Power And Accountability – Chapter 6

Slumbering Giants: The Institutional Investors

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Slumbering Giants: The Institutional Investors

“We Have Met the Market and They Is Us”

Institutional Investors: Who They Are and What They Want

A Federal Law of Ownership

Private Pension Funds: The 900-Pound Gorilla

The Inactive Institution: The Raider’s Best Friend

Bank Trusts: A Contradiction in Terms

Mutual Funds: One-Night Stands

Insurance Companies: The Untouchables

Universities and Foundations: The Ivory Tower

The Public Pension Plans: Big Daddy’s Legacy

The 1,000-Pound Gorilla: The Federal Employees’ Retirement System

Social Investing, Part I: “But the Pension Fund Was Just Sitting There!”

Social Investing, Part II: Whose Money’s Worth?

The Sleeping Giant Stirs

One Step Forward

Shareholder Proposals in 1991


Slumbering Giants: The Institutional Investors

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Institutional shareholders now hold the majority of common stock. Pension plans alone will be the majority shareholders in most companies by the turn of this century, less than a decade away. This makes it possible to have in the United States what has been a key ingredient in Japanese and German competitiveness: a dominant class of corporate owners with a long-term orientation.

“We Have Met the Market and They Is Us”

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Institutions own such a large percentage of the market that two of the elements driving short-term orientation – the need for liquidity and the competitive advantages of active fund management – are no longer important, or even prudent. As Assistant Secretary of Labor David Ball said, institutional investors can paraphrase Pogo: “We have met the market and they is us.” Nonprofessional investors have become so scarce that it is no longer profitable for funds to expend resources necessary to beat them. The rewards are simply too low. While a target’s shares go up in a takeover, the acquirer’s shares go down, and institutional investors, who usually hold both companies’ common stock and their bonds as well, are left with no net profit, even in the short term. The only way for them to enhance value is through effective involvement in the affairs of the portfolio companies they hold in virtual perpetuity. This is especially true for the indexed portfolios.

Much of the present concern with conflicting interests, takeovers, and social responsibility arises from the structural conflict between the corporation’s continuing need for long-range commitment and the half-century old pattern of short-term stockholder focus. The possibility of eliminating this conflict appears to offer a sound continuing basis for the legitimating of private power and for minimizing the adverse impact of large corporations on society without the need for increased government restrictions.

Institutional Investors: Who They Are and What They Want

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Institutional investors are just beginning to discover and flex their ownership muscles. It’s important to take a look at them, to understand who they are, what they are looking for, and where they are going.

The Institutional Investors

[I]nstitutional investors are by no means a monolithic group, since they have vastly different investment objectives, tolerance to risk, understanding of their fiduciary mandates, and perceptions of their appropriate role in corporate governance. Notwithstanding major differences among them, institutional investors as a group, have vastly expanded their economic sphere of influence in a number of important ways. Moreover, while they may be diverse, a high concentration of economic power resides among a relatively small and extraordinarily stable group of institutions.

Dr. Carolyn Kay Brancato

Source: The Pivotal Role of Institutional Investors in Capital Markets: A Summary of Research at the Columbia Institutional Investor Project, Center for Law and Economic Studies, Institutional Investor Project, Columbia University, New York, June 14, 1990, pp. l-2.

Institutional investors are indeed a diverse crowd. They include pension funds, trusts, mutual funds, and endowments – all pools of money invested for different purposes and with different obligations. They have only one thing in common: They manage assets on behalf of someone else, someone to whom they owe a duty as fiduciaries. Institutional investors go back to the earliest development of property law. In the 1780s, for example, Benjamin Franklin established a trust fund out of his salary as Governor of Pennsylvania because he did not believe that public servants in a democracy should get paid. The [[sterling]]2,000 sterling he set aside vested in part 100 years after his death, in 1890, with the rest to be paid out in 1990. After 200 years, that portion was worth $16.5 million. The beneficiaries were citizens of Boston and Philadelphia, and politicians from both cities spent most of 1990 fighting over how to spend it. 1

The five largest groups of institutional shareholders had the following equity holdings (in billions) in 1989:2

Private pension funds $666.7
State/local pension funds 290.2
Open-end investment companies 239.2
Life insurance companies 116.7
Other insurance companies 94.3

The holdings were skewed toward the larger-capitalization companies, with the result that, by 1989, institutional ownership of the top 50 corporations had reached 50 percent.

The growth in the last 25 years has been encouraged by federal tax policies that give favorable treatment to funds committed for retirement and charitable purposes. To ensure that public policy is carried out, the tax law usually requires that the funds be held in the form of a trust. Thus, to adapt Gresham’s well-known law, “tax-aided savings drives out all others.” Increasingly, the savings of America are being held in institutional form, and the owners of corporations are becoming large and concentrated.

Majority ownership of our largest companies is managed by institutional investors. The question, then, is on whose behalf? And are the concerns of the beneficiaries being met?

A Federal Law of Ownership

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All of the major institutions collectively estimated to own 45 percent of the total of all equity securities in publicly held U.S. companies are subject to the strictest standard developed by our legal system, the fiduciary standard, for the same reason it is imposed on corporate directors and officers: it’s not their money they are handling. In this case, though, the fiduciary standard is more than myth; it is a very tangible reality. Almost every institutional investor is governed by existing federal regulation and supervision as to how they exercise their responsibility as owners of the portfolio companies. That makes it possible, through purely administrative action, to create a “federal law of ownership” right now.

The institutions have little in common beyond their trust structure. Although institutional investors may own, through their trustees, a majority of the equity of the principal companies in the country, it is virtually impossible in the case of mutual funds, insurance companies, universities, foundations, and banks to define either the beneficiary by name or to establish a constant set of values for governing the operation of the trust.

It makes no sense, then, to think of institutional investors as a class capable, without some outside stimulus, of formulating plans for extensive common action. Even if they wanted to, it would be impossible. They are all impeded not just by the endless litany of procedural obstacles to collective action by shareholders,3 but, more important, by the “prisoner’s dilemma” discussed in Chapter 2, which prevents shareholder action of any kind in most cases. This dilemma, also called the “collective choice” problem, means that any shareholder who wishes to act must underwrite all of the costs, for only a pro rata share of any returns, if there are any. Everyone else gets a free ride.

Economists have come up with a term for the individual investor’s involvement that sounds almost oxymoronic: rational ignorance. Institutional investors have also been rationally ignorant; they have received no benefits from paying attention to voting. They face some of the same obstacles to collective action, but a more serious impediment is the extreme conflicts of interest, as noted in this book, along with their neglect and inefficiency – even abuse – of ownership rights.

Meanwhile, corporate management has no such barriers to action. They control the agenda, timing, and financing of corporate action. There has been little progress in developing structures for collective action by owners, possibly because the largest owners in today’s society are the employee benefit plans of those companies most satisfied with the current governance system; the scope of shareholder decision making has been accurately described by one of the nation’s finest scholars as nominal, tainted, coerced, or impoverished.4 “Corporate democracy” became a vestigial notion, a polite fiction that remained a part of our vocabulary only because it underlies the exercise of private power.

Institutional investors collectively are large enough to make activism not just feasible, but prudent as well. As we noted earlier, a study showed that adoption of the 1990 Pennsylvania antitakeover law depressed share value of companies incorporated there by 4 percent; it is therefore reasonable to assume that shareholder action calling for reincorporation to another state with more favorable laws could increase share value.

But an initiative such as a shareholder proposal calling for reincorporation is expensive. Although it takes only a couple of hours of a lawyer’s time to draft and submit such a resolution, it takes much more time for the lawyer to fight it out when the company tries to get permission from the SEC to exclude it from its proxy. There are additional necessary expenses: without a proxy solicitor – one of a handful of (primarily) New York City firms that have the practical knowledge of where proxy cards are physically located – it is virtually impossible to get majority support for a shareholder resolution. It can cost one-half million dollars to hire one (if you can get one; in one case, our client retained a proxy solicitor only to be told the next day that the solicitor had thought about his other relationships and decided it would be bad for business to do the job). Let’s say the institution decides to proceed, spends the money, and gets a majority vote. It is still nonbinding. There has never been a shareholder resolution that was drafted to be anything more than advisory, although we believe it is possible to have one under some state laws, including Delaware’s. How can a fiduciary, committed to prudence and diligence, justify proceeding on that basis, even if the institution in question has enough stock to be likely to make more than the cost of its effort if the company does reincorporate in another state?

Now let’s make this example more realistic. Let’s say that the institution in question also has a commercial relationship with the Pennsylvania company; let’s say it is a bank that loans it money, or an insurance company that provides liability insurance, or a money manager who manages its pension fund, or a brokerage house that underwrites its securities. It’s a lot easier just to accept the depressed stock because the alternative course would most likely mean a loss of business. Fiduciary obligation is nice, but commercial relationships are business, and every commercial institution and every private institution has relationships it does not want to discourage. As discussed below in this chapter, institutional investors are subjected to the most extreme conflict-of-interest pressures. Meanwhile, institutional fund managers do not get paid extra for voting; indeed, hardly anyone knows if they vote or not.

The public institutions, like the state pension funds, for example, have relationships, too. When the Wisconsin state pension fund wanted to object to General Motors’ $742.8 million of greenmail to Ross Perot, it was stopped by the governor, who was trying to get General Motors to build some plants in his state.

Private Pension Funds: The 900-Pound Gorilla

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Gordon Binns presides over a staff of 50 people managing some $35 billion in pension assets that General Motors has amassed in its pension system. There are over 848,000 participants and beneficiaries in the domestic plans. There may be some question as to the position of GM in the automobile world, but there is no question that Binns and his people have solid claim to preeminence in the world of pension investments.

I first met Gordon when I was the ERISA (Employee Retirement Income Security Act) administrator. He invited me to an informal dinner at the Harvard Club with the responsible officers of the large plan sponsors having principal offices in or near Manhattan. As I sat down with General Motors, Bethlehem Steel, AT&T, USX, IBM, General Electric, Dupont, and Exxon I was struck by the extraordinary concentration of investment capital in the private pension system. I have continued to feel that this base of resources and talent provides the best possibility for restoring a system of accountability to corporate governance in America.

General Motors hires about 65 “external” managers. The range of investments covers the spectrum of possibilities, from country funds, real estate, and oil and gas to ventures of all kinds. They have been adventuresome, and successfully so. The investment results have exceeded their actuarial projections by a wide margin over recent years. In fact, the success rate of the plan has encouraged GM to raise the assumed earnings rate several times, and the 11 percent rate currently being used is one of the most aggressive among funds. To the extent that the pension funds can continue to generate such returns, the size of the company’s annual payments can be reduced. Also, it is possible to use these “excesses” to fund obligations for which there is no other source, such as inflation adjustments in the payments made to those already retired. Binns would certainly question whether these results could be achieved if GM were required to “index” the domestic equities portion of its portfolio, as is suggested later in this book.

Binns has been an industry leader and has testified for ERISA plans before Congress. He was the first chairman of the Committee on Investment of Employee Benefit Assets (CIEBA), a technical committee of the Financial Executives Institute. GM has been highly conscious of its responsibilities in the area of corporate governance. In keeping with its policy of delegating investment authority to “outside” managers, GM depends on these experts to function as responsible owners, but it insists that they demonstrate their commitment to thoughtful, prudent exercise of voting rights, and it monitors them to make sure that they are meeting their responsibilities.

Binns is the best example there is of the class of institutions that make up the largest pot of money in the world. These are, of course, the pension and welfare plans covered under ERISA, pension funds established by corporations on behalf of their employees. The Labor Department estimated ERISA funds to be worth $2 trillion in 1990. It took 11 years to pass federal legislation encouraging and regulating the creation of private pension funds, and during that time no one anticipated that the impact would be so dramatic. I once asked the chief sponsor of ERISA, the late senator Jacob Javits, whether he had any idea that the money gathered under this statute would reach such proportions, and he said, “I have never been accused of modesty, but I will tell you in all sincerity that it never occurred to me.”

The statute was passed after years of testimony from employees who found themselves destitute upon retirement. There were several different drafts of the legislation, principally directed at state and local government employees. Effective lobbying of local interests resulted in the exemption of public plans, so that it was transformed into a program for private sector employees. The result was ERISA, which many people claim stands for “Every Rotten Idea Since Adam.” The statute is incredibly complicated; having served as the political appointee charged with administering it, I admit that even I do not understand it all, and that, indeed, I have met only two men who do: Mort Klevan and Alan Lebowitz, both at the Department of Labor and both men of stunning intellect and integrity.

The idea behind ERISA is simple. Congress wanted to make it worthwhile for private companies to create pension plans for their employees, and then it wanted to protect the money after the plan had been created. The statute was designed to resolve questions of conflict of interest and liability that had left the private pension system uncertain, and, in some cases, chaotic. ERISA was designed to resolve them with one massive federal law, preempting all state law in this area. ERISA itself, however, still created the potential for abuse, and it raised questions that required volumes of regulations, guidelines, and advisory opinions.

ERISA pension funds are modeled on trust law. But trust law never contemplated a group of beneficiaries as large and diverse as pension plan participants. As we discussed in Chapter 2, in our description of Trip’s investment in Boothbay Harbor, pension plan participants include those who just started work, those a few years from retirement, and those who are already retired. The common law of trusts also never contemplated a trustee like Widget Co., Trip’s employer, one with not only a lot of other business concerns to occupy its attention, but with an inherent conflict of interest. The CEO’s obligation as trustee of Trip’s retirement money can conflict with his obligations in running Widget Co.

ERISA permits a “nonneutral fiduciary” in recognition of the fact that in pension plans, unlike traditional trusts, employers and employees are both settlors and beneficiaries.5 This is also acknowledgment that the plan sponsor is the party at risk if the plan is poorly run. Employers would be understandably reluctant to establish a pension fund if they had no say in selecting those who manage the assets or deal with benefit claims. The statute makes it clear that, between those two obligations, that of fiduciary of the pension plan comes first. A fiduciary must act “for the exclusive benefit” of plan participants. In practice, this standard has been difficult to understand and enforce.

Today’s ERISA funds include every possible kind of investment – not just in the domestic market, but, increasingly, in the global market. The global market is investing here, too. Pension funds and other institutional investors in Europe and Japan hold significant stakes in American companies.

ERISA requires that a “named fiduciary” with responsibility for the plan be designated by the company, called, in ERISA’s myopic terms, the “plan sponsor.” Typically, a major corporation designates a committee of the board of directors as the “named fiduciary.” ERISA recognizes that these people are too busy and important to watch over the pension fund money, so it permits them to delegate authority (and responsibility and potential liability) to an investment manager. So long as the selection of the investment manager is prudent and the plan sponsor monitors its performance, the sponsor company will not be liable for the investment manager’s mistakes. The standard is utterly process-oriented. As long as there is a reasonable process, and it is followed, the Labor Department will not second-guess the results.

ERISA might as well have been named the “consultant employment act.” So much attention has been paid to ensure that selection of an investment manager is “prudent” that an entire industry of consultants has been created to provide the substantive and independent “proof” that a particular investment manager meets the standards necessary to justify selection. And another new species of expert has been generated to provide the most exhaustive analysis of the performance of the investment managers. Hiring these consultants is itself evidence of prudence and diligence and thus functions as sort of an insurance policy.

Corporate managements really have not decided what to do with their pension assets. For two reasons, their focus has been on the procedural aspects of ERISA. First, the issues raised are remote from whatever goods or services the company produces, so it is easier to file the pension fund away under “human resources.” And the government seems to agree – administration of ERISA was given to the Labor Department, not the Treasury Department. Second, meaningful exercise of the ownership rights of the pension assets is worse than thankless. No investment manager, in-house or outside, ever got paid a dime for voting proxies especially well. On top of all of the practical and procedural obstacles listed in Chapter 2, it is a threat. ERISA funds face the same problem of collective choice that all shareholders do: can it be prudent to expend resources knowing that, without the ability to communicate with other shareholders, any positive results are unlikely? Even if the results are positive, any returns to the active shareholder will only be proportionate to its holdings, with all of the other shareholders getting a free ride. Furthermore, to the extent that Widget Co.’s pension department adopts an activist posture with respect to portfolio companies, it risks retribution – retaliation in the marketplace and an invitation to other pension professionals to take an equally aggressive view of their own functioning when they vote the shares they hold in Widget Co. From the point of view of all institutions, then, it is simplest to do nothing, to try to maximize value by trading, despite all evidence that the majority of those who do so fail to outperform the market.

Without any sense of irony, much less responsibility, the CEOs who condone this policy at the office condemn it when they are outside. The takeover hearings conducted on March 4, 1987, by the Senate Committee on Banking, Housing, and Urban Affairs included testimony by a panel of 16 chief executive officers. They all argued that institutional investors provide the momentum for violent and unchecked hostile takeovers, that they are rapacious and omnivorous, and that they have a short-sighted commitment to quarterly figures that skews the market and that can only be addressed through new federal legislation. None of them mentioned that they themselves controlled well over $18 billion through their corporate pension funds. None of them suggested that they themselves were taking any steps to direct their pension funds – through trading policy or proxy policy – according to the longer view.

Indeed, the top level of corporate management has paid relatively little attention to a program that, in a surprising number of cases, represents the company’s greatest asset and its greatest liability. In the corporate hierarchy, the chief pension officers are like orphans. Most CEOs are interested in the company’s core business, and all they want to know from the pension fund is whether it is adequately funded. They do not hesitate to terminate pension plans when it is expedient. In some corporations, pension officers are assistant secretaries, in others assistant treasurers, in some vice presidents – in none are they considered participants in the principal activity of the corporation. I don’t know of a single large company’s chief pension officer who is also a director of that company.

Although a pension officer may through a particular investment “make” more money for the company, in the sense of decreasing the amount it is obligated to contribute to the pension system in a given year, than the operations of a whole plant, he is not compensated in the same manner as an operations person who achieved the same dollar results. No one in 1974 thought that, within 20 years, one of the largest problems of the pension system would be what to do about the surpluses. Today, many of the largest companies have surpluses – that is, assets with a market value exceeding the actuarial amount of liabilities in the billions. AT&T’s is over $10 billion as of this writing.

The Inactive Institution: The Raider’s Best Friend

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Because activism raises difficult questions, corporate plan sponsors have, until the most recent times, generally preferred to delegate the problems to their money managers. This inaction by the largest shareholder group has had the ironic effect of providing support for others whose interest, in many cases, is hostile to incumbent corporate management. The “raider” who acquires 4.9 percent of a corporation’s stock has the additional leverage of “knowing” that the largest single class of shareholders holding on average 20 percent, and in the case of large companies substantially more will be on his side. Arguably, therefore, the passivity of the plan sponsors in developing policies for their pension plan holdings is, on the one hand, a major contributor to the success of the raiders and, on the other, a conspicuous loss of opportunity to maximize the value of their own holdings – the arbs got that money! Corporations, their shareholders, and their employees lose both ways.

The emerging importance of proxies, due to increased contests for control and public pension plan support for shareholder resolutions, has led corporate management to rediscover ERISA funds as another kind of asset. As documented in the Cohen committee report,6 some officials pressured investment managers to support them, at the risk of losing business.

Returning to Trip’s investment in Boothbay Harbor, this is what would happen: Boothbay is the target of a hostile takeover attempt, because the CEO has spent more time playing golf than watching the business, its facilities are out of date, and dividends are down. The group running against incumbent management has substantial credibility, and the investment manager handling Trip’s pension fund, hired by Widget Co., Trip’s employer, is inclined to vote for them.

But the investment manager handles pension money for 10 different companies, including, by coincidence, Boothbay Harbor itself. The manager gets a call from the CEO or CFO of Boothbay that goes something like this: “I see that you hold our stock, not only in our pension fund, but also in your nine other funds. You know, when we think about where to put our money, we think about the kind of judgment we look for in an investment manager. In my opinion, a vote for the other side shows bad judgment. We sure would like to keep paying you that nice management fee, and we’re sure we can count on your support.” Keeping in mind that Trip, on whose behalf this stock is being held, will never find out how the stock is voted, that Trip’s employer will never ask, and that the CEO of Boothbay will know how the investment manager votes and will act on what he knows, would you vote for the opposing slate?

Or maybe the money is handled by a bank trust department, which goes ahead and votes for the takeover. This time, the CEO calls up his old friend, the head of the loan department at the bank, or maybe even the bank president, and politely reminds him that Boothbay is one of the bank’s biggest loan customers (or is thinking of becoming one). It is the simplest thing in the world (and the hardest to trace) to call up the trust department and tell them to submit a new proxy card. This friendly arrangement was the norm for some time, until 1987, when Avon, Rockwell, GTE, and International Paper took it one step further.

GTE’s Request for Help from CEOs

December 12, 1986

I am writing to share my concern about the heightened unfriendly merger and acquisition activity, and related greenmail, and what I consider to be the increasingly unhealthy short-term speculative nature of the nation’s financial markets. I also want to ask for your assistance with respect to a specific aspect of this problem related to GTE.

We both recognize the economic and social implications of what I believe to be an overemphasis on short-term financial performance. Both of us have spent many years building organizations which proudly serve the varied interests of our shareholders, employees, communities and customers.

The GTE Board of Directors has called for a special meeting of our shareholders because of its unanimous belief that prudent corporate stewardship dictates that we act decisively to enhance values for all shareholders while satisfying our responsibilities to other constituents. The proposals that our shareholders are being asked to approve undoubtedly have been discussed by most executives and their Boards and already have been adopted by shareholders of many public corporations. GTE’s proxy statement is included for your information.

I am writing to you because I feel strongly about this subject and because your corporation has a very large pension fund. Accordingly, there is a good chance that your pension fund owns shares of GTE voting stock.

Because of the short-term orientation of certain money managers, absent specific voting instructions from plan sponsors, such money managers will vote against certain proposals similar to those proposed for adoption by GTE’s Board. Consequently, some plan sponsors have instructed their money managers not to vote against such proposals without the sponsor’s specific approval. If you have not taken this step – and if you agree that the proposals will benefit GTE’s shareholders in the long term – I would greatly appreciate your providing specific voting instructions to your money managers to vote for the proposals adopted by GTE’s Board.

Since the GTE special meeting of shareholders will be held on December 24th, time is of the essence. I would, therefore, very much appreciate your expedited action on this matter.

I welcome your thoughts and encourage your support in our joint goal to continue to improve the economic environment in which we all work and live. If you have any questions, please do not hesitate to telephone me at 203-965-2103.

Sincerely yours,

Theodore F. Brophy

Chairman of the Board

Source: James E. Heard and Howard D. Sherman, Conflicts of Interest in the Proxy Voting System,” Investor Responsibility Research Center, 1987, Washington, D.C., pp. 99-100.

Those companies responded to the first wave of corporate governance resolutions sponsored by institutional investors by putting pressure on someone higher than the money managers and bank trust departments; this time the pressure was put on their fellow CEOs. The shareholder resolutions that sparked this response concerned the adoption of poison pills; the resolutions either asked that they be rescinded or asked that they be put to a shareholder vote. Even if these resolutions received majority votes, they would still be nonbinding, and advisory only.

Nevertheless, some of the CEOs of companies that received these resolutions from shareholders wrote letters to other CEOs encouraging them to make sure their pension funds shares were voted against the resolution, suggesting something like: “You support me on this one, pal, and I’ll support you when it gets to be your turn.” Some of the letters included the implication that a vote against these proposals would be in the interest of shareholders/plan participants and therefore consistent with the fiduciary duty imposed by ERISA. International Paper’s letter, however, did not even bother with that.

The Labor Department responded on February 23, 1988, with a widely released letter to Avon formally adopting what had been the consistent policy of the department since the passage of ERISA: ownership powers, including proxy voting, because they have economic value, are an asset of the plan and are therefore subject to the same standards as the other assets. This was followed by a series of increasingly focused statements and rulings by DOL that, along with the rising activism of public pension funds, provided the momentum for the seismic impact of institutional investors on corporate governance.

The simple statement that the right to vote must be exercised with as much “care, skill, prudence, and diligence” (ERISA’s fiduciary standard) as the right to trade doesn’t sound as if it could turn the world upside down, but, coupled with the Labor Department’s promise to start enforcing that standard, it did, at least in that part of the world that votes proxies. The later rulings and releases, including the 1989 “Proxy Project Report,” underscored the department’s commitment to this issue.

A fiduciary who fails to vote, or casts a vote without considering the impact of the question, or votes blindly with management would appear to violate his duty to manage plan assets solely in the interests of the participants and beneficiaries of the plan. We will be vigilant in assuring that pension fund fiduciaries handle proxy voting as they handle any other corporate asset – namely not for the benefit of themselves or third parties, but for the benefit of participants and beneficiaries.7

Investment managers could no longer shrug off the responsibility; the Labor Department said they were stuck with it, and stuck with doing it right, unless the plan sponsor retained the voting authority itself, in which case they were stuck with the responsibility of doing it right.

This put corporate management in a catch-22. In the late 1980s, thousands of corporations urged their own shareholders to let them adopt various antitakeover devices. But is what you can adopt, with permission (however obtained) from your shareholders, different from what you can support, when you are acting “for the exclusive benefit” of pension plan participants?

For example, one popular item was “elimination of the right to act by written consent.” Most states, including Delaware, permit shareholders to take any action they could take at an annual meeting at any other time, by “written consent”something like a petition or referendum. Corporate management saw this as a threat, and why should they feel vulnerable 365 days a year, when they could bring it down to 1 (the day of the annual meeting) by eliminating that right? (The ever-ingenious Martin Lipton recently proposed to reduce this “feeling of vulnerability” even further by holding the “annual” meeting and election of directors only once every five years.) So, many boards then quietly did away with the right to act by written consent by asking shareholders to give it up, claiming that it promoted “instability.” And in every case but one (Honeywell, to be discussed later), they did.

Now let’s say that the management of one of these corporations is considering how to vote its proxies (or how to evaluate the way that their investment managers vote its proxies). Can they, acting as fiduciaries on behalf of their current and retired employees, find any way to justify relinquishing the right to act 364 days of the year? On the other hand, how could corporate management have one policy for the provisions they urged on their own shareholders and another for the provisions they evaluate when they themselves are shareholders, through their pension fund?

Elmer Johnson has a unique perspective on the private pension system in America today. He was one of the few individuals ever to be engaged by General Motors at the top level – general counsel and director – and then return to the private practice of law. He recently wrote a trenchant analysis of today’s private pension system in the Harvard Business Review, urging corporations to become more involved in the administration of their pension funds, including their ownership rights.

Ever since the creation of ERISA in 1974, boards of directors and their legal counsel have been driven chiefly by the fear of legal exposure. In establishing the apparatus for the administration of corporate pension plans, they were mainly concerned with how best to insulate directors and officers from fiduciary liability. As a result, boards abdicated even their ethically nondelegable role of establishing overall direction and purpose. That abdication can no longer be excused in light of the explosion in the size of pension assets and the failure of the investment community to provide a climate conducive to the building of long-term wealth-generating institutions. Legal counsel needs to become much more imaginative in protecting boards against undue risk of liability, while reasserting the board’s oversight role.8

On the face of it, no one could have more interest in trying to develop a system of corporate governance based on ownership than the private companies whose pension plans are themselves the largest holders of equity. Elmer Johnson suggested a place to begin: “For example, large corporations might create a special top-level executive office to identify opportunities for long-term equity investments of very substantial size and voting influence.”9

But many of the largest and most influential ERISA plans are run by the largest companies, such as AT&T and General Motors, which were considered takeover-proof and were therefore impervious to many of these problems. One of the most serious consequences of the failure to organize private plan ownership is that the agenda is being created without their input, which in some cases results in waste of effort and needless confrontation. For that reason, plus increased Labor Department scrutiny, and, not the least, because the best way to guarantee support for management is to let management make the decisions, corporations are taking an increased interest in the way they vote their pension plan proxies .

The Business Roundtable has encouraged its members to bring proxy voting inside the company, no longer leaving it to the money managers. A. Brewster Atwater, Jr., chairman and CEO of General Mills and chairman of the Business Roundtable’s Task Force on Corporate Governance, proposed in a letter of January 17, 1990, that corporations consider taking back the voting authority customarily exercised by their investment managers. This is a step that could be either in the right or in the wrong direction. If it is simply a device to ensure that the process is carefully controlled to guarantee pro-management votes, the plan sponsors’ take-back of the vote could involve serious violations of law and further destruction of trust. After all, this means that corporations will be voting the stock they hold in their customers, their suppliers, their competitors, possible players in a friendly or unfriendly business combination, and even in themselves. On the other hand, if the corporation is prepared to undertake the difficult problems of managing this asset in a structure protected from conflicts of interest, this could be the critical step in reestablishing the competitiveness and legitimacy of American corporations. Atwater’s suggestion was pivotal for the development of governance. We believe, however, that it can be accomplished only by the creation of an entity within the corporation that is itself protected from conflicts of interest – probably a subsidiary organized under the Investment Advisor Act – and reporting directly to a committee of outside directors of the board.

Bank Trusts: A Contradiction in Terms

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Another large category of institutional investor is the banks, which act as trustees for everything from gigantic pension plans to the estate that rich Uncle Hubert left to Aunt Marie (who can’t be bothered about the details of money and just needs to cash her dividend checks) and wayward son Richie, who can’t be trusted with the principal. For the moment, though, we will concentrate on Aunt Marie and Richie, and other individual beneficiaries designated by the person establishing the trust. Trust administration is dominated by the complexities of federal income, gift, and estate taxes. Like other institutions, trusts have different classes of beneficiary with different kinds of interests. Aunt Marie may want to invest for income, whereas Richie might want to invest for growth or to persuade the trust to invest in one of his get-rich-quick schemes.

In most instances, the trust is irrevocable; unless there is fraud, which is almost impossible to discover or prove, the bank can continue to serve and collect fees as trustee, regardless of its investment performance. The security of the trust business may well be the reason for the traditional poor investment performance by banks. After all, in literal terms, they – unlike the beneficiaries – have nothing to lose. Again, the issue is “other people’s money.” What kind of theory will underlie the way the bank trustee votes proxies?

A bank trust officer is a very special kind of person. He derives his sense of accomplishment from being reliable and from being able to meet the needs of his clients, and he usually defines those needs as reliable payments. What you get with a bank trustee is a level of confidence that the trust assets will not be looted. Usually he exists outside of the main culture of the bank; he is not on the track to the CEO’s office.

And this is just what the bank wants. Someone setting up a trust is entitled to believe that the U.S. Trust Company, for example, is going to maintain certain standards – and these do not include encouraging iconoclastic trust officers. Banks generally get the most profitable, and certainly the most interesting, portion of their business from prominent local corporations. The smaller the community in which the bank is located, the more its tone is apt to be dominated by the locally based businesses. There is no way that a bank executive is going to be promoted on account of courageous positions of any kind, especially with respect to positions contrary to management’s recommendations on proxies. The mediocrity inherent in a lowest-common-denominator culture that applies to personnel as well as policies, added to a lack of incentive for risk taking, ensures that bank trusts will be administered in an atmosphere of establishment orthodoxy.

In the late 1980s, Karla Scherer watched the value of R.P. Scherer Corporation, a company her father had founded, deteriorate under her husband, the CEO. As a major shareholder and board member, Ms. Scherer soon realized that the inefficiently run company would be more valuable to shareholders if it was sold. However, the board repeatedly refused to consider this option, forcing her to take the matter to shareholders in the form of a proxy fight for board seats. She also ended up in court, challenging the way her trust shares were being voted.

Scherer recalls that the most devastating blow to the ultimately successful campaign to force a sale occurred when she had to deal with certain institutional investors.

Manufacturers National Bank, the trustee of two trusts created by my father for my brother and me, indicated it would vote all 470,400 shares for management, in direct opposition to our wishes. Remember the bank’s chairman sat on our [company’s] board and collected director’s fees as well as more than one-half million dollars in interest on loans to [R.P.] Scherer. During the trial, the then-head of the bank’s trust department admitted under oath that he did not know what the “prudent man” rule was. He also stated that he had arrived at his decision to vote the stock for management in less than 10 minutes, without conferring with us and after affording management an opportunity to plead its case over lunch in a private dining room at the Detroit Club . 10

Several years ago, the then-CEO of the U.S. Trust Company ran a series of advertisements in which he offered to resign as trustee of any trust at the request of a customer. On behalf of my wife, beneficiary of a trust established by her late grandfather, I decided to accept his offer before it was withdrawn. I began by asking a simple question: How was the trust doing? It turned out he couldn’t tell me. His letter, written seven months later, is a miracle of polite obfuscation.

Daniel P. Davison to Robert A.G. Monks, October 15,1986

Dear Mr. Monks:

I apologize that no one has replied to your letters of March 8 and March 31. There is no excuse for such lack of courtesy, but a reason may be that we cannot really be responsive to your request for a review of your trust to see how it has fared vis-a-vis inflation, nor are we prepared to resign. Let me explain.

As to the first, it would be doubtful if we could track back all the necessary transactions through the decades. We would be looking for some needles among literally billions of transactions. If we could perform the well nigh impossible, it would cost tens or possibly hundreds of thousands of dollars to do it.

Secondly, the information gathered would then have to be weighed against some background factors such as the constraints of the instruments and the intentions, oral and written, of the settlor, beneficiaries and remaindermen. Some of these might be quite subjective. We would then have to set up data bases and adopt inflation criteria, e.g., CPI regional, national or international or GNP deflator or whatever. Then we would have to agree on what method of performance measurement we should adopt – dollar weighted, time weighted, etc. etc.

To state the matter bluntly, we probably can’t do it; if we could it would be horrendously expensive, and if we could and did the results would be hard to judge. U.S. Trust has a business of measuring the performance of others. We don’t do it retrospectively. It makes some sense to do it when the results are read by sophisticated investors who understand the limitations of the process.

I believe the best reply to your query would be that the study of history is somewhat beside the point. Our joint interest is that future performance be up to snuff. Adequate compensation is no guarantee of this – but inadequate compensation almost certainly will result in inadequate performance.

You point to an accurate press quotation that I advocate provisions in trust instruments permitting a change in trustees. I think this provision is important from the Company’s point of view. There is nothing more enervating than a customer that can be taken for granted. However, we cannot insist on this provision since settlors frequently do not want beneficiaries to have this kind of discretion and usually for some sound reason. If we agreed to resign upon request where the instrument has no specific provision we would almost certainly be hauled into court and charged as a faithless trustee.

I have a certain sympathy for persons who are charged higher rates and don’t have the right to refuse them by walking. There is however real protection. The law requires us to charge uniform rates. About 50% of our business can be terminated at will by our clients; thus we must remain on the market or we will soon be out of business.

Pardon my prolixity, but I thought you should have as full an answer as possible, especially in view of our failure to reply to your first request.


Daniel P. Davison

Translated into English, the letter says that he couldn’t tell me how the trust was doing, because it would require separating transactions pertaining to her trust from thousands of others undertaken by the trust department. Imagine getting the same response if you asked the bank for a record of your checking account. Could they possibly respond that it would be too difficult to separate your checks from those of all their other customers?

He then goes on to say something that boils down to this: We do actually look at performance of accounts managed by other people, as one of the services we make available to people, unlike me, “sophisticated” enough to understand it. (Too bad they don’t use that service themselves.) Anyway, we don’t really look to the past in figuring out performance; we look to the future. In other words, forget what we have done so far, and listen to how well we will do someday.

Finally, he says that, despite the apparent claims in his ad, the bank just could not step down as trustee, no matter who asked for it. Not a bad deal. The guy who set up the trust and appointed him trustee is dead, and the trustee is therefore set for as long as the trust exists.

I was in that business myself in the late 1970s, as chairman of the board of the Boston Safe Deposit and Trust Company, and I was astounded to find a generally low level of service and minimal fiduciary concern for beneficiaries throughout the industry. One example of this was the practice, virtually universal until recent times, of administering trusts as if they had uninvested cash balances, attributable to delays in settlement and the like. In fact, the banks had very sophisticated “clearing” capabilities, required by their corporate pension clients, which permitted the daily retrieval of all cash entitlements. These differences between collected and reported cash were invested for the bank’s own account and represented a significant share of the bank’s total profits. This is what lack of accountability to beneficiaries produces.

Bank trusts are established with money made by some ancestor who at some time in the past successfully invested in a business. Tradition has it that few of the heirs inherit the ancestor’s appetite or business acumen. That may or may not be true, but it is certainly true that most inherit the belief that a system that made them rich is not all bad. They can’t even get reports on how the trust is doing; even if they want to know how the proxies are voted, why would the bank tell them? Aunt Marie and Richie won’t notice whether the ownership rights are being exercised, much less encourage their trustees to assert them. A bank trust department has nothing to lose from voting with management on every proxy, and a lot to gain in commercial relationships. Therefore, there is little support anywhere in the banking system for trust officers to take on themselves responsibility as owners of portfolio companies.

But, like corporate pension funds, bank trusts are beginning to recognize that they have an obligation to take on that responsibility. The reason is the same: a strong interest from the federal government. Institutional Shareholder Services wrote to the office of the Comptroller of the Currency, asking what its policy was on voting proxies, and we got a letter saying that it generally endorsed the standard set forth by the Labor Department in the Avon letter. The Federal Reserve Board has proxy voting on its audit checklist.

Largely because of the role banks play in voting ERISA securities, they are becoming more sensitive to these issues, but because they are risk-averse and conformist by nature and practice, banks will respond to regulation and to conventional wisdom established by others. They will not be pioneers.

Mutual Funds: One-Night Stands

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Mutual funds are trusts, according to the terms of the Investment Company Act of 1940, which governs them. Otherwise, they bear little resemblance to the other institutional investors because of one important difference: they are designed for total liquidity. The “one-night stands” of institutional investment, they are designed for investors who come in and out on a daily basis, or those who just want to be able to.

Congress wrote a law distinguishing two kinds of pooled investment vehicles for public shareholders – good ones, which are called “diversified,” and bad ones, which are the rest. Diversification is required for entitlement to the favorable tax treatment of Internal Revenue Code Subchapter M, which alone makes mutual funds a competitive mode of investment. In general terms, it requires that mutual funds act as passive participants and not as owners of the companies in which they put their money.

Although the aggregate shareholdings of the mutual fund industry are large, they are scattered over a large number of individual funds. Each represents a specific investment objective. If you want to invest in a mutual fund, you can pick one that focuses on high-tech companies, on “socially correct” companies, or on whatever companies are likely to produce quick profits. You can invest for income or for growth. The fund is more liquid than a piggy bank. The investors are entitled to take their money out at any time, at whatever the rate is that day. The investment manager has no control over what will be paid out or when a holding will have to be liquidated. The fund manager thus must view investments as collateral to the promise to shareholders to redeem their shares at any time. This is not the kind of relationship that encourages a long-term attitude toward a company the fund happens to invest in, and if there is a tender offer at any premium over the trading price, they have to grab it.

Mutual funds perform an astonishingly difficult task in providing to potential investors a hybrid investment alternative. Each fund proclaims its own objectives, its own balance of risk and reward, of current and deferred income. There is no one corporation that embodies the precise promise made in a mutual fund prospectus. That promise is realized only by the blend of holdings that the fund manager picks. In the face of the real need to attract new money and to retain investors in a world of perpetual competition, the mutual fund manager cannot be concerned with the long term; his investors may all show up today, and he has to be prepared to deliver.

Edward C. “Ned” Johnson III is the archetype of an entrepreneur and a proprietor. He is the controlling shareholder of Fidelity, the largest privately held money management group in the world, and he can be considered the founder of the modern mutual fund industry. When you walk up Park Avenue in New York north of Grand Central Station, you may wonder what happened to all of the street-level bank offices that were once on every corner. Indeed, in this 10-block span, there is only one walk-in office in the financial services industry; it is Fidelity, on the northwest corner of 51st and Park. Johnson has outbanked the banks.

Fidelity has the customers and the money. It loans money to banks. This revolution in the American financial industry is substantially attributable to the vision, the persistence, and the genius of Ned Johnson. When Johnson started with Fidelity, there really was no “industry.” Investing was an art; in good times people bought shares, and in bad times the managers held on. The problem was sales. A direct sales force cost too much, and the brokerage community was always uneasy about using its salespeople to distribute someone else’s product. Johnson began a direct sales campaign that, over a period of several decades, has resulted in an estimated four million customers.

To accomplish this, he had to think in the longest possible terms and defer Fidelity’s earnings for years at a time. He revolutionized sales, customer service, computerization, product design, and diversification. Johnson’s own commitment goes beyond money. There was a time not long ago when American Express was prepared to talk in terms of 10 figures for the purchase of Fidelity. It was both meaningless and unthinkable for Johnson. His commitment is one of personal creativity, of using money, people, and determination to keep creating better and more useful products.

Johnson is himself an excellent investor. A footnote in the history of Fidelity is that while Gerald Tsai’s highly publicized fund was the group’s second best performer, Johnson’s was number one. Fidelity owns some stock in virtually every publicly owned company. There are few people alive who have a keener sense of the responsibilities (and opportunities) of ownership and of the managerial ethic than Ned Johnson.

Johnson on the Managerial Ethic

There is another challenge, one that has been written about piece-meal in the press and has received none of the fanfare that is reserved for tax reform. It has to do with the diminishing rights of the individual shareholder in the American corporation and the heretofore passive role of mutual fund and pension fund managers.

As corporate managements have attempted to thwart hostile mergers and takeovers, with various devices – staggered board of director terms, golden parachutes, golden handcuffs – they have, in the process, erected impenetrable barriers between themselves and their shareholders. The situation can be compared to the declaration of war by a faltering democracy.

American corporate management is declaring martial law. And although they succeed in defending themselves in the short run, they have sacrificed the rights of the individual corporate shareholder in the long run. Their actions may also be demoralizing to employees and may affect the performance of every part of the corporation.

There are no easy responses to this phenomenon, but I am certain that we will see a time when shareholders and government regulators step in and call ‘time out.” And it will become extremely difficult for mutual fund managers and pension fund managers to maintain the totally passive role of dormant shareholder. As individuals, we must consider responding when corporate managements demonstrate overreach, as in the recent merger of two industrial companies, Allied and Signal, to cite but one example.

To exercise our rights as shareholders is only sound business practice. If the companies whose actions we ignore should fall on hard times because of highly questionable management decisions, then our investments lose their value.

Edward C. Johnson, speaking at the Annual Meeting of the Investment Company Institute, May 21, 1986.

Fidelity has played a powerful behind-the-scenes role in many corporate dramas. One might well ask why Ned Johnson is not the shareholders’ champion. It is not that Johnson lacks tenacity, is unaware of the problem, or, like other investment managers, is cowed by commercial relationships – quite the contrary. In selected situations, he has been the model of a concerned, involved shareholder, even when it has cost him clients. The problem is that the stewardship of a business such as Fidelity requires a sense of priorities. No matter how Johnson feels about the problems of a particular corporate management, he must recognize Fidelity’s principal mission. His overall goal – and his obligation as a fiduciary – is to make money for his own investors. He does not want his analysts to be at a disadvantage in talking with company managements. And although he is willing to lose a client or two in a given situation, he does not want to be “blackballed” in every competition to manage corporate pension funds. 11He is also restricted by the limits of his funds, which are designed to meet the needs of people who want constant access to their money. In short, he is restricted by the same problem of collective choice that restricts any shareholder, of any size: how can he underwrite all of the costs of activism for only a pro rata share of the profits, if there are any?

Institutional Investors and Shareholders

[O]wning stock and not being able to assert your ownership rights is like owning a piece of land over which you have little control. If you can’t walk on it, garden it, put a fence around it, or build on it, it isn’t worth much. If American corporations are owned by stockholders who can’t assert their ownership rights eventually the ownership may not be worth much either. . . . I believe that a number of steps must be taken to reinforce the rights of shareholders or they will be completely disenfranchised.

First, institutions must act like the permanent owners of the businesses in which they have invested and exercise their shareholder rights. Institutional investors, especially those who are investing other people’s money, have an obligation to be intelligent shareholders. They must read and vote proxies, understand the factors affecting a company’s business, and make their views on important issues known to managers and directors.

Second, institutional investors should put pressure on directors to be more responsive to shareholder concerns about long-term strategies and the productive use of corporate assets. If directors are consistently unresponsive to shareholders, they should be voted against when they are up for election or reelection to the board of directors of any publicly held company.

Source: Letter to shareholders from Edward C. Johnson, April 3, 1990.

But he has removed some restrictions. In 1990, he announced some changes to the charters governing his funds, putting his investors and the companies he invests in on notice that he understands the value of involvement in corporate governance. Fidelity is founded on the notion that equity securities represent valuable merchandise. As it becomes clearer that courts, legislatures, and lobbyists have changed the nature of the tens of billions of dollars of common stock held by the various Fidelity funds, Fidelity and Johnson may have no choice but to move governance up to their highest priority.

Dean LeBaron, trustee and sole owner of Batterymarch, may well be the most innovative and creative professional money manager presently active. He developed index funds before there was such a thing. To list some of his many initiatives – copra plantations in New Guinea, farmland in the American middle west, British Commonwealth Funds, Brazil Funds, and innovation in developing computerized trading – is like describing the visible part of the iceberg. Most recently, he developed the fund allowing American companies access to technology developed by the Russians. It is virtually impossible to reflect on any aspect of the modern money management business without following the intellectual or professional path of Dean LeBaron.

The son of a Boston doctor, LeBaron managed to survive prep school and Harvard’s college and business school with his enthusiasm and creativity undampened. His brief apprenticeship as respected research director of a nationally renowned brokerage firm led, seemingly inexorably, to his self-employment as the principal of Batterymarch, one of the largest and most successful money management firms in the country. LeBaron has been uniquely willing to speak out about what he sees as management abuse of owners. It is certain that this concern has cost him the opportunity to manage the pension funds of companies, whose executives consider “ownership activists” the enemy. It has cost him a great deal of money. He has been so successful that the loss of some business does not matter to him. But that is not the point. The point is that only the rare person who is accountable, from a business point of view, only to himself can articulate concern over the governance of corporations. For LeBaron to do so means commercial loss; for others it means slow death.

Confronted by the indifference of fiduciaries to the value of their voting rights on the one hand and by the volume and ingenuity of the proposals he was receiving for the use of his voting position on the other, Dean LeBaron developed a typically imaginative proposal. He advocated separating the vote from shares and establishing a separate trading market for each – a market for voiceless shares and a market for voice. This would demonstrate the “dirty little secret” that everyone was trying so hard to ignore: that votes have value, and the value belongs to the owners of the shares. No longer would trustees, out of desire to avoid work, expense, and possible confrontation, be able simply to decline the responsibility for voting portfolio holdings.

LeBaron is an energetic and charming advocate. He made an unforgettable appearance on a forum with T. Boone Pickens. Pickens expressed his outrage with the notion of “vote selling,” calling it “un-American” even “prostitution.” Dean coolly replied that if “you are going to use it, you had best be paid for it.” In many ways, Dean’s memorable demonstration that votes have value may be considered the beginning of the modern period of shareholder activism.

Insurance Companies: The Untouchables

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Insurance is the only major industry that has successfully avoided any significant federal regulation, although life insurers’ “separate accounts” and money-management subsidiaries often invest ERISA fund assets and are subject to ERISA and other federal rules when they do. Life and casualty insurance companies prefer to deal with state legislatures, with whom they have historically had a close relationship. As chairman of the Finance Committee of the Republican party in Massachusetts, I listened to the chief executive officer of one of the largest mutual insurance companies explain why it would not buy a book I had published, as a means to enable corporations to support us without making a direct political contribution. “You don’t understand, Bob. We have already purchased both parties in the legislature through directing agency commissions, and buying your book would just make us do something extra for the Democrats.”

State law has, until most recent times, severely circumscribed the extent to which insurers are allowed to invest their own funds in equities. Even today, only 14 percent of insurance fund assets are invested in common stocks. The current limit on stock is 20 percent of a life insurer’s assets, or one-half of its surplus. But insurers still cannot take influential blocks; life insurers cannot put more than 2 percent of the company’s general account assets into the stock of any single issuer, and property and casualty insurers cannot control a non-insurance company. 12

The insurance industry has been able to dominate state legislatures. Even though they are clearly in the mainstream of interstate (and often foreign) commerce, they have successfully and assiduously avoided general regulatory supervision by the federal government. However, this did not prevent the industry from arguing vociferously before the United States Supreme Court, in the fall of 1990, that the federal Constitution should be applied so as to limit “punitive damages” awarded under state law. The insurance industry really is best thought of as a foreign country with interests that are not always congruent with those of the general public.

The insurance companies, perhaps more than any other class of institutional investor, have a symbiosis with the companies in which they invest. First, they are usually holders of debt securities of any company in which they have an equity investment; debt instruments are very compatible with their needs because they have a reliable, set payout. Second, either they have a commercial relationship with the company by selling it insurance against a variety of risks, or they would like to. Third, they certainly want to sell the company insurance company products to meet its pension obligations. Finally, like other institutional shareholders, they are under no obligation to report to their non-ERISA customers on their proxy voting (but the companies whose proxies they vote – and with whom they do business – do know), and, like all other shareholders, the collective choice problem makes any form of activism uneconomic. Therefore, it is not surprising that the insurance industry consistently votes with management, regardless of the impact on share value. A major IRRC report recently stated:

A major insurance company that had established a policy of voting proxies against “fair price” provisions reversed itself under pressure from several of its largest corporate clients.

Another insurance company, owned by a large industrial company, had a similar, tough policy but is now being advised by its parent company on how to vote on antitakeover amendments – in most cases based solely on the parent’s relationships with its client. 13

A considerable exception is the Teachers’ Insurance and Annuity Association and the College Retirement Equity Fund (known universally as TIAA-CREF), the retirement fund for college professors and administrators and other employees of nonprofit institutions. With over $80 billion in assets invested in virtually all sectors of the U.S. economy and in the economies of 26 foreign countries, TIAA-CREF is a prominent presence in the financial arena. It includes both insurance and mutual fund components. TIAA-CREF is the institution that most closely approximates the ideal institutional shareholder, as is clear from a few introductory words from its own 1990 publication, TIAA-CREF: A Concerned Investor:

TIAA-CREF management and trustees have always emphasized the need for careful examination of the pension system’s investments and their relationship to various shareholder issues, both social and economic. As a shareholder in some 2,400 companies, CREF exercises both a right and a responsibility in voting shareholder proxies, since the outcome of such votes can affect investment values. Concern with, and participation in, issues affecting its operating environment is consistent with TIAA- CREF’s own corporate mission, which stems from Andrew Carnegie’s recognition that retirement security for educators is important public policy. 14

As you would expect from an institution having notably educated and concerned individuals as a constituency, TIAA-CREF has exemplified thoughtful presentation of both the financial and the social issues of concern to shareholders. Over 20 years ago, TIAA-CREF decided that the time had arrived to challenge the “Wall Street Rule” of sell or vote with management with respect to its 608,700 shares of General Motors.

In explaining CREF’s new policy, Chairman William Greenough wrote GM CEO James Roche:

Much is said of maximization of profits as if it is a concept incompatible with improvements in the quality of life. Not at all – especially not in the long run…. We want and expect the companies in which TIAA and CREF invest to take leading roles in solving economic and social problems related to the products these companies produce. We are confident that this will be the only way to maximize the long-range profitability of those companies and justify our continuing investment in them as a means of enhancing retirement security of college teachers. 15

In the years since, TIAA-CREF has been innovative and imaginative but always low-key in exercising its ownership responsibilities. Dr. Clifford Wharton, the highly respected chief executive of TIAA-CREF, told a distinguished audience at Northwestern University in November 1990 that the existing legal and regulatory structure does not at all accommodate the needs of owners and managers. If a legitimate and effective institutional presence can emerge as an essential long-term element in the governance of American corporations, certainly TIAA-CREF – on account of its tradition, its leadership, and its constituencies – will play a leading role. Otherwise, the prospects for constructive involvement by the insurance industry are poor.

Universities and Foundations: The Ivory Tower

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Universities and foundations are institutional shareholders because they are usually funded through endowments. People contribute to a fund, and the interest that fund generates is used for whatever charitable or educational purpose the endowment permits. The J. Paul Getty Trust has $3.98 billion. The Ford Foundation has $5.83 billion, and the MacArthur Foundation (the one that gives out the “genius grants”) has $3.13 billion. This money is put into widely diversified investments, including common stock. Nonprofit institutions are as rigorous as any other investor in making sure their investments produce high returns. But they have not been rigorous about exercise of ownership rights.

Universities teach ethics, and charities fund efforts to promote a higher level of conduct, including ethical conduct. Both groups spend a lot of time thinking about the best ways to use the income generated from their endowments to achieve these goals. But it is rare for them to consider their own ethical responsibilities in connection with the governance of the companies they invest in. Sometimes the universities taught better than they knew; student protests in the 1970s over endowment investment in companies doing business in South Africa led Harvard and a group of others to found the Investor Responsibility Research Center (IRRC), a nonprofit charitable group, to research the issue.

Foundations and universities are no less subject to commercial pressures than banks and insurance companies. After all, their money comes from alumni, who are often business executives, and from businesses themselves. One study reported that in 1985 corporate contributions to American universities and colleges “surpassed donations from alumni for the first time.”16 Indeed, nonprofits are “selling” a much less tangible product, so they must be extra diplomatic. Foundation and university trustees are usually drawn from the business community. The trustees of the Ford Foundation, of Harvard, of any museum or symphony, and of the New York Public Library are usually drawn from the same list as the directors of the S&P 500. In Chapter 3 we mentioned the college whose president served as head of the compensation committee of the company headed by his chairman of the board and large contributor.

Possibly the most poignant anecdote illuminating this trend concerns the premature resignation of Henry Ford II from the Ford Foundation, of which he was a founding trustee and his family were the sole contributors. He made it clear that the policies and grants of the foundation were fundamentally so antithetical to his sensibilities that resignation was the only honorable course. Sic transit gloria $3 billion.

Employees are beneficiaries of the pension funds. Investors are the beneficiaries of mutual funds. Who are the beneficiaries of charities and endowments? At Boston University, no one seems to know. The university sunk nearly one-third of its endowment in a risky biotechnology venture, and none of the beneficiaries has standing to sue for any eventual loss to the endowment. In 1987, Boston University president John Silber – who is largely credited with turning the university into one of the best in the country academically – persuaded his board to invest $35 million in Seragen, a small biotechnology firm organized around the work of a scientist at a BU-affiliated hospital. The investment was a $25 million stake, giving BU 70 percent of the company and a $10 million loan guarantee. Since then, the university has sunk $50 million in the firm, and discussions were under way for an additional $100 million investment in the spring of 1989.

Since the 1987 investment, Seragen has produced no product and no revenues, and plans for a public offering – which would give BU some of its investment back – fizzled in the wake of the October 1987 crash. Seragen’s product, a toxin to cure leukemia – and possibly AIDS and cancer – can take up to 10 years to test, and only I in 10 such drugs receives FDA approval. Meanwhile, BU has assumed the full cost of Seragen’s day-to-day operations.17 One BU official told Forbes: “It comes down to this: We’ve got a $1.25 million-a-month biotech habit, and there’s no way we can kick it.”18

Then, in late 1990, as Silber was running what looked like an unbeatable campaign for the governorship, Boston’s public TV station revealed that nine BU trustees and two BU officers were indirect investors in a Seragen subsidiary. The subsidiary had been sold off at a huge profit, while the parent company’s future continues to be uncertain. At a minimum, this raises questions of conflicts of interest.

Whoever the beneficiaries of Boston University’s endowment are whether the students, the faculty, or the administration – management of the Seragen situation does not appear to be in their interests. Nor is it in the interests of the people who contributed to the endowment in the expectation that its dividends would be used to benefit the university. One in three of the endowment’s dollars is in a firm whose survival is entirely dependent on the university’s continuing support, a firm that will not turn a profit until 1993 at the earliest. Yet beneficiaries are captives of the university’s investment scheme; none of them has the right to sue. Apparently, the only person who might have the right to sue is the state attorney general, who could claim that the rights of the public as a whole have been violated.

In the case of Harvard College, the trustees are the self-perpetuating members of the corporation. But for whom do they act as trustees? Current students? Current faculty? Future students and faculty? The long and the short of it is that one cannot really identify any individual or class as the object of fiduciary responsibility in the context of universities. In the case of foundations, it is even more difficult, and the only obligation that can be articulated is a generalized one of concern for the human race in the long run.

Derek Bok, the conscientious and insightful president of Harvard University, has over many years deplored efforts by military and intelligence agencies and businesses to use universities for purposes of their own choosing: “Social activists press the university to use its stock…to fight against apartheid and other evils and injustices.” He most eloquently stated his view of “institutional integrity” on the occasion of Harvard’s 350th birthday in September 1986, objecting to those who ask the university to “risk its independence by entering into political battles or ask it to act in ways that compromise the openness and freedom that characterize a healthy research environment. In all such cases, the problem is not that people seek the university’s help to solve a social problem but that they urge it to act in ways that contradict its proper nature and threaten its most essential functions.”

Bok expressed similar views on the university’s responsibilities as owners of stock in a letter of May 2, 1979, to me.

If Harvard undertakes to move affirmatively to police the social and ethical practices of corporations, we cannot deny the rights of others to exercise similar responsibilities vis-a-vis our own academic activities. I do not wish to encourage this process, not because I have anything to hide, but simply because I have come to distrust the competence and objectivity of many who would be likely to undertake this work and because I cannot afford to cooperate with any more investigations than are already thrust upon us by government agencies, accrediting bodies, visiting committees and the like.

Bok’s vision is of a world where the laudable objectives of education can be pursued without peripheral distraction. To be sure, American universities are not well equipped to be the leaders of activism. Whether this serves the beneficiaries of the endowment, present and future students, faculty, administration, and the community at large is one question. Whether it is necessary or merely convenient is another question. Perhaps the most important question, though, is whether society at large has any alternative better than the universities.

The Public Pension Plans: Big Daddy’s Legacy

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It all began on a morning in 1984, when Jesse Unruh, then the treasurer of California, read in the morning newspaper that Texaco had repurchased from the Bass brothers their 9.9 percent shareholding for $1.3 billion, a $137 million premium over the market price. He picked up the phone, called the chief investment officer of CalPERS, and asked, “Say, do we own any of that Texaco stock?”

The answer was startling: “Own any? We are one of their largest shareholders. “

“Do you mean these people can elect to buy out one class of shareholder at $55 and leave the rest of us in at $35?” Unruh asked the CalPERS staff. Yes, they can, they told him. “Like hell!” said Unruh. 19

As state treasurer, Unruh was trustee of the huge California public employees’ retirement system (PERS) and the state teachers retirement system (STERS). The treasurer job was almost an afterthought in a political career that spanned being JFK’s “man in California” at the 1960 Democratic convention to achieving the best results of any of Ronald Reagan’s four electoral opponents. In the early days of his speakership of the California House, his larger-than-life presence – both physical and political – made “Big Daddy” a natural sobriquet. The man who once said “money is the mother’s milk of politics” ended his career as a trustee for the largest agglomeration of institutional assets in the world. Unruh had a world-class personality, a world-class mind, and a world-class political sense. Although he was never particularly interested in business, there seemed to him something so fundamentally wrong with Texaco “greenmailing” the Basses that his formidable creative energies began to grope for an appropriate response.

There is a reason “greenmail” sounds like “blackmail,” although it is really more like extortion. Someone buys a large stake in a company and begins to make his presence known, perhaps by making noises about trying to take over the company. Management does not want him, so they offer to buy him out, at a substantial bonus over what he paid and what the stock is now trading for. But the trick is that management does not make this same offer to the other shareholders. They are stuck with what they can get in the market, which will almost certainly be less, as a result of this large cash payment being made to silence a potential dissenting voice.

This kind of payment is not in the interests of the shareholders. If someone wants to try to take over a company, there is always some value in seeing what he has to offer. How can derailing such an effort possibly be consistent with management’s duties of care and loyalty? Nevertheless, greenmail was widespread during the 1980s.

Someone once said that true change comes about when what has been seen as misfortune becomes seen as injustice. Greenmail was just the right issue to drive that home. Unruh quickly perceived that greenmail was an issue that, in political terms, could be sold in Pasadena. He got in touch with the trustees of other large public funds, which are less susceptible to commercial pressure than private plans. At this time, I was serving as the principal federal official in charge of the private pension system under ERISA and had begun to speak about the need for pension trustees to act like owners. Unruh and I met in Chicago on an August night when the temperature never got below 100 degrees. He described his notion of an association of institutional owners that would meet periodically to develop an ownership agenda and to provide a forum for learning about ownership issues. And so, the very Republican federal pension official and the very Democratic state treasurer agreed that the interests of fiduciary owners transcended partisan politics, and we worked together to promote these issues until Unruh’s death a few years ago.

This was the beginning of the Council of Institutional Investors. At one of the first meetings of the council, cochairman Roland Machold, the executive director of the New Jersey funds, presented the Shareholder Bill of Rights, a comprehensive statement of the core beliefs of the ownership group.

The Shareholder Bill of Rights


American corporations are the cornerstones of the free enterprise system, and as such must be governed by the principles of accountability and fairness inherent in our democratic system. The shareholders of American corporations are the owners of such corporations, and the directors elected by the shareholders are accountable to the shareholders. Furthermore, the shareholders of American corporations are entitled to participate in the fundamental financial decisions which could affect corporate performance and growth and the long range viability and competitiveness of corporations. This Shareholder Bill of Rights insures such participation and provides protection against any disenfranchisement of American shareholders.

I. One Share – One Vote

Each share of common stock, regardless of its class, shall be entitled to vote in proportion to its relative share in the total common stock equity of the corporation. The right to vote is inviolate and may not be abridged by any circumstance or by any action of any person.

II. Equal and Fair Treatment for All Shareholders

Each share of common stock, regardless of its class, shall be treated equally in proportion to its relative share in the total common stock equity of the corporation, with respect to any dividend, distribution, redemption, tender or exchange offer. In matters reserved for shareholder action, procedural fairness and full disclosure is required.

III. Shareholder Approval of Certain Corporate Decisions

A vote of the holders of a majority of the outstanding shares of common stock, regardless of class, shall be required to approve any corporate decision related to the finances of a company which will have a material effect upon the financial position of the company and the position of the company’s shareholders; specifically, decisions which would:

  1. Result in the acquisition of 5 percent or more of the shares of common stock by the corporation at a price in excess of the prevailing market price of such stock, other than pursuant to a tender offer made to all shareholders;
  2. Result in, or is contingent upon, an acquisition other than by the corporation of shares of stock of the corporation having, on a proforma basis, 20 percent or more of the combined voting power of the outstanding common shares or a change in the ownership of 20 percent or more of the assets of the corporation;
  3. Abridge or limit the rights of the holders of common shares to:
  1. Consider and vote on the election or removal of directors or the timing or length of their term of office or;
  2. Make nominations for directors or propose other action to be voted upon by shareholders or;
  3. Call special meetings of shareholders to take action by written consent or;
  • Permit any executive officer or employee of the corporation to receive, upon termination of employment, any amount in excess of two times that person’s average annual compensation for the previous three years, if such payment is contingent upon an acquisition of shares of stock of the corporation or a change in the ownership of the assets of the corporation;
  • Permit the sale or pledge of corporate assets which would have a material effect on shareholder values;
  • Result in the issuance of debt to a degree which would leverage a company and imperil the long-term viability of the corporation.

IV. Independent Approval of Executive Compensation and Auditors

The approval of at least a majority of independent directors (or if there are fewer than three such directors, the unanimous approval of all such outside directors) shall be required to approve, on an annual basis:

  1. The compensation to be provided to each executive officer of the corporation, including the right to receive any bonus, severance or other extraordinary payment to be received by such executive officer; and
  2. The selection of independent auditors.

It all came down to one principle: that informed shareholders should, proportional to their invested capital at risk, have the right to approve fundamental corporate actions.

Unruh’s greatest legacy was his articulation of ownership responsibility as something our nation desperately needed. It seems particularly appropriate that leadership has been exercised by those following him at CalPERS. Significant change is apt to involve a very few key individuals. The chief executive officer of PERS, Dale Hanson, and its general counsel, Rich Koppes, are perhaps the most important. The affable Hanson had spent his entire career in the Wisconsin retirement system before being chosen by the PERS trustees in 1987; Koppes’ service was in the health care sector of California state government.

The public servant against the corporate executive has a “David and Goliath” air about it. Few state governments have the staying power to challenge a major local corporation. We have already discussed in Chapter 4, the number of states that enacted special legislation to protect a particular company. But California is larger than any single corporation. So Hanson was able, for example, to ask for a change in the board of directors of Lockheed, an important California corporation. Hanson and Koppes routinely press the ownership agenda in conferences with executives and lawyers who earn as much in a month (in some cases, in a week) as they do in a year. Their strength is not in how much money they make, but in how much they manage and – even more important – in the patient, credible, and effective presentation of their agenda. This explains why they are the leaders in a cause that is of equal interest to all other owners.

It is fitting that the people most outspoken on the issue of accountability are themselves supremely accountable. Hanson is very conscious of the fact that he works for the 13 trustees of CalPERS, and Koppes is equally conscious of the fact that he works for the same trustees, as well as for Hanson. The PERS board meets monthly in sessions that can last three or four days. Trustees are hardworking and unpaid. The board includes a majority who are appointed nominees of the governor and representatives of other elected officials, the state treasurer, and the controller, totaling seven. The other six are elected representatives of the active and retired participants in the system.

The critical element in the board’s capacity to represent long-term membership interest is exemplified by the current president, Bill Ellis, a member for 15 years. Not only does he provide needed continuity, but his personal commitment that “the members’ interest takes precedence” is reflected in every aspect of the process and substance of the board’s activities. Ellis is always aware that he represents real people in contrast to abstract legal principles.

During a meeting in February 1990 at the Treasury Department in Washington, Hanson was asked by undersecretary Bob Glauber, “What is the secret? How can we create other boards like CalPERS?” At its core, the PERS board is grounded in the societal consciousness that ensures the compatibility of private power and the public good. The weight and tenacity of the PERS board is a reflection of the combination of constituencies representing current political concerns and the focused interest of the public employees, the character of the trustees, the willingness to commit long hours to a vast agenda, relative immunity from commercial pressures, and a competent and well-led professional staff.

CalPERS has $58 billion and expects to have more than $200 billion by the year 2000. Most of its equity securities are invested in index funds, as close to a permanent investment in the 1,500 largest American corporations as there is. This kind of trustee is a long-term owner of corporate America, who can be relied on to exercise the “legendary supervisory role” of the shareholder that James Willard Hurst talked about.

Dale Hanson was a compromise choice of a badly split board; it is testament to his skill and his collegial sensitivity that he has been able to get virtually unanimous support from the board for a careful but far-reaching agenda of corporate governance. Once a year, PERS adopts a corporate governance plan. The current plan identifies three major goals: to ensure that shareholders have the ability to select freely the best directors; to ensure that a company’s directors have the ability to fully and competently supervise the managers; and to promote shareholder participation in those areas that represent a potential conflict between the interests of directors and managers and the interests of shareholders.

PERS pursues these goals, in part, by submitting shareholder resolutions to companies of particular concern, to be included on the company’s proxy material. Some submitted in the past and expected this year include confidential voting of proxies, submitting poison pills to shareholders for their approval, and creation of shareholder advisory committees, the better to permit ownership-coordinated action. CalPERS works hard to be cooperative. The letters accompanying its proposals invite each company’s chief executive officer to meet with them to discuss ways in which PERS’s concerns could be met without the need to pursue the shareholder proposal. Hanson’s style is patient and direct. PERS withdrew proposals to create a shareholder advisory committee at TRW and Occidental Petroleum because management promised to provide an improved level of communication. “To the extent that PERS’ goal is to improve the responsiveness of company management to shareholder concerns, a corporate willingness to compromise represents an even greater indicator of ‘success.’ The vote results with respect to those shareholder proposals in which the companies were unwilling to compromise . . . create pressure for the companies to recognize the large number of shareholders who share a common concern.”20

Hanson and Koppes have a good perspective. Between the two of them, they participate in almost all of the academic projects targeting governance; they are the prime movers in institutions such as the Council of Institutional Investors; and they encourage, support, and cajole the energies of other funds and activists in the area. Above all else, they are thoughtful and professional in dealing with company managements. They do not want to run the companies; they are attempting to restore some level of monitoring to the corporate system.

PERS is only one of hundreds of public pension plans serving employees of states and cities, including everyone from the public school teachers and the librarians to the firefighters, police officers, dog catchers, state legislators, mayors, and governors. Each one is different. Hanson was selected by trustees, themselves selected by elected officials and by the beneficiaries of the system. New York’s Edward Regan is elected, one of only four statewide office holders.

As the elected candidate of the State of New York, Ned Regan is in the extraordinary position of being the sole trustee for the state’s common retirement fund. He also is a fiduciary for the state teacher’s pension plan. There have been repeated proposals in the legislature in recent years – Ned Regan’s among them – to create a more traditionally composed board. This “power” of Ned Regan drew a hostile reaction in the 1990 elections when his Democratic opponent Carol Bellamy revealed that Carl Icahn was a huge contributor and fund raiser for her campaign. Icahn was openly angry that Regan had voted against him and with Texaco management in the 1988 proxy contest. The comptroller is a thoughtful expert in governance matters and has authored several well-received articles on the subject. Regan has been so prudent in the exercise of his authority that there seems little public interest in taking it away.

New Jersey’s Roland Machold is a bureaucrat, a civil servant, and an important contributor to the development of the Council of Institutional Investors. New York City’s pension plan, for a long time under the jurisdiction of Harrison J. Goldin, a brilliant finance expert, is now run by former congresswoman Elizabeth Holtzman, who was also elected to the office and has brought her own perspective, with more emphasis on corporate performance. Each system produces different perspectives and priorities, yet there has been remarkable consistency in vision and goals in governance matters.

The 1,000-Pound Gorilla: The Federal Employees’ Retirement System

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Until 1986, employees of the U.S. government did not have a funded pension plan. The money would go in today, deducted from the paychecks of current employees, and it would go out tomorrow, to current retirees. The passage of the Federal Employees’ Retirement System Act of 1986 (FERSA)21 was, according to Newsweek, the biggest unreported story of the year. The reason it was unreported is obvious. The title alone contains at least three words that put people to sleep faster than Mandrake the Magician. And its purpose – creation of a funded retirement plan for federal employees – seemed unobjectionable in purpose and irrelevant to anything outside of Washington. But the statute is of unparalleled importance as a legislative accomplishment and for its inevitable impact on the stock market and the economy. As Newsweek said, the fund created by the statute may become “the largest lump of investment capital ever known, a wad that – if its managers so desire – has the clout to make or break huge companies, even national economies.”22 The Washington Post called it “a leap into the unknown,” adding: “At once it creates a new source of investment capital and a new benefit for federal workers, while at least holding the potential to become an administrative nightmare, a political football, a way of cheating on deficit reduction or a temptation for Congress to play the stock market.”23

This legislation was fueled by hopes of reducing the deficit. The total pension payout to nonmilitary employees was $26.7 billion annually.24 More than 25 percent of the federal payroll was going to pay people who were retired. The new statute reduced the federal cost to 22 percent of payroll.25 More important, it funneled a substantial portion of the outlay into government securities and changed part of the plan from defined benefit (like Social Security, where the benefit is established without referring to how much the employee put into the fund) to defined contribution (where the return on the employer’s and employee’s contributions to the plan determine the payout). The system is set up so that in its first few years, the investments mostly go into government securities, but as time goes by, more and more of them will go into common stock.

In a world of 900-pound gorillas, where a small pension fund controls $100 million and the top 20 pension funds control $621.8 billion,26 the FERS fund will soon be a 1,000-pound gorilla. The provision for lending the funds to employees for home purchase, education, or emergency may turn this program into one of the largest lending institutions in the country.

The federal government has thus had to consider in careful detail the question of its involvement as shareholder in private companies. During the legislative proceedings, concerns were raised about either Congress or the President being able to bring political influence to bear on large pools of thrift plan money. 27 The system was designed to prevent this kind of manipulation by use of an index fund. The government therefore established the unmistakable policy that pension funds for the benefit of federal employees may be administered only for the interest of participants and that equity investments will be made only by formula, to eliminate entirely the possibility of discretionary involvement by federal officials 28

The federal government carried over this policy of disinvolvement into the area of appropriate shareholder conduct. The statute prohibits the board from exercising voting rights associated with ownership of securities in the thrift fund, finding: “It is inappropriate for the federal government or its employees to vote these securities.”29 Who should do it, then? Former Social Security commissioner Stanford G. Ross squarely raised this question in his testimony before the Senate committee considering the legislation.30 The conference rejected the proposal in the Senate draft for a specially elected employee advisory committee to vote the fund’s shares and otherwise act as owner, and just said that it shouldn’t be a federal employee.

Social Investing, Part I: “But the Pension Fund Was Just Sitting There!”

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It is a truth universally acknowledged that a large pot of money set aside and dubbed inviolate will immediately be subject to all kinds of assaults. A pot of money the size of the pension funds could not escape notice. As Doonesbury’s Uncle Duke put it, “But the pension fund was just sitting there!” Although the laws creating public and private pension funds speak in traditional trust law terms of singleness of purpose in protecting and enhancing the value of the fund, that pot of money has been an irresistible target for policy initiatives. The traditional trust concept of an undivided duty of loyalty may not be possible in the context of pension funds, where both fiduciaries and beneficiaries are so divided in needs, priorities, and responsibilities .

Social investing is the term most often used for these activities, which cover a wide range of issues and methods. As we use it, social investing means making investment decisions, and other decisions relating to the exercise of stock ownership rights, on grounds that are unrelated to or in addition to the traditional investment concerns of minimizing risk and maximizing return. These investments are made because they are thought to provide intangible “quality of life” benefits to the pension plan participants and the community as a whole.

Social investing thus includes divestment from companies (otherwise investment-worthy) doing business in or with South Africa, for example. It also includes sponsoring or supporting shareholder resolutions opposing the sale of baby formula in third-world countries, the manufacture of materials for the Strategic Defense Initiative, or loans to Chile, or resolutions supporting the adoption of the Sullivan principles (equal rights in South Africa), the MacBride principles (equal rights for Protestants and Catholics in Northern Ireland), or company-specific initiatives on comparable worth and equal employment. And it includes investment in securities that might otherwise not meet investment criteria for risk and return, such as city employees’ pension fund investments in the city’s municipal bonds. Jesse Jackson’s economic recovery program, widely distributed during his presidential campaign, was founded on the use of public pension plan funds for programs such as low-income housing, the investments to be federally guaranteed.

Social investing usually involves selling off stock in a company to protest specific activities, such as doing business in South Africa, or buying securities that would otherwise not meet standards for risk and return, such as local municipal bonds. Sometimes social investing involves exercise of ownership rights, like submitting shareholder resolutions. An unusual example of social policy-related financial management was the State of Pennsylvania’s boycott of Shearson Lehman Hutton in 1988. Shearson was assisting in the takeover of the Pittsburgh company Koppers, a takeover many people feared would lead to huge layoffs. Shearson was not only acting as investment banker for the acquiring firm, but had loaned it $500 million and had agreed to acquire 46 percent of Koppers for itself if the takeover was successful.

Although the state had invested in Koppers common stock, it did not have enough to stop the takeover, so the state did what it could to influence the deal. State treasurer G. Davis Greene, Jr. suspended all state business activities (including bond business) with Shearson and its subsidiaries. Although this did not include any state pension fund investment business, a newspaper article reported that three subsidiaries of Shearson were eliminated from consideration for management of state pension fund assets.31 One state official was quoted as saying that Shearson managers could submit bids, “but they would have a hard row to hoe.” The takeover was ultimately completed in a manner that satisfied the state’s concerns, and the suspension was removed.

Social investing is the result of the clash of two competing policies. We want to guarantee workers a retirement income, and to do that the laws speak the language of trust law. But employees want to retire into a world free from pollution and injustice. And why should their money be used to support something they oppose?

As already noted, trust law did not contemplate a group of beneficiaries as large and diverse as ERISA plan participants. The interests of young workers, workers nearing retirement, and retirees are quite different even in conflict. A young worker might consider that social investing that ensures his continued employment is in his best interest. A retiree is looking for benefits right now. Some beneficiaries may consider it worthwhile to limit their returns and support divestment from companies doing business with South Africa. Others may feel that, for them, that trade-off is not justified, but other kinds of social investments are.

For defined contribution plans, where the workers put in a set amount and get back whatever the returns add up to, there is a stronger argument for allowing beneficiaries to make social investing decisions. Indeed, some pension funds give employees a choice among various investments, including one that is South Africa-free. The problem here is one of logistics – how do you select and present the choices? Social investing is based on the most personal moral priorities. If there is a way for an individual to make the decision, with the resulting investment still likely to produce a reasonable return relative to the other options, it should be permitted.

A defined benefit plan presents more problems. Under such plans, the company promises to pay a certain benefit. It may not be possible to allow individual plan participants to make social investing decisions because they are not the ones who will feel the consequences. The only option here is to choose between what some commentators refer to as “two prudent investments of equal financial merit.” A typical suggestion is that, in deciding between two such investments, “trustees should be able to choose the investment offering the more desirable indirect benefits to the pension fund or the greater benefit to its participants’ community.”32 But is there such a thing as “two prudent investments of equal financial merit”? Even if there is, it is more prudent per se to spread the risk by dividing the investment between the two. Divestment requirements limit the fund’s ability to diversify, however, and they may skew the investments away from particular categories of investments, such as large capitalization companies, which because of their size are more likely to do business internationally. Defined benefit plans do not permit the key element necessary for social investing: a way for the people who pay the price to make the decision.

Public plans, more in the political spotlight and more accessible to political maneuvering than private plans, have been more aggressive at pursuing social goals through the use of pension fund assets. Public funds are confronted with the same issues that government agencies face in any commercial endeavor. The government is not just a party to a contract, even one as much a part of the ordinary course of business as the purchase of supplies or the managing of pension fund assets. The federal government puts dozens of restrictions on grant money that have nothing to do with the purpose of the grant but promote other policy initiatives. Anyone building a highway with federal funds, for example, must certify that the construction company does not discriminate on the basis of race, sex, age, religion, national origin, or handicap, and that it meets certain other standards with regard to, for example, wages and environmental impact. The theory is that the government should not be promoting policy goals with one effort and subverting them with another. Despite the fact that compliance with each of these restrictions imposes costs (in addition to the costs of certifying compliance), there is some finding, through the political process, that the trade-off is worth it.

The same thinking has led to decisions – some legislative, some not that public pension funds should not, for example, invest in companies doing business in South Africa. Such policies are likely to limit the return to the fund (and the payout to retirees, and the risk to taxpayers, who must take up the slack if the fund falls short of its obligations). Some of these policies speak in terms of “two prudent investments of equal financial merit,” a standard whose problems we have already addressed. Others are designed to disregard or supersede the risk and return considerations. At some level, a trade-off is made.

The question is whether it is made by the right person, at the right level. By that, we again mean those who pay the price – the pension plan beneficiaries themselves, either directly or through agents with some accountability. Legislators are the only people in a position to amend a statutory mandate to maximize returns, and they may not be reelected if their social policy initiatives are inconsistent with the social goals of the electorate. From that perspective, they are in the best position to make the trade-offs.

But other aspects of their special role with regard to pension funds make them less suitable. The prospect of taking political action with no quantifiable, short-term budgetary impact is just too tempting. And because the expenses are off-budget, at least when they are made, there is a real risk of action being taken without careful thought.

The clearest example of this is the differing policies of the New Jersey, New York City, and New York State pension funds. The New Jersey fund, required by state law to divest, ended up selling out of two New Jersey pharmaceutical companies whose only dealing with South Africa was the sale of medicine used exclusively by blacks. This policy fails on moral grounds, by any standard. It fails on fiscal grounds, too. The Wall Street Journal estimated that the divestment policy has cost the plan $330-$515 million in two years.33 This is no different from taking as much as $515 million out of the state budget and spending it on a program that at least in this case, cannot be said to be successful. This should be seen as an expenditure, subject to the same procedural protections and deliberations as other expenditures of public funds.

Divestment can also interfere with the pursuit of other important goals. The California Public Employees’ Retirement System and Texaco have worked together to achieve unprecedented progress in achieving corporate governance goals, which benefit all shareholders. CalPERS is obligated by state law to sell out of Texaco, however, cutting short an effort that has been immensely productive. Pennsylvania PSERS, which worked with CalPERS on the Texaco bankruptcy committee and supported Texaco management during Carl Icahn’s proxy contest, was also required to divest its Texaco stock. The divestiture requirement is limiting the pension fund’s ability to work for goals that protect and enhance the value of its shares.

The city of New York, on the other hand, adopted a more flexible policy on South Africa. It began by writing letters to express its concerns and then sponsored and supported a number of shareholder resolutions calling for companies to adopt the Sullivan principles, a commitment to providing equal opportunity in their South African facilities. They sold out of a limited number of companies that they determined had business dealings that promoted apartheid, like those who do business with the police and military there. This more flexible approach is clearly the better way to promote the two social goals of protection of pension benefits and protection of human rights.

The New York State and Local Retirement Systems take a third approach to this issue. Confronted each year with a legislative proposal that would require it to divest its portfolio of stock in companies doing business in South Africa, valued between $3.9 and $9.2 billion, Edward V. Regan, the Systems’ sole fiduciary, formulated an alternative plan. Rather than selling their shares, the Systems used them to commence a massive program of shareholder resolutions calling for divestment from South Africa. Regan’s view is that mandated sale of stocks (for any reason) would impose unreasonable financial costs on the portfolio and force higher contributions from the taxpayers. By use of the shareholder franchise, he has negotiated results with the companies, thus meeting the objectives of divestment legislation without incurring the significant financial losses of such a program.

Social policy initiatives from pension funds have clearly been based on special-interest politics. This is not to suggest that the interests have been illegitimate; certainly, opposition to apartheid is an essential moral obligation of our time. However, the intersection of pensions and politics has led to peculiar consequences. There are countries with worse human rights abuses than South Africa, and yet we do not see them as targets of these initiatives.34 There is no reason to believe that divestment is a more effective means of stopping apartheid than other avenues. Many thoughtful people, inside South Africa and outside, have argued that staying in the companies and working through them to improve the opportunities for black South Africans is more worthwhile.35

And there have been challenges to social investing. An important distinction in deciding these cases seems to be whether the challenged provision permits or requires the investment. A New York State pension fund invested in Municipal Assistance Corporation bonds, which were issued by New York City to protect itself from bankruptcy. This investment, legislatively mandated, was invalidated on the grounds that it violated the state constitution’s prohibition against “impairing” the benefits of pension plan participants.36 On the other hand, the New York City teachers fund’s challenge to the law permitting their fund to invest in the MAC securities was not successful: “Under the unique circumstances presented – in which the survival of ‘the fund as an entity’ necessarily achieved prominence – the trustees’ investment decision was such as to fulfill their fiduciary obligations to the [retirement system].”37

A Michigan state law requiring state-run colleges to divest from companies doing business in South Africa was also struck down because it encroached on investment decisions that were the sole province of the school’s regents.38

Public plans also risk losing their tax-exempt status by making investments on other than strict financial grounds. Several proposals for a public-plan version of ERISA have been introduced, but state and local governments have been successful so far in keeping control over the public plans. These plans are subject to some federal standards, however: to maintain their tax-exempt status, they must comply with IRS requirements that have come to be known as “creeping ERISA” because of their reference to ERISA language on fiduciary obligation. 39

As a practical matter, public funds advocating social policies will find themselves in opposition not only to private investors but also to the fiduciaries of the private pension system, who are obligated under ERISA to consider exclusively the interests of plan participants and beneficiaries in their management of plan assets. The question, then, might be posed this way: Is there a useful purpose in having public plans propose a social agenda when it appears clear that a substantially larger shareholder block will be obligated to oppose it?

Those who hope to use pension fund assets to promote social policies have one important commitment and two important opportunities. Their commitment is to the funds themselves and to the beneficiaries whose investment they manage. They must therefore be utterly scrupulous in making sure that their investments provide the greatest possible protection for retirement income. But this does not mean that they have to ignore social concerns. Social goals can pay off. There is some evidence that “good guy” funds perform as well or better than funds managed without regard to social policy issues.40 Investment policies can be designed to reflect direct benefits from social investing.41 Pension funds have an important opportunity to create value through socially motivated investments, and they should do so.

An equally important opportunity is for pension funds to promote welfare through exercise of their rights as owners. Shareholder resolutions calling for specific action can be more effective – and more cost-effective – than divestment. Pension funds can sponsor and support resolutions drafted for an individual company’s situation. They can meet with management to discuss various options. Together, they can work for solutions that do well by doing good.

Social Investing, Part II: Whose Money’s Worth?

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If politicians and others with a social policy agenda were the first to recognize the potential uses of pension fund money, corporate management was right behind them. If pension fund money can be used to bail out New York City, they reasoned, why can’t we use it as well? What social policy goals could possibly be as important as the economic system of our own community? The issue here, again, is who decides what those goals are and how should they be implemented?

One of the most comprehensive examples of this second wave of social policy initiatives was the 1989 report prepared by the New York State Task Force On Pension Fund Investment, established by Governor Mario Cuomo. This is the clearest example of an effort by politicians and representatives of business to consider how they can use state pension money. Although this kind of inquiry is useful and important, and other states have examined this issue without abandoning their primary commitment to state employees and retirees, we believe that the Cuomo commission recommendations shift the focus of the pension fund from retirement security for state employees to job security for state corporate management.

The report included recommendations on the role public pension funds should play in the economy and the way they should respond to the increasingly complex issues they face as fiduciaries and as shareholders. Its recommendations would permit a wider range of investments, based on a wider range of investment objectives, which are based on a broader interpretation of the notion of beneficiaries. It called for “optimizing” rather than “maximizing” returns on behalf of “stakeholders” rather than mere “shareholders.”

The task force accepts without challenge and concludes without support that public pension funds play an important role in actions such as takeovers, which harm the economy of the state, that they should therefore be used as what amounts to a subsidy program for local businesses, and that doing so will in fact benefit pension plan participants and/or the state economy.

The task force reflects some of the compromises necessary for anything produced by a committee, especially one with membership as diverse as its own. But parts of the report are downright inconsistent. For example, it recommends that shareholders use “voice” rather than “exit”in other words, that they use their ownership rights to express their views, rather than following the Wall Street rule of selling out, if they disagree with management. As enthusiastic supporters of active involvement by shareholders in corporate governance, we agree wholeheartedly with this recommendation – until we get to the fine print, where it says that the use of “voice” should not extend to the “shareholder rights” issues, thus removing the substance of the recommendation. Without shareholder rights to establish the framework, there may be a “voice,” but whose voice, and what can it say?

The task force is also vague in answering the most important question, which is whether they are recommending that pension funds be used for investments that would otherwise not be considered prudent, in hopes of benefiting the state economy. They deny making such a recommendation, but if not, what are they talking about? The task force proposes the creation of a new state agency to identify, screen, and diversify the geographic and credit risk of “investments aimed toward economic development.” The problem with this recommendation is that there is really no proof that the asset managers currently employed by public pension funds are not providing this function. Indeed, it can easily be argued that the issue is not whether these kinds of investments are being identified by the funds’ current asset managers, but whether any truly investmentworthy opportunities are being missed. To the extent that such investments are not being identified by the wide range of commercial asset managers, using every kind of security analysis, market analysis, and innovative structuring of investments available, they are probably not prudent investments. Setting up such an agency could indeed interfere with the market’s ability to structure such investment rather than enhance it. Furthermore, similar programs have performed poorly and have been vulnerable to political manipulation and abuse.

The task force also recommends that the state provide credit enhancement of pension fund investments, additional guarantees for pension funds trying to carry out new economic development-oriented investment policies. However, there is no evidence that worthy investments are not adequately guaranteed. To the extent that the investments contemplated here are more risky, why should the state – or the taxpayers – make up the difference? It is important to remember (as if the savings and loan bailout could let us forget) that guarantee programs are not free, and can sometimes be very expensive.

We have no problem with the notion of “optimizing” returns, if that means no more than permitting pension funds to take the long-term view in analyzing their options. But the sense of the report is that the factors to be considered are so broad and so diverse that virtually any action can be justified, no matter how adverse the impact on shareholders or pension beneficiaries. Although the task force claims that it is not talking about social investing, putting money into investments that do not meet traditional standards of risk and return is, in fact, social investing, and that is precisely what it is talking about.

The task force’s bias is suggested by the title of the report: Our Money s Worth. Who is included in “our”? It is not “our” money; it is money that has been set aside to pay retirement benefits to state employees. It is only “our money” to the extent that it is managed poorly, requiring additional tax dollars to make up the difference. Broadening the range of constituent groups whose concerns must be considered may sound appealing, but accountability to everyone is accountability to no one, and without accountability the system falls apart. The critical point missed by the task force is that the accountability provided by a strict fiduciary standard for both pension fiduciaries and corporate managers is the best guarantee not just of pension fund security, but of a strong economy.

The Sleeping Giant Stirs

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It is a measure of the long-time silence of shareholders that the first steps to involvement in corporate governance have been met with such alarm. “The Big Owners Roar!” proclaimed a headline in Fortune last year. In fact, progress has been significant, but hardly a “roar” more like clearing its throat.

It’s just that it is such a big throat. Institutional investor activism would not have been possible were it not for the legendary Gilbert brothers, who cleared the path. In 1932, Lewis Gilbert attended the annual meeting of New York City’s Consolidated Gas Co. Gilbert, who held only 10 shares of the company’s stock, was disturbed by the chairman’s refusal to recognize shareholder questions from the floor.42 Gilbert formed a group with his brother to purchase small amounts of a company’s stock and attend its meeting to introduce proposals from the floor. When the SEC adopted Rule 14a-8 in 1942, requiring companies to put shareholder resolutions to a vote, the Gilberts were able to express their corporate governance concerns directly to shareholders via the proxy process. The Gilberts focused on expanding corporate democracy and making management financially accountable to owners, with proposals on such issues as locating meetings at sites that encouraged a large attendance, issuing postseason reports, and opening up the election process.43

With the social upheaval of the 1960s, shareholder activism began to focus on social responsibility. In 1966, Rochester, New York, radical Saul Alinsky aimed his two-year-old FIGHT (Freedom, Integration, God, HonorToday) organization at Kodak. FIGHT, a coalition of over 100 black groups, targeted Kodak’s minority hiring record. Kodak was by no means the worst offender, but it was Rochester’s largest employer, representing 13 percent of the city’s work force. FIGHT was hoping for a filter-down effect by selecting Kodak. When negotiations broke down over a plan for Kodak to hire and train 600 unskilled blacks, FIGHT took the issue to shareholders by asking them to withhold their proxies, assign them to FIGHT, or vote against management. Nowhere near enough proxies were voted in favor of FIGHT for any kind of mandate, but Kodak did agree to a less stringent minority hiring program. A similar proxy contest was waged at Honeywell over the manufacture of antipersonnel weapons in 1969, led by the heir to the Pillsbury flour company fortune, Charles Pillsbury.

Shareholder activism, however, was limited by Rule 14a-8 in what it could address through the proxy process. Specifically, 14a-8(c)(7) was particularly limiting, its vague language permitting the exclusion of any proposal “relating to the conduct of the ordinary business operations of the issuer.” This rule evolved after the SEC allowed Greyhound to omit a 1946 proposal to exclude a resolution that it abolish segregated seating on buses, on the grounds that the rule enabling shareholders to file proposals was not intended to permit proposals of “a general political, social, or economic nature. Other forums exist for the presentation of such views.”44

The commission formally amended its rules in 1952 to comply with the Greyhound opinion. The SEC explained this reasoning to Congress as necessary “to confine the solution of ordinary business problems to the board of directors and place such problems beyond the competence and direction of the shareholders. The basic reason for this policy is that it is manifestly impracticable in most cases for the stockholders to decide management problems at corporate meetings.”45

But a different direction was taken in 1970 by a U.S. Appeals Court decision, Medical Committee for Human Rights v. SEC, overturning the SEC decision permitting Dow Chemical to omit a proposal requesting that the board “consider the advisability of adopting a resolution setting forth an amendment to the composite certificate of incorporation of the Dow Chemical Company that the company shall not make napalm.”46 In a way, Dow lost the argument by admitting in its own materials that its napalm operations lost money. The court pointed out the hypocrisy of claiming management’s exclusive authority over ordinary business when that business lost money for owners: “Management in essence decided to pursue a course of activity which generated little profit for the shareholders and actively impaired the company’s public relations and recruitment activities because management considered this action morally and politically desirable.”47

In defense of its decision, the court cited the reasoning of SEC v. Transamerica Corp.: “A corporation is run for the benefit of its stockholders and not for that of its managers.” The court concluded: “We think that there is a clear and compelling distinction between management’s legitimate need for freedom to apply its expertise in matters of day-to-day business judgment, and management’s patently illegitimate claim of power to treat modern corporations with their vast resources and personal satrapies implementing personal, political or moral predilections.”48

After this precedent was adopted by the SEC, the floodgates were opened for social proposals. The SEC usually permitted them, provided they had some claim to the economics of the company and involved a legitimate public concern. The commission refined the ruling further in 1976, stating that 14a-8(c)(7) could exclude only proposals involving business matters “that are mundane in nature and do not involve any substantial policy or other considerations.”49

Perhaps the most famous effort by social activists was Campaign GM. In 1970, four public interest lawyers set up the Project on Corporate Responsibility to reform public corporations. They decided to attack the corporation directly because, as one of the founders explained, “regardless of new laws or consciousness, [social objectives] would not be accomplished without a commitment of our corporate institutions, which have enough power to implement or deny national goals.”50 Once again, GM was selected not because it was the worst offender but because it was a symbol for the large American public corporation.

The project decided to run Ralph Nader for the GM board, but Nader declined the offer. Instead, the project submitted shareholder proposals for GM’s 1970 proxy, calling for an amendment to the corporate charter stating that GM’s operations would be consistent with “public health, safety and welfare,” the establishment of a shareholder committee on corporate responsibility, and the expansion of the board to allow for three public interest representatives. Within three weeks six more proposals were added concerning auto safety, pollution control, mass transit, and minority hiring, but the SEC ultimately permitted all but two to be excluded from the proxy. The remaining two – concerning a shareholder committee and the expansion of the board – were enough to make the 1970 GM meeting a spectacle. Three thousand attended the May 22 meeting, which turned into a lengthy question-and-answer session regarding GM’s commitment to social issues. Although neither proposal gained 3 percent of the vote, GM went on to create a public policy committee and a special committee of scientists to monitor the corporation’s effect on the environment; it also appointed an air pollution expert and its first black director to the board. The project deemed Campaign GM enough of a success to launch Round two the following year, which focused lobbying on the 20 largest institutional investors, rather than the relatively small holdings of universities that were the target of the 1970 campaign. Round two, however, was not as successful, perhaps because GM had taken steps following Round one.

Although institutional investors began with social policy proposals, the takeovers of the 1980s and the defensive actions they prompted raised concerns about the impact on share value. They were too big to follow the traditional Wall Street rule – a sale of that size could itself depress share value. And these questions went beyond disagreement with a particular management; nearly 1,000 companies adopted poison pills without shareholder approval, and no one could sell out of all of them.

In 1987, institutional investors submitted their first governance-related shareholder proposals. These proposals, many calling for poison pills (called “rights plans” by management) to be put to a shareholder vote, received substantial support – from around 25 to 30 percent. The following year, two of these resolutions received majority votes, both at companies where a contest for director seats and attendant full-scale proxy solicitation provided the momentum.51

In 1989, institutional shareholders joined with a large individual shareholder (and with ISS) to mount a successful full-scale proxy fight over corporate governance issues. North American Partners, the California Public School Employees’ Retirement System, the Pennsylvania Public School Employees’ Retirement System, and ISS cleared proxy materials through the SEC. We circulated our own proxy card, asking shareholders to join us in opposing two items submitted for management approval by shareholders. The issue was not control of the company; there was no contest for seats on the board. The issue was two proposals by management – one to classify Honeywell’s board so that only one-third of the directors would be up for re-election each year, and one to eliminate the right of the shareholders to act by written consent, so that they would not be able to take action at any time other than the annual meeting.

The question raised by these proposals struck at the core of the relationship between shareholders and management; could shareholders prevent management from changing the corporate charter to reduce accountability? The answer was yes. The success of the shareholders in defeating these proposals set the stage for more collective action. Instead of waiting for a company with disappointing performance to become a takeover target, with the acquirer reaping most of the gain, shareholders found they could join forces to enhance value and engage in a productive dialogue with management. Enhanced value was clearly demonstrated at Honeywell, where the announcement of the counter-solicitation sparked a sharp rise in the share price. Although takeover rumors played a role, the market was clearly reacting to the positive impact of active shareholder involvement; the market understandably recognizes the value of large institutions holding management accountable. The increase in share price exceeded the expense of the proxy solicitation by several orders of magnitude. Activism became one of the soundest investments of the season.

In 1990, shareholder resolutions again received significant support. Two poison pill resolutions sponsored by the Wisconsin state pension fund received majority votes, without any special solicitation effort.

But perhaps the most important development of the 1990 season was the way that governance issues affected contests for control. Harold Simmons led a proxy fight at Lockheed, running on a “platform” of support for the four pending shareholder proposals at the company. At the last minute, Lockheed management announced it, too, would support the proposals. They won,52 but so did the proposals; majority votes were received for all of them, the highest 97 percent. Carl Icahn, instead of waging a battle for board seats at USX, submitted a shareholder proposal that the company separate its oil and steel businesses and spin off to shareholders at least 80 percent of the steel business as a special dividend. Rather than attempt to acquire the company, he used his position to try to influence management to implement a restructuring.

Most shareholder resolutions have fallen into either the social policy or the governance category, but three recent resolution issues are a kind of hybrid, with aspects of both categories. They are resolutions concerning tobacco, defense contracts, and the environment. The overlap of these social issues into the economic arena was reflected by the SEC Division of Corporation Finance’s reversal of its prior policy that shareholder proposals concerning tobacco products could be rejected by management. Previously, tobacco company managers were protected by 14a-8(c)(7)permitting the omission of a proposal concerned with the conduct of ordinary business actions – from any shareholder proposal that the company divest itself of tobacco operations. Not any more. The SEC staff decided that tobacco was an issue encompassing significant social and public policy issues.

The SEC explained its decision to overturn previous rulings: “Those prior letters failed to reflect adequately the growing significance of the social and public policy issues attendant to operations involving the manufacture and distribution of tobacco related products.” Former SEC commissioner Bevis Longstreth, retained by Philip Morris, complained that the SEC had, in effect, “change[d] the meaning and operation of Rule 14a-8(c)(7) as applied to practically all products and businesses, since there are very few, if any, businesses that are immune from any important issues of social and other public policy.”

But the SEC found that tobacco, increasingly stigmatized by the mass public, may no longer be a great investment. Although tobacco profits are currently sustained by massive exports to the third world and Asia, American society may not tolerate such behavior in the future. Shareholders, rather than see their company decline and fall with the erosion of the tobacco market, can decide as a group whether the company would do better with a spin-off by the year 2000.53

One Step Forward

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One of the great success stories of shareholder activism is Texaco. James W. Kinnear, the president and CEO of Texaco, has begun to restore the element of trust in relations with his shareholders, which is ironic because the modern shareholder activism movement started with Texaco, or, more specifically, with California treasurer Jesse Unruh’s objection to its greenmailing of the Bass brothers in 1983. Through all of the vicissitudes of the Pennzoil litigation, the appalling course of “Texas justice,” and its resulting bankruptcy, Texaco may have unfairly symbolized to some the worst fears of capitalism. Kinnear had been part of a management that paid close to $400 million in greenmail. He had been at the company when the acquisition of Getty Oil led to the most expensive litigation in history, took the company into bankruptcy, and diverted significant shareholder resources to a contest with the company’s largest shareholder. As Kinnear ascended to chief executive officer, he showed a commitment to the company’s shareholders. He managed to keep the company viable for the future, even when it was forced into bankruptcy, and into the settlement with Pennzoil.

The Texaco bankruptcy was unusual in many ways, first because the company had substantial assets, and no one ever expected it to really go under. Thus, the shareholders had an importance in the Texaco proceeding for which there was little precedent. So much money was involved and so many parties had important but legally different roles that high confusion was inevitable. To begin with, some of the largest shareholders were public pension plans, which were excluded from the equity committee because bankruptcy law prohibits a government agency from participating. Against the opposition of the parties, with the exception of the U.S. Trustee, the California Public Employees’ Retirement System and the Pennsylvania Public School Employees’ Retirement System fought their way onto the equity committee as ex officio members by obtaining a court order. They were permitted to join the committee, along with six large individual shareholders and two smaller institutions. (The company’s largest shareholder, Carl Icahn, who had newly acquired 14.9 percent of the outstanding stock, declined membership on the committee when it refused to make him chairman.)

The bankruptcy proceedings provided a rare forum for public debate over the charter and bylaw provisions concerning the governance of Texaco that would emerge from the bankruptcy proceedings. Originally, all of the ownership groups were anxious that Texaco give up its takeover defenses, especially its poison pill. Several participants also had a very special notion of appropriate additions to the board themselves!

Under bankruptcy law, management has the prerogative of proposing a plan of reorganization. Shareholders can vote for or against it; they have no right to amend or to propose alternatives. That notwithstanding, Carl Icahn asked the court to permit a vote on his reorganization proposal, which was identical with the one proposed by Texaco management except for elimination of certain antitakeover proposals. The company wanted continuing “protection”; Icahn wanted freedom for the marketplace to decide. The institutional investors withdrew their support from Icahn’s proposal, and the court ruled in Texaco’s favor. The judge did not permit Icahn’s proposal to be voted on by the shareholders.

Both Kinnear and Icahn appeared before a special meeting of the Council of Institutional Investors to state their cases. The sentiments of those in the room were geared slightly toward Icahn, when Kinnear appeared to make the first presentation. He made three simple points that won the entire room over. First, he said that he had every penny of his own money in Texaco. There is no better guarantee of scrupulous attention to shareholder value than a CEO whose net worth depends on it, and this had an enormous impact. Second, he said Texaco would never pay greenmail again. Third, he talked about the oil business and his plans for the future once the bankruptcy was behind them. Everyone in the room could feel his commitment, his enthusiasm, his expertise. Icahn came in. He did not give any specifics about his plans for the company, and he could not claim that he put everything he had into Texaco. The group was open-minded, but he just could not compete.

One condition of the reorganization plan approved by the court was that Kinnear and the Texaco board would not oppose certain charter amendments proposed by shareholders. In fact, after meeting with shareholders, Kinnear and the board went beyond that requirement and endorsed the proposals. This willingness to consider ownership concerns was again manifest in Kinnear’s later publicly soliciting and using a list of nominees provided by CalPERS as a source for a new Texaco director.

Former congressman Brademas, the president of New York University, was an unexceptionable choice for director. His name could have been proposed from almost any source. And yet Kinnear went out of his way to credit PERS as being the source and to acknowledge the importance he placed on that recommendation. From that day to this, no representative of CalPERS has exchanged a single word with director Brademas. What happened is not that a large shareholder acquired power; what happened is that a sensitive management publicly acknowledged the importance of getting director nominations from outside sources. Compared to other company reactions, such as Northrop’s “The nominating committee does not consider stockholder nominees for director,”54 one can appreciate the true value of Kinnear’s small step for healthy governance.

Shareholder Proposals in 1991

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As we write, shareholder proposals for 1991 have been submitted. By the time this book comes out, they will be ready to be voted on. There are more of the same resolution issues that have become standard: poison pills, confidential voting, creation of shareholder advisory committees, annual election of directors, and opting out of state antitakeover laws. There are resolutions calling for reincorporation out of Pennsylvania, in response to the passage of the new antitakeover law and the evidence on its impact on share price. There are more proposals directed at board composition and structure, calling for a majority of outside directors, for nomination committees to be made up of outside directors, or for the chairman of the board to be someone other than the CEO. New York State Common Retirement Fund already abstains from voting for 10 to 13 percent of the boards of the corporations it invests in, for the sole reason that the company’s boards do not have enough independent directors.

It is increasingly clear that institutional investors are focusing their attention on the composition of boards as well. CalPERS has worked with ISS in developing a director database, with information on the directors of the S&P 500. In the fall of 1990, CalPERS wrote to each of them, asking them to verify or correct the information and asking some other questions about their roles as directors. Looking to the successful example of PRO-NED, the clearinghouse/headhunter firm for directors established by Britain’s institutional shareholders, we hope that the information we are assembling will make a difference with shareholders, who can make a difference with the companies they invest in.


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1 Fox Butterfield, “From Ben Franklin, A Gift That’s Worth Two Fights,” New York Times, April 21, 1990, p. A-1.

2 Carolyn Kay Brancato, “Breakdown of Total Assets by Type of Institutional Investor, 1989,” Riverside Economic Research, February 21, 1991.

3 A comprehensive list of impediments to collective action by shareholders is included in Alfred Conard, “Beyond Managerialism: Investor Capitalism?” University of Michigan Journal of Law Reform, 22(1), Fall 1988. Impediments are vulnerability of voting rights, emptiness of shareholder proposal rights, liability of controlling persons, freezing stockholding, the forfeiture of short-term gains, and group filing requirements. See also Bernard S. Black, “Shareholder Passivity Re-examined,” Michigan Law Review, 89(3), December 1990, pp. 520 608.

4 Melvin Aron Gisenberg, “The Structure of Corporation Law,” Columbia Law Review, 89(7), November 1989, pp. 1461, 1474.

5 Daniel Fischel and John H. Langbein, “ERISA’s Fundamental Contradiction: The Exclusive Benefit Rule,” University of Chicago Law Review, 55(4), Fall 1988, pp. 1105, 1117.

6 The Department of Labor ‘s Enforcement of the Employee Retirement Income Security Act (ERISA), Subcommittee on Oversight of Government Management of the Committee on Governmental Affairs, United States Senate, April 1986, S. Prt. 99-144, pp. s3-s8. See also James E. Heard and Howard D. Sherman, Conflicts of Interest in the Proxy Voting System, Investor Responsibility Research Center, Washington, D.C., 1987.

7 David Bell, Assistant Secretary, Department of Labor, speech before the Financial Executives Institute, January 23, 1990.

8 Elmer W. Johnson, “An Insider’s Call for Outside Direction,” Harvard Business Review, March/April 1990, p. 54.

9 Ibid.

10 Karla Scherer, “Some Facts They Never Teach You in the Classroom,” speech delivered at the Tenth Annual Awards Banquet, Wayne State University School of Business Administration, Detroit, Michigan, April 20, 1990.

11 The proxies at Fidelity are voted by a staff that is independent of the investment managers.

12 Mark J. Roe, “Legal Restraints on Ownership and Control of Public Companies,” paper presented at the Conference on the Structure and Governance of Enterprise. Harvard Business School, March 29-31, 1990, p. 8.

13 James E. Heard and Howard D. Sherman, Conflicts of Interest in the Proxy Voting System, Investor Responsibility Research Center, Washington, D.C., 1987, p. 44.

14 “TIAA-CREF: A Concerned Investor,” Teachers’ Insurance and Annuity Association, 1990, p. 1.

15 William C. Greenough, It’s My Retirement MoneyTake Good Care of It, Richard D. Irwin, Homewood, Ill., p. 191.

16 Larry Rohter, “Corporations Pass Alumni in Donations to Colleges.” New York Times, April 29, 1986, p. A-16.

17 Peter G. Gosselin, “BU Writes Off $16m of Seragen Stake,” Boston Globe, December 29, 1989, p. 63.

18 Dana Wechsler, “Letting the Losses Run,” Forbes, April 17, 1990, p. 116.

19 Nancy J. Perry, “Who Runs Your Company, Anyway?” Fortune, September 12, 1988, p. 141.

20 Richard H. Koppes, “CalPERS 1990 Corporate Governance Report,” July 10, 1990.

21 Federal Employees’ Retirement System Act of 1986, PL 99-335. (“FERSA”).

22 Jonathan Alter, “The News that Didn’t Fit,” Newsweek, December 29, 1986, p. 57.

23 Judith Havemann, “U.S. Employees’ Thrift Plan to Create New Capital Fund: New Benefit May Become Political Football,” Washington Post, February 18, 1987, p. Al .

24 Robert A.G. Monks and Nell Minow, “The Federal Employees’ Retirement System Act,” Barron’s, June 15, 1987, p. 44.

25 Report of the Committee on Governmental Affairs, United States Senate, To Accompany S.1527, Federal Retirement Reform Act of 1985, 99th Congress, 1st Session, Report 99-166, October 30, 1985, U.S. Government Printing Office, Washington, D.C. , p. 87.

26 Brancato, The Pivotal Role of Institutional Investors in Capital Markets, p. 24.

27 Conference report to accompany H 2672, Report 99-606, p. 136 et seq.

28 See testimony by Robert A.G. Monks, before the Subcommittee on Labor-Management Relations of the House Education and Labor Committee, February 9, 1989, suggesting a “safe harbor” for ERISA funds invested in indexes.

29 Supplemental Information Regarding the Federal Employees’ Retirement System Act of 1986, Report of the Committee on Governmental Affairs, United States Senate, 99th Congress, 2nd session, Report 99-184, October 1986, U.S. Government Printing Office, Washington, D.C., p. 29.

30 Hearings before the Committee on Governmental Affairs, United States Senate on S. 1527, S. Hrg. 99-754, p. 520 et seq.

31 See Jacqueline Campbell and Elizabeth S. Kiesche, “Koppers Battles to Repel a Suitor,” Chemical Week, April 6, 1988, p. 13.

32 Beverly Ross Cambell and William Josephson, “Public Pension Trustees’ Pursuit of Social Goals,” Journal of Urban and Contemporary Law, 24(3), 1983, p. 47.

33 James A. White, “Divestment Proves Costly and Hard,” Wall Street Journal, February 22, 1989, p. C-l.

34 See John H. Langbein, “Social Investing of Pension Funds and University Endowments: Unprincipled, Futile, and Illegal,” in John J. Langbein, Roy A. Schotland, and Albert P. Blaustein, Disinvestment: Is It Legal? Is It Moral? Is It Productive? National Legal Center for the Public Interest, Washington, D.C., 1985, pp. 9-12.

35 Of course, the verdict is still out on divestment, an issue that divides institutional investors perhaps more than any other. When ISS recommended a vote against a New York State proposal for divestment of South Africa operations at Echlin, Thomas Pandick, Director of the Office of Investor Affairs, wrote back: “In our opinion, continued presence in South Africa can have significant adverse financial impact on the company. Recent announcements by Mobil Oil and Goodyear cited the double taxation of profits earned in South Africa (Internal Revenue Code, [[section]] 911), resulting in an effective rate of 72 percent, as a major factor in their decision to disinvest. In addition, the increased incidence of state and local governments’ refusal to contract for services and products with companies doing business in South Africa will certainly impact negatively on share values if the company losses a significant market portion as a result.”

36 Sgaglione v. Levitt, 37 N.Y. 2d 507 (1975).

37 Withers v. Teachers’ Retirement System, 447 F. Supp. 1248 (S.D.N.Y. 1978), aff’d. without op. Withers v. Teachers’ Retirement System 595 F.2d 1210 (CA2 N.Y. 1979). See also the opinion of Ian D. Lanoff of Bredhoff & Kaiser, dated January 17, 199 1, with reference to a local public pension plan investing in debt securities of the city of Philadelphia. The opinion concludes: “The Board lawfully may conclude that the purchase of the Notes would not cause the Municipal Retirement System to fail the qualification requirements of Section 401(a) of the Code” (p. 32).

38 Regents of the University of Michigan v. Michigan, 419 N.W. 2d 773 (1987).

39 Campbell and Josephson, “Public Pension Trustees’ Pursuit of Social Goals,” p. 84.

40 Matthew Bromberg, “Social Investing: The Good Guys Finish First,” Business and Society Review, No. 67, Fall 1988, p. 32.

41 Edward A. Zelinsky, “The Dilemma of the Local Social Investment: An Essay on Socially Responsible Investing” Cardozo Law Review, 6, Fall 1984, p. 111.

42 This section is adapted freely from Lauren Talner, The Origins of Shareholder Activism, Investor Responsibility Research Center, Washington, D.C., July 1983, and Helen Booth, The Shareholder Proposal Rule: SEC Interpretations & Lawsuits, Investor Responsibility Research Center. January 1987.

43 Talner, p. 3.

44 Peck v. Greyhound Corp., 97 F. Supp. 679 (S.D.N.Y. 1951). The court is citing SEC Release No. 3638, dated January 3, 1945.

45 Medical Committee for Human Rights v. SEC, 432 F.2d 659, 678. The court is citing Senate Hearings.

46 Ibid.

47 Ibid.

48 Ibid., p. 681.

49 Booth, The Shareholder Proposal Rule, p. 10.

50 Talner, The Origins of Shareholder Activism, p. 13.

51 One was an anti-greenmail resolution at Gillette, and the other was a poison pill resolution at Santa Fe Southern Pacific. Although both were precatory only, boards at both companies responded. Gillette adopted a bylaw provision prohibiting greenmail, and Santa Fe Southern Pacific, although not rescinding its poison pill, did amend it.

52 However, this “victory” is being challenged in federal court with reference to the validity of the ESOP votes (see pp. 61-64).

53 Michael Deal, “Should Philip Morris Snuff Out Marlboros?” Business and Society Review, No. 74, Summer 1990, pp. 36-39.

54 Northrop Notice of Annual Meeting of Stockholders and Proxy Statement, April 2, 1990, p. 5.