24 July 2009

The Case Against Institutional Investor Power

Stephen M. Bainbridge is the nation's foremost academic advocate of the "Wall Street Rule," a model of corporate governance in which dissatisfied investors sell their stock rather than trying to participate in corporate governance to improve a corporation's performance. In contrast, I am a strong proponent of expanding shareholder power in publicly held companies for essentially the reasons he sets forth in the abstract of a recent article that he has written:

The logic behind the shareholder empowerment project is that institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, institutional investors could play a far more active role in corporate governance than dispersed individual investors traditionally have done. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm’s performance and to make changes in the board’s composition when performance lagged.

His reason for disagreeing with this approach is as follows:

In fact, however, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not—and cannot—prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

While these are legitimate arguments, and institutional investor activism "has not" proven a panacea for the pathologies of corporate governance, I don't think that his case as all that solid.

Yes, unions and state or local public employee pensions are shareholder activists now. But, this has to be seen against the backdrop of a process that is now largely futile. Unions and public employee pensions mount symbolic protests as a form of expressive conduct in battles that they can't expect to win. They are behaving like placeholder candidates in political races where the other side has an overwhelming majority.

Institutional investors might get involved if they had a meaningful chance of prevailing because they were on a level playing field in the process. They might act more like candidates in viable political campaigns than token gadflies if they had reason to hope that this approach might work. They also may be refraining from exercising their full powers under existing law for fear of SEC liability, something that could be clarified with simple regulatory changes. And, Professor Bainbridge overlooks some plausible alternative models of investor action.

Most prominently, hostile takeover transactions have become an important and recent addition to the arsenal of those dissatisfied with corporate governance. These traditions are one of the important reasons for the rise of private equity firms as an important player on Wall Street. One has seen similar actions by acquiring firms in industries that are consolidating. And, the example of the often quite canny behavior of creditor's committees in Chapter 11 bankruptcies also illustrates the capacity of major Wall Street players to participate effectively in corporate governance when given the opportunity to do so in firms that are almost by definition poorly governed. We are also waiting on the sidelines to see what kind of corporate governance emerges in companies where the need for bailout funds from the federal government has turned them into fully or partially government owned enterprises.

I am not among those who think that institutional investor activism would look much at all like existing union and public employee pension activism in an era of empowered institutional investor shareholders. If anything, empowered shareholders would cut a tougher deal with employees and regulators than existing corporate boards of directors. But, there are other important corporate governance failings that empowered shareholders would be less prone to allow. They would be far less likely to permit supersized, grossly self-dealing, executive compensation packages for senior corporate executives. Those pay packages come almost entirely at their expense.

Empowered institutional investors would also be far less tolerant of mediocre senior executive performance. The scandal of modern corporate America is not just that CEOs get paid a lot, but that CEOs of dismally performing corporations are often paid particularly well. The example of professional sports franchises with a significant number of unrelated private owners might be instructive. If senior corporate management in big business was under as much pressure to perform as professional sports coaches are, and was as likely to be removed for poor performance, the productivity of corporate America would be materially improved. Indeed, the belief that empowered institutional investors would keep senior corporate executives on a shorter leash, rather than excessive executive compensation, which is really only a symptom of the problem and does little harm to those who are not shareholders, is the real public interest behind proposals to empower institutional investors. Allowing multi-billion dollar companies to wallow indefinitely under weak leadership until a corporate raider can muster the funds to take the company private is not a good way to build a healthy economy.

Both of these issues go to a fundamental weakness with Professor Bainbridge's argument. He claims that increased shareholder power will undermine "the board of directors as a central decision-making body, thereby making corporate governance less effective." The basic criticism of modern corporate governance, however, is that the board of directors is not, absent the most extraordinary of circumstances, a decision-making body at all, and hence, is not effective. Instead, the modern board of directors is something more like the Australian Governor-General or British monarch, a collective figurehead, beholden to the CEO, that is kept in the loop for appearances sake and exercises real power only in very narrowly defined circumstances to clarify ambiguities in senior management succession.

My assumption is that institutional investors would function not primarily through proxy fights over particular issues brought to shareholders, but by appointing genuinely independent representatives to the corporate boards in which they had substantial stakes; representatives with the resources of their institutional investor patrons to free them from reliance upon management for information and analytical guidance.

Why should institutional investors stay and fight, rather than resort to the usual "Wall Street Rule"? Mostly because they have no place else to take their money. While institutional investors are almost never required to invest in every single company on the market, they are often required by state law and their own program of investment to be very broadly invested. While to don't have to invest in every company, they do have to invest in a substantial percentage of them, often in a way that limits the ability of these institutional investors to avoid buying simply because a company is poorly governed.

This too is something new under the sun on Wall Street. Historically, no investors have been big enough to face this problem.

Perhaps the most serious problem with shareholder empowerment is the last one that Professor Bainbridge identifies:

[R]elying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

Maybe, but there is reason for hope. A large share of institutional investors (mutual funds and many mutual life insurance companies for example) are customer owned, non-profit or closely held. Examples include the mutual fund companies Vanguard and TIAA-CREF, the insurance companies Northwestern Mutual and Mutual of Omaha, and a host of closely held private equity funds. Union and public employee pension funds are often employee owned and similarly are not known for having serious principal-agent problems compared to those of publicly held companies. These kinds of enterprises, collectively, have much better histories of risk management and refraining from self-dealing with senior executives than conventional investor owned publicly held companies do. The quality of corporate governance in German publicly held companies, which have more independent supervisory boards that sit in judgment above more American style boards of directors made up entirely or mostly of senior managers and their close advisers, seems to be better.

Also, I am not proposing a fundamentally new role for a corporate board of directors. Like existing corporate America, I see empowered shareholders as still having essentially only one role -- to act as the boss of the CEO and his or her senior management colleagues (none of whom would sit on the Board). Principal-agent difficulties are greater for complex tasks than for simple ones. When the Board is charged primarily with hiring, firing, and compensating the CEO, and with insuring that the company's auditors are honest, there is less room to obscure principal-agent duties and thereby leave room to breach those duties.

Would it be a panacea? No. But, it doesn't have to be a perfect solution. The proper question is whether empowered institutional investors would be better than the status quo. The case that they would be is a compelling one. The strongest of Professor Bainbridge's concerns, moreover, that the new boss would be no better than the old boss, doesn't suggest that there is anything great to lose from trying. He makes no solid argument that principal-agent problems at the institutional investor level would be worse than those at the publicly held company level, even if they might not be much better.

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