What is the relationship between fiduciary responsibility and institutional or corporate responsibility? Can institutional investment management be an effective agent for change? Jon Ralls asks what institutional investors could be doing, and speaks with two men who have very different perspectives. (INTERNATIONAL FUND STRATEGIES, June 1997 © 1997, Centaur Communications Ltd.)

The history of corporate governance in the twentieth century is that of one of the greatest collective abdications of responsibility in the history of the world. In almost any frame of reference it is worrying - in terms of property ownership it is extraordinary - in broader systemic terms the implications can be terrifying. Many corporations are effectively more powerful than governments, yet the only people and institutions with any significant power to call them to account - their shareholders - choose to look away. Two questions are implicit throughout 'the corporate governance debate' - "Who pays?" and "Who cares?"

Corporate governance is a bit like European Monetary Union (see last issue) - it seems complex and 'over there', and thus a big turn-off until a major shareholder action like the combined effort at Shell's UK AGM. It is making the headlines and bookstands, but with institutional investors frequently portrayed as the "boys' club" whose tacit support lets egregious companies get away with anything. But what is it really all about - how should investors clean up their act, and in whose interests?

Sarah Teslik is Executive Director of the Council of Institutional Investors in the US, whose members manage a trillion dollars. She is refreshingly straightforward in her approach:

"Corporate governance is what you do with something after you acquire it. It's really that simple. Most mammals do it. (Care for their property.) Unless they own stock." [She continues:] "... it is almost comical to suggest that corporate governance is a new or complex or scary idea. When people own property they care for it: corporate governance simply means caring for property in the corporate setting."

Anything else you buy, she argues, you would look after, have serviced, keep a close eye on anyone else you entrusted to look after it for you ... but not your shares. Indeed, if you do take an active interest, you may be labelled an 'activist', told you don't know what you are talking about, or even sued.

There appear to be fundamental changes in the nature of ownership that contribute to this strange state of affairs. There is an alienation of individual shareholders from the consequences of their actions (or inaction) brought about by the layers of transaction and control between the holding of a share certificate and the actual production of goods, services, waste etc. Further, incorporation means limited liability, which implies limited responsibility. But while a company's shareholders cannot be held liable in law for all its transgressions, they can, in theory at least, hold the management accountable and demand that changes are made in policy or in the management itself.

One of the reasons why corporate governance is now making the news is that people are finding, one way or another, that some mechanisms for accountability do still exist and are learning to use them. Institutional investors can no longer afford not to get involved with corporate governance. As Scott Bowman has pointed out, the more money goes into indexed portfolios and large institutional holdings, and the larger the transnational corporations become, the more important shareholder democracy becomes. The 'invisible hand' of the market is tied, as it becomes harder to divest from large blue-chip corporations. The index fund is the "nearest to a permanent shareholder there is." (Monks & Minow).

Although their votes on many issues remain advisory rather than binding on management, shareholders are increasingly taking action to protect and exercise their economic rights in key areas. CalPERS, one of the largest and most active US pension funds in the corporate governance arena summarised these (see Box 1). CalPERS has also produced more specific documents - Corporate Governance Principles for the UK and Principles for France, two countries where it holds significant amounts of stock, and both countries where recent government reports (the Cadbury Committee in the UK and the Viénot Report in France) have been highly critical of the state of corporate governance and made sweeping recommendations.

In practice, familiar areas have become the main focus of activity and publicity for a variety of reasons, but it is worth a concrete reminder that these issues are of more than academic interest! Organisations are springing up, both commercial and not-for-profit, to share information and guidelines and co-ordinate action against companies seen to be contemptuous of shareholder rights (for example, in the UK, PIRC and the UK Shareholders' Association).

Executive compensation has been high on the list, because of ludicrous salaries and option schemes directors have awarded themselves, sometimes despite poor company performance. Boards have attempted, in the name of 'stability' to protect themselves from accountability by means including staggering re-election to the board, lengthening directors' terms of office and appointing 'independent' directors whose true independence is comprised. Other mechanisms such as doing away with votes on particular issues are now vigorously resisted, as Commercial Union discovered when they attempted to deny shareholders a vote on accepting the annual report and accounts - it may genuinely have been an attempt to cut costs, but it illustrates the ease with which accountability can be quietly whittled away.

A particularly contentious area, especially in the US, is the combating of anti-takeover measures such as 'poison pills', on the grounds that they protect management from the ultimate market sanction of a hostile takeover. Since this frequently results in a considerable windfall (or recovery of value) for shareholders (see Jim Mellon interview following), and the very act of removing a 'poison pill' itself boosts a company's share price, the justification is obvious. The systemic assumptions and implications are less obvious. Many takeovers are not because of management failure, and legal and financial structures in industrialised countries favour large acquisitive companies. While removing takeover defences may improve accountability on a case-by-case basis, if it encourages concentration into larger and larger corporations, the overall effect may be the reverse.

At the heart of modern corporate governance is proxy voting, since such a high proportion of stock is now held by institutions rather than the ultimate beneficiaries, and it is the mechanism through which they exercise (or fail to exercise) ownership control. Jim Mellon and Stephen Viederman (see below) have different explanations for institutions' failure to use their proxies responsibly, but the key point is that not voting (or supporting management by default) is a vote for the status quo and is rife. A huge institutional investor such as Allianz may claim to be a "conservative and largely benign player on the world's financial markets", but conservative and passive behaviour is blocking vital changes in the way corporations run themselves and the world. It is not only active shareholders who recognise this problem - the US Department of Labor's 1989 "Proxy Project Report" requires pension fund managers to regard proxy voting as part of their fiduciary responsibility.

The mechanisms of proxy voting do not favour such action. The paperwork is time-consuming, there is often a deluge of background information to absorb, and co-ordination with other investors may be needed to gain a result. Most off-putting of all, there is fear of establishment censure, with effects on other business relationships - management knows how an insurance company voted (though it is almost impossible for one of that insurer's policyholders to find out). Once the ball is rolling, however, Jim Mellon points out that other institutions come along. Investors who take action on governance have earned substantial returns (See Box 2). Regent's results came from reconstruction of closed-end funds, CalPERS' from a structured approach targeting underperforming companies within their (largely indexed) portfolios. The results speak for themselves.

Conflicts of interest arouse passion among shareholders, but what you perceive as a conflict of interest can depend on what you are interested in. Some are undeniable - an 'independent' director who turns out to have a commercial interest in supporting existing management, for example. It is also productive to focus on conflicts of interest within management, and any obvious conflicts between self-serving management and shareholders.

But individual conflicts mask serious systemic problems arising from the change in the nature of ownership mentioned above. It serves bad management to perpetuate the myth that the institutional investor is in fact "a 26-year-old in front of a CRT, ready to pounce on every quarter-point, with a 6-second attention span and a 10-second position in anything." (Monks & Minow). This belief arises from two problems: "First is the commercial pressure - money managers compete for business by pointing to last quarter's results. Second is a misunderstanding of a fiduciary obligation - the belief that it requires managers to jump at any premium." (op.cit.) There is a very real conflict between institutional investors appearing to have to be short term investors, and corporations who need long term committed owners to function properly - for good corporate governance to work. Further, the degree of dissonance and systemic dysfunction built into the common understanding of economics and fiduciary responsibility makes an exclusive focus on shareholder value unlikely to deliver good governance into the next century. Our two interviewees have very different perspectives on these issues.

"I have heard a money manager say: 'As a parent and citizen I am concerned, but as a money manager I am constrained.' This is denial." - Stephen Viederman

Wider Responsibility...

"I realized I was part of the problem ... while in my office at the Boston Safe Deposit and Trust Company, where I was Chairman of the Board. I was looking over the proxies that it was our responsibility, as trustee for $7 billion in assets, to vote, and I was preparing to do what we had always done - vote with management on all of them. I picked up the proxy for the company that produced the industrial sludge I had seen, and I realized that if I voted for management, I was endorsing this activity. Those of us who managed money on behalf of others had the opportunity, and the responsibility, to tell management that this activity was unacceptable. But none of us was doing it." (Robert Monks in Monks & Minow, "Power & Accountability") (Picture courtesy of Surfers Against Sewage)

Mellon and Viederman have very different views of corporate governance and, in particular, of fiduciary responsibility. Jim Mellon's world is one of markets, returns and exogenous factors - within this frame of reference, there is an internal consistency to his views. Companies belong to shareholders who have a right to seek the best management to deliver the highest returns. Institutional investors have a responsibility to make the best financial return for their beneficiaries - unitholders, pension plan participants, insured. Period.

CalPERS, recognised as a standard-bearer for the corporate governance movement, states: "Our mission is to advance the financial and health security for all who participate in the System. We will fulfill this mission by creating and maintaining an environment that produces responsiveness to all those we serve." (emphasis added) Although CalPERS makes clear that its corporate governance activity is firmly returns-based, a mission to advance the health of plan participants could naturally extend into so-called "social" shareholder activism, as a natural progression of fiduciary responsibility.

Carolyn Kay Brancato, in "Institutional Investors and Corporate Governance", sees investor activism as going through four stages: social issues; opposing anti-takeover devices; urging structural and procedural changes; then analysing performance to target underperforming companies (as in the CalPERS system). The problem with this is that it becomes increasingly reductionist and does not address the systemic problems - it is back to front. It starts off with a broader view, then ultimately brings it safely back within the economic paradigm - a mechanistic system aimed at improving financial return. She does, however, point out that non-financial issues "are increasingly perceived to add to the financial viability of the corporation."

One of the most serious conflicts of interest arising from increasing institutional share ownership is that the institution is in the position of owner, but subject to the same systemic constraints as the companies owned. Narrow fiduciary responsibility reduces accountability and reinforces the dysfunction. As Sarah Teslik simplified corporate governance to 'looking after property', one could simplify the question of rights and responsibilities by asking: "What is the purpose of a company?" The stock answer might be: "To make a profit for its shareholders," but this begs wider questions. Since one cannot eat, play a tune on, or shelter from the rain beneath a banknote, there must be a more fundamental answer. In the context of a detailed historical analysis, David Korten describes it thus:

"A corporate charter is a grant of privilege extended by the state to a group of investors to serve a public purpose." (Korten, p.54)

Incorporation is about creating a structure in which people can co-operate to do something which, for individuals or with unlimited liability, would be too large or too risky a venture, but which is for 'the common good'. Somewhere along the line, profit has been substituted for 'the common good', or equated with it. It is axiomatic to free-market economics that competition will deliver the goods, ignoring "the central fact that managers and entrepreneurs [are] constantly trying to escape or control competition" (Fligstein). Efficient management would regard it as a duty to increase profitability by reducing a company's costs - whether or not that means externalising them onto the community, reducing 'the common good'. Outside attention to corporate governance can often be about preventing abuse of privilege.

But there are critical elements of good governance which do 'serve a public purpose', including employee rights, environmental protection, race and gender equity, and accountability to the community. These are all measures of a company's performance in the broadest sense - that they advance the 'common good' - and there is increasing evidence that they improve the financial bottom line as well.

Stephen Viederman touched on a fundamental when he talked about language, and regular IFS readers will recognise this approach to systemic problems. The solutions are shaped by the words in which the problems are discussed, and by assumptions about the meaning of those words - neoclassical economics effectively redefines the 'common good' in terms of the sweeping assumptions under which competitive markets produce 'socially optimal' outcomes. The modern concept of the 'prudent man', on which fiduciary responsibility rests, seems to assume that institutions exist for the sole purpose of making money, and that prudence means sustaining capital.

"The prudent person of the 21st century must be farseeing because we know that corporations do not necessarily support the public good, that tobacco kills, and that waste has no place to go. To be prudent, farseeing, returns the word to its original 14th century meaning." (Viederman, 1996)

There are many constructive paths out of the reductionist and dissonant place in which market capitalism finds itself - one being to look at how its frame of reference and terminology limits people's capacity to think systemically. "[Fligstein's] message [is] that human minds create and control market forces, instead of the reverse..." (Corporate Governance). So if companies must act only in the economic interests of shareholders, perhaps the definition of economics is far too narrow, and the concepts of 'externalities' and 'exogenous factors' should go. If fiduciary responsibility means seeking the best possible return on behalf of ultimate beneficiaries, perhaps a new set of performance indicators is called for - the accounting convention of profitability demonstrably fails to take account of either the total costs or benefits to society from a company's operations. Scott Bowman points out that with the rights of 'legal persons' came the expectation of corporate social responsibility consistent with the ideological concept of 'citizenship'.

But most fundamental is the personal dissonance that Stephen Viederman and Robert Monks identify so graphically. It has been said that the majority of the [financial] sector's decision-makers either genuinely believe that their activities are for the greater good, or leave their misgivings in the car park. This is the clearest example of a business's operations being fundamentally at odds with the values of the individuals within it (Ralls, 1997). Being active in corporate governance is about integrity, which, according to Yale law professor Stephen Carter, must include knowing right from wrong, acting on that knowledge, and speaking out in defence of what is right.

Bearing in mind Fligstein's observation about markets, the message of the corporate governance debate is that the way each institution and individual acts makes the rules. Viederman, CalPERS and others have shown that activism is not just about shareholder value, but neither is it about sacrificing financial returns to pursue a social or political agenda. But, having made the connection, an individual's or institution's inaction is either denial or a choice to support the status quo - and the dissonance evident in investment management is breathtaking.

A great deal of practical information and assistance is available - newly active investors do not all have to climb Viederman's learning curve! Fund managers can start by reviewing voting opportunities on a regular basis, and by taking an interest in other investors' actions, rather than assuming that they are noisy activists with a hidden agenda. A great deal of information available on the Internet, together with many recent books, and official reports in a number of countries including the UK, France and Canada. Monks and Minow suggest two concrete first steps:

1. Establish explicit policies with respect to the discharge of ownership responsibilities of portfolio securities, and disclose voting records showing how proxies for the previous year were voted and why.
2. Establish structures for collective action.

Institutional investors can gain a great deal, in both personal and career terms, by allowing a sense of wider responsibility to influence decisions - instinct based on integrity is frequently right and, with 'sustainability' rising up corporate and political agendas, active corporate governance is the future. And dealing with cognitive dissonance and denial can be relieve an unbelievable amount of stress.

Major sources:

Internet:

• CalPERS
• Corporate Governance Site
• The LENS Inc including...

• Monks, Robert. "The American Corporation ..."
• Monks, Robert. "Relationship Investing"

• Monks Robert, & Minow, Nell, "Power and Accountability"
• Teslik, Sarah, Council of Institutional Investors (CII)
• Viederman, Stephen, Harvard Seminar Dec.'96 ("From Prudent Man to Prudent Person: Sustainability and Institutional Investment for the 21st Century")

(particular thanks to The Corporate Governance Site, via which many printed sources were referenced)

Printed:

• Blair, Margaret, "Wealth Creation & Wealth Sharing"
• Bowman, Scott, "The Modern Corporation and American Political Thought"
• Brancato, Carolyn Kay, "Institutional Investors and Corporate Governance..."
• Dunn, Betty Jane (ed), "Significant Issues Facing Directors: 1997 ..."
• Fligstein, Neil, "The Transformation of Corporate Control"
• Greider, Willam, "Citizen G.E." in "The Case Against the Global Economy"
• Institutional Investor, "The Swashbuckler at Regent Pacific", Jan.'97
• Korten, David, "When Corporations Rule the World", 1995
• Mander, Jerry, "The Rules of Corporate Behaviour" in "The Case Against the Global Economy"
• Ralls, Jon, Business column, "Green Futures", Feb.'97
• Viederman, Stephen - various papers/speeches (incl. Harvard Seminar above)

[Full bibliographic references available on request, though many can be found on the Corporate Governance site.]

Acknowledgements:

I am grateful for the assistance of a number of people who assisted both directly and indirectly in the research for this piece, especially Frances Laing, an Independent Policy Analyst from whom I learned key analytical tools; also particular thanks to Virginia Morck and Siobhan Brownlow.