Corporate Governance (posted 27 Feb 99)

Shareholders demand high returns on their equity investments, while executives of public companies typically want a peaceful life with good remuneration and minimal outside intervention. These conflicting interests and how to achieve some kind of alignment between them - to give corporate managers the incentives to act in the best interests of corporate owners - are the central questions of corporate governance. They have become increasingly important in the 1990s as instead of choosing 'exit' - simply selling their holdings in underperforming companies - investors are beginning to exercise their 'voice' - telling managements they do not like to change their ways.

In the 1980s, the most powerful external pressure on executives for stock market performance was the threat from corporate raiders, poised to bid for companies with underperforming shares. Latterly, challenges have come more from institutional investors, the activist shareholders who demand long-term value creation from the companies whose shares they own. This activism has been most dramatic in the United States, and has been supported by regulation: for example, the Securities & Exchange Commission (SEC) has mandated the reporting of value creation in the proxy statement.

In the UK too, the pressures have shifted from the threat of takeovers to shareholder activism, often around the subject of top managers' pay and its weak relationship to corporate performance. For example, guidelines on remuneration published by the investing institutions' professional bodies (the National Association of Pension Funds - NAPF - and the Association of British Insurers - ABI) demand a clearer link between performance and pay. In turn, many UK companies now explicitly target the creation of shareholder value.

Corporate governance guru: Bob Monks

The 1970s and 1980s saw the growing dominance of institutional shareholders with an ability and propensity to trade away their unhappiness with the way their assets are employed. Meanwhile, Bob Monks was Assistant Secretary of Labor, the federal official responsible for supervising the public interests of pension funds - exactly the right place to observe the lack of interest of institutional investors in taking part in corporate decision-making, effectively enfranchising managements whose stewardship of assets was questionable.

When Monks left public service, he applied this lesson to develop a profitable investment management style resuscitating slack companies. In early 1990, he launched Lens, a fund that takes active equity positions in companies whose management needs shaking up. He appealed to shareholders and directors to function as they were legally charged, to monitor and, as a late resort, remove hard-of-hearing managements who forget that they are employees, not owners. The investment record of Lens has been outstanding, surpassing the S&P 500 every year since 1990.

In 1991, Monks electrified the investing world by running a credible race for director of Sears Roebuck as a unique way of calling attention to that company's failed strategies. Sears changed, as did Eastman Kodak, Westinghouse, American Express and several other companies in which Monks and Lens have asserted their rights as shareholders. It helps that as a candidate for an activist board seat, Monks is well qualified as a successful business person and public leader. He is not a single issue advocate with nothing else to offer, but a fully skilled manager that any board would be privileged to have on its roster.

Lens describes itself as an activist money manager, buying stock in a limited number of companies that meet two investment criteria: they must be underperforming in the light of strong underlying values and susceptible to increased value through shareholder involvement. Once the fund has established its position, it approaches company management and directors, with the goal of enhancing value for its clients and other shareholders. Creating value requires specialized knowledge, hands-on involvement and vigilance. It is the fund's activism, coupled with expertise in law, corporate governance and business, that gives it a measure of control in its investments beyond that available to passive managers (see INDEXING).

Physically and intellectually imposing, Bob Monks puts his stamp on any activity in which he engages. A successful investor for over forty years - the founder of Institutional Shareholder Services, the world's premier proxy advisory firm, and former chairman of the Boston Company, a prominent institutional investor - Monks has an unrivaled understanding of how to lead shareholders in cost-effective initiatives to increase value.

After leading the charge to wake up US shareholders to their stake in corporate affairs, Monks has been taking the message to Europe and Asia in response to the increasing globalization of capital markets. Markets outside the United States are following his lead in examining rules for shareholder participation and giving new energy to its firms. The 1998 strategic alliance between Calpers (the California Public Employees Retirement Scheme) and Hermes (the UK pension fund for British Telecom and the Post Office) is a good example of such international shareholder activism, as is the role of Lens and Hermes in removing the chief executive of the UK's Mirror Group in early 1999.

Like growing numbers of people in the business and investment community, Monks has adopted the new tools of adaptive complexity and computer simulations to demonstrate his points about shareholder activism. His latest book, The Emperor's Nightingale, describes how corporations behave through the stages of their life cycles, and shows that synergy really does exist - not as a single burst of energy but as a continuous, healthy adaptation to business conditions. He does not condemn corporate managers for their ironclad budgets, rigid forecasts and attempts to control the uncontrollable. Rather, he provides informed support for the view that business must consist of smaller independent units, which pursue their own aims but collectively achieve what is beyond their individual capability.

Counterpoint

The corporate and investing worlds are typically constituted of interconnected networks of trustees, executives and managers. These create a wide variety of conflicts of interest that can make corporate governance less effective than it should be.

Bob Monks comments: 'The question of the ineffectiveness of institutional investors is most important, particularly as it relates to 'conflict of interest'. Even the best chief executive of a fiduciary organization is not going to be willing to be activist, or to be perceived as activist, because 'my customers don't like it'. Until the government enforces the fiduciary laws respecting conflicting interests, there has been an attitude of benign neglect in the Anglo-American world. Thus, we have the irony that among institutional investors, only those least qualified by education, training and outlook are free to be activist.'

The concept of corporate governance has its roots in the legal structure giving companies unique status with an allocation of powers among owners, managers, customers and society. But do many advocates of shareholder activism go too far, pushing the interests of shareholders too strongly to the exclusion of other 'stakeholders'? After all, a firm is not just a bunch of shares but a collection of relationships between its owners, managers, employees, customers, suppliers and society as a whole. Thinking of the firm as a social institution rather than a capital market vehicle has important implications for corporate governance.

Bob Monks comments: 'I don't think of the firm so much as being 'social' as being a question of 'power': who has the power to create reality, whose standards will prevail?'

Stock option plans have become increasingly popular among UK and US corporations, as they are generally regarded as effective tools of corporate governance, rewarding executives for enriching their shareholders. But such corporate compensation plans are due for a major overhaul and reform. At present, they are a travesty and may become a source of litigation and anger on the part of workers and shareholders: not only has executive pay increased the gap between lower-level workers and senior executives, but these executives have given themselves attractive golden parachutes that pay off handsomely in the event they are let go for incompetence or any other reason.

Furthermore, executive pay is increasingly tied to stock incentives or stock options. On the surface, this seems fine except that if the stock price goes down, options are nearly always rewritten to the lower stock price. This is a compensation scheme that cannot lose for the executive. Compensation by this technique is not typically a deduction in income and does not reduce reported earnings per share, though it should as it is a regular part of the compensation package. But in the United States, the Business Roundtable has bullied the accounting profession and the US Senate to the extent of creating an accounting practice that does not take the current cost of options into the profit and loss account.

Another concomitant of executive remuneration increasingly tied to stock prices is that companies and investors are accused of short-termism. There is a very simple solution if we want long-term ideas and focus on the part of our companies. Instead of having executives paid with bonuses or stock options related to current results, we could change the time frame to three to five years hence. In other words, a chief executive would be paid according to the results of the company three to five years from the time in which the bonus or option was set.

In the event of a sustained market decline, executive compensation could become a critical issue with potentially big payoffs for lawyers: when shareholders lose money in an absolute sense and then find that executive compensation has been high; when options have been ratcheted upwards to be more attractive and adjusted when the stock price goes down so that it is always a winning strategy for the executive; and when executive compensation includes very large payments for severance. Executive compensation could be the touchstone for the next market decline.

Where next?

Corporate governance is all about the relationship between investors and the companies in which they invest. But what does investor relations really mean? To the practitioner, it means a craft of communication striving to be a profession. To a shareholder receiving its output, it is a necessary way to understand markets and companies. To corporate officials, it is a convenience to fend off the time-consuming quest for information that is often a distraction from running a business. All these views are correct but they are far from the story of investor relations today.

An unprecedented eighteen year bull market has multiplied all financial service tasks. Abby Joseph Cohen of Goldman Sachs notes that compensation for financial service workers has been the only area of wage inflation in the present business cycle. And many others note that financial assets are the only inflating assets in a deflationary economy. It is reasonable to look at the macro-influence of a bull market creating the need for ever more competent and ever more highly paid investor relations people. But that is not the whole story either.

At its base, investor relations is about communication of fact. Usually, it is what is today called 'push' through releases, attractive venues and targeted sources. Investor meetings and lunches have given way to conference calls and internet group emails in turn to global videoconferences. Facts are still distilled by lawyers but, curiously, with the most important facts withheld during blackout periods when the most significant developments are taking place.

With computer databases and search capabilities, remarkable things can be done to turn masses of data into information. Most of the innovations have already taken place in the corporate world, especially in comparative retail sales. Now, they are finding their way into finance: for example, screening of the type used at www.fortuneinvestor.com can survey sixteen thousand securities on six hundred variables; and charts of historical activity on almost anything are available at www.bigcharts.com and www.yardeni.com. Hundreds of tools like these are converting the 'push' from investor relations into a 'pull' by users in control of what they want, what they do with it and the conclusions to be reached.

Investor persuasion is moving to the user through the empowerment of technology. The nub of judgment remains in an elusive corner of agency finance, behavioral sciences and computation. But each single user has access to machinery to do the chores, which is low-cost, readily available, global and instantaneous. Like Microsoft endorsing the internet, which may ultimately be its downfall, so the alert investor relations person will provide these tools to make the users job easier and better.

The next steps for investor relations are straightforward:

· First, companies, funds and countries that wish to inform their constituency should maintain and publish 'FAQs' (frequently asked questions), a common practice in industry. All questions with whatever favorable or unfavorable answer can be made available on a bulletin board. It is the next step to the ultimate in transparency, the ultimate being when the answers are created automatically regardless of the questions asked.

· Second, companies should actively trade their own shares with open disclosure of transactions on an instantaneous basis. Companies would reveal their own interplay between business conditions, availability of capital and their assessment of prospects by their actions.

· Third, and in the same vein, insiders would be encouraged to trade with no reservations on when except that they would have to be identified as an insider.

Technology makes all these possible and investor relations would be advanced, providing the user with live, real and significant information individually customized for each. It is possible today. But no one has done it.

Guru response

Bob Monks comments: 'I would add a fourth bullet point to your summary of the next steps for investor relations: as 'institutional' ownership approaches the 50% level in the OECD world, the question arises repeatedly, quis custodiet ipsos custodes - who is watching the watchers?'

'I believe that internet technology will allow trustees to communicate with pension beneficiaries, mutual fund operators with the beneficial owners, and union trustees with the membership. The mechanics of communication and consent will need to be worked out over the next fifty years. What is important is to require that there be some requirement on the trustees to take into account the fact that they are acting for others. Modern technology provides a relatively cheap and reliable means for doing this.'

Read on

In print

Bob Monks, The Emperor's Nightingale, (Capstone & Addison-Wesley, 1998)
Bob Monks and Nell Minow, Watching the Watchers: Corporate Governance for the Twenty-First Century
Bob Monks and Nell Minow, Corporate Governance
Bob Monks and Nell Minow, Power and Accountability

Online

www.ragm.com and www.lens.com - Bob Monks' websites
www.hitachi.com - an example of a corporate bulletin board
www.fortuneinvestor.com; www.bigcharts.com; and www.yardeni.com - examples of websites with various historical data and investment management tools