Corporate Governance, Universal Ownership and the Current Economic/Financial Crisis: A Conversation with

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Corporate Governance, Universal Ownership and the
Current Economic/Financial CrisisA Conversation
with

• Professor Jim Hawley
• Director, Elfenworks Center for the Study of
  Fiduciary Capitalism
• And
• Professor Andy Williams
• Graduate Business
• July 2010

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Road Map

• Introduction
• Fiduciary Capitalism / Universal Ownership
• Corporate Governance I, II and III
• Universal Owners and the Economic/Financial
  Crisis
• Conclusion Q and A

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Roots and Perspective An Approximate Chronology

• Ethical Investing to Influence Corporate
  Behavior--SRI (socially responsible investment)
• Corporate Governance
• Responsible Investment
• Fiduciary Capitalism
• Universal Owners
• Reemergence of ethical investing in Europe,
  UK and US
• Often called sustainable or responsible
  investment

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Background Roadmap

• Fiduciary Capitalism
• Universal Owners
• The Modern Corporation..
• And Adam Smith

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Adam Smith, the Corporation, Nature of Private
Property, and the Agency Problem

• The directors of such companies joint stock
  companies however, being the managers rather of
  other people's money than of their own, it cannot
  well be expected that they should watch over it
  with the same anxious vigilance with which the
  partners in a private copartnery partnership
  frequently watch over their own. Like the
  stewards of a rich man, they are apt to consider
  attention to small matters as not for their
  master's honor, and very easily give themselves a
  dispensation from having it. Negligence and
  profusion, therefore, must always prevail, more
  or less, in the management of the affairs of such
  a company. (Emphasis added.)

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Managerial Capitalism

• Berle/Means, Chandler and others
• private property has changed with the rise of
  the modern firm.
• Ownership and control are separated in the modern
  corporate form
• Private property in a new form not your basic
  Adam Smiths (or Karl Marxs) capitalism
• Markets are typically not laissez faire large
  firms have traditionally internalize markets
  (vertical integration and/or tight
  subcontracting alliances, R and D sharing,
  etc)

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The Modern Managerial Corporation

• Logic of public equity markets and
  professionalization of management leads to
  separation of ownership and control
• Separation leads to the agency problem
• How to constrain managerial opportunism?
• Growth of institutional ownership and the
  concomitant decline of individual ownership
  presents challenges and opportunities.
• The rise of fiduciary capitalism--

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What is Fiduciary Capitalism?

• Institutional ownership dominates
• Also called Pension Fund Capitalism (Clark)
• Financially Intermediated Society (Bogle)
• La République des actionnaires (Gomez)
• The New Capitalists-Citizen Investors (Davis,
  Lukomnik, Pitt-Watson)

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Fiduciary CapitalismWhy the Adjective
Fiduciary?

• Describes and recognizes a changed ownership
  structure
• Institutional Investors
• Nature of institutional ownership in many
  countries-fiduciary or fiduciary-like
• Duty of Loyalty
• Duty of Care
• Other emerging duties
• Impartiality
• Short term/long term
• Ethical
• best interests of investors/beneficiaries
• An ownership revolution and its implications
• U.S. as an example.

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The Rise of Institutional Ownership in the United
States 1945 - 2008
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Main Types of Institutional Ownership

• Local/regional Pension Funds
• Public corporate hybrid
• Sovereign Wealth Funds
• Sovereign Pension Funds
• Mutual/Unit Funds
• Universal Banks
• Insurance Firms

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Fiduciary Obligations, Law and Ownership Structure

• Common law countries (vs. civil law)
• Equity market financing (vs. bank)
• Emergence of non bank, non equity financing
• E.g. commercial paper
• Diversified ownership (vs. bloc)
• Post 1970 institutional ownership vs. individual
  (and controlling blocs main banks, etc.)

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Implications of Institutional Ownership /
Fiduciary Capitalism

• Professional Ownership
• Universal Ownership
• Universal Monitoring

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Implications of Professional Ownership

• A professional owner is a fiduciary, at minimum
• Duty of loyalty
• Duty of care
• All of the rights and responsibilities of
  ownership except the right to the profit (or
  loss) from investment decisions
• Implies active ownership Avon Letter, U.S.
  Dept. of Labor, 1984.

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Emergence of Universal Owners

• A Universal Owner owns equity, debt and other
  assets representing a broad cross section of the
  economy. E.G. CREF and CalPERS in US, USS in
  England and The Government Pension Fund Global
  in Norway.
• A Universal Owners return depends on the
  performance of the economy as a whole as much as
  on the performance of individual companies.
• Why?
• Diversification Strategy
• Index Strategy

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Sea Change in Ownership Underlying UOs

• Common law countries UOs are fiduciaries for a
  large proportion of employees and investors
• 60 or more of the adult population--U.S.,
  Canada, UK, Netherlands (civil law)
• Examples countries where UOs are emerging
• Some are sovereign wealth or pension funds
  others not
• France
• Ireland
• China (?)
• Japan
• Norway is a special and influential case
• Most other countries UOs are few, ownership
  dominated by families, managers and/or
  governments

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Hawley/Williams-Elfenworks Center www.fidcap.org
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Implications

• Economic interest in externalities
• Negative or positive impact on third parties
  not party to a contract.
• They are partially internalized by a UO
• Global Climate Change
• The Mother of all Externalities
• Public Health and Education
• Clean Drinking Water
• Etc.
• Long-term perspective Sustainability
• Particularly for pension funds

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UOs

• Due to internalizing externalities, the
  performance of the whole is great than the sum of
  its parts.
• Calculate performance holistically, not only on a
  firm by firm (smoke stack) basisCHALLENGE/OPPORTU
  NITY 1
• Have a quasi-public policy interest given
  investment-return horizon and investment
  diversityCHALLENGE/OPPORTUNITY 2

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A Closer look at Externalities Pecuniary and Non
Pecuniary

• Externalities affect return on investment by
  imposing costs or returning benefits to firms
  which are neither typically accounted for or
  controlled.
• Pecuniary create costs or benefits that are
  measurable in monetary terms.
• E.g. dumping effluent by an upstream plant.
• Non Pecuniary create costs or benefits not
  directly and initially measurable in monetary
  terms, but may have important economic
  consequences.
• E.g. lost future productivity of a child who
  labors in a factory rather than going to school.

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Logic of Universal Ownership

• Most universal owners cannot or do not sell they
  are indexed or shadowed indexed.
• If they sell (many do for relatively short term
  perceived gains) they still hold very diversified
  assets across asset classes
• Most universal owners portfolios mirror each
  other
• Thus, they cannot sell without fear of market
  disruption (and therefore loss)
• Consequently, the importance of non-market means
  of influencing firmscorporate governance
  activismEngagement using voice rather than
  exit

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Logic continued

• Since they cannot sell they must care
• Care
• Not only focusing on individual firm performance
  and behavior,
• BUT on the interactive externality effects within
  a universal owners portfolio.
• Secondarily link Risk
• Related to norm shifts and the various types of
  contingent liabilities norm shifts often create.

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Logic continued

• Furthermore, major agency-governance concerns
• Internal (vis à vis to whom they are loyal and
  their internal investment managers)
• External (vis à vis their investment
  chain/external managers/consultants)
• CHALLENGE/OPPORTUNITY 3

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Whats Unique 1

• Large funds
• Increasingly concentrated
• Largest 100 U.S. fiduciary institutions hold over
  60 of all publicly traded equity
• Indexed (actual or shadow)
• Too big to sell- Must care (Hirschmans voice)
• Not a stock picker

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Whats Unique 2

• A long term investor (or should be)
• Corporate governance/engagement/voice--is key.
• Long-term economic performance is governance goal
• Is a governance activist of necessity--Or
  fiduciary duty should obligate it to be

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• In SumThe concept fiduciary capitalism captures
  these trends
• Ownership sea change
• Broadly diversified across most asset classes
• Large scale, long-term focus (or should be)
• Highly diversified, therefore internalizing many
  externalities
• The agency problem is manifest in the investment
  chain, and perhaps internally
• A corporate governance activist because
  large-scale exit blocked
• Voice (governance) the alternative
• Corporate governance goal Long-Term Performance

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Corporate Governance Stages I and II

• CG I focus on accountability, with some
  improvements in transparency
• On-going, far from complete (e.g. CEO pay for
  performance realistic performance measures
  board independence separation of chair from CEO)
• Significant globalization
• CGII Includes accountability but increased focus
  on transparency
• Incorporation of ESG (Environment, Social,
  Governance) and Principles of Responsible
  (sustainable) investment
• Significant globalization

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Corporate Governance Stage III

• A response to the financial crisis
• Additional concern with sustainable finance and
  sustainable economy
• Increasingly focused on
• What should be proper role of financial sector
  globally
• What can/should UOs do to achieve this role
• Only recently emerging

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UO Examples and Some UO Type Activities

• CalPERS/CalSTRS/NYcers - US
• Environmental Initiatives Investor Climate
  Change Network Carbon Disclosure project
  (represents/tracks assets of 35 trillion)
• Hermes-UK
• Dont rob Peter to Pay Paul (Principle 10)
• Pharmaceutical Shareholders Group Enhanced
  Analytics Initiative
• Fonds de Réserve pour les Retraites -France
• Searching for extra-financial factors which
  influence value
• Caisse de Dépôt et Placement du Quebec-Canada
• Interest in UO implications
• Many UOs support various aspects of proposed
  financial reforms (U.S., Canada, UK, EU)
• Norwegian Government Pension Fund an SRI fund?
  2008-2010 focus on
• Child labor in developing countries
• Political lobbying by firms they
  own/environmental issues

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A UO Investment Implication

• Searching for Alpha but perhaps long-term
  finding Beta?
• Alternative investments, asset diversification
  and benchmarked returns
• Raising absolute returns means increasing
  productivity total market real (not just or
  only financial return
• That is, increasing economic welfare, market
  efficiencies.
• Must find a way to incentivize increased this
  type of absolute, long-term return
• Implies new benchmarks for the internal and
  external investment chainCHALLENGE/OPPORTUNITY
  4

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Transparency Focus

• In three areas ESG separately and
  interactively
• Environmental (new)
• Social (new)
• Governance --established in principle
• Some in practice
• Macro failure (e.g. Enron, current financial
  crises)
• E deals with externalities
• S deals with risk (market, reputational,
  regulatory, political, etc) and some
  non-pecuniary externalities (e.g. child labor)

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Materiality Focus

• ESG brings elements of socially responsible
  investment (ethical investment) to mainstream
  institutions
• Viewed in terms of risk and opportunity
• Not ethical per se, nor political nor moral
• Significant evidence for correlation between E
  and G and performance (S more difficult to
  study/quantify)

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Institutional Example U.S. TIAA-CREF

• Environmental and Social issues begin to look
  like governance did 10 years ago
• TIAA_CREF corporate boards should track and
  disclose S and E issues
• Engagement on
• environment
• human rights
• Labor conditions (e.g. ILO standards)
• product responsibility and society
  (minimize/eliminate negative impacts on
  communities)

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Analytical Example Trucost and
CalPERS/STRS-Utillities and Carbon

• Carbon adjusted rate of return (CARR)
• TruEVA weighted avg. cost of capital including
  cost of carbon externalized on firm-by-firm basis
• Of largest 25 U.S. utilities, only 6 had positive
  TruEVA
• A measure of firm/sector risk but also of costs
  externalities.
• Next step measure how externalized costs are
  internalized, by firms/sectors.
• What is nature and size of value destruction?
• Specifically on whom?

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Externality Costs of.
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Internalization of Externalities in Portfolios

• Flow through costs of externalities to equity
  portfolios

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A UO Perspective Expands the Business Case for
Responsible Investment (RI)

• Emergence of ESG and RI Materiality
• Ways and means to bring the not yet financial
  or emerging financial (extra financial) into
  the bottom line. E.g.
• Market pricing of governance
• Climate risk (and opportunity)
• Principles of Responsible Investment and the
  Freshfields Report
• PRI 24 trillion and over 300 signatories
  (July 2010)
• Watson Wyatt sustainability as substitute for
  SRI?

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A Closer Look at Market and Public Policy
Implications

• Universal owners cannot avoid externality effects
  as they own the economy and do not stock pick.
• If they stock pick and have high turn over, they
  still own the economy over time
• Fiduciary duty should mandate identifying and
  accounting for interactive externality effects on
  an investors portfolio.
• Fiduciary duty and due diligence should mandate
  consideration of what actions (if any) would in
  the long-term result in minimizing negative and
  maximizing positive externalities.
• The value of a universal portfolio would increase
  due to the growth of productivity in the economy.

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Further Implications of Universal Ownership

• Strong interest in market wide policies
• Accounting standards
• Rating agencies
• Security regulation
• Governance structures (e.g. incentive systems,
  board composition/structure)
• Financial regulation
• A quasi-public policy interest in efficient macro
  economic policies
• Free Trade
• Effective Education
• Health Care
• Regulatory and deregulatory activities and
  policies
• Bubbles

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The Recent Economic Crisis

• Origins
• Low interest rates early in the decade
• Chasing yield in the housing market
  gtsecuritization in many forms
• But not just a U.S. crisis in origin
• Chasing alpha and ever higher yields
• Financial Innovation e.g. Collateralized Debt
  Obligations (CDOs)
• Misaligned Incentives
• Excessive reward for short-term risk taking
• Regulatory failures
• Due in part to lobbying by financial firms
• Faith in self-regulating/correcting financial
  markets with minimal regulation/supervision.
• Toxic assets and economic meltdown

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Impact on Institutional Investors

• Big
• Government Pension Fund Global in Norway
• Market value
• December 31, 2008 2,275 billion NOK
• Return for the year
• Overall -23.3
• Equity Portfolio -40.7
• Fixed Income Portfolio -0.5

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Another Example

• California Public Employee Retirement System
  (CalPERS)
• Assets at year end 2007 253.0 billion
• Assets at year end 2008 183.3 billion
• decrease -27.5 - much greater in the equity
  portfolio alone
• Assets at year end 2010 207.1 billion
• decrease -18 -- 3 years after the beginning
  of the financial crisis

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Institutional Reaction

• To use Corporate Governance tools to express
  displeasure at past policies and to try to
  influence future policies.
• An Example Bank of America
• CalPERS holds 22.7 million shares
• Decided to vote against all board members
• The entire board failed in its duties to
  shareowners and should be removed, said CalPERS
  Board President Rob Feckner.  April 29, 2009
• Result Kenneth Lewis was removed as the
  Chairman of the Board, but continues as CEO

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Universal Owner Response

• Since universal owner returns depend on the
  performance of the economy as a whole universal
  owners have to take a holistic view of the
  economy
• Monitor for Systemic Risk
• Accounting
• Financial
• Regulatory
• Etc.
• But can UOs impact firms and sectors behavior?
• If not (and many think they cant), then..
• Lobby government and regulators for better
  policies

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Further Response

• Outlier Monitoring Hyper Performers
• Complement to programs that monitor
  underperformers.
• If it is too good to be true, it probably is!
• The New Economy, circa 2000
• Enron / World Com
• The New Finance, circa 2006-7
• Financial Innovation
• Bear Sterns
• Lehman Brothers
• AIG
• Etc., Etc,
• Problem of assuming rational economic persons
• The animal spirit problem (Keynes)

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Conclusions

• Institutional Investors in general and Universal
  Owners in particular must be active to protect
  their interests and to fulfill their fiduciary
  duty to their beneficiaries.
• Universal Owners need to pay particular attention
  to externalities among firms in their portfolios

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Corporate Governance, Universal Ownership and the
Current Economic CrisisA Conversation with

• Professors Jim Hawley and Andy Williams
• July 2010

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