May 01, 1998
Let me start with some questions to set the framework for thinking through this issue of corporate governance: why do we care about "corporate governance" and why do we have "corporate governance" in the first place? Most current observers would argue that our system of corporate law has embodied "corporate governance" principles for some time and, therefore, there is no need to explore now why we have these principles or why we care; rather the important questions are what specifically should a corporate governance scheme look like, and how do we change it to make it look more like something a particular constituency favors. Moreover, popular debates about corporate governance are generally placed in the context simply of shareholders versus management, as if corporate governance is a zero sum game. Corporate governance then becomes a question of who wins and who loses.
Such a perspective is mistaken. Because the Federalist Society seeks, in part, to reexamine basic principles and starts with a somewhat free market perspective, it is appropriate to ask the fundamental question of whether we need corporate governance in the form in which we traditionally have conceived it.
For example, how would a system work that allows managements to do what they wish? If the corporation performs poorly, its products or services will be too expensive, or too low in quality or otherwise not be competitive. Presumably the corporation will make less profits. Lower profits will drive down share prices. Eventually, the corporation may become bankrupt. In the context of privately-held small businesses, this laissez-faire scenario occurs every day. Nobody worries about having outside monitoring or shareholder control or corporate governance; small businesses compete in a single market, which is the market for their products and services, and governance simply follows the need to make a profit.
But for large public companies in the United States, we have something different. These companies compete in two different markets. Obviously one is products and services. But a second is the market for corporate control, the market for corporate governance.
Particularly in the realm of corporate monitoring, this dual market system distinguishes the United States from the corporate governance scheme in, for example, Japan. In Japan, the bank at the center of a Keiretsu provides central financial services for a large family of complex businesses, while at the same time monitoring those businesses. Very simplified, one can describe this Keiretsu system as one involving large, non-diversified centralized investments, combined generally with expert monitoring and control at the management level. Importantly, the individual businesses within a Keiretsu are not required to compete in the external market for corporate control or for capital. Rather, they compete for corporate control and capital in the internal market within their Keiretsu.
This international comparison leads to two questions about our system of corporate governance and monitoring. First, does our structure of corporate governance via dispersed shareholdings in which shareholders generally provide the basic monitoring function by examining board and management action constitute a better structure compared, for example, to the Japanese Keiretsu model? A few years ago one might have said no, today one might say yes. The lack of external discipline as to financing allocation and management selection decisions in these non-U.S. models seems, at least for the moment, to have been a long-term negative. Another question of more recent origin is whether the incredible developments in communications and information technology will permit the emergence of a different type of structure for corporate governance in this country. Today I would like to focus on this second question.
History provides valuable insight on what the future shape of corporate governance may look like. Corporate governance in the U.S. one hundred and fifty years ago shared some similarities with today's Japan, and it actually shares some characteristics with what is found currently in Silicon Valley. It's similar to the notion of venture capital.
In the first half of the 19th century, most large corporations had a few very large shareholders or even a single shareholder. Those shareholders were generally not diversified; they made large investments in a relatively small number of companies, usually companies in the same industry. Also, they were specialized and expert in their investments, they tended to sit as directors on the boards of the companies in which they invested and they frequently selected management. These shareholders were in a position to monitor well the companies in which they invested.
The idea that there would be dispersed ownership and control was impractical then for a variety of reasons. One was that 19th century technology did not allow for efficient trading markets. Another was that there was no public disclosure of information, and no standardization with regard to information necessary to monitor effectively. There was also no guaranteeing the veracity of information that did filter out to the public.
With such a dearth of investment information, it is possible to provide low-cost capital to a business only if the supplier of such capital is in a position either to exit efficiently or to monitor efficiently. For the reasons I just noted, exiting efficiently was difficult. Thus, instead, companies were able to obtain reasonable cost capital by attracting large investors who, because of their large stakes and non-diversification, obtained, understood and acted on the information necessary to profit from their investments.
Gradually, however, managers and investors started to understand the benefits of providing information to larger pools of capital. A more diffused demand resulted in higher prices and easier capital formation, and greater diversity allowed for a broader business base. With a rising market, sufficient technology to allow for some level of trading and a view that information (or "rumors") could be trusted, the system worked well enough until at least the 1920s. Then, a variety of public concerns were raised regarding the abuses of outside investors by inside investors and management.
The benefits from increasingly large, dispersed pools of smaller investors, including specifically lower cost capital, could start to become outweighed by the perception of risk and by the inability of these investors to monitor appropriately. What was needed, in essence, was the equivalent of or surrogate for a major investor, an entity that can demand truthful information that can be understood and acted upon. Enter then the Securities and Exchange Commission ("SEC"), which standardizes disclosure, provides enforcement of those disclosures, ensures their veracity and at the same time helps to structure an efficient marketplace for trading. Moreover, this structure provides the benefits of various types of diversification: capital is supplied by different investors with different preferences to different companies in different industries. All in all, it's a brilliant system for ensuring informed investment decisions and efficient exits when companies are performing poorly. But it was not a system geared towards promoting shareholder monitoring from the "active oversight" or "corporate governance" perspective.
In fact, in the 1930s a number of observers such as Berle and Means made strong arguments that America's corporations were losing their ability to maintain their competitive edge because nobody could appropriately monitor or supervise them. But the war devastated most of this nation’s potential competitors and U.S. corporations clearly reigned in the world. A few decades later, however, former foes had turned into economic competitors and they began to do quite well. Our markets’ response to the lack of active monitoring by long-term shareholders was a vibrant takeover market. But slowly, a modest form of active monitoring began to emerge with giant pension funds like CalPERS leading the way. The explosive rise of mutual funds in the '80s, with Fidelity and some others becoming involved in certain types of corporate governance then supplemented this active pension fund activity.
So what does all this mean for corporate governance? The provision of truthful and reliable information means that smaller, dispersed investors could make informed investment decisions, with the resulting benefits noted above. This structure had evolved so that investors could monitor and could decide whether they believed the company was doing well. And these investors had an exit and could sell their shares if they did not like what they saw, but they did not have a significant ability to influence the management of the company. Indeed, some of our laws – supposedly there to protect shareholders – actually undermine shareholders in this regard. For example, requirements that were previously reasonable requiring large shareholdings and shareholders’ agreements to be disclosed have now been twisted so that they discourage shareholders from acting collectively. Some of that hopefully will be changed, but progress here is slow.
By contrast to legal changes though, technology, particularly the speed, accessibility and flexibility of communication over the Internet may well enable major changes in corporate governance. For the first time, technology is allowing the average shareholder not only to obtain information needed to invest more effectively--that has already occurred--but to exercise an effective voice in determining corporate policy and direction. In a way, the result of monitoring is turning once again to "active oversight" as opposed to efficient "exit".
So, we are now entering the age of technology and corporate governance. And here the potential is great. The Council of Institutional Investors ("CII"), as an example, could set up a Web site and provide to anyone information about the shareholdings of all their major institutional members. Their membership represents about a trillion dollars worth of stock. Were the CII to create such a Web site, it would present a formidable step towards ensuring that investors know which other investors they should contact in order to air an issue regarding a specific company.
There is also the ability to create chat rooms so that shareholders can communicate about a company and its management on an instantaneous basis. Using the Internet, shareholders could place a resolution, for example, on a Web site and have a referendum as to whether shareholders believe the resolution should be submitted and, if it were submitted, whether the shareholder would vote yes or no. This would be what I call corporate governance in real-time. Shareholders could provide their views about a company, where it's going, and whether management is particularly good or bad, not just once a year at the annual meeting, and not just in 500 words or less, and not just through a proxy mechanism with no interactive capabilities, but through a mechanism that allows shareholders to express their views in detail and on a real-time basis.
Nonetheless, there can be significant problems with such rapid fire corporate governance. I believe strongly that there are benefits in shareholders having a long-term perspective. One of the great attributes of the old style of relationship investing championed by J.P. Morgan and today by Warren Buffet is that these shareholders actually understood the businesses they were investing in. They were or are there for the long haul. They worked hard to make sure their investments paid off. Today's trend toward relationship investing by some large, but still very few, funds resembles this old J.P. Morgan approach.
But the problem with many new investors is that they are not in it for the long haul. They are diversified, they don't particularly care about any particular company and, consequently, the concept of maintaining an interest in a company through thin times as well as fat times is not a strategy that is necessarily logical. As a result, some of the benefits that come from recent technologies -- the efficiencies of trading, the ability to exit, better information, and quicker analyses – encourage an increase in short-term perspective.
That is troubling. Moving more and more towards real-time corporate governance, and more and more towards shareholders being able to provide resolutions on a Web site and obtain an almost immediate response, can mean a convergence of short-term "exit" strategies and short-term governance views. If major institutional investors and others who will exercise their voice don't start to ensure that they understand the long-term businesses of companies, and most importantly don't start to ensure that they understand how to support companies as well as discipline them, we will likely create a system that results in increased short-term perspectives and worse governance over the long term.
If the result is more short-termism, I suspect it will be not only some of our larger investors, but also our legal system and, to some degree, managements who are to blame. Managements do poorly in explaining to their shareholders their future strategies. They don't do a good job of doing the kinds of things that they used to do with their large inside shareholders, that they still do today in start-up companies with venture capitalists and that Japanese companies do with central financing entities in a Keiretsu system. The most valuable information – the forward looking strategic information (not what passes for forward-looking information today, namely next quarter’s earnings) that would allow investors to evaluate where the company is going – not just where it has been -- is difficult to provide to the market. We have laws, for example, that make it difficult to disclose important inside information to shareholders. But managements have not rushed to think of ways within the law to educate their shareholders better about their long-term strategies.
Our regulatory structure then may create some impediments to creating a system that would work better – or at least refocus attention on longer-term business plans. One structural answer has been relationship investing funds – funds that are willing to maintain their position in a company over a long period and agree through contract to do so. Because they are not trading the company’s stock, these funds can then be provided information that otherwise would be viewed as "inside." But for institutions that for fiduciary reasons believe they cannot be required to maintain an investment in a particular company (a view of fiduciary requirements that I would challenge), then concerns regarding insider trading may combine to promote a short-term perspective .
Conversely, technology allows corporations to have more interaction with their shareholders – permitting their horizons to be extended. I have suggested and some corporations are now starting to consider the notion, for example, of having chat rooms on their own Web pages where management would respond to shareholders' inquiries. These chat rooms would allow for useful and regular, real-time interactive communication instead of the once-a-year conversation that occurs at annual shareholders' meetings or the conversations with analysts (of course, posting analysts' meetings on the Web would be useful too). Making corporate governance better then means providing more and better information to shareholders.
In sum, this little part of the world is changing dramatically, and for the first time in our history, technology will be the driver behind a new style of corporate governance. Whether it will be for the better or the worse depends on how shareholders implement their new found power, and that will depend on managements. If managements embrace the technology and the opportunity it provides for better communication and education of their companies’ shareholders, then I believe we will have a new, improved system. If managements see the new technology merely as encouraging harassment, time consuming and irritating, then shareholders will respond in kind. Unfortunately, our legal policies for the moment – again for purposes that were originally good -- encourage division between managements and shareholders while discouraging dialogue between them. But I am hopeful that the system will continue to be improved. In a real way, our future depends on it.
Steven W.H. Wallman is a former commissioner of the Securities and Exchange Commission. Immediately prior to serving as a commissioner, he was a partner in the law firm of Covington & Burling. The author currently, among other things, consults regarding corporate governance and related issues. This article is adapted from his remarks given at the Federalist Society's Conference on Corporate Governance, held in Palo Alto, California in October of 1997.