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by: Veronica Hagenes


Veronica Hagenes
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This 13 page Class Notes was uploaded by Veronica Hagenes on Monday October 26, 2015. The Class Notes belongs to BUSFIN1311 at University of Pittsburgh taught by Staff in Fall. Since its upload, it has received 43 views. For similar materials see /class/229357/busfin1311-university-of-pittsburgh in Finance at University of Pittsburgh.




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Date Created: 10/26/15
US securities regulations protect investors and enhance market liquidity But do they alienate managers and shareholders eficient Governance by Amar Bhide Without a doubt US stock markets are the envy of the world In contrast to markets in countries such as Germany lapan and Switzerland which are fragmented illiquid and vulnerable to manipu lation US equity markets are widely respected as being the broadest most active and fairest any where The Securities and Exchange Commission strives mightily to keep them that way Thanks to the SEC s efforts trading costs in the United States are half those of any other market In the twinkling of an eye Wall Street s professionals buy and sell blocks of millions of shares The average American too can trade with little fear of rigged markets or insider dealings For Main Street companies however the nirvana of perfectly fair and liquid markets fostered by Wall Street s regulators has a dark side Unwittingly the system nurtures market liquidity at the expense of good governance Rules that protect investors and the integrity of stock markets also foster antagonis tic arm s length relationships between sharehold ers and managers The system prevents sharehold ers from engaging managers in candid dialogues and providing informed oversight and counsel It en courages capable executives to neglect their fidu ciary duties and thus injures the longterm inter ests of companies and shareholders Rules to ensure accurate and complete disclosure the incarceration of insider traders and the elimination of shady trad ing practices may actually hurt US managers and stockholders An Extensive Web of Regulation US rules protecting investors are the most coni prehensive and well enforced in the world The ori gins of the system can be traced to the extensive losses suffered by the public during the Crash of 1929 Between September I 1929 and Iuly l 1932 PHOTO BY STEPHEN SIMPSONFPO stocks listed on the New York Stock Exchange lost 83 34 of their total value and onehalf of the 50 hil lion in new securities that had been offered in the 19105 proved to be worthless The losses were widespread e the crash followed a decade during which sortie 20 million Americans took advantage of postwar prosperity and tried to make a killing on the stock market Responding to the outrage of vot ers Congress passed the Securities Act of 1933 and in 1934 passed the Securities Exchange Act and created the SEC Prior to the early 19305 the traditional response to financial panics had been to let the victims bear the consequences of their greed and to prosecute frauds and cheats The new legislation was based on a different premise the acts sought to protect in vestors before they incurred losses They did this in three ways 1 To help investors make informed trading deci sions the acts required issuers of securities to provide information about directors officers un derwriters and large shareholdersincluding remu neration the organization and financial condition of the corporation and certain material contracts of the corporation Issuers were also required to file annual and quarterly reports following specific guidelines issued by the SEC Over the years the SEC s efforts have substantially increased the num ber of reports that companies must file For exam ple companies must disclose management perks and overseas payments and provide replacement cost accounting and segment or lineofbusiness accounting Annir flirt1e is an associate professor ill the Harvard Business School in Boston IVlnssuchusetts Formerly a VJL E president lll EF Hutton he served on the Brady CUIUIZIAA IUH staff investigating the 1987 stock market Crash He published a more technical article on this 011A lt39 last year in the Journal of Financial Economics The acts backed the disclosure rules by providing criminal penalties for false or misleading state ments and empowering the SEC to suspend the reg istration of securities that didn t comply with the reporting provisions Regulators also expected as sistance from classaction lawsuits In 1946 for ex ample SEC officials testified that notwithstanding quotthe abuses of strikers and their raids on the cor In the 1930s SEC chairman William 0 Douglas threatened the New York Stock Exchange with takeover if it didn t reform porate treasury quot they commended the prophylac tic and deterrent effect of the stockholder suit and had occasionally urged the courts to adopt a liberal attitude towards class suits I 2 To discourage insider trading the securities laws required every officer director and 10 equi ty owner to report the securities they owned Such insiders had to turn over any shortterm trading profits those that resulted from purchases and sales within any sixmonth period to the company The laws provided criminal sanctions for failure to report such transactions The SEC has zealously prosecuted the insidertrading provisions of the laws given wide publicity to their sanctions and helped federal prosecutors send offenders to jail 3 To protect investors the 1934 Securities Ex change Act sought to eliminate the quotmanipulation and sudden and unreasonable fluctuations of secu rity pricesquot The laws prohibited several practices including engaging in transactions to manipulate prices or to create an illusion of active trading making material false and misleading statements and spreading rumors about market rigging Stock exchanges had to register with the SEC had to agree to comply with the securities acts and had to help enforce compliance by members The SEC could deny registration to any exchange that failed to comply with its rules and rapidly used its powers to close nine exchanges In the late 1930s Chair man William 0 Douglas virtually threatened the New York Stock Exchange with takeover if it didn t institute reforms In further pursuit of frictionless markets the SEC in 1971 gradually began deregulating stock commissions After amendments to the securities acts in 1975 made brokerage fees negotiable com 130 SECURITIES REGULATIONS missions paid by large investors declined from an average of 26 cents per share in April 1975 to 75 cents in 1986 Over the years Congress has also sought to pro tect investors by regulating the financial institu tions that manage funds For example the Invest ment Company Act of 1940 which followed the collapse of investment trusts set minimum levels of diversification for mutual funds and precluded them from holding more than 10 of a company s stock Complaints about the self serving management and the under funding of corporate pension funds led Congress to pass the Employee Retirement Income Security Act in 1974 ERISA prohibits pension plans from holding more than 10 of the sponsor s own stock or 5 of any other company s stock and specifies conservative rules for pension fund trustees The Basis of Market Liquidity On the surface anyway the populist regulations to protect the small shareholder mutual fund in vestor or pension fund beneficiary have benefited US companies by sustaining an efficient and liq uid stock market Wall Street s financiers who ar gue passionately for free enterprise in fact owe a great and unacknowledged debt to their regulators The SEC reassures speculators who make market liquidity a reality by certifying the integrity of ex changes Casinos with reputations for rigged games eventually drive patrons away Penalties for insid er trading similarly undergird a liquid market in which many buyers bid for stocks offered by anony mous sellers The fear of trading against better informed insiders would otherwise lead buyers to demand access to companies books Buyers would also want to identify and understand the motiva tions of the sellers Are they unhappy insiders or selling just because they need the money There fore without insider trading rules stock trades like used car or real estate transactions would probably require protracted negotiations between known buyers and sellers The SEC s enforcement of accurate and complete disclosure similarly facilitates trading of the stock of companies that neither buyer nor seller has ex ainined from the inside For example the SEC re cently filed a complaint accusing the Bank of Boston of failing to disclose fully the deterioration of its loan portfolio If the allegations prove true the bank faces SEC sanctions for violating secu HARVARD BUSINESS REVIEW Novcnibeerccemher I994 rities laws as well as possible shareholder suits Whatever the merits of the case such actions re assure traders that they can buy a company s stock without an independent audit of its books The laws that protect mutual fund investors and pension plan beneficiaries by enjoining broad diver sification of portfolios also contribute subtly to market liquidity The more investors diversify the more fragmented the stockholding of any company And fragmented stockholding promotes liquidity by increasing the odds of a trade just because some one needs the money or believes that a Certain stock is mispricedr The historical evidence suggests that without regulation stock markets would be marginal insti tutions Financial markets in Europe and in the United States developed around debt issues not equity Prior to 1920 Ionathan Baskin notes in the Summer 1988 Business History Review there were no largescale markets in common stock shares were viewed as akin to interests in part nerships and were simply conveniences for trad ing among business associates rather than instru ments for public issues Promoters of canals and railroads the few businesses organized as joint stock companies restricted ownership to known investors whom they believed to be both wealthy and committed to the enterprise The public at large at that time perceived equities as unduly speculative and tales of the South Sea fiasco evoked in stant horrors Public markets for debt issues however can be traced back to the 1600s The first instrument to be ac tively traded in Britain was the na tional debt there and in the United States most publicly traded securilt ties consisted of government issues until 1870 Later railroad debt became popular and at the turn of the century preferred issues financed the great merger wave It is noteworthy too that unlike the public equity markets which would evaporate for long periods following specula tive bubbles the debt markets bounced back from serious crises The impact of US regulators can also be seen by looking at the illiquidity of European markets in which restraints on insider trading disclosure re quirements and manipulative practices have tradi tionally been weak In the Belgian market during the 19805 which one expert described as quota sad largely deserted place insider trading was consid ered unethical but not illegal Most European coun tries had no statutes against insider trading until HARVARD BUSINESS REVIEW NUVL39I39HlWL lrUCCCIUbt I 1994 the mid19805 when the European Community di rected member countries to adopt a minimum level of shareholder protection laws US occupation forces instituted laws against insider trading in japan after World War 1 but officials there have largely ignored them According to a 1991 survey of 35 markets by En nis Knupp amp Associates a pension fund consulting firm in Chicago markets outside the United States don t require disclosure of the stock owned by prin cipal shareholders directors and officers Financial reporting is also less frequent in most nonUS markets and the reporting lag is typically longer Companies in most European countries have quotbroad latitude in creating and allocating funds in to and out of reserves a practice that makes it dif ficult to interpret reported earnings Companies generally don t provide fully consolidated state ments or individual lineof business information both of which are required in the United States The Catch What s wrong with this picture Shouldn t the managers and stockholders of US companies love the rules under which they operate In theory mar ket liquidity makes it easy for investors to diversify their risks and thus reduces the costs of capital for Instead of yielding shareholders who provide informed oversight US rules promote arm s length diffused stockholding companies But there s a catch US rules that pro tect investors don t just sustain market liquidity they also drive a wedge between shareholders and managers Instead of yielding longterm sharehold ers who concentrate their holdings in a few compa nies where they provide informed oversight and counsel the laws promote diffused arm slength stockholding Pension and mutual fund rules that require ex tensive diversification of holdings make close rela tionships with a few managers unlikely ERISA fur ther discourages pension managers from sitting on boards if the investment goes bad Labor Depart ment regulators may make them prove they had adequate expertise about the company s operations Concerned about overly cozy relationships be 131 tween unscrupulous fiduciaries and company inan agers the regulators have effectively barred all but the most distant relationships The seemingly irrcproachable insidertrading i rules place special restrictions on investors who hold more than 10 of a company s stock serve on its board or receive any confidential information about its strategies or performance They must re port their transactions forfeit short term gains and avoid any hint of trading on inside information But why should investors become insid ers and be subject to these restric tions just so that EVEI39YODC else can enjoy a level trading field They don t Institutional investors with fiduciary responsibilities usual ly refuse to receive any private information from managers They may grumble about a company s performance but they will not sit on its board for fear of compromising the liquidity of their hold ings institutions also make sure they stay below the 10 ownership limit that puts them under the purview of insider trading restrictions Thus the rules make large investors resolute outsiders In a freeforall market the same institutions would likely demand access to confidential information before they even considered investing Disclosure requirements also encourage arm s length stockholding For example rules that inan date the disclosure of transactions with insiders Institutional investors will not sit on companies boards for fear of compromising the liquidity of their holdings make a company s banks suppliers and Customers less willing to hold large blocks of stock or to serve on boards Disclosure rules also make anonymous shareholding safe If companies reports were sketchy or unreliable shareholders would demand an inside role as well as ongoing access to confiden tial information Market liquidity itself weakens incentives to play an inside role All companies with more than one shareholder face what economists call a free rider problem The oversight and counsel of any one shareholder benefits all others with the result that all may shirk their responsibilities This issue is 132 SECURITIES REGULATIONS particularly relevant when a company faces a crisis In illiquid markets the shareholders cannot run away easily and are forced to pull together to solve any problem that arises But a liquid market allows investors to sell out quickly at under a nickel a share in commissions In economist Albert Hirschman s terms investors prefer a cheap exit to an expensive voice Thanks to the extensive rules transient outsiders now hold a significant share of US stocks Diversification rules that cause institutions to fragment their portfolios and the stockholding of the companies in which they invest compound the freerider problem The chance that a 20 stock holder will expend resources for the benefit of the group is much greater than a 01 stockholder doing so Thanks to these extensive rulcs transient out siders now hold a significant share of US stocks The typical institutionalinvestor s portfolio in the United States contains hundreds of stocks each of which is held for about a year Institutions tend to follow the socalled Wall Street rule sell the stock if you re unhappy with the management Former SEC commissioner Ioseph Grundfest observed in a special issue of the lourmrl of Financial Economics in 1990 In both Germany and japan corporate investors and intermedi arics are able to reach deep into the inner workings of portfolio compa nies to effect fundamental manage ment changeln the United States in contrast when large institutional investors suggest that they might like to have some influence on management suc cession at General Motors a company that has hardly distinguished itself for skillful manage mentithey are met with icy rejection and explicit warnings that presumptuous investors had better learn their place Outside the United States the situation is differ ent There we see large investors whose holdings are immobilized by special classes of restricted stock long term financing or other business rela tionships Economists Kenneth French and Iames Poterba estimated in 1989 that in Iapan 48 of outstanding share value was held on a nearperma IIARVARD IIURINESS REVIEW NovemlieiDecen1lici39 994 nent basis by a network of affiliated banks insur ance companies suppliers and customers In all but two countries outside the United States large longterm block holdings account for more than 20 of market capitalization Richard Breeden former chairman of the SEC claims in the lanuaryFebruary 1993 issue of HBR that German and Iapanese governance models are not appropriate to US traditions In his view the closed nature of the foreign systems contradicts US values of openness and accountability How ever the historical evidence suggests that investor protection rules not deeprooted traditions or val ues have fostered the unusually fragmented and arm slength stockholdng that we find in the Unit ed States today Before the New Deal investors who took an ac tive inside role in governance played a major role in financing US industry DuPont family money helped William Durant 7 and later Alfred Sloan7 In most other countries large longterm block holdings account for more than 20 of market capitalization build General Motors Investors represented by 11 Morgan helped Theodore Vail build ATampT and Charles Coffin create the modern General Electric The investors were in it for the long haul the DuPonts fought Iustice Department efforts to make them sell their GM stock and they played an im portant oversight role Pierre DuPont watched over the family investment in GM as chairman of its board he reviewed in a regular and formal fash ion the performance of all its senior executives and helped decide on their salaries and bonuses Ac cording to Alfred Chandler and Stephen Salsbury DuPont left the details of financial and operating policy to the company s executives but took part in the finance committee s critical decisions on im portant capital investments Even today investors in private companies act more like big German and lapanese stockholders than like US institutional investors Michael Gor man and William Sahlman s research shows that partners in venture capital firms typically manage nine investments and serve on the boards of about half of them They visit the companies every few weeks help recruit and compensate kcy employ HARVARD BUSINEW REVIEW N4weinhenDei tmber 1994 ees work with suppliers and customers and help develop strategy and tactics The investment strategy of Berkshire Hath away s Warren Buffett also suggests that Pierre DuPonr39s carefuloverseer approach conflicts more with 115 regulations than with the traditions or values that Breeden invokes Buffett isn t subject to the same regulatory pressures to diversify as the typical pension fund manager he his wife and his longterm partner and vicechairman Charles Monger own well over half of Berkshire s stock Berkshire seeks to quotown large blocks of a few secu rities that we have thought hard about Buffett ex plains At the end of 1992 992quot of Berkshire s 1 11 billion common stock portfolio was invested in only nine companies Buffett serves on their boards and will in a crisis intervene to protect his investments For example in the government hond auction scandal at Salomon Brothers in 1991 he stepped in as chairman to make sweeping changes in management Apparent ly Buffett s large holdings of Berk shire stock and the tax conse7 quences of realizing gains make him more willing than other institution al investors to submit to the liquidi tyreducing rules that insiders face Buffetts favorite holding period is foreverRegardless of price we have no interest at all in selling any good businesses that Berkshire Hath away owns and we are very reluctant to sell subpar businessesgin tummy managerial behavior dis card your least promising business at each turn is not our style he says The Effect on Governance The degree of closeness of managershareholder relationships has a significant influence on the gov ernance of companies The basic nature of execu tive work calls for an intimate relationship dif fused arm slength shareholders cannot provide good oversight or counsel and often evoke mistrust and hostility Managers aren t like agents who execute specific tasks under the direction of their principals like doctors or lawyers they hav a broad responsibil ity 7 a fiduciary one 7 to act in the best interests of stockholders As with other fiduciarics their performance cannot be assessed according to a mechanical formula Shareholders must weigh the outcomes that they observe against their guesses about what would have happened if managers had followed other strategies Losses do not necessarily 133 establish managerial incompetence the alterna tives might have been worse If concrete perfor mance objectives are set shareholders must iudge whether managers are playing games with the tar gets for example if they are meeting cash flow goals by skimping on maintenance To make truly fair evaluations therefore share holders must maintain a candid ongoing dialogue with managers But such a dialogue between inan agers and arm slength shareholders is impossible Practically diffused shareholders cannot have much contact with senior executives in the typical public company most shareholders catch only an occasional glimpse of the CEO in a carefully staged road show or a presentation to analysts Neither can managers share sensitive data with shareholders at large indeed managers must Cmt t rlf strategic in formation from them When a company like Apple struggles to convmce potential buyers that its handheld computer is here to stay for example its managers cannot reveal to stockholders how disap pointing the early sales have been Moreover man agers who disclose more than what the rules re quire of them risk shareholder suits 17 of CEOs surveyed earlier this year by the American Stock Exchange reported that their companies had been sued in the past five years over voluntary disclo sures they had made in analysts meetings press rev leases or speechesquot Managers are forced to be circumspect they can t debate critical strategic issues in public and insider Managers cannot debate critical strategic issues in public and insider trading rules discourage private discussions trading rules discourage private discussions Allt most inevrtably their dialogues with the invest ment community revolve around quarterly earn ings pcrsharc estimates even though both sides know well that those figures have little longrun significance How wholeheartedly managers will advance the interests of anonymous shareholders is also ques tionable Basic honesty and concern for their own reputations as well as fear of public ridicule inhibit flagrant disloyalty and fraud but the abuses that shareholders must worry about are often more sub tle In Hurlmrium 11 the Gate for example authors 134 SECURITIES REGULATIONS Bryan Burrouin and lohn Helyar report how Ross lohnson former chairman of RIR Nabisco acquired a luxurious fleet of corporate icts and ordered flights inst for his dog But having CEOs wait in air ports for standby seats doesn t serve sharehold ers well either How and where should managers draw the line Social norms provide little guidance In Japan the chairman of the national airline is expected to resign when a pilot s error causes a plane crash But in the United States there is no standard for how Exxon39s chairman should atone for the multibil liondollar V11ch disaster Rather the identity and values of the particular individuals whose approval managers seek have a much greater influence on their behavior For example CEOs who want to im press other CEOs and who have no contact with their shareholders will find it ea ier to convince themselves that a corporate iet makes them more productive Executives who know their stockhold ers and value their esteem however will probably be more careful stewards Similarly shareholders are more apt to ascribe poor performance to man agerial incompetence than to bad ltick if their per ceptions have been shaped by colorful reports in the press than by personal relationships with a compa ny s managers Unfortunately thanks to the rules managers and shareholders in the United States now regard each other with suspicion CEOs complain that inves tors are fixated on quarterly earnings and are ig norant of companies markets com petitive positions and strategies and therefore cannot evaluate man agers Investors see many CEOs as entrenched overpaid and selfserv ing As Peter Lynch the former man ager of Fidelity s Magellan Fund halfiokingly remarked I only buy businesses a fool could run because sooner or later one will Converse ly CEOS could well ask how the manager of the multibilliondollar fund even rc membered the names of the 1000 or so securities in which be invested The alienation of stockholders and managers makes public equity markets an unreliable source of capital Accepted beliefs notwithstanding the exceptional liquidity of US markets apparently does not give publicly traded companies advantages in issuing equity Ionathan Baskin finds that large public corporations from all the major industri alized nations including the United States appar ently issue common stock to raise funds only in the most exigent circumstances and that macro HARVARD HUKINPSS KEVILW Nm clnherdIel39cmhel W M economic evidence suggests that quotthe quantity of funds raised by new equity issuesAespecially by established companies appears to be relatively insignificantquot When public companies do issue equity Paul Healy and Krishna Palepu report in the Fall 1989 Continean Bunk ournal of Applied Corporate Fi nance it is rarely to fund attractive new projects Instead they issue equity to reduce their leverage in anticipation of increased business risk and there fore increased probability of bankruptcy Investors in turn regard stock issues with great suspicion quotInvestors recognize that managers have superior information and interpret equity offer announce ments accordingly Healy and Palepu write Their study shows an average 31 riskadjusted drop in stock price in the two days surrounding an equity offer announcement The stock market does on occasion allow com panies in fashionable industries to issue stock at lofty prices But such instances usually represent episodes of market mania or what underwriters call quotwindows of opportunity When the window closes investors dump the stocks wholesale and don t give the category another chance for a long time For example when the market for biotech nology issues was hot any company whose name included some part of the words biology technolo gy or genetics could issue stock without any prod ucts revenues or profits But later when valua tions dropped back down to earth good biotech companies couldn t raise capital in the public mar kcts to fund their RampD Arm slength stockholding subjects managers to confusing signals from the stock market Wall Street isn t shortsighted in fact the market often values favored companies at hardto bclieve multi ples of their future earnings But companies fall in and out of favor unpredictably the market abruptly switches from a rosy longterm view of biotechnol ogy to a fascination with multimedia companies Understandably so without inside knowledge of companies strategy and performance investors fol low the crown Managers in turn pursue strategies to protect their companies against apathetic or fickle in vestors Uncertain about access to capital when the company might need it managers avoid paying our earnings to stockholders even when it does not They reinvest profits sometimes in marginal proj ects and outside shareholders can do little about the situation In the 19605 for example managers of cashrich companies in mature industries made acquisitions in businesses that were unrelated to their core capa DRAWINGS BY MARK STEELE CEOs complain that investors are fixated on quarterly earnings while investors see many CEOs as entrenched overpaid and selfserving 135 bilities The result was many organizations of un manageable size and diversity quotBefore World War 11 Alfred Chandler observes in the MarchApril 1990 issue of HBR the corporate executives of large diversified international enterprises rarely managed more than 10 divisionsl3y 1969 many companies were operating with 40 to 70 divisions and a few had even more Senior managers in the companies frequently had quotlittle specific knowl edge of or experience with the technological pro cesses and markets of the divisions or subsidiaries they had acquired In more recent periods the managerial propensi ty to retain earnings has led to investment in busi nesses that should be shrunk in industry after The workings of a stock market that supposedly facilitates capital flows actually help immobilize capital industry with excess capacity Michael Jensen writes in the Iuly 1993 lourna of Finance rnan agers quotleave the exit to others while they continue to invest so they will have a chair when the lTlll sic stops General Motors Iensen calculates spent nearly 70 billion on its RampD and investment pro gram between 1980 and 1990 only to end up with a company of 262 billion in equity value GM s investments he observes would have been more than enough to pay for the equity value of Toyota and Honda which in 1985 totaled 215 billion Thus the workings of a stock market that supposed ly facilitates capital flows actually help immobilize capital within companies indifference and hostility are also reflected in operating inefficiencies The worst affront to RIR Nabisco s stockholders wasn t the perks for the CEO s dog it was the instructions to the head of the Nabisco division not to generate too much profit in any one year so that the company could report smoothly growing earnings Apparently many managers don t try very hard for anonymous shareholders Several studies have documented dramatic improvements in profit mar gins cash flows sales per employee working capi tal and inventories and receivables after leveraged buyout transactions that replaced diffused public stockholders with a few private investors Steven Kaplan s landmark study of LBOs in the 1989 our 136 SECURITIES REGULATIONS nu of Financial Economics shows that average op erating earnings increase by 41 and cash flows by 96quot in the three years after public companies are taken private The Limitations of External Discipline What about the socallcd market for managerial control How can CEOs who provide poor steward ship survive the unsolicited tender offer Alfred Rappaport calls that the most effective check on management autonomy ever devised in the Ian uaryFcbruary 1990 issue of HBR Actually unsolicited tender offers constitute a tiny fraction of takeover activity Most mergers are friendly affairs negotiated by execu tives of established companies who are seeking wellmanaged profit able targets and will pay premium prices for them The managerial club frowns on hostile offers Raiders serve as a check only against flagrant incompetence or abuse Profitmotivated raiders like Ronald Perelman or Iames Gold smith operate under significant con straints they must raise money deal by deal mak ing their case from publicly available data Even at their peak in the mid1980s raiders posed a threat to only a small number of targets diversified com panies whose breakup values could be determined from public data to be significantly higher than their market values Raiders could not and did not go after turnaround candidates any more than friendly acquirers did Outside shareholders analysts or takeover spe cialists cannot easily distinguish between a CEO s luck and ability Again Warren Buftctt because he is a director and major investor in Salomon Broth ers could much more easily assess the culpability of Salomon s CEO and the consequences of replac ing him in 1991 than outside shareholdch could Judgments by managers and therefore of managers are necessarily subiective and require considerable confidential and contextual information The case of IBM dramatizes the inadequacies of external scrutiny Between the summers of 1987 and 1993 IBM s stock lost more than 60 of its val ue while the overall market rose by about the same percentage The magnitude of the shareholders losses was comparable to the gross domestic prod uct of several countries But while IBM s stock price dropped relentlessly the company s management did not face the least threat of a hostile takeover or proxy fight Outsiders had no way of knowing HARVARD BUSINESS REVIEW NovmnbevIkeembcr i994 whether or not managers were struggling as compe tently as they could with problems beyond their control National business magazines actually car ried glowing cover stories in 1991 and 1992 about how CEO John Akers was taking on the IBM bu reaucracy and breaking up the company into 13 de centralized units One year later journalists found little good to say about his entire tenure Wall Street has responded to reduced internal oversight by stockholders by providing better ana lysts reports and somewhat greater support for hostile takeovers But Wall Street s external scru tiny and discipline lack force and have actually in creased the alienation betwecn managers and their stockholders Company executives lobby for anti takcover laws and poison pills to fend off raiders shareholders band together to fight what they view as managers attempts to entrench themselves The Moral Consequences Arm slength relationships force managers who have a fiduciary duty to their shareholders into a difficult moral position Fiduciarics have a broad obligation to put their clients interests ahead of their own clients come first before the fiduciary s pecuniary selfinterest and before his or her person Managers may obey the laws and ignore their consciences but that yields a soulless existence a values The primacy of Clients interests may thus require fiduciaries to perform aets they per sonally consider repugnant unless they obtain their clients consent to pursue another course The example of an entrepreneur who runs a com pany that machines and drills flanges provides a concrete illustration His business was threatened by what he considered an unfair antidumping tariff that would wipe out his suppliers of raw forgings so he sought to have the tariff removed In the course of his efforts however he found a loophole that eliminated his business problem Now taking on federal trade regulators did not serve the best in terests of the investors in his business but as a good citizen he felt impelled to continue his efforts to change the regulations Fortunately the entrepreneur could reconcile his fiduciary responsibilities and the tug of his con science He could approach the small group of in HARVARD BUQINESS REVIEW Novenibeertcember 1994 vestors who had backed him on several previous ventures and get their permission to do whatever he thought was right Managers of companies with hundreds of anonymous shareholders can t do that Managers may therefore always seek to maxi mize shareholder wealth and obey all laws but ig nore the dictates of their own consciences But that option can force executives into a soulless exis tence and yield a barren amoral organizational cli mate for their subordinates Alternatively managers may unilaterally choose to put their personal values ahead of their share holders interests For example former Zenith chairman Iohn Nevin waged a campaign against the alleged dumping of TVs by Iapancse exporters a battle that caused the Chicago press to dub him the Don Quixote of Dumping Nevin s efforts which came to naught arguably represented a personal crusade rather than a strategy to maximize share holder returns Zenith s shareholders might have been better served 7 even if the national interest wasn vby an accommodation to the alleged dump ing But putting patriotism or other personal values ahead of financial returns without shareholder consent undermines the basis of free enterprise the moral obligation of individuals to discharge the fiduciary duty they voluntarily undertake Some managers might insist that their moral values always coincide with the longterm interests of their shareholders But that s tantamount to denying the existence of moral business dilemmas If wealth always followed virtue we would have con flicts only between the long term and the short term or between stu pidity anti wisdom In fact nothing in the record suggests that the wicked always get their comeup pance Many blue chip companies were put togeth er at the turn of the century under circumstances approaching securities fraud and the fortunes of their promoters have survived several generations Rationalizing away conflicts between moral values and shareholder wealth is simply one more way of breaching fiduciary duties The Case for Reform Although more managers investors and policy makers than ever before recognize the gravity of the problem ignorance of the connections among investor protection market liquidity and gover nance has led to ineffectual or even counterproduc tive measures For example according to Richard Breeden in the BER article already cited the SEC 137 If wealth always followed virtue we would have conflicts only between the long term and the short term or between stupidity and wisdom 138 SECURITIES REGULATIONS has sought to strengthen broadbascd participation in corporate governance and thus ensure both a strong and open investment market and prompt and meaningful managerial accountability Ac cordingly the SEC recently eased restrictions on communications among shareholders and mandat ed disclosure of the process that companies follow to determine executive compensation Michael Porter has suggested that companies report strate gic as well as financial data to get investors to focus more on longterm prospects than on shortterm earnings But I believe that both Steps only encour age armslength shareholding exacerbate the prob lem of inadequate internal oversight and increase conflicts between shareholders and managers Good governance requires real policy tradeoffs Clever tinkering with insidertrading and disclo sure laws cannot get around the basic conflict be tween market lquIiClitval liCl l requires transient arm s length shareholding and close honest share holdermanager relationships If they understood the trade offs better however the beneficiaries of the existing system probably would resist changing the rules The number of shares traded per year now exceeds 60 of all out standing shares If trading fell to the 10 to 20 rate of previous decades the fall in commissions which in 1993 exceeded 15 billion would send shock waves through New York s financial dis tricts Without SEC safeguards to reassure in vestors underwriters could do fewer public stock offerings Profits from analyzing and packaging in formation on market prices and corporate perfor mance would decline Without disclosure require ments some companies utilities for example might continue their current reporting practices but many others would not If inside stockholders could block egodriven ac quisitions many megafee deals would disappear If stockholders were able to provide informed over sight they could limit corporate diversification and growth very large public corporations would be limited to sectors with compelling economies of scale or scope Fund managers would be forced to retool many who now seek discrepancies between a stock s price and its intrinsic value would like venture capitalists have to try to increase compa nies values through counseling and oversight An active governance role for institutional in vestors would also conflict with a riskaverse regu latory ethos Allowing mutual fund and pension fund managers to concentrate holdings and sit on boards increases the risk of selfdealing and would require clients to exercise more vigilance and pru dence Occasionally greed lax scrutiny or inge HARVARD BUSINESS REVIEW NovemberDecember 1994 nious fraud could lead to serious losses But should good public policy sacrifice the interests of the many to guard against the imprudence or bad luck of the few Should the possibility of a few pension fund scandals get in the way of better governance for many companies Better governance could unlock enormous value by reducing the invisible inefficiencies that external markets can t detect Although more trust creates opportunities for greater fraud we should recognize that hostile arm slength relationships embedded in a liquid market have led to the widespread dissipation of re sources According to one estimate the total cost of trading stocks consumes resources equal to about onesixth of the total earnings of US corporations The 30 to 50 premium over market prices which is usually paid when companies are taken private suggests that better governance arrange ments could unlock enormous value by reducing the invisible inefficiencies that external markets can t detect For at least two decades public corpo rations with diffused ownership have not invested their vast resources wisely Entrepreneurial pri vately held companies have taken over as the en gines of innovation and job growth To justify re i form increased internal oversight has only to block some faddish mergers shake up a few companies like IBM or GM before their losses become a public embarrassment or promote a leanand mean ethos l before a recession forces painful restructurings Moreover the stock liquidity that would be lost is dispensable investors can and should use bonds and bank deposits for their liquidity needs and treat stocks as longterm holdings Liquid markets play a valuable economic role in physical commodities or well secured standardized contracts such as gov ernment bonds or currency futures No one would expect to trade claims on the services provided by i doctors or lawyers so why should the services of managers be treated differently HARVARD BUSINESS REVIEW Novemhcercceniher 994 Mi Managers too would benefit from reforming a system that undermines the legitimacy of their role Informed oversight by inside stockholders might bother insecure executives who would prefer to deal with pliant boards of directors But I believe most managers would feel liberated Fiduciaries who must make difficult judgments gain from the support of informed principals GM s investments in the 19805 might have proved just as un rewarding with a Pierre DuPont as airman but GM s executives would not have been accused of self serving or insular behavior Stock holders should bear the ultimate re sponsibility for ratifying longterm strategies and for selecting and re warding managers Moreover the current system robs managers of the opportunity to gain the re spect and approval of their shareholders Now they are stuck having a duty of care and fidelity to face less stockholders whose gratitude they can never experience Trust that the people with whom you deal will not only obey the law but will also fulfill the fidu ciary responsibilities inherent in their relation ships is as essential to the working of the capitalist system as a sound currency and a reliable legal sys tem Herbert Stein writes US regulators have unwittingly weakened that trust Managers and their stockholders have a common interest in the reforms that would restore it Gansnn Purcell Rogers Foster and Alfred Hill Corporritiorir Enoru mg the Accountability of Cnrportitc Management and Related ACHVHMA o the SEC New York Practicing Law institute 1946 1 Kenneth French and times Poterl ia Are aptitmst Stock Prices Trio High iChlcagn llllnuls Centextorirtsezuch in Securities Price Universi ty of Chicago 1989 3 Alfred D Chandler and Stephen Salsbui y I ierru S DuPont rind the Making of the Modern Corporation New York Harper Si Row l97l pp 571587 391 Michael Gorman and William Sahlrnan What Do Venturc Capitalists Do Itinmill of Business Venturing vol 4 no 4 ILin 1989 pp 231248 5 Warren E Buffett Letters to Shareholders Omaha Nebraska Berk shire Htithawaylnc 1987 Andy Zipscr Litigation Run Amok ls Making CEOs Clam Upquot Bur lm39s May 2 1994 p 2 7 lonarhan B Baskin quotThe Development of Corporate Financial Markets in Britain and the United States 600 19l 4 Overcoming Asymmetric in formation Business HISZOY Review vol il Summer 19 pp 199237 R Herbert Stein Blame unk Bond Dealers Not Iunk Bondsquot Wall Street Inuniiil February 23 1990 p A U Reprint 94602 13 Ll nu Pun n u L i J grani permission u access or H An uni quot 39 39 LI through 39 quot 39 transmission 4 quot 439 usage contact permissionshbspharvard2du


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