07.12.09

How do we get Shareholders to Care about Governance?

Posted in Blog at 8:42 pm

The following comments were originally written in response to an online inquiry:  “What needs to happen . . . to stimulate shareholders to agitate for change at mismanaged companies?”  My reply has been stitched together from an exchange with the questioner, Alexander Krakovsky, of ContourGlobal.

The cause of better corporate governance is not being pursued aggressively by fund managers because the majority of them do not believe in it. Too many investors believe in a champion CEO, who, like a champion athlete, has the miraculous ability on his own to change the outcome of any competitive activity. Such a CEO could single-handedly turn a dog of a company into a miracle-performing investment. Interfering with such a magnificent beast in any way might ruin his performance—at least, it would if he were quarterbacking for your favorite team, or competing at the Olympics.  As long as fund managers believe in such fairy tales, they will not do anything to involve themselves in the affairs of a company in which they have invested money—especially when that money is someone else’s. In fact, they often do everything in their power to hamstring the efforts of corporate governance activists even from their own firms, because they are afraid this will ruin the magic spell, and not incidentally call into question the whole mystique of their investment process.

Then there is the problem of free-market fundamentalism.  Many portfolio managers and not a few of their clients are imbued with a false ideological binarism in which everything either slides uncontrollably toward social democracy—in which the entrepreneurial energies of a society are shackled, over-taxed, and progressively destroyed—or towards a darwinist economic paradise—in which the entrepreneurial energies of society are “unleashed,” and the proverbial ‘better mousetrap’ can make unknown individuals into billionaires.  This simplistic libertarian economic view is often invoked to condemn the efforts of all reformers, including those dedicated capitalists who want the system to work better, or at least to stop allowing others to defraud them.  Thus many, thinking to defend free markets, are convinced that anyone who publicly questions a CEO must be a Socialist or worse. It would be useful if one could banish ideology from the debates over majority voting for directors, or pay for performance, for example.

I am being ironical. What ‘libertarian’ investors think they’ll get is an entrepreneur’s paradise. What they do get instead is the status quo, with entrenched interests managing to stay on top, because if you refuse to intervene in the operation of the economic system, others still will. Stigmatizing everyone who tries to change things as coming from the same camp—lumping together shareowner advocates who try to make boards responsive to their owners together with radical environmentalists and with neo-Marxists who regard all profit as a form of theft—is a convenient form of demagoguery for those who wish to remain in power despite their abuses of investors’ trust. The only thing that the different groups of shareholder activists have in common is that they want others to do something.

But free-market libertarianism may be only an excuse.  If you really dig further into those managers who paint all activists with the same brush, you will often find what could more properly be called ‘cynical quietism.’ The libertarianism is in many cases simply an excuse for inertia.  ‘Someone else should go first, and besides, it’s not my job even if I’m losing money because of bad managements.’  45 years ago, we had the horrible case of 38 apartment dwellers who heard and saw a slow-motion rape-murder in the courtyard of their building; some shouted for the knife-wielding assailant to stop, but no one called the police over a period of more than half an hour. Explain this phenomenon, and maybe you can explain the inertia of fund managers.

Given mid-level indifference, cynicism, and inertia, the greatest culprits for the failure of fund managers to address corporate governance deficiencies must be the directors and trustees of the managers and the pension funds.

As is well known, the cadres of any organization can and often do frustrate a clear impetus from above. However, in the case of governance activity, the problem is rather that no such clear impetus comes from the top of the fund or fund management company.  Boards are either conflicted and try to suppress the activity, or they send contradictory signals.  Many claim to be concerned about corporate governance while spending nothing to promote it.  They banish their very few governance monitors to obscure positions within compliance or legal departments. Whenever there is a disagreement between governance and fund management or asset allocation, it is the investment managers, not the governance staff, who get their way. The board never hears of it, nor do they want to. With only a few happy exceptions, fund trustees never turn up at governance conferences or seminars. They brag about their governance programs while starving them for needed staff and budget. Board committees that are supposed to discuss governance issues are dominated by the “see no evil, hear no evil” approach to administration.

No wonder that the message senior fund managers receive is more likely to be that corporate governance is a public relations ploy with no economic payback. ‘Don’t offend CEOs who also chair their boards, because we have three such individuals on our board.’ ‘Governance is important, but so is maintaining friendly contacts with managements.’ ‘Don’t support “say on pay” because if CEOs get paid less, we will get paid less.’ ‘Responsible voting is important, but only if it doesn’t cost us anything and doesn’t take up an extra minute of management time.’ ‘We value our corporate governance program so much we buried it inside our legal department along with other pure overhead functions.’ ‘Since governance activity benefits everyone equally, we can save money by letting someone else to do it.’ Many senior executives echo 19th-century political boss Mark Hanna: ‘We should be virtuous, but let’s not be too damn virtuous.’

Either boards are as thoroughly imbued with the libertarian approach to economics as their hired guns, or they naively believe that one governance employee can do the work of twenty because the task is so simple, even trivial. Whatever their motivation, they are doing their beneficiaries a great disservice.  Until and unless trustees and directors are forced to consider the corporate governance of their portfolio holdings as an essential part of their mandate to manage funds for someone else, this state of affairs will continue, and it will be up to governments to legislate all changes.  Given that governments usually get such things wrong, pass laws which end up being counter-productive, and insert amendments and loopholes at the request of corporate lobbyists over the objections of investors, I have little hope that this route will lead to much real progress.

One way to get boards, and therefore managers, to pay attention would be to legally define the failure of a fund or its managers to act in the circumstance of a portfolio holding’s egregious governance malfeasances as neglect of one’s fiduciary duty, and then let litigation take its course. I am generally not in favor of the American model of regulation by litigation, but this would have the advantage of focusing the minds of directors wonderfully.  The terror of lawsuits would compel funds either to involve themselves actively in all their significant holdings, or to rigorously screen out any prospective investment with questionable governance, which would have the effect of starving suspect companies of capital and promoting better governance as a by-product.

Regulators might prefer the course of requiring some specific degree of governance activity, e.g. that owners and managers of assets have a minimum number of meetings or exchanges of correspondence per year with companies to discuss governance issues for any holding representing more than (say) 1% of their portfolio or 2% of the outstanding capital of that class.  This seems to me to be intrusive, difficult to enforce, and likely to lead to anodyne and time-wasting meetings. No one can mandate the pertinence of that which is discussed, although one could mandate a check-list of topics, which is exactly what is not needed.  Serious governance monitoring is impossible to mandate because no one can foresee the variety of problems, or the variety of solutions which might best deal with them.  If anyone can come up with a better solution than holding boards liable, I’d love to hear it. Otherwise, this seems to me to be the most promising solution going forward: if a holding blows up on your watch due to foreseeable governance problems, and you didn’t do anything to try to forestall them or ameliorate the situation, you’re liable, buddy—in triplicate.

But I doubt we shall see this happen.  There is that convenient inertia, on boards as well as off.  If you refuse to see a problem, you don’t have one, do you? And then, the corporate lobby is very powerful, especially when it can offer retiring politicians seats on the boards of so many fund managers and pension funds.

Permalink