Oct 28 2009, 9:48AM
we now know all too well, the credit crisis and the global recession
stemmed, in important part, from stark failures of boards of directors and
operating business leadership in important financial institutions: the
witch's brew of leverage, poor risk management, creation of toxic products,
lack of liquidity---all made more poisonous by compensation systems which
rewarded short-term revenues/profits without regard to risk.
Buffeted by the recession and the seizing up of the credit markets, GM and
Chrysler veered into bankruptcy, burdened by decades of questionable
As a result of these dramatic collapses in both the financial and industrial
sectors, trust in corporate leaders--indeed in the ability of corporations
to govern themselves--has eroded dramatically (even though there are, of
course, well run corporations in both areas of the economy). This crisis in
confidence, due to problems real or perceived, has spawned numerous public
sector initiatives, both here and abroad, to impose new limits on private
sector governance and self-determination.
In the financial sector, the regulatory debate is robust. It has focused on
imposing direct, substantive government rules limiting private sector
discretion: e.g. counter-cyclical capital requirements, liquidity
protections, revised accounting standards, credit rating agency reform,
regulatory review of executive compensation, regulatory approval of certain
complex products, better consumer protection, assessment of systemic risk,
and special oversight for large complex financial institutions.
But for all publicly held corporations, financial and industrial, a
dominant, recurring theme has been to "improve" the process of corporate
governance by mandating an enhanced role for shareholders as a check on
boards of directors and business leadership.
But a fundamental, recurring question needs to be asked and answered: are
"shareholders" part of the solution or part of the problem in this
governance crisis of confidence ?
• One public policy initiative would be to give shareholders more "voice,"
primarily through advisory votes at annual meetings on the executive
compensation regimes approved by the boards of directors ("say on pay").
This would mandate uniform federal "process."
Historically, this area of law has been governed by states and
company-by-company shareholder efforts to secure the right to
have such "say on pay" votes.
• A second regulatory change would increase the ability of small groups of
shareholders to nominate alternative candidates in the annual shareholder
election of directors ("ballot access"). Today, shareholders customarily
vote for slates of directors nominated by the directors themselves---and it
is expensive and cumbersome for shareholders to field additional candidates.
(Of course, powerful economic interests can buy large blocks of stock and
force directors onto boards or launch a hostile takeover for the whole
These are "hot" shareholder issues. Both the Obama Administration and
Congress support "say on pay" shareholder votes for all publicly held
corporations in the U.S. And the SEC, which has debated the subject for
years, now has a Democratic majority to approve some version of a "ballot
The problem: the easy assumption about "shareholder" as "solution" ignores
some obvious issues which have gained force in recent years.
• There is no such animal as "the" shareholder. Instead there is an
extraordinary menagerie: large and small individual investors; public and
private pension funds; a wide array of mutual funds; endowment funds for
educational, health and other non-profit institutions; and an equally wide
array of hedge funds. Almost all these institutional shareholders are
trying, in one way or another, to beat their "benchmarks." These benchmarks
could include the Dow Jones, the NASDAQ, relevant S&P or MSCI indexes, or
the goal to make annual, absolute profits for themselves to justify the fees
charged clients (in part, the 2 percent fee and 20 percent of profits often
required by hedge funds).
• Institutional investors now own approximately 60 percent of U.S. equities
(using other people's money). Some observers say, while there are some
long-term value holders, many of these investors are driven by the goal of
short-term performance in their portfolios, and so they engage in relatively
short-term trading strategies and have little interest in corporate creation
of long-term economic value by the corporations whose securities they own
and trade. (Shares of stock are now held, on average, for far shorter
periods than was the case 10 or 20 years ago.)
• Indeed, important questions have been raised about the role institutional
investors played in causing the melt-down by pressuring financial service
entities to take undue risk for short-term profits. Did the short-term
investors crowd out long-term value investors in influencing corporations,
and, if so, is this likely to be the future pattern?
• Questions have also been raised about what kinds of salary and bonus plans
do the institutional investors provide to their fund managers--the people
who drive the stock market and may be an important source of the short-term
pressure on companies? And, how are powerful institutional investors--from
pension to mutual to hedge funds--governed and what are their fiduciary
duties to individuals whose money they "manage"?
• Ultimately, how imperfect are shareholders and the stock market in valuing
companies given the widely divergent time frames and objectives of
institutional investors and the irrationalities (e.g. herd mentality) and
inefficiencies of the market at any moment in time?
Henry Kaufman, a prominent Wall Street economist for decades has written in
a recent book The Road to Financial Reformation, most "investment
relationships today are very fickle. Portfolio performance is measured over
very short time horizons...Day trades and portfolio shifts based on the
price momentum of the stock---rather than anything having to do with the
underlying fundamentals---are commonplace."
Or, as Ira Millstein, a godfather of the corporate governance movement and
long-time advocate of more shareholder voice, has recently written (in
Directorship magazine): "...the model of shareholder activism...envisioned
in the 1980s and 1990s [is] under severe strain. Institutional investors
were once presumed to share a common goal when exerting pressure on boards
to monitor management and effectively guide firm strategy. That assumed
homogeneity is long gone...The diversity of shareowners has brought a whole
new host of agendas, strategies and values to the table. Some of these
owners have limited investment horizons and are only interested in realizing
a short-term profit, and others have hedged or shorted their positions and
consequently have a financial interest in the failure of the enterprise."
Non-U.S. regulatory bodies like the multinational Financial Stability Board
or the UK's Financial Services Authority in their lengthy post-mortems on
the financial crisis have analyzed the harmful effects of investor short-termism.
And when the Federal Reserve Board recently announced that it would
supervise, and if necessary regulate, executive compensation at the nations
banks, its proposed rule noted that a shareholder perspective was
inadequate: "Thus a review of incentive compensation arrangements and
related corporate governance practices [as through "say on pay" votes] to
ensure that they are effective from the standpoint of shareholders is not
sufficient to ensure they adequately protect the safety and soundness of the
In fact, there is now a growing movement to examine the institutional
shareholders critically and systematically as a cause of the short-termism
that drives bad corporate behavior (the Millstein Center for Corporate
Governance and Performance at Yale's School of Management and Aspen
Institute Business and Society Program come to mind). The important issues
noted above need systematic, empirical, and prescriptive exploration.
Seen through the lens of history, this is, in fact, just the latest chapter
in an historic argument about the respective powers of shareholders, boards
and management to control corporations (within the context of legal rules
and regulations). Shareholders "own" the company and elect the directors,
but often in the past there was no real electoral competition because the
only candidates were those selected by the board itself, with heavy CEO
influence, and management had a monopoly on important information. A famous
book, The Modern Corporation and Private Property, by Adolf Berle,Jr.
and Gardiner Means in 1932 described this separation of "ownership" and
"control." Game on---for more than 75 years.
To be sure, those advocating a bigger role for shareholders are addressing
real and important issues.
• Companies should consult shareholders, but not just on pay in a formal
annual meeting vote. More importantly, corporate directors, CEO's and senior
business leaders need to give all stakeholders--creditors, employees,
customers, suppliers, communities--"voice", not just shareholders. All are
critical to the health of the corporation. All come in different shapes and
sizes. All have important, but divergent interests. Company leadership must
hear and balance all these concerns in reaching a decision about how to
carry out the corporation's fundamental mission. But how many listen well?
• Shareholders have also raised the profound issue of board and CEO
"accountability." The problem, as noted, is the self-perpetuating nature of
corporate power: CEOs suggest board members, board members nominate each
other for routine shareholder election. If the company leadership is
complacent or making bad decisions, how fix the problem. (GM?) The broad
answers have their own issues. Regulation can be too heavy handed, have
unintended consequences and stifle creativity and innovation (especially
regulation about governance in contrast to laws protecting a social good
like the environment). Turning corporations into political entities with
blocs of shareholders fighting continuously about control and direction
would sap precious time from providing great services. And the stock market
may value companies correctly in the long run, but, in the short run, be
irrational and punish companies for taking actions for long term growth
(investments, R&D) that depress profits in short term.
The ultimate question which underlies virtually all of the regulatory
debates is: "voice" and "accountability" in the service of what mission?
Many would argue that the dominant mission of the past two decades of
creating shareholder value is too narrow and too prone to short-termism.
Many market participants (and we need much more study to understand
precisely) are not interested in what most would argue is the the basic task
of corporations: to create sustainable economic value by providing great
goods and services which customers want and which benefits all stakeholders
using sound risk management and with high integrity (law, ethics, values).
Put a slightly different way, boards and CEOs must balance risk taking
(innovation and creativity) with risk management (financial and operational
discipline) and must fuse high performance with high integrity (to address
legal, ethical, reputational, and policy risk). Carrying out this mission by
defining and attaining key operational goals in performance, risk and
integrity dimensions--and compensating according to those goals--is the
fundamental role of boards of directors and senior management. This what
creates long-term shareholder value.
In light of the deleterious focus of many institutional shareholders on
short-term results in their own, not the corporation's interest, we need to
understand in a much clearer way when shareholders can be part of the
solution--and when they are a major part of the problem--in advancing that
fundamental corporate mission. But the deeper problem is finding the right
accountability mechanisms which allow the right measure of corporate
self-determination at the board/CEO level but which also holds them
Heineman, Jr. was GE’s Senior Vice President-General Counsel for GE
from 1987-2003, and then Senior Vice President for Law and Public
Affairs from 2004 until his retirement at the end of 2005. He is
currently Senior Fellow at the Belfer Center for Science and
International Affairs at Harvard’s Kennedy School of Government,
Distinguished Senior Fellow at Harvard Law School’s Program on the
Legal Profession, Senior Fellow at Harvard Law School’s Program on
Corporate Governance and Senior Counsel to the law firm of Wilmer
Hale. A Rhodes Scholar, editor-in-chief of the Yale Law Journal and
law clerk to Supreme Court Justice Potter Stewart, Mr. Heineman was
assistant secretary for policy at the Department of Health, Education
and Welfare and practiced constitutional law prior to his service at
GE. His book, "High Performance with High Integrity", was published in
June, 2008 by the Harvard Business Press. He writes and lectures
frequently on business, law and international affairs. He is also the
author of books on British race relations and the American presidency.
In 2007, he served on the Independent Review Panel on the World Bank
Group’s Department of Institutional Integrity (the Volcker Panel) and
is currently on an international panel advising the President of the
World Bank on governance and anti-corruption. He is a fellow of the
American Academy of Arts and Sciences, a member of the National
Academy of Science’s Committee on Science, Technology and Law and
recipient of the American Lawyer’s Lifetime Achievement Award and the
Lifetime Achievement Award of Board Member Magazine and was named one
of the 100 most influential individuals on business ethics in 2008 by
Ethisphere Magazine. He serves on the boards of Memorial Sloan
Kettering Cancer Center, the Center for Strategic and International
Studies, Transparency International-USA and the Committee For Economic
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by The Atlantic Monthly Group.