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A tension-raising list of questions.

"Corporate governance in the United States is going through a major transformation," says Dr. Clifton R. Wharton Jr., Chairman and Chief Executive Officer of Teachers Insurance Annuity Association and College Retirement Equities Fund. TIAA-CREF is the largest pension fund in the country, with an asset base of $100 billion. In the following article he presents some of the key governance questions that management and investors need to resolve. These observations are excerpted from his remarks as a featured speaker at a major conference on governance issues sponsored by Northwestern University's J.L. Kellogg Graduate School of Management, SpencerStuart, and Booz Allen & Hamilton Inc.

I think all of us would agree that corporate governance in the U.S. is going through a major transformation. But from my perspective as I have looked at it in the recent years, I believe that the current legal and regulatory structure and provisions are no longer fully adequate. They do not match the needs of the underlying new realities.

The following section of the path-breaking work of Adolph Berle and Gardner Means is very appropriate, as we look at what I believe to be the fundamental change in the new realities we have today.

They wrote: "Those who control the destinies of the typical modern corporation own so insignificant a fraction of the company's stock that the returns from running the corporation profitably accrue to them only to a very minor degree. The stockholders, on the other hand, to whom the profits of the corporation go, cannot be motivated by these profits, since they have surrendered all disposition of it to those in control of the enterprise. The explosion of the atom of property destroys the basis of the old assumption that the quest for profits will spur the owner of industrial property to its effective use. It consequently challenges the fundamental economic principle of individual initiative in industrial enterprise. It raises for reexamination the question the motive force back of industry, and the ends for which the modern corporation can be, or will be, run."

They saw these developments as a negative, challenging the fundamental economic principle of individual initiative in industrial enterprise. They raised for reexamination the question of the motive force of industry, and the ends for which the modern corporation can be, or will be, run. That was back in 1932.

As one looks at the current era, I would argue that rather than an "explosion" of the atom property, what we are now experiencing is an "implosion." We're moving back to a few dominant, large owners. One need not go through all the statistics, but one thing I would observe is that some of the numbers give me pause. Over a period of two, three, or four years, institutional ownership of corporations can change very dramatically. It raises fundamental questions about what constitutes the meaning of institutional ownership.

Another dimension is a blurring -- a significant blurring -- that is occurring between the rights of owners, i.e., equity holders, and the rights of others, especially lenders.

I observe this very dramatically in my present position, with the bifurcation between TIAA and CREF. I don't know how many of you have come to see us for direct placements or private loans on the TIAA side, while at the same time on the CREF equity side somebody is dealing with you in terms of a shareholder proposition or resolution. Here we are, the same two companies with the same basic goal. And yet, when I watch what happens with regard to due diligence on the fixed-investment side, the ease with which communication occurs between my officers and you on a direct placement, the amount of information that is provided, and the way in which we interact...and then I look at the equity side, I find the relationship very significantly different.

Let me give another example. Every time I read The Wall Street Journal describing a restructuring in which lenders and bondholders dominate the "play" and the owners or shareholders are left out, I wonder about the accuracy of economics and legal textbook definitions of fixed vs. equity rights. I really wonder if we haven't reached a stage where there's a very significant blurring between equity and debt.

Let me wind up with a few questions. First, even when one focuses on performance, I would ask, are all instances of stock undervaluation due to poor performance by directors or by management? I do like think that sometimes general economic conditions do play a part.

Next, how can corporate management deal with an institutional investor as a large shareholder in differentiation from a small one without violating the latter's rights?

How can a large institutional investor communicate concerns regarding management and strategy without really interfering in or replacing management? (Plus there is the related concern about the danger of liability).

Does an institutional investor holding shares in an index fund have a different interest in them and in governance than an active manager? Does passivity in choice of stock equal passivity in shareholder concerns?

Communicate concerns

When is it difficult, or virtually impossible, for an institutional investor to walk (that is, to sell the stock to reflect their concerns)? How do institutional investors express their concerns? How do they influence management?

Doesn't a shareholder advisory committee run the danger of merely replacing the board of directors, who also are legally supposed to represent the interests of shareholders? At least I'd like to think that is why they were elected. Why wouldn't corporate managers eventually ignore the board of directors and pay attention only to the advisory committee?

How can, or should, corporate management deal with large investors, especially arbitragers, whose predominant concern is short-term performance and quick gain, not long-run corporate health and vigor? During the fever of a takeover bid in which arbitragers corner larger and larger blocks of the stock, how can a board weigh the often conflicting motivations and views of small long-term holders and long-term institutional investors, and the short-term arbitragers?

What special relationship, if any, should a corporate board of directors have with large institutional investors? Are all shareholders "created equal but some more equal than others"?

How can an institutional investor take on the role of direct involvement in a selection of a particular board director without actually making that individual the representative of a special segment of the shareholders rather than of all the shareholders? And if that person acts as a representative of the institutional investor, acquiring director/insider information, is the institutional investor sponsor prepared to assume all the liabilities that are involved?

If institutional investors own 60% or 70% of a corporation's stock, what are the implications for the corporation's directors and board? Whom are the directors representing? How do they secure the views of these institutional investors? And what is the board's responsibility to the smaller individual shareholders, if their interests diverge from those of the institutional giants?

In the case of pension funds, how do institutional investors know that they are truly reflecting the views of their individual beneficiaries? Even in the case of defined-benefit plans, are all beneficiaries solely motivated by pure share value maximization? If a minority is not, how do you respond to their wishes while observing your fiduciary responsibilities both to them and to all of the others?

Although many institutional investors are well able to assess the performance outcome of company management, "bottom-line" stock value, and board policy directives and also their long-run corporate strategy, what special competence do institutional investors have to assess individual board members? Even if one assumes that individual director assessments could be done properly, how can one justify the cost/benefit involved in doing such assessments for thousands upon thousands of corporations and 10 to 15 times that number of individuals?

Heightening of conflict

In conclusion, I think that the current situation in which the corporate governance structures have not caught up with the underlying realities has led to a heightening of conflict and confrontation between corporate managements and institutional investors. However, the Department of Labor is mandating that institutional investors exercise their fiduciary responsibilities and vote their stock. Tensions are thereby exacerbated by the regulatory bodies.

We are mandated to play a role. But in my view, it is unclear what that role ought to be in today's corporate setting. The situation cries out for a very serious look jointly by management and institutional investors.
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Title Annotation:corporate governance
Author:Wharton, Clifton R., Jr.
Publication:Directors & Boards
Date:Jan 1, 1992
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