speech by James McRitchie
Presented to the International Company Secretaries Conference
With the U.S. economy doing well in comparison to many others, there is a tendency, especially among many Americans, to believe our model of corporate governance will soon be adopted by the rest of the world. That would be a terrible mistake. There is no “universally” appropriate model of corporate governance, just as there is no universally accepted form of political governance. It is obvious that corporate governance must be tailored to the individual company, its stage of development, its legal, economic and cultural environment.
Strength and resiliency come from diversity. The downsides of unpredictability and conflict are far outweighed by the creativity and synergy that results when different perspectives are brought together to solve problems. However, those seeking to attract funds will be under inevitable pressure towards convergence because investors want the ability to ensure their investments will pay off. Investors are more likely to invest where their rights are known and protected and where those using their money can be held accountable.
As corporate governance systems are developed to increase accountability, more wealth will be generated. That generalization applies both to financial investment strategies and to investments in human resources. Any “universal elements,” developed by the Organization for Economic Co-operation and Development (OECD), should lean in the direction of systems of accountability which are broadly based among those with a direct interest in the enterprise; they should stimulate democracy both at the corporate level and in the workplace.
Democracy: A Preface
Democracy is clearly a value laden term. Among those of us who accept it as a positive value, the tendency is to apply democracy to one’s favorite government or corporation and to point with disdain at rivals. What is democratic appears to be, at least in part, dictated by personal background and preference. Each of us will have a different viewpoint. However, at its core democracy is government by the people, whether directly or through representatives. The strength of democracy generally lies in is its ability to generate ideas and to harmonize different viewpoints, while protecting the rights of minorities.
Ownership and Control of Multinational Corporations
Who owns and controls (at least potentially controls) most of the large multinational corporations? In the U.S., institutional investors hold about 60% of the stock. Pension funds, such as the California Public Employees Retirement System (CalPERS) and the New York State and Local Employees’ Retirement System, and mutual funds, such as Fidelity, Putnam and T. Rowe Price, are the fastest growing institutional investors. The top 25, hold about 20% of the stock, up from 17% in 1996. Pension funds tend to be long term investors, while most mutual funds turn over their portfolio’s at a rate of 85% a year.
Pension funds, especially public funds, have been more active in corporate governance reforms. One reason is that their own governance is often more open and democratic than that of mutual funds. However, a movement of self-examination may be just beginning within mutual funds which may result in a transformation of how they do business and govern themselves. Once these reforms begin to take hold, corporate governance reforms can be expected to accelerate substantially.
Typically, mutual funds are governed by “independent” directors, unaffiliated with, but appointed by management. As John Bogle, founder of The Vanguard Group has noted, “we would prefer not to advise the companies in our portfolios about governance when our own houses are so fragile.”1 The result, is an industry that has lagged the market return by about 2.25% over the past 15 years. Bogle has issued a challenge to the fund industry to examine its own governance standards. This, combined with the recent turmoil atYacktman Fund, could presage a new era where fund managers no longer retain undisputed control but must share power with owners.
Similarly, although public pension funds have led most of the recent reforms, with the CalPERS at the forefront, a little self-examination may in order. CalPERS, for example, calls on others to limit the number of boards directors sit on, discourages directors who overstay their usefulness, calls for companies to adopt qualification standards and avoid conflicts of interest. Yet, its own board has members who sit on up to nine other investment boards and have served for over 28 years. The CalPERS investment committee is headed by a member who has declared personal bankruptcy twice and the Board has rejected petitions to adopt regulations which would prohibit its members from accepting gifts from those doing business with the System.
Just as individuals, such as John Bogle, are working to reform the mutual fund industry, others, such as myself, are attempting to hold public pension funds to their own high principles. If we are successful, not only will governance of these funds become more representative of the interests of their ultimate owners but investment strategies are likely to change as well.
Common Investment Strategies of Institutions
Most institutional investors fall into one or a combination of three categories.
- Technical analysts and market timers look at events and price movements in the market for clues as to when to buy and sell.
- Fundamental analysts and value investors are more concerned with the soundness of particular industries or companies.
- Indexers don’t try to predict, they just buy and hold a representative sample of the market.
Of these strategies, indexing is most consistently successful. This is explained in the United States by laws against insider trading, the efficient disclosure of market information and lower administrative costs. Indexing doesn’t work as well where markets are less efficient.
Even where indexing works, it does not allocate money efficiently. Instead, money goes to who already has it, rather than to those who can best make it grow. And, important to our discussion, while indexers help liquidity and contribute to lowering the cost of capital, they are only just beginning use their knowledge to add additional value. CalPERS does this party by focusing on about ten underperforming targets each year, out of its portfolio of thousands, and using its clout as a voter to induce changes. The Council for Institutional Investors, which represents members with assets of $1 trillion, goes through a similar process.
Although CalPERS targets companies to raise performance, they don’t increase their investment prior to targeting. However, even without adding to their investments, reasonable evidence substantiates that targeting increases the value of their portfolio.2
Corporate Democracy and the Growing Role of Relational Investors
There is a fourth, and growing, category of investors which, whether aware of it or not, are pushing corporate democracy. Known as “relational investors,” or less politely, “noisemakers.” Some go for the quick fix by cooking the books or forcing the one-time sale of underutilized assets. Others take a more long term approach, attempting to implement several good ideas over a sustained period of time.
In the 1980s, when money became expensive in the U.S., corporate raiders took the lead in corporate governance. Their buyouts often brought layoffs and costly disruptions. Today’s relational investors use a more peaceful negotiated approach. Whereas professional fees and expenses from buyouts and takeovers averaged between 2 and 4% of transaction value, charges for proxy driven changeovers have run “considerably below” 1%.3 Patrick McGurn of Institutional Shareholder Services, reports that 18 contests in 1998 resulted in changing control of boards. That number can be expected to accelerate as shareholders come to realize the value of their vote.
Voting Rights Are Assets
Thanks to Robert Monks, the U.S. Department of Department of Labor which regulates private pension funds, realized the value of voting years ago when they mandated that pension funds treat their voting rights as assets and use them solely in the interest of members. In a 1984 speech, Monks proclaimed:
It is the duty of the fiduciary of a pension plan under ERISA to scrutinize those actions of management which are put to a shareholder vote and to vote for the course of action which is best for the company, as that will be reflected sooner or later, in an increasing the value of the company’s shares, all other things being equal. Sitting on the sidelines, or blindly voting for management, would not in my opinion, discharge the ERISA fiduciary’s duty as a shareholder. Casting a ballot, one way or another, with respect to an antitakeover measure, with an eye toward one’s banking relationships rather than to the intrinsic merits of the measure, clearly violates ERISA.4
Unfortunately, the law Mr. Monks helped to firmly establish has never been put to the test; it has never been enforced. In 1996 only 35% of plans who delegated voting authority could show they monitored their votes.5 A recent survey in the UK found that, while institutions own 80% of the shares, fewer than 40% voted.
Nonetheless, investors are gradually coming to realize the value of their vote. Warren Buffett and Michael Price are well known for their use of voting rights. In addition, relational funds are being created at an increasing pace. American groups such as groups such as Providence Capital, Greenway Partners, and Relational Investors have been joined by the European Renaissance Fund and ABF Euro V.A.
The LENS Fund, “which invests in a handful of poor performers and then relentlessly pesters their managers to adopt a better strategy,” has been beating the S&P 500 index for several years. Already linked through a joint venture, LENS recently announced they have been acquired by U.K. based Hermes Pensions Management Ltd. In addition, large pension funds have begun teaming up with relational investors. LENS has been working with the State of Wisconsin Investment Board, while Relational Investors and Active Value Capital LP (UK) are cooperative with CalPERS. Late in 1998, CalPERS and Hermes announced they would team-up to create a strategic alliance, the first of its kind in the world.
Knowledge, Combined With Action, Adds Value
What is being created is something of a soft revolution, making corporations more responsible to their shareholders. It takes knowledge of the firm to be a good value investor, but without action, that value may never be realized. Relational funds and strategic alliances among investors and are accelerating the action and adding value.
Disclosure Is A Bare Minimum to Win Investors
To win investors, companies need to provide timely and accurate information about performance and potential risks. However, to really take advantage of the knowledge experienced investors can bring, companies need to allow themselves to be vulnerable to influence by minority shareholders. If companies are truly going to emphasize shareholder value, they must facilitate independent monitoring of management and shared accountability.
The risk of operating in a climate conducive to relational investment is that control of the company is subject to change. If a relational investor points out what should be done to increase profits, and you don’t take their advice, you run the risk of a challenge for control. On the other hand, if you work with them on implementing their good ideas, you are likely to generate more wealth. Listed below are a few “universal elements” which would enhance corporate democracy.
- Facilitate active participation by minority shareholders and allow proportional representation.
- Emphasize voting rights as part of fiduciary responsibilities.
- Allow shareholders to communicate with each other without undue burden.
- Require institutional investors to meet the same fiduciary standards for voting proxies in the interests of members/shareholders as U.S. pension funds under ERISA.
- Make it easier for owners to nominate board members; true board independence is based on an independent power base. Board elections should be real contests with platforms and opportunities to debate.
Getting More Out of Human Resources
The same principle applies to employees; share power and generate more wealth. How important is labor? 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% most recently. Intangibles contributed by employees, such as labor, patents and trademarks, now contribute 75% of the total value.
Margaret Blair, with the Brookings Institution, has made a significant contribution to our understanding of “knowledge work” and its application to corporate governance. She contends that employees, like shareholders, have firm-specific investments at risk, in the form of human capital.6 The key to wealth maximization is to be found in providing ownership-like incentives to “those who control critical, specialized inputs.” (see interview with Margaret Blair)
In its April 1998 report, Corporate Governance: Improving Competitiveness and Access to Capital in global Markets, an advisory group to the OECD, led by Ira Millstein, gives a nod to aligning the interests of employees with corporate performance through stock-based incentive. That is a plus, but in the United States many studies have shown that merely paying a portion of wages in stock and bringing employees in as owners is not enough to make a sustained difference. Meaningful participation in decision making is key. Just as cooperative relationships with investors generate more total wealth for those willing to share information and control, the same is true in relation to employees. Stock alone acts as a temporary incentive which often doesn’t sustain increased productivity.
Millstein notes that, increasingly, the board becomes a “mediator of rents.” “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.”7
In law, accounting, and consulting partnerships, human capital is already king. Whereas in capital intensive industries, financial capital still rules. Most firms will lie somewhere in the middle. Yes, it is crucial to get knowledge workers on board but the evidence of benefits found further down the “food chain” are overwhelming.
More democratic workplaces make better use of employee capacities and generate more wealth. A 1986 study by theNational Center for Employee Ownership (NCEO) found that firms with significant employee ownership and participation in decision making grew 8 to 11% faster than their counterparts.8 A year later the General Accounting Office found that such firms experienced a 52% higher annual productivity growth rate. Studies also show that companies with “open-book” management also have higher average growth rates.9 These are companies where employees are given the financial and performance data needed to make a good decision, as well as the training needed to understand the financial impact of their work.
Scientists have known for years that such organizations would generate more wealth. For example, back in the 1970s a panel of experts reviewed the extensive findings of 57 field experiments in job satisfaction and productivity for the National Science Foundation and concluded:
Human involvement at the work place in all facets of the work is a prerequisite for the enhancement of quality life as well as performance and satisfaction…. The organizational policy, therefore, should work towards enhancing such aspects of work which encourage people’s ownership of the work place as well as the work itself, collaborative efforts among coworkers, and decision-making processes based on participate models.10
Other scholars have long reached the same conclusion:
It is paradoxical that the standard justification for autocratic practice in industry is its alleged efficiency, since the empirical research results do not support that conclusion. In fact, increased rank-and-file responsibility, increased participation in decision-making and increased individual autonomy are associated with greater personal involvement and productive results.11
Even department store clerks are crucial to profits. Sears, for example, recently found that if employee attitudes improve by 5%, customer satisfaction will jump 1.3%, resulting in a 1/2% rise in revenue.12
Status as an Impediment to Generating Wealth
Why, against the findings of so many studies, do organizations continue to allow workers so little control over their jobs? Our best guess is that most decision making structures are designed around status needs related to dominance and control over others; they are not designed to maximize the creation of wealth. In order to gain higher status, individuals seek to dominate more and more people, leading to “a widespread dynamic over time which shapes the organization so as to move the locus of control upward.” In order to generate more wealth, we need to take advantage of all the brains in our organizations. We can do so by pushing decision making down to the lowest practical level. Listed below are a few “universal elements” to enhance workplace democracy.
- Encourage employee ownership.
- Provide employees access to the voting rights held by their pension funds and stock ownership plans either directly or through representatives which they elect.
- Facilitate participation in decision making through programs such as “open book management” which provide employees with information and training needed to analyze their jobs and their contribution to the firm.
- Allow free communication between employees, including collective bargaining.
The corporations that embrace democracy, both at the corporate level and at the workplace, should be better equipped to create wealth, compete in global markets, and solve the highly complex problems of the 21st century.
James McRitchie is the editor of Corporate Governance, an Internet-based publication at corpgov.net. He recently ran for a seat on the CalPERS Board and lost, in part due to election irregularities which favored the incumbent. An earlier version of this paper was delivered at the International Company Secretaries Conference in Hong Kong on November 23, 1998.
2Stephen L. Nesbitt (firstname.lastname@example.org), “Wilshire Associates Long-Term Rewards from Shareholder Activism: A Study of the CalPERS Effect,” Journal of Applied Corporate Finance, Winter 1994:75-80.
8NCEO notes that firms with more than 10% broad employee ownership outperform the market. They argue that giving employees token ownership can create cynicism; 5% is a minimum and the average is 8-10% of pay per year. Cynicism also results from the gap in worker expectations if decision making is not shared. Employee owners expect to have a say; they expect new opportunities to analyze their jobs, raise issues, and to propose and help design changes in the work place.
9Equity-Based Compensation for Multinational Corporations, October 1998. 136 pp. see National Center for Employee Ownership (NCEO).
12 Wall Street Journal, 7/22/98, page B1.
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