On the SRI side. Mutual funds are using more sophisticated screens. Instead of banning entire industries, more are moving to eliminate the worst offenders or invest in companies with best practices. This will be combined with corporate governance and social activism, resulting in a double payoff; better economic returns and social reforms.

Here’s an example. Innovest, an investment advisor, found that the top half of firms ranked by environmental sensitivity outperformed the bottom half by up to 21.8% over a two year period, depending on industry. Their Eco-enhanced S&P 500 outperformed the actual index by 11% over the same period. SRI funds and pension funds like CalPERS will use Innovest’s information to screen out the worst offenders and enhance their return.

At the same time, social activists, such as the Rose Foundation for Communities and the Environment, are drawing attention to a 1998 study by the US Environmental Protection Agency that revealed 74% of companies failed to meet SEC disclosure requirements regarding environmental liabilities that exceed $100,000. Only once in the past 25 years has the SEC taken action to enforce the disclosure of environmental liabilities. The Rose Foundation wants the SEC to require that companies aggregate environmental liabilities so that more must report….and it is leading a movement to have the law enforced. Enforcing the law will further improve the return of investments in companies that are already acting more responsibly.

Enron and the events of 9/11 are accelerating a merger of interests between the worlds of corporate governance and social resolutions. This season finds “crossover” resolutions that fuse corporate governance and social issues. Examples include resolutions asking for increased racial and gender diversity on corporate boards, and those asking for executive compensation to be linked to corporate social responsibility. Robert Monks, prominent in corporate governance, is now working in conjunction with the ExxonMobil campaign to address global warming and split the CEO and Chair.

Enron and Arthur Anderson have raised the stakes. The SEC has traditionally banned shareholders resolutions on such “ordinary business” practices as choosing an auditor. But many now see that “voting mindlessly with management is no longer classified as the responsible thing to do.” (asSIF Chairman Timothy Smith recently noted)

As I have mentioned, the law requires pension funds to vote shares in the best interest of beneficiaries. However, that law has never been enforced. Now we have a pronouncement by the head of the Securities and Exchange Commission that the same fiduciary law applies to mutual funds; voting rights must be treated as an asset, not as a mechanism for money managers to get more business at the expense of shareholders.

Enforcement won’t happen until it is easy to recognize how to vote in the best interests of shareholders. That’s where research findings will come into play. Disclosure should also be required. How can we hold our pension and mutual fund fiduciaries accountable unless we know how they vote?

Growing Sophistication

We’re going to see more reports that point to the need for greater democracy and eventually the laws requiring votes to be cast in favor of pension fund beneficiaries and mutual fund owners will be enforced.

Corporate Governance and Equity Prices” is the title of a study by Paul A. Gompers, Joy L. Ishii, Andrew Metrick, published in August 2001 supports the need for greater democracy at the top…to reduce management entrenchment.

They used 24 corporate governance provisions to build a proxy for shareholder rights. These fall broadly into the categories of

  • tactics for delaying hostile takeovers,
  • voting rights,
  • director/officer protections
  • state laws

They looked at 1,500 firms and found a striking relationship between corporate governance and stock returns. Firms in the lowest decile of the index (strongest shareholder rights…the democracy portfolio) earned 8.5% higher returns than firms in the highest decile of the index (weakest shareholder rights…the dictatorship portfolio) during the 1990s. Furthermore, they found that weaker shareholder rights are associated with lower profits, lower sales growth, higher capital expenditures, and a higher amount of corporate acquisitions. Pension and mutual funds that vote in favor of weakening shareholder rights could now face legal action.

Other studies demonstrate the need for greater democracy at the lower rungs of the corporate ladder are equally, if not more, important. Firms with significant employee ownership and participation in decision making grew 8 to 11% faster than their counterparts (NCEO, 1986). The GAO found that such firms experienced a 52% higher annual productivity growth rate.

In the U.S. tangibles contributed by capital, such as property, plant and equipment, accounted for 62% of the total value of mining and manufacturing firms in 1982 but only for 25% more recently. Intangibles contributed by employees, such as labor, patents and trademarks, now contribute 75% of the total value.

A 1998 report, “Corporate Governance: Improving Competitiveness and Access to Capital in Global Markets,” written by an advisory group to the OECD (led by Ira Millstein), concluded: “The more important human capital is to a business, the more those investors should stand to gain – or lose – and the greater voice they should have in governing it.”

Those who vote against measures designed to empower workers will in the not too distant future face lawsuits for not voting in the interests of shareholders.

Alan Greenspan, Chairman of our Federal Reserve Board, recently addressed the need to restore public trust in the governance of corporations after Enron. His is a pessimistic assessment of the situation. According to Greenspan, the “CEO-dominant paradigm, with all its faults, will likely continue to be viewed as the most viable form of corporate governance for today’s world. The only credible alternative is for large–primarily institutional–shareholders to exert far more control over corporate affairs than they appear to be willing to exercise.” Further, “if the CEO chooses to govern in the interests of shareholders, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave in ways that produce de facto governance that matches the de jure shareholder-led model.”

It is unfortunate that Mr. Greenspan appears to place more importance in appearances than in reforms that would give shareholders more real rights. Mr. Greenspan is probably correct in his short term assessment of the politics of the situation but institutional investors have made a difference and will again. One area where they’ve made an enormous difference is in CEO pay…but in the wrong direction.

CalPERS had helped set up the Council of Institutional Investors, whose members control well over a trillion dollars in assets. They wanted to be able to communicate more freely with each other concerning corporate governance issues but an SEC rule required them to file a lot of paperwork and made strategizing on corporate campaigns impractical.

At the time, there was a large public outcry about CEO pay and the fact that it kept rising, even when company profits fell. In order to get a change in the SEC rules, CalPERS and others agreed to support the more popular notion that executive pay should be linked to performance. Unfortunately, that language was poorly crafted and the unintended result was that while workers’ pay rose 28% in the 1990s, CEO pay rose 443% and there doesn’t seem to be much of a correlation between performance and compensation. Now CEOs are earning 500 times what their workers make and CEOs are still getting raises when their companies underperform.

Lesson: Watch out for unintended consequences.

Reforms on the Horizon

  • Transparency. We will continue to work for transparency in all aspects of corporate operations, including disclosure of off-balance sheet debt and offshore tax havens.
  • The Audit. The integrity, independence and reputation of the audit must be restored. Auditors won’t also be able to serve as the firm’s a business consultant and should be rotated periodically.
  • Campaign Finance Reform. Corporate donations corrupt the one-person one vote system of political democracy. We’re making strides but money will find other routes.
  • Boards of Directors. Boards will be closely monitored for independence, diversity, interlocking positions and conflicts of interest. CEOs shouldn’t chair Board of Directors.
  • Executive Compensation. Pay shouldn’t be so linked to share and option price that executives put their own short-term gain over the long-term health of the company. Stock options should be expensed. In 2000, the net profits of Standard & Poor’s 500-stock index companies would have been 9% lower reported, according to Bear, Stearns & Co.
  • Professionals. Too often accountants and attorneys represent senior management, not the company. Professional organizations must do a better job through education and discipline to minimize these abuses.
  • Role of Stock Exchanges. The New York Stock Exchange and NASDAQ should impose stronger standards for director independence and education, shareholder approval for all material equity plans, and policies that seek out conflicts of interest.

Unlikely Anytime Soon, But Sorely Needed

  • Tax Policies. We need to encourage long-term ownership… perhaps through increase in short-term capital gains tax.
  • The law should require that employees get to elect the trustees for their 401(k)s and pension plans; it’s a simple matter of democracy and controlling our destiny.
  • Broker voting should be eliminated. Currently, if shareholders don’t vote their proxies within 10 days of the annual meeting, their brokers will for them…always in favor of management’s recommendations.
  • Board elections. The SEC prohibition against using the resolution process to nominate directors must go. The only way shareholders can run candidates is to pay for a solicitation, while the current management uses our funds to tout their candidates on the company proxy. When this prohibition happens, you’ll know the shareholder revolution has been finally won.

Thank you for the opportunity to address such a distinguished audience. If any of you are ever in Sacramento, California please look me up. I’ll take you to lunch. In the meantime go to CorpGov.Net on the Internet and drop me an e-mail. Let’s keep in touch.

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