A good deal of regulation has been imposed on financial institutions and markets since the Sarbanes-Oxley Act of 2002, which tried to address the corporate scandals that began with Enron, Tyco and WorldCom. But scandals continue to emerge, with abuses also revealed in the mutual fund and insurance industries. A panel of industry experts met recently at the 14th annual Net Impact Conference, “Business Leaders Building a Better World,” to discuss whether confidence in corporate America can be restored through improved governance.
Raymond D. Horton, the Frank R. Lautenberg Professor of Ethics and Corporate Governance at the School and director of the Social Enterprise Program, moderated the panel, whose members represented institutional investors, unionized employees and senior managers, just some of the stakeholders with an interest in the corporate governance of firms. Horton noted the difficulty in aligning stakeholders’ interests, adding that consumer and social/environmental interests usually are excluded entirely from business-policy decisions.
“We’re really not seeing a failure of business,” said Carol Bowie, director of governance research at the Investor Responsibility Research Center, which provides impartial research and guidance to more than 9,000 companies in the United States and abroad, “but a failure of control — a failure of governance in most of those cases, right from the securities analysts, to the mutual funds to the insurance folks.”
Shareholder Proposals and Recent Reforms
Traditionally, Bowie said, investors who were unhappy with companies had ways to leave them: they could sell stocks that appeared too risky, an exit strategy known as the Wall Street Walk, or they could get out once disaster struck. But those have become less viable options in recent years, particularly for institutional investors who own large blocks of stock. Furthermore, those two options don’t give investors much opportunity to implement change before they leave. So, more and more investors are looking to engage companies and to promote change toward better governance policies, with the objective of controlling that risk.
2004 was a record year for governance-related shareholder proposals, Bowie said. As of November, her company had tracked more than 800, compared with 791 in all of 2003 and roughly 500 or 600 in a typical year before that. Judging from those proposals, Bowie said, investors seem to be most concerned with executive compensation and board accountability.
Two pay-related proposals gained particular support among investors: caps on so-called golden parachutes, or generous severance arrangements, and transparency through stock-option expensing. Investors also support proposals to eliminate unclassified boards, which stagger elections so that only a third of directors can be replaced in any given year. “This along with other limits on shareholder rights tends to drive investors crazy, institutional investors in particular,” Bowie said. “It also seems to have the effect of reducing director accountability and potentially entrenching poorly performing managers.”
Union members’ concerns regarding corporate governance are similar to those of institutional investors, said Michael I. Garland, corporate transactions coordinator for the AFL-CIO’s office of investment, which represents 13 million unionized employees. “Union members participate in the capital markets largely through their benefit plans,” Garland said. “Both the job security and retirement security of our members rest largely on the integrity of the capital markets and the corporate governance system.”
Like long-term institutional investments, union members’ benefits are mainly tied up in funds that take longer to disinvest from when companies fail and individual investors jump ship. “Our funds were among the hardest hit, and the worker funds lost $35 billion at Enron and WorldCom alone,” Garland said.
Of all the reforms passed in response to those scandals, Garland said he thinks two recent proposals will go furthest to level the playing field and deal with conflicts of interest. The Financial Accounting Standards Board has proposed a reform that attempts to close the loophole giving preferential accounting treatment to stock options by requiring that they be expensed on executives’ income statements. The second proposal, proxy access reform, would reform the process for electing board members to give shareholders the power to nominate directors. The desperate resistance to these reforms from the executive community, he said, is the best indication of their importance.
“Institutional investors don’t want to manage companies and we don’t believe that the boards should be responsible for managing day-to-day issues,” Garland said. “The board is our representative of the corporation, and we expect the board to hold management accountable, to compensate executives appropriately. If they’re not carrying out those obligations, we need the right to hold them accountable.”
“I agree with almost everything my two colleagues have said,” said Henry B. Schacht, managing director and senior adviser at Warburg Pincus and senior adviser (and former chairman and CEO) of Lucent Technologies. “I think executive compensation is outrageous and I’ve said so publicly for years; I think accountability in the board needs to be improved; I think we ought to expense stock options; I think we ought to limit severance; I think proxy access is a tempest in a teapot; and SarbOx [Sarbanes-Oxley] is probably OK — but that none of them is sufficient. Not even close.”
That’s because enacted and proposed reforms address what happened not why it happened, Schacht said, and none of them deal with the fundamental problem. “I think the root cause is the short-term orientation of the entire system,” he said. The system is based on the concept of ownership, and management is supposed to be powered by the owners. “We have no owners,” he said. “The average length of hold by an institutional shareholder is less than nine months. We have to figure out how that new representative owner, which is the manager, is incented to behave like an owner.”
This short-term orientation, Schacht continued, is putting pressure on the system and creating a bubble that will eventually burst. “Human systems cannot be made immutable to pressure,” he said. And the pressure can be reduced only by reinstituting the concept — if not the reality — of ownership. The focus has to be on the management of a firm. Management incentives must be redirected. Neither boards nor absentee institutional owners nor outside pressure can substitute for management because they cannot understand soon enough what is going on. “You’ve got to reduce the chances of the pressure building, as opposed to trying to legislate containing the pressure and the consequences of the pressure,” he said. Those reforms just put a bigger cap on the top of the old-fashioned pressure cooker, he said. “It’ll hold it a little longer — and the bang will be bigger.”
Schacht went on to offer a controversial solution: change the tax system to create economic incentives for shareholders to behave like owners and stick with investments through ups and downs rather than trade as quickly as possible, and apply the same tax system to executive stock compensation. “I would say you can own a share any time you want and you can trade it any time you want, but you don’t get voting rights unless you hold it for x period of time,” he said. “If you trade it within x amount of time it’s 50 percent taxed, then it’d be 40, then it’d be 30, then it’d be 20 and then 0.” “Everybody says I’m interfering with the efficient markets,” he said. “But I’ll tell you something: The system’s broke, and until we fix the root cause, all the things my colleagues are talking about will not be even close to enough in my book.”
“There is a question of market efficiency,” Bowie said. “And we’d certainly be risking losing that efficiency. We’re already talking about investors who are in an index fund who are stuck. What you’re suggesting would make it even more painful to get out.” If this reform does not increase performance and good behavior by management, it potentially punishes responsible investors, she said. “The long-term view and the benefits of having a tax system that would benefit that long-term view sound very attractive. For some institutional investors, those kinds of tax penalties for selling when they think it’s time to sell are not attractive.”
In fact, three-quarters of Britain’s FTSE 100 have “restricted stock” schemes that allow executives to sell their shares only after a number of years and only then if the firm meets minimum performance standards relative to its rivals, the Economist noted in a December 11 article, “Pay For Performance: Running Out of Options.” But the American business community so far has resisted this strategy.
The panelists did agree that corporate social responsibility is important for company profits and that economics, governance and environmental and social concerns are all linked. Corporations, they said, need to integrate corporate, social, environmental and human responsibility into their performance or they will suboptimize economically over time. “The only way to maximize economic profit over a reasonable period of time,” Schacht said, “is to behave responsibly towards all the stakeholders.”
Nearly 1,400 MBA students, professionals and sponsors attended the 2004 Net Impact Conference, ÒBusiness Leaders Building a Better World,Ó which took place November 11 to 14. The sold-out conference drew participants from 80 business schools, 167 companies and 11 countries. Hosted by a different business school each year, Net ImpactÕs annual conference is one of the largest and best-known gatherings of socially minded business leaders in the world.