Potential Roadblocks to Effective Shareholder Activism

Mutual funds and pension funds are trying to make money. One of the shortcomings of chasing after financial gains may be that the process may be also harming the funds. For example, many active and anxious investors have a speculative or short-run view of the stock market. They make trading and investment decisions based on short- term trends. Therefore, should we really be surprised if some funds have the same short-run views?

Darrell K. Rigby of Bain & Company asserts that institutional investors might be interested in propping up results for the short term and then selling the stock to move on to something else. ^[22] John C. Bogle, founder of the Vanguard mutual funds, makes the same contention . He has been calling on mutual fund managers to engage in more activism, but instead he witnesses mutual funds engaging in speculative investing. He claims that during 2001, four out of every ten equity funds turned their portfolio over at an annual rate of more than 100 percent. ^[23] That is, if equity funds don't like the future prospects of a firm, they sell the stock instead of helping to change the firm.

In a BusinessWeek commentary , John A. Byrne was even more accusatory. He argued that shareholders deserve a good deal of the blame themselves . After all, it was the institutional investors, shareholder advocates, and corporate raiders who made popular the principle of "maximizing shareholder value." ^[24] He is not alone in this opinion. Beverly A. Behan of Mercer Delta Consulting makes the most damaging assessment by stating that "Institutional investors could just as easily turn a blind eye to accounting practices that might increase the stock price in the short-term." ^[25]

These accusations carry some weight. For example, prior to the onslaught of corporate scandals, where were these large shareholders? Why did they stand by while boards were obviously tainted? Why wasn't the independence of auditors questioned? In general, why didn't they more strongly impose better governance standards? Is it because they only care about making a quick buck? Linda E. Scott of the New York State Retirement Fund openly admits, "It's all bottom line. It's 'How much money did you make for us this past year?' We're not here to make sure that boards are composed of good directors. We're here to make sure boards make money for us." ^[26]

In fact, there were even some murmurings that CalPERS had known about Andrew S. Fastow's questionable self-dealing partnerships with Enron but remained silent. ^[27] Indeed, CalPERS invested $250 million in Enron's offshore partnership JEDI. ^[28] Later, CalPERS invested more money in the partnership JEDI II. What makes these investments even more interesting is the fact that they were recommended by the investment advisor Pacific Corporate Group (PCG). This is interesting because PCG's fee for its recommendation came from Enron. ^[29] How can an institutional investor ”one that is trying to champion proper corporate behavior ”neglect an obvious conflict of interest? Perhaps it was CalPERS's profiting $132 million on the first Enron deal that had something to do with it.

Another potential problem with funds is that they may be subject to the same problems that regular businesses are subjected to. For example, mutual funds and pension funds also have boards of directors. How do we know that they are meeting their fiduciary obligations? After all, corporate boards are rife with potential problems. In 2002, CalPERS was criticized for having questionable board members itself. ^[30] Specifically, CalPERS has a $1 million stake in Premier Pacific Vineyards, whose CEO is a major fundraiser for California Governor Gray Davis ”who just happens to have assigned three of the CalPERS board seats. CalPERS also invested $700 million with a fund run by Ronald Burkle, who makes campaign contributions to two CalPERS board members. In fact, two other board members had previously worked for Burkle. Is this board a bit too cozy? How can CalPERS be expected to exert proper governance standards on the firms that it owns if it doesn't have a board that is squeaky clean?

Other than the activism of public pension funds, what about private (or corporate) pension funds? Are they active? Actually, they are extremely quiet on the activism front. Jamie Heard, CEO of Institutional Shareholder Services, is not aware of a single corporate pension fund that has become a governance activist. ^[31] This is too bad. In total, private pension funds own almost 50 percent more assets than public pension funds. As a group, private pension funds could be a strong monitoring force and exert influence to protect shareholders. However, private fund advisors face a huge conflict of interest problem ”they are hired by corporate executives to manage the pension assets. If they take an aggressive approach with a firm's management, they probably won't be retained to manage the assets for very long. That is, no executives want to see activism by shareholders because it interferes with their activities. Therefore, executives would not hire pension fund advisors who are activists.

These corporate pension funds own many companies, so the conflict of interest intensifies because, as pointed out by Robert Monks, a well-known shareholder activist, one CEO can make an agreement with another CEO to have his or her respective pension funds not raise issues with each other's company. ^[32] This being the case, private funds usually just go along with a firm's management, even though their fiduciary duty is supposed to be with their beneficiaries, the employees and retirees. William Patterson, head of the AFL-CIO Office of Investments, argues that a large investment firm like Fidelity gets hired by a company like Enron to run its 401(k) plans. Therefore, it wouldn't endanger its own business activities by voting against a company's managers. ^[33]

Private funds can get away with their subtle violation of their fiduciary obligations because the votes of shareholders are not public information. While the firm knows how all of the shareholders voted, shareholders are not necessarily privy to how other shareholders voted because the company is not required to make this kind of disclosure. This may change. In a December 9, 1999, speech to the Investment Company Institute, SEC Commissioner Paul R. Carey urged for more disclosure by the funds. ^[34] Recently, some private fund managers, such as Bill Miller of Legg Mason Value and Chris Davis of Selected American, have actually been more forthcoming with voicing their displeasures. ^[35] But much more activism by private pension funds, given their size and ownership, may now be needed.

The regulatory and political environment may also hinder large institutional shareholders from engaging in activism. Under the Investment Company Act, mutual funds that own more than 10 percent of any one company must face additional regulatory and tax burdens. Half of the mutual fund assets must be vested in at least 20 firms (that is, a firm cannot constitute more than 5 percent of half of the fund's portfolio). These ownership restrictions apply to pension funds as well. Specifically, ERISA imposes a rather strict diversification standard on them. As stated by Benard S. Black, a Columbia law professor and well-known advocate of shareholder activism, " pension funds are encouraged by law to take diversification to ridiculous extremes." ^[36] Why do these restrictions exist? In general, the public fears having single entities with so much power. This means that funds are limited in their ability to become a major shareholder of any one firm, and thus they are constrained in their ability to become stronger and more influential owners .

Bernard S. Black and another law professor, Mark J. Roe, have adamantly argued that legal restrictions stand in the way for large investors to engage in the beneficial oversight of corporations. ^[37] They contend that the legal and regulatory environment prohibits or discourages institutional investors from becoming too big, from acting together, and from becoming a significant owner. At the same time, these investors also face tremendous SEC paperwork if they do wish to accumulate a significant stake in a firm ”while facing unfavorable tax ramifications in the process. Meanwhile, there are few laws that actually encourage or make it easier for institutions to be effective owners.

Finally, funds have too many different assets under management and are therefore unlikely to be able to effectively monitor all of their holdings. For example, CalPERS was completely blindsided by WorldCom's demise and lost $500 million in its holdings in this stock alone. ^[38] We shouldn't blame them because everyone else was caught off-guard, too, but it highlights the company's limitations in its ability to look out for the smaller investors. What's the lesson here? Large shareholders could make a difference because they are a more powerful version of the individual shareholder, but they also have significant limitations.