The Federalist Society

Good Corporate Governance and its Advocates: The Governance of Public Pension Funds and the Governance of Public Companies

Corporations, Securities & Antitrust Practice Group Newsletter - Volume 3, Issue 3, Winter 2000

February 1, 2000

Philip R. Lochner, Richard H. Koppes

The growth of public pension fund assets has been widely noted, and the data need not be recited here. The fact is that public pension fund assets over recent decades have grown far faster proportionately than the assets of other significant investor categories. Public funds — with some very minor exceptions — have also gradually and unceasingly increased both the numbers of their beneficiaries and the pension and other benefits to which those beneficiaries are entitled.

Not only have public pension funds risen, but some other, formerly prevalent vehicles for institutional investing have correspondingly suffered a relative decline as well. Thus, for example, though private sector union pension assets remain large, the steady decline in the private sector unionized workforce and the gradual migration of manufacturing to lower cost areas will eventually take — and to some extent have already taken — a toll. More significantly, traditional company pension funds are also in relative decline. Companies which have been in business for years have cut payrolls, frozen pension funds, reduced benefits, and replaced defined-benefit pension plans with 401(k) or other defined-contribution plans that leave in the employees' hands the decisions of whether or when or how to invest for their futures.

Furthermore, companies have less and less to do with these defined-contribution plans, which are effectively operated by others, such as mutual funds. For newly formed business enterprises it is a rarity on the order of a unicorn sighting to adopt conventional defined-benefit pension plans. A public better educated about investing, and more willing to shoulder the burdens of investment decision-making, has coincided with the development of a much more mobile work force, which seems less and less likely to be employed by any one corporation for the duration of any working life, and hence unlikely to ever qualify for a meaningful pension from a single source. Added advantages for companies to these changes allegedly include lower costs of benefits, less legal and compliance risk, and lower levels of employee dissatisfaction — at least so far — with benefit outcomes.

Thus, while private businesses — subject to the whims of the markets, among other things — come and go in mergers, acquisitions, bankruptcies, and breakups, and private employers provide less and less in the way of benefits and more and more employee investment choice, the public funds remain stable in number and grow in assets, benefits and numbers of beneficiaries. Of course, other institutional investment categories have grown, too; principal among them are mutual funds, though their growth may reflect the new realities of dwindling corporate pensions and the stock market boom as much as their independent success. It seems fair to wonder whether their recent great growth spurt will continue through any substantial market downturn. Historically, in contract, economic cycles have had comparatively little effect on the continuing growth of public pension funds. All this is to say that for the foreseeable future public pension funds will remain enormously important factors in the financial markets, and that importance can only be expected to increase with the passage of time.

Some in the corporate community profess to find the growth of public pension funds unsettling, not because they fear the expansion of government that the growth of the public funds reflects, but rather because they are concerned about the rising influence public funds may exert on businesses and business decision-making. Such fears would appear, at least to this point, largely overblown. Relatively few public funds have evidenced much appetite for making most decisions ordinarily left to corporate managements, such as which products to market and at what prices.

Related issues may raise more legitimate questions. For example, one concern voiced about public funds is that they sometimes are not superior managers of their own assets, and that the investment performance of the public funds has lagged the widely used public benchmarks for investing or at any rate the levels of success attained by well-managed nonpublic funds. This criticism is important — if true — to the extent that poor returns must be made up by the taxpayers so that public employee pensions and other benefits can be paid, and to the extent that public funds hold themselves out as critics who should be listened to when objecting to the investment, acquisition, merger and similar plans of corporate managements and boards.

If there has been any failure of investment performance at the public funds, the responsibility for it must be placed in part at the feet of those who establish salary scales for public fund investment employees, and the civil service mentality that pervades at least some public funds. It may be telling to any understanding of the psychology of some state public funds that they are headquartered in what may be relatively provincial state political capitols rather than the financial and commercial centers of the states concerned. But wherever the blame for any performance failures lies, such failures call into question the role some public funds (but certainly not all) have adopted as corporate business and investment strategists and critics; managing one's own affairs well may be thought by at least some to be at least one prerequisite for advising others and their businesses.

Another concern is that much about the true investment performance of at least some public funds remains unknown. While steps have been taken in developing common and commonsensical accounting for public agencies in recent years, it remains substantially more difficult for persons (in some cases even beneficiaries) to discover how some very large public funds perform and to compare that performance to that of their peers, than it is to discover how the smallest of mutual funds performs and to compare its performance to that of its peers. Just as investors may legitimately seek a fuller understanding of corporate performance, so too a variety of interested parties legitimately may seek to be able to — for example — compare performance of public fund portfolios by investment category. The reluctance of some public funds to disclose —even through freedom of information procedures — how and what they are doing, may lead to suspicions that the reluctance masks bad news or an unwillingness to engage in open discussion about how those funds are fulfilling their mandates.

While few believe that the collection of federal agencies and departments — the Securities and Exchange Commission, the Internal Revenue Service, the Pension Benefit Guarantee Corporation and the Department of Labor — charged with responsibility for corporate pension funds and mutual fund disclosures has generated a model regulatory structure, the absence of such a structure for public funds may not be unrelated to their disclosure being both less comparable and less full than might otherwise be the case. In the long run it appears plausible that public funds could reinforce their own legitimacy, as well as help ward off any pressures to submit to more governmental oversight, were they to disclose more information, more regularly, in a common format and make it more generally available. It might appear particularly odd that some public funds decline to disclose much information about their practices and performance, while at the same time asking private sector firms to make public more such data about themselves.

The most important, or at least the most widely voiced, concern which the private sector has about the role of the public pension funds relates to public fund activism in the governance arena. That concern is based on a number of factors, some of which are legitimate and substantial, while others of which are less noteworthy. For example, some of the corporate concern arises from a genuine inability to correlate good governance and economic performance. Certainly the academic studies of the relationship are both numerous and inconclusive. However, one can believe in good corporate governance for reasons wholly unrelated to whether it engenders good economic performance. One might, for example, not unreasonably endorse good corporate governance as a way to reinforce the legitimacy of private economic decision-making and limited government, in a society and economy where executives wield substantial decisionmaking power in areas which would otherwise appear to go largely unreviewed. It is worth considering whether some advocates of good governance have allowed themselves to be fundamentally distracted from more crucial matters by continuing to pursue the grail of the relationship between governance and performance.

The power of the ideal of good governance, of course, has proven to be substantial, whatever its limitations as an empirically verifiable model linking internal corporate rules to economic success. This is to some extent in spite of the misuse to which the idea has been put, and the sometimes unsavory nature of a few of its supporters. A number of rogues and scoundrels, as well as some just seeking to get rich, have chosen to make use of the rhetoric of good governance to support whatever short-term and self-serving goals they may have had. Few things can cause an idea or a slogan to be discarded faster by the public, as well as those who purport to lead the public, than finding that some of those who march under the same banner are mere opportunists or worse. In our society it is nearly impossible to prevent those who ill-serve a cause from taking it up; but to avoid contamination, the well-intentioned are best advised to create as much distance in tone and practice as they can from their shadier allies. Again, the criticism of some public funds is that they have been — in the best American tradition — opportunistic in their choice of allies. But there are long-term costs in so proceeding, and those costs may to some extent undermine the good governance cause as well as the ultimate effectiveness of some public funds.

This observation leads to a different set of criticisms of the public funds. These criticisms are focused not on the legitimacy of the ideal of good governance but on the flaws displayed by some public funds who advocate good governance. For example, it is sometimes pointed out by critics that all public funds have not had unblemished records of financial rectitude. This is, of course, correct; for example, a number of public pension fund employees, officers and directors have been found to have engaged in a variety of forms of self-dealing. Public pension fund luminaries have accepted substantial gifts from suppliers, have lined their own pockets, have provided favors to friends out of fund resources, and have engaged in other insupportable practices. Public funds which not unreasonably expect purity from corporate officers and directors have turned out not to be so pure themselves. While this is deplorable, of course, public funds are hardly unique in their susceptibility to these sadly all-too-human failings. However, at least to protect themselves from the sort of public embarrassment which has to some extent undermined, and may in the future more seriously undermine, their credibility, the public funds might usefully consider adopting the kinds of stringent standards and policing measures which are now expected — though not always found — in the more highly regulated private sector.

Another criticism of certain of the public funds — and a more serious criticism — is that they are not particularly well governed themselves. While conceding both that the variety of structures of public fund governance is so wide that generalizations are difficult to make, and that the funds' governance structures may largely be set by legislative fiat or state constitutional mandate, it is not possible entirely to dismiss this criticism. Public fund boards are often made up of political appointees, or representatives of public employees, whose qualifications by training and experience to oversee multibillion dollar asset pools may be limited at best. While public funds may naturally question the experience, expertise and independence of some corporate directors, it should not be surprising that some might question whether these qualities are also present among the leadership of some public funds. Similarly, while some public funds preach to the corporate community the virtues of small boards, substantial investments of time by directors, director and board evaluations, incentive-based pay for directors, and responsiveness to those for whom directors are fiduciaries, not all public boards appear to take all these ideas very seriously when it comes to their own governance.

Nor is it a completely sufficient answer to these criticisms for public funds to claim that the issue of who is on their boards and how those boards operate are ones over which they have no control; not infrequently these funds go to state legislatures, and less frequently to the voters, and seek — and more than occasionally get — changes in the laws affecting their powers and activities. Why would it not be appropriate for the funds to seek changes which could markedly improve their own governance? Furthermore,, making significant changes in board operating procedures may largely be within the discretion of some public fund boards, and in those cases substantial governance improvements would be possible without legislative or voter consent. This is not to say, of course, that it is always appropriate for public funds to mimic the structures of for-profit public companies, for surely the public funds have somewhat different missions and responsibilities. It is to say — and most public fund leaders acknowledge the point in private — that public funds could be better governed themselves whatever their missions and responsibilities. Few would claim that the governance structures of all public funds, which are as often the result of political or historical accident as of careful and thorough analysis, are those which would be chosen were the issues entirely open for serious consideration. Improved public fund governance can only strengthen fund legitimacy and credibility when funds raise governance questions about private sector companies.

A related criticism of public fund governance is that public fund assets have in some cases been misinvested in projects whose returns are questionable and whose motivations appear frankly political. What the funds rightfully expect of the private sector is that its investment decisions be made for the long-term economic benefit of the enterprise, and public fund beneficiaries as well as the public at large may rightfully expect the same sort of logic on the part of public funds. It can reasonably be argued that the most responsible investing is that which generates the best risk-adjusted returns for beneficiaries and, more remotely, taxpayers, and that investments not meeting this criterion should be strenuously avoided. While readily conceding that there are a variety of respectable theories for identifying the best risk-adjusted returns, investment practices which begin with a plausible generally-accepted investment theory and then find the qualifying investments are to be preferred over those which start with an investment and then search for a theory. That some business enterprises occasionally violate this rule is not a sufficient justification for some public funds to do so, and public fund credibility and legitimacy can only be improved by strictly avoiding investment which is motivated by political or public relations considerations.

Another investment practice sometimes engaged in by some public funds has also led to criticism; that practice is the obverse of the one just described. Instead of investing in questionable projects with questionable returns, some funds divest from some legitimate investments with excellent returns. The motivations, again, are either openly political or, more disturbingly, entirely personal and idiosyncratic to public fund management. The political motivations are sometimes forced on the funds by state legislatures anxious to curry voter favor and unconcerned with lost opportunities to the funds, which opportunities may be largely invisible to the outside world and hence easily and safely ignored in a generally short-sighted political system. But in other cases the funds themselves either readily acquiesce in the imposition of these limits or, worse, adopt those limits themselves to satisfy the personal political or social predilections of fund managers or trustees. In certain instances the choice implicitly made cannot even be validated by reference to social or political predilections of fund beneficiaries or of taxpayers, and even where such reference is made, it is rarely made in a meaningful fashion. It is one thing to ask if some legal product or practice is deplorable; it is quite another to ask what cost should be incurred to avoid that deplorable product or service. Losses from choosing not to invest for superior risk-adjusted returns are not trivial either; in a number of cases the lost opportunities have been quite substantial for public funds. Just as public funds find executive or director ego or political preference an insufficient justification for corporate decisionmaking, so too public funds would be well served to resist the normal human tendency to conclude that what its managers or trustees personally prefer coincides with the interests of those for whom they are fiduciaries. Public funds can only harm themselves and the governance causes which they eloquently espouse, when they fail to act in accordance with generally acknowledged standards for making investment decisions.

To some extent, the public funds have been the beneficiaries of benign neglect by the national financial and business media, which for the most part has not sought to report on the public funds in anywhere near the detail in which they cover, for example, similarly-sized corporations. But given the size, wealth and influence of the public funds, the absence of regular and sustained examination is unlikely to continue indefinitely. At some point — perhaps as a result of some scandal or crisis — both the media and the political process may bring the public funds under extensive examination. Far better for the funds to reform themselves voluntarily and at their own measured pace before such eventualities occur, than to find themselves vulnerable to criticism and forced to change — perhaps inappropriately or counterproductively — in circumstances not under their own control. It has not been unknown in our society and political system for the legislative or regulatory cure to turn out to be worse than the illness whose cure is sought. Thus, it may not be just the corporation whose legitimacy and future prospects can be enhanced by good governance practices.

Philip R. Lochner, Jr., is a member of the Board of Directors of Clarcor Inc., and of Apria Healthcare. He is also on the Board of Advisors of Republic Bank and the National Association of Securities Dealers, and is an adjunct faculty member at Columbia Law School. Mr. Lochner is a governance consultant, and formerly was a Commissioner of the Securities and Exchange Commission and the Senior Vice President and Chief Administrative Officer at Time Warner, Inc.

Richard H. Koppes is Of Counsel with the international law firm of Jones, Day, Reavis & Pogue and a Consulting Professor of Law and Co-Director of Executive Education Programs at Stanford Law School. He is a member of the Apria Healthcare Board of Directors and is the former Deputy Executive Officer and General Counsel of the California Public Employees' Retirement System.

(The views expressed here are solely those of the authors.)


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