Who's Running the Company?

Spurred by challenges to corporate competitiveness in world markets, institutional investors, outside directors, and employees themselves are trying to gain more influence in corporate governance. Large Pension Funds Grow More Assertive

PENSION funds, mutual funds, and other institutional investors own more than half of the publicly traded stock in America.

Now they are exerting more of that power. This spring, for example, the California Public Employee Retirement System (CalPERS), put its weight behind four shareholder proposals designed to make Sears Roebuck & Co. more responsive to investors.

None of the proposals won a majority of votes cast, but they came close enough to rattle Sears, whose core retailing business has failed to live up to investor expectations. A measure that would require future proxy votes to be conducted through a secret ballot received 41 percent of the vote, yet the company agreed voluntarily to change its policy. Other proposals would have required that the entire board of directors stand for election each year, instead of every third year, and that the chief executiv e officer not be board chairman.

Shareholder activism is getting the attention of corporate America, albeit company by company.

Where the 1980s was the decade of hostile takeovers, "the '90s will be the era of the proxy fight," says Donald Frey, a Northwestern University professor.

The question of how far this trend should be carried is being debated by policymakers, investors, and academics.

A longstanding theory in the United States holds that shareholders are "passive" investors, too numerous to have meaningful input on corporate strategy.

In this environment, boards of directors - elected by shareholders but with strong representation from inside the company - serve as middlemen between owners and managers.

Many of the recent shareholder proposals are intended to make boards more accountable to shareholders and less to corporate executives. Others focus on encouraging both directors and executives to act more like owners by tying their pay to company performance.

But even as shareholder activism is catching on, some observers say it does not go far enough.

Michael Porter of the Harvard Business School argues that policymakers should encourage institutional investors to play a role more akin to that of the big banks in Germany or Japan. These banks have regular meetings with managers and support investments by the company to stay competitive over the long term. Thus, although the banks do not own a majority of stock in the companies they finance, the share is large enough to make the banks act as permanent owners.

"The US system may come closer to optimizing short-term private returns. The Japanese and German systems, however, appear to come closer to optimizing long-term private and social returns," Mr. Porter writes in "Capital Choices," a study published in June by the nonprofit Council on Competitiveness.

Porter does not suggest that the US could or should adopt Japanese or German approaches outright. Those systems have flaws of their own, he notes. But Porter and others suggest that the US change laws that encourage big funds to be "outsiders" rather than "insiders."

"All the rules are against them investing enough ... to actually know anything" about the inner workings of a company, "which is absurd," says William Sahlman, another Harvard professor.

Banks, with $3 trillion in assets, have long been barred from holding stock. Experts say this should not be changed without reform of federal deposit insurance, under which the government pays depositors if a bank fails. Insurance firms ($2 trillion in assets) are regulated by state laws that generally prohibit investing more than 2 percent of a firm's assets in any one company.

Pension funds ($2 trillion in assets) have a freer hand, but face legal requirements to invest prudently. This currently means portfolios are diversified among hundreds of stocks.

Mutual funds ($550 billion in assets) are encouraged by tax law to be diversified, meaning they can hold no more than 10 percent of any one firm's stock. And fund managers would come under increased regulatory scrutiny if they sat on a corporate board.

So America's owners tend to be outsiders. They invest based largely on analysis of current financial information that companies must disclose quarterly and annually. Behind this system is a noble regulatory goal: to put big and small investors on a level field. The result, Porter argues, has been inefficient and insufficient investment that damages US competitiveness. Firms tend to focus on maximizing shareholder return in the short run. In support of his view, he cites research showing diverging priorit ies among Japanese and US managers (See box, this page). Bad money management

Meanwhile, professional investors have trouble placing the nation's capital where it will earn the greatest return. A Brookings Institution study finds that professional money managers as a group have failed to beat Standard & Poor's 500 stock index, underperforming that market average by 2.6 percent a year from 1983 to 1989.

Little wonder then that an increasing portion of the assets in US pension and mutual funds are "indexed" to track the market. Porter calls index funds the "ultimate absurdity," revealing a rudderless investment system. Capital-gains tax changes

Part of the answer, he suggests, is to make capital-gains taxes favor long-term holding and to remove barriers to blockholding by funds. But there are numerous obstacles to a wholesale reform of the US system of corporate governance, not least of which is Americans' longstanding concern about concentrating economic power in a few hands.

Also, money managers are not trained to be insiders.

"There aren't many Warren Buffett's out there," says Mr. Sahlman, referring to the savvy Nebraska investor whose Berkshire Hathaway company has taken large stakes in many US corporations. Unlike many money managers, he puts his own fortune at risk as well as the money of his shareholders.

But there is much that the institutional investors can do. Dale Hanson, CalPERS' head, is keen on getting more dialogue with boards through "shareholder advisory committees."

Not every fund is following CalPERS' lead, but 70 public funds with $400 billion in total assets have joined the Council of Institutional Investors, which was founded in 1985 to encourage shareholder activism.

"Our entire investment philosophy is based on the premise that we are long-term investors" Mr. Hanson says. But for now CalPERS is content to influence boards rather than sit on them.

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