In 1932, a classic book called The Modern Corporation and Private Property spelled out the view that underlies most of the corporate governance activism in the United States today. Written by two academics named Adolf Berle and Gardiner Means, the book explained how the birth of the modern publicly owned company in prior decades had brought about a fundamental split between ownership and control.
Before, most large companies had been owned by trusts or families controlled by people like Carnegie, Frick, and Rockefeller. They either ran their companies themselves or hired—and fired—managers to work under their direction. There was no question that the owners were in charge.
Berle and Means pointed out that when ownership passed to millions of anonymous stockholders who bought and sold on a daily basis, the corporation was transformed into a self-perpetuating institution controlled not by the owners, but by the executives. This, they asserted, posed a fundamental governance dilemma: How do investors ensure that executives are working in the best interests of the owners, rather than in their own interests—while at the same time assuring that the company will be managed in the most profitable fashion possible?
This basic issue still animates almost every governance debate we have today, from proxy access and broker voting to director independence and “say on pay.” Activist investors, led primarily by a handful of large pension funds, have been demanding more accountability—i.e., more control—over both corporate managers and directors, on the theory that too many management decisions are made without the best interests of the owners in mind. Executives and board members, backed by powerful voices such as Martin Lipton of Wachtell Lipton, counter that the activists’ remedies go too far and leave companies open to shareholder micromanagement or abuse that could undercut profitability.
Both sides agree with a central premise underlying Berle and Means’ view, that a board’s role is to ensure that the company is run in the best long-term interests of shareholders, says Weil Gotshal & Manges partner Ira Millstein, a pivotal figure in corporate governance who last year helped found a center on the subject at Yale University (See “An Architect of Governance,” page 26). But much of the agreement ends there. “The whole issue under debate all these years has been clarifying the powers of management, the board, and shareholders,” says Richard Koppes, a long-time leader among the activists who served from 1986 to 1996 as deputy executive officer and general counsel at the California Public Employees’ Retirement System (CalPERS). He now is of counsel to Jones Day and advises companies on governance issues.
A California Giant
Although Berle and Means’ concerns have welled up periodically over the decades, today’s shareholder activism really got underway in the early 1980s. It was a time when corporate takeovers were raging and companies were fending off raiders such as T. Boone Pickens and Bass Brothers, a Fort Worth, Texas-based investment firm run by the Bass family. They issued poison pills and paid greenmail, tacking on golden parachutes for top executives in case these defenses failed. Such actions gave rise to charges that entrenched management was putting its own interests ahead of those of stockholders.
One of the strongest responses came from CalPERS, whose status as the country’s largest pension fund made it a major institutional investor. At first, it tried lawsuits, but quickly realized that this wasn’t a cost-effective way to deal with hundreds of companies that had adopted what it considered offensive practices, remembers Robert Carlson, who was CalPERS’ president at the time and remains on its board today.
A better alternative was to try to convince management to act on behalf of long-term investors. That approach would work better if CalPERS could join forces with other pension funds and institutional investors with similar goals. But Carlson and his colleagues quickly found that the Securities and Exchange Commission prohibited such collaborations. So they spent the better part of two years lobbying to get the SEC to change its rule.
They got a big boost when California State Treasurer Jesse Unruh joined the CalPERS board in 1982. A fiery Democratic politician who had dominated the state assembly as its Speaker in the 1960s, Unruh railed against the greenmail that companies such as Texaco were paying out. Once the SEC finally cleared the way, he recruited public pension fund leaders from New York and New Jersey to found the Council of Institutional Investors (CII) in 1985. Today the CII, along with CalPERS, its largest member, is probably the most powerful voice for shareholder activism in the United States. It represents 130 public, labor, and corporate pension funds with collective assets of more than $3 trillion.
The founding of the CII constituted a sharp break in the historical behavior of investors in the United States. Until then, most large institutional stockholders addressed Berle and Means’ dilemma with what’s sometimes called “The Wall Street Walk”: If you don’t like something about a company, sell. This attitude flowed from the same perspective many investors use to make almost every investment decision. If you didn’t like something about a stock—the company’s performance, its industry’s outlook, the new CEO who just came aboard—you take your money elsewhere. In other words, you vote with your feet.
From Passivity, Activism
To fully appreciate why CalPERS and eventually other large pension funds came to be so dogmatic about shareholder activism over the past two decades, it’s important to understand why they came to the conclusion that the Wall Street Walk doesn’t make sense for them.
Oddly enough, their activism flows directly out of the passive investment philosophy to which most adhere. This strategy stems from the economic insights spelled out by Princeton University economics professor Burton Malkiel in a 1973 book called A Random Walk Down Wall Street. Malkiel argued that in an efficient market asset prices will reflect all publicly available information. In other words, you can’t beat the market, at least not unless you have inside information other investors don’t share. Sure, maybe some pros can spot inefficiencies that others haven’t noticed. But on average, over the long haul, most investors won’t outdo market prices.
For pension funds, and really almost every investor, that translates into a passive indexing investment strategy. CalPERS still actively invests some of its funds, but today more than 80 percent of its $240 billion is committed to index funds designed to track the S&P 500 and other market indices.
Passive indexing conflicts head-on with the Wall Street Walk, because it requires investors to be invested in the entire market for the long term. They can’t sell stocks they dislike, no matter what the reason, whether it’s a company headlong in bankruptcy or one whose internal governance is a mess. You don’t buy and sell, you buy and hold.
“So we can’t sell the shares,” long-time CalPERS board member Charles Valdes explained in a 2000 interview about the fund’s history. “What else can we do? We try and fix the problem, which is to get in there and get them to perform better, get the board to look at the CEO, and find out if he and his team are doing what they should be doing: setting up a review committee on salaries, putting in provisions preventing poison pills, greenmail, and all of these other little things that they love to do, or loved to do in the past.”
Still, it took some two decades after the CII’s founding for CalPERS and other activist pension funds to make significant headway. Throughout the early and mid 1980s, they focused on poison pills, ill-advised mergers, and golden parachutes, as well as external governance issues such as South African apartheid. Then in 1987, Millstein gave a speech to CalPERS urging it to focus on corporate boards and the responsibility they have to oversee such actions. This hit like a revelation, prompting the fund to start advancing the case for board oversight of management, a strategy that has become increasingly accepted today.
Proxy Power
That same year the proxy resolution, another major weapon in the activist arsenal, emerged as well. While CalPERS was protesting raiders and greenmailers on the West Coast, the awkwardly named Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF) was searching for ways to take action from its headquarters in New York. Peter Clapman, the general counsel at the time, knew that proxy resolutions long had been used by social activists to protest issues such as companies doing business in apartheid South Africa. But he also knew that such resolutions weren’t usually taken seriously by investors. In fact, most pension funds didn’t even bother to vote their proxies no matter what the subject, leaving companies free to ignore them.
So when TIAA-CREF’s chief investment officer asked Clapman for ideas, he suggested proxy resolutions mostly as a throwaway line, remembers Clapman, who left the fund two years ago to become CEO of Governance for Owners USA Inc., which advises institutional investors on governance issues. Nonetheless, in 1987 Clapman and the chief investment officer filed resolutions at 10 companies with objectionable takeover defenses, including American Cyanamid, International Paper, J.C. Penney, and Pitney Bowes. The first one to come to a vote, at International Paper, lost handily. But the nearly 28 percent yes vote it received was several times higher than what most of the social issue resolutions ever got, sending a powerful message to management that other investors shared TIAA-CREF’s concern.
Since then, proxy resolutions have become a powerful influence in Corporate America. Indeed, companies this year faced hundreds of resolutions on governance issues, including 137 requiring a majority vote to elect directors, 66 having an advisory shareholder vote on executive compensation, and 62 repealing classified boards, according to Institutional Shareholder Services (ISS), the proxy advisory firm.
Today leading pension funds and other activists are still searching for the best governance structure. The scandals at companies such as Enron, Tyco, and Worldcom accelerated the process, leading to the Sarbanes-Oxley Act of 2002 and other new rules requiring greater accountability and disclosure by both management and boards.
CEOs today rarely hand-pick their boards. And most directors are independent of the companies on whose boards they serve. Despite all the changes, though, activists aren’t completely satisfied.
Majority Rules?
Yet the central question posed by Berle and Means has yet to be answered: How should control of the corporation be apportioned among management, the board, and shareholders? Increasingly, activists have come to focus on Millstein’s suggestion that boards should oversee executives more closely, to ensure that they operate the company in the best interests of shareholders.
One method has been the push for majority voting for directors. In the past year or two, more than 300 companies have adopted such procedures, which typically require the resignation of a board member who does not receive at least 50 percent support from shareholders when up for election. Advocates want the idea to be standard procedure at every company. Majority vote is ultimately the best weapon for shareholders. “If every large company had majority voting, a lot of the governance problems we see would be ameliorated,” says Clapman.
He and other shareholder advocates also have been prodding the SEC to issue rules to allow shareholders to change corporate bylaws governing the election of board members. The move has sharply divided activists and business groups. At the latter’s urging, the two GOP members of the commission passed a proposal in August that would disallow any election-related changes by shareholders. The two Democratic appointees voted for a proposal that backs the activists. It would allow shareholders with a 5 percent stake to put election-related bylaw changes on a company’s proxy. SEC Chairman Christopher Cox voted for both proposals and their outcomes remain unclear.
Shareholder advocates such as Koppes think the United States should go further and adopt a system like that in Britain. There, just 10 percent of shareholders can call an extraordinary general meeting at which a majority of stockholders can remove any or all directors for any reason (assuming there’s a quorum at the meeting). Even though British shareholders rarely use their power to eject boards, their ability to do so makes both directors and executives more responsive to their interests, says Robert Monks, a long-time U.S. governance advocate who founded ISS, The Corporate Library, and other governance advocacy institutions.
Another approach shareholder groups have taken is to insist that the chair of a company’s board be someone other than the CEO, to set up a structure that drives home the point that management reports to an independent board. Currently less than a fifth of large companies split the two positions, and often only temporarily, to allow a retiring CEO to stick around and give guidance to a succecssor for a year or two. “We’ve still got a long way to go” to achieve the right balance of power in the corporate governance structure,” says CalPERS’ Carlson. “Many large companies have gotten the message and know they need truly independent boards, but they still have to start walking the walk. And a lot of smaller and midcap companies haven’t even gotten the message yet.”
Finding a Balance
Of course, many executives and business groups disagree with his assessment. While some companies have acquiesced to demands for majority voting for directors and separate chair and CEO posts, much of the business community sees no need for new SEC rules or other major changes.
Groups such as the Business Roundtable and the U.S. Chamber of Commerce argue that giving shareholders too much power could backfire. If new rules allow some shareholders to exert undue influence over director elections, for example, they could benefit at the majority’s expense.
Besides, points out Lipton and others, shareholders are a heterogeneous bunch with diverse interests. Some have short-term investment horizons and would be happy to see a company boost profits and the stock price today, even if it threatened its long-term prospects. Pension funds and others with a multi-year strategy want just the opposite. “We should defer to the board to reconcile these interests, along with all the other constituents of a company such as employees, suppliers, and the communities in which they operate,” says Lipton.
While most activists disagree with Lipton’s conclusion that the status quo governance system works just fine, some do agree that their demands for greater shareholder rights shouldn’t obscure the goals of a corporation in the first place, namely, to provide goods and services as efficiently and profitably as possible. “The board’s job is to pick great CEOs and then let him operate,” says Millstein. “Boards need to be able to remove the CEO, to not overpay him, and to get him to focus on performance. But those are externals to the real job of a company, which is to perform. That’s the CEO’s job, not the job of the board.”