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How to Empower Shareholders and Improve Corporate Management in Two Easy Steps

Politics / Market Regulation Jan 22, 2010 - 05:21 AM GMT

By: Money_Morning

Politics

Best Financial Markets Analysis ArticleMartin Hutchinson writes: wrote last week that Wall Street bonuses should be cut back by the shareholders, not by the government.

Well, a reader wrote back correctly to remind me that the majority of shareholders are institutions that would not want to antagonize major corporations that gave out fund management mandates for their pension funds and 401(k)s by agitating against top management bonuses.


Good point. Very good point. And it highlights a central flaw in today's capitalism. It's far too controlled by corporate management. And it's time something was done about it.

showed that the free market works in general, but he wasn't a great fan of large companies (of which there were a few in his day) where the shareholders don't control the management. He wrote: "The directors of such companies ... being the managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance ... Negligence and profusion must always prevail, more or less, in the management of such a company."

Even fifty years ago, individuals remained the main power behind most corporations. Institutions in 1950 controlled only 15% of shares in U.S. publicly quoted companies. Then two forces turned that around, so that by 1980 institutions controlled 50% of shares in U.S. publicly quoted companies, a percentage that has tended to increase since.

First, estate taxes started eating away at individual fortunes. The modern estate tax was introduced in 1916, but it went above a 20% rate only with Herbert Hoover's ill-starred 1932 tax increase. Even by the 1950s, there were many individual fortunes associated with major corporations that had not yet suffered its depredations.

As the decades went on, however, fortunes were decimated by the estate tax. Even more damaging, rich people started putting their money in trusts or giving it to charitable foundations in order to avoid the estate tax. The result was that large individual shareholdings in public companies became much less important.

Then, starting in the 1950s, middle class people had pensions through their jobs – first in funded systems and later in 401(k) plans. As a result the amount of money that was invested on behalf of middle class savers grew exponentially and at the expense of the savings they accumulated on their own, which became less important. Rising house prices, encouraging people to build their net worth through real estate investment, intensified this effect.

Theoretically, managers of investment funds have the incentive to behave just like individual shareholders, voting their fund's shares to maximize shareholder value. In practice, they don't. And it's easy to see why not. Institutional fund managers aren't the best and brightest in the financial services business – those guys are on Wall Street or in hedge funds, where the money is better – they are competent bureaucrats working their way up the gently sloping career structure of the investment management business.

So there is really no incentive for them to rock the boat by entering into a dispute with the greedy management of a company whose shares they own. It's much better just to sell the shares, or to hold them, but keep voting for management and ignoring the greed.

No amount of "good corporate governance" initiative will energize institutional investors into beating corporate management about the head with a two-by-four; it's not in their nature. However, without institutional shareholder aggression, the current situation will get worse. Egged on by compensation consultants, management will get ever greedier, pushing up its rewards by 8-10% per annum at a time when others' pay is flat.

That will be bad for the U.S. economy.

Whereas shareholder capitalism has been shown time and again to produce optimal results, there is no equivalent theory praising the results from managerial capitalism, where the ownership of capital and the management of resources have become so detached from each other.

There are, however, two things that can be done to improve matters.

First, the U.S. Federal Reserve can set interest rates at a sensible level, so there isn't this huge surplus of money sloshing around everywhere. Corporate empire-building – like Kraft Food Inc.'s (NYSE: KFT) bid for Cadbury PLC (NYSE ADR: CBY) – or huge profits by pointless rent-seeking trading are both products of the current very cheap money environment. Once interest rates rise, it will be tougher for companies to build empires and impossible to make such exorbitant returns through leverage and excessive lending.

The second change needed is the repeal of the estate tax, or at least its reduction to a 20% maximum rate. Ideally, this should be combined with the elimination of income tax deductions for home mortgage interest and charitable donations. That will ensure that modest middle class fortunes will be invested in productive enterprises and not frittered away on expensive houses and wasteful charity.  

With these changes, the shareholdings of ordinary investors and of families whose ancestors found companies will gradually increase at the expense of institutional money. That in turn will make management more responsive to individual shareholders, and less likely to waste shareholder money.

The kind reader was quite right about institutional shareholdings preventing capitalism from working properly. It's time something was done about it.

Source: http://moneymorning.com/2010/01/22/corporate-management/

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