Essay on Corporate Governance, ERISA, and TIAA-CREF

Corporate Governance

Poor and restricted are our opportunities in this life; narrow our horizon; our best work most imperfect; but rich men should be thankful for one inestimable boon. They have it in their power during their lives to busy themselves in organizing benefactions from which the masses of their fellows will derive lasting advantage, and thus dignify their own lives .

Andrew Carnegie (The Gospel of Wealth)

In 1974, the U.S. Congress passed the Employee Retirement Income and Security Act (ERISA).

The Department of Labor is the administrator of the Act.

The purpose of ERISA is to protect workers covered under retirement plans.

The law obliges companies to keep pension promises to employees. However, ERISA does not require a firm to provide pensions. In fact, the administrative costs of ERISA have discouraged new pension plans.

In the 1980s, in a move away from company sponsored retirement plans, Congress created Individual Retirement Accounts (IRAs) and 401(k) plans.

Corporate Governance and ERISA

Before the 1970s, fund managers were in the minority at shareholders' meetings.

When a portfolio manager was unhappy with management, the solution was to sell the stock.

Fund managers did not try to vote against management.

This changed after the Department of Labor asked pension fund managers to exercise voting rights on stock in their portfolios.

In the 1970s, the Department of Labor asked pension fund managers to vote shares held in portfolio.

The Department of Labor issued directives and letters that were the basis for the corporate governance movement.

The Department tossed a fuzzy concept at pension fund managers by asking them to set up guidelines as to how they would vote their proxies and promote corporate governance.

Since then, the largest pension funds have issued formal statements that give an insight into what motivates fund managers and how they view corporate goals.

Corporate Governance and the IMF

The U.S. pension fund corporate governance codes attracted interest in other areas of government, and the movement metastasized to every corner of the world.

The World Bank has a program for corporate governance, as does the International Monetary Fund.

The World Bank and IMF now have programs for Corporate Governance.

Many countries have installed commissions and hearings and have promulgated various rules.

Many consultants and newsletters live off the corporate governance craze.

The major accounting firms are involved, seeing a chance for consulting fees.

Although the topic is relevant in markets with democratic capitalism, internationalization has brought the movement to countries dominated by owner-managers or even state-owned enterprises.

Roots In Hostile Takeovers

The proxy wars and hostile takeovers of the 1960s and 1970s were the initial stimulus for the corporate governance movement.

Speculators and raiders fought for shareholders' votes in the new democratic capitalism.

An arsenal of rude methods aided the struggle between raiders and hired managers.

Practices with catchy names like poison pill and green mail caused concern at the Securities and Exchange Commission and the Department of Labor.

Some thought that investors and pensioners might be at risk. Others said that corporate takeovers were only capitalism at work.

Hesitancy In Enforcing Common Law

The government ruling that portfolio managers take a stance on corporate governance was politically driven.

No one knew how to resolve inconsistencies between the ideal of democratic capitalism and the inevitable wresting and misuse of power by hired management.

In theory, there is no need for a corporate governance code, since securities, corporate, and common law already deal with breaches of fiduciary responsibility.

However, neither shareholders nor the securities regulator seemed willing or able to use the law.

Investors are not powerless. They can sell stocks of companies they do not like.

Moreover, investors are not powerless. Although the law may be ineffectual, portfolio managers and other investors can sell stocks of poorly managed companies that they do not like. That is the purpose of a stock exchange.

Despite legitimate doubts as to the usefulness of corporate governance guidelines, the movement now dominates political discourse whenever shareholders lose money.

The Enron scandal and the market crash in 2000 gave renewed impetus to the movement.

The subject is heavily laden with well-intentioned nonsense and quackery.

However, because of the reach of American institutional investors and the enthusiastic support of the World Bank and the IMF, corporate governance will be a buzzword for years to come.

Codifying Corporate Governance

There are many codes of corporate governance. Compliance is usually voluntary.

Generally, all codes contain admonitions regarding proper disclosure and the fiduciary responsibility of directors – things that are already a matter of law.

The independence and accountability of corporate directors are common themes.

Corporate governance codes in various countries reflect local company law and customs.

In countries with company law similar to that of Europe, the position of director is different from that in the United States.

The IMF and World Bank force Indonesia to accept nonsensical rules.

The World Bank and IMF use corporate governance codes to persuade countries to adopt aspects of American company law.

During the 1990s, Company Law in Indonesia did not provide for a supervisory board of directors, as is the U.S. custom. Instead, directors were also managers. Consequently, the concept of 'independent directors' was pure nonsense.

Nevertheless, the World Bank and the IMF used their influence, after the collapse of the Rupiah in 1997, to force Indonesian companies to adopt American style codes of corporate governance, including the requirement of independent directors.

Unionized Teachers Set Rules

In order to get a clear idea of what corporate governance is about, it is necessary to look at the specific provisions of the codes adopted by the major American pension funds.

CalPERS and TIAA-CREF have been leaders in this area. They maintain large web sites promoting their codes.

The 2001 Policy Statement on Corporate Governance issued by the Teachers Insurance and Annuity Association – College Retirement Equities Fund (TIAA-CREF) is representative of the codes sponsored by American institutional investors.

This code is a statement of the policy that TIAA-CREF will observe when voting shares held in its portfolios.

TIAA-CREF expects public companies to follow its code in order to earn the support of its fund managers.

The main points of the 2001 code were:

For the point of view of Capital Flow Analysis, the position on stock buybacks and preemptive rights is significant. TIAA-CREF did not prohibit or limit the size of buybacks.

The restriction on repurchase above market merely echoed the SEC safe-harbor rule regarding manipulation.

The point in favor of buybacks combined with the condition that executive compensation be attractive and linked to maximizing shareholders' wealth was consistent with the abusive buyback-option schemes that had driven stock prices during the 1980s and 1990s.

Conflicted Bedfellows: Funds and Brokers

On the other hand, TIAA-CREF's elimination of pre-emptive rights was against the interests of long-term shareholders.

Value investors understand that without the protection of preemptive rights, an equity position may be diluted, especially on occasion of mergers, acquisitions, and private sales of equity to favored investors.

In Europe, particularly in Great Britain, there has long been support among professional investors of preemptive rights.

In countries with strict preemptive rights, issuers can raise capital at less cost by offering shareholders proportionate rights to subscribe to new shares below market. If the investor is not interested, the rights may be sold.

TIAA-CREF's corporate governance code favors investment bankers over long-term investors.

However, investment bankers, especially in the U.S., aggressively oppose preemptive rights because this shareholder protection reduces their underwriting fees and their flexibility in another important profit center – mergers and acquisitions.

Fund managers, looking to short-term price appreciation, also oppose preemptive rights since cash subscriptions to finance long-term projects or reduce debt have a short-term negative effect on market capitalization.

While supporting buybacks and attractive executive salaries, and opposing preemptive rights, TIAA-CREF had nothing to say about dividends.

Since dividends are the investors' primary legal claim to participate in corporate profits, omitting a position on dividends emphasizes the focus on capital gains.

Public Employees Like Buybacks

The California Public Employees Retirement System (CalPERS) is another active promoter and leader of the corporate governance movement.

CalPERS is the largest pension plan in the U.S. and the third largest pension fund in the world.

In 2001, CalPERS, like TIAA-CREF, seemed to be primarily interested in forcing short-term appreciation of stock prices.

America's largest pension manager rewards hired corporate executives for short-term swings in stock prices.

CalPERS took corporate governance a step further in what it called 'relational investing'.

In June 1995, the CalPERS board approved a funding commitment of two hundred million dollars to a 'relational investing partnership' in which the pension fund was to engage in corporate takeovers, similar to T. Boone Pickens, seeking distressed companies to acquire, restructure, and sell for a profit.

Considering that the corporate governance movement had originated out of concern for abuses of corporate raiders in the 1960s and 1970s, there is bizarre irony in that a generation later the leaders of the movement wanted to turn themselves into corporate raiders.

The codes in effect in 2000 and 2001 are useful in the analysis of the market crash at the millennium.

We may expect that codes of corporate governance will evolve with changes in market culture.

Governance and Competitive Pay

The American corporate governance movement tells managers of public companies that institutional investors will judge their performance by stock price appreciation.

The TIAA-CREF policy in 2001 called for executive compensation tied to the maximization of shareholders' wealth – in other words, market capitalization.

By setting stock price gains as the primary corporate objective, TIAA-CREF implicitly endorsed the bubble culture of aggressive stock buybacks, creative accounting, increased debt, and short-term management.

Their code in 2001 made no mention of dividends.

They preferred companies that would not use preemptive rights to raise capital for long-term investments. They favored executive pay linked to the stock market.

The stock price of public companies fluctuates with the market index. Most portfolio managers are believers in Modern Portfolio Theory and know that a large part of total return, from year to year, depends on the stock price index, rather than on corporate earnings.

No one expects an executive to be responsible for the Dow Jones Average.

Furthermore, it takes a long time to organize marketing and productive resources on a large scale.

Corporate profits are more likely to be the result of investments and decisions made in prior years, than in the current year.

By linking executive pay to stock prices, TIAA-CREF rewarded executives for something unrelated to their own actions and that may have resulted from what others did in the past.

Consequently, by linking executive remuneration to the current level of stock prices, TIAA-CREF endorsed a policy that rewarded executives for something unrelated to their own actions (the level of stock indices) and for something that may well have resulted from what others did in the past (current earnings).

In case the board did not understand the message that price appreciation was the goal, TIAA-CREF insisted that directors own shares in the company in an amount equal, at least, to one-half their annual remuneration.

Since directors are elected for short terms, the TIAA-CREF code encouraged decisions related to immediate market gains.

CalPERS was even more explicit in setting increased market capitalization as the goal. On their web site, they referred to studies by Wilshire & Associates (Santa Monica) and The Gordon Group.

These studies claimed that CalPERS' support for corporate governance had caused the price of certain stocks to rise.

Furthermore, the increase in market capitalization, compared to the amounts spent on buybacks and executive salaries, indicated that CalPERS' efforts were 'cost effective'.

Goals of Institutional Investors

From this, we see clearly the reason for corporate behavior in the 1990s. Institutional investors offered riches to executives that ramped up stock prices.

There was no differentiation between shareholder wealth related to the long-term intrinsic value of a company and wealth resulting from short-term capital gains related to market manipulation and false reports.

Fund fiduciaries encouraged depletion of corporate reserves.

There was no alarm about inflating price-earnings ratios, decreasing dividend yields, or increasing leverage.

Executives were not encouraged to take advantage of low capital costs by raising funds when price-earnings ratios were high.

Instead, these fiduciaries promoted buybacks at ever-higher prices, encouraging the depletion of corporate reserves.

Compensation Without Limits

There was no sign of unease about the level of executive pay in the TIAA-CREF 2001 code, other than to say that remuneration should be sufficiently high to attract candidates.

The pension fund mentioned 'competitive' salaries and the dictionary definition for 'competitive' is, 'trying to do something better than others or win something'.

This means that boards should not seek to bargain and pay reasonable or fair salaries, but rather should pay salaries that are higher than the market, in a bidding war.

Recruiters have an incentive to inflate and exaggerate a candidate's worth.

There is no efficient market for managerial skills. Instead, executives are hired through recruiters who receive a fee based on the size of the executive's contract.

The recruiter has an incentive to inflate and exaggerate the candidate's worth and the difficulty of the recruiting process.

The board, following TIAA-CREF guidelines, should pay whatever might be necessary to hire a candidate.

Substituting Resumes For Competence

Since there is no sure way to evaluate a manager, the propensity would be to seek managers who have held similar jobs and who appear to have been successful.

There may be one thousand qualified candidates with excellent records of achievement in companies with one hundred million dollars in assets.

However, when the recruiter is seeking to fill a position in a billion dollar company, the number of candidates will be far less, although the size of the company may have nothing to do with the ability of a candidate to do the job.

The prime consideration is that the candidate looks good to Wall Street analysts.

There is competition for executives with a 'proven track record', which is different from competence.

An executive may receive credit for heading a company during times of rising profits caused by decisions of other executives a decade before.

Executives foster the myth that multi-million dollar salaries attract competent managers.

The executives who made the wise decisions may even have been fired, because capital investment often reduces earnings in the short run.

Executives promote the myth that it is necessary to pay multi-million dollar salaries to attract competent managers, just as public servants claim that they could make more in the private sector, which in most cases is not true.

A Medal for Courage

The dictionary defines courage as, 'the ability to face danger, difficulty, uncertainty, or pain without being overcome by fear or being deflected from a chosen course of action.'

CalPERS granted its 2000 Corporate Governance Award of Courage to several companies and individuals, including Time Warner's Chairman and CEO, Gerald M. Levin.

The idea of associating courage with corporate governance is intriguing.

However, CalPERS' idea of courage appeared to be somewhat different.

Dr. William D. Crist, President of CalPERS' board said,

'We honor these companies and individuals for their courage and dedication to shareowner interests. In each area, they represent shining examples of effective governance.'

A Shining Example

Throughout the 1990s, Time Warner stock was highly volatile, trading at such lofty levels that Standard & Poor Corporation considered the price earnings ratio to be 'not meaningful'.

The company had not paid dividends for over a decade.

The CalPERS press release explained that,

'During the time Levin was Chairman of the Board in 1992 through March 31, 2020, Time Warner's stock price earned a compound annual return of approximately thirty percent versus an eighteen percent compound annual return for the S&P 500 Index. CalPERS owns more than 5.6 million shares of Time Warner stock.'

It is understandable why CalPERS might be pleased with this increase in market prices.

However, it is not clear whether CalPERS recognized that this increase in shareholders wealth was transitory and whether they sold Time Warner stock in time to lock in capital gains.

The dread and danger that Mr. Levin faced, justifying this award for courage, were not clarified in the CalPERS press release.

In 1999, Mr. Levin had received compensation of over forty-three million dollars from Time Warner in the last five years, certainly an attractive and competitive pay packet that would give many executives the inner strength to confront their fears.

Independent Directors and Unicorns

The common element in codes of corporate governance is the call for independent directors.

In the last decade, every financial crisis has resulted in clamoring for independent directors.

Is this a solution to intrinsic flaws in democratic capitalism, or just a foolish political diversion?

Without the concept of independent directors on boards of public companies, the corporate governance movement lacks its central theme.

The idea of the independent director is the central theme of the corporate governance movement.

As indicated in the TIAA-CREF code, in order for a director to be independent, he or she should have 'no present or former employment with the corporation, or any significant financial or personal ties to the company or its management.'

The ideal independent director would be a wise, impartial person who would fairly represent the interests of widely dispersed minority shareholders.

Considering the time spent by people at the World Bank, the IMF, and on hundreds of commissions, seminars, and conferences, and the fees of innumerable consulting and advisory firms – the cost of the quest for the mythical 'independent director' has been considerable.

Prudent entrepreneurs usually will not accept positions as independent directors because the legal liability is disproportionate to the pay.

If successful, they are also too busy.

Independent directors are also unlikely to be proficient in the business, because such expertise would be limited to competitors or former company executives.

Commonsense tells us that an independent director, like a unicorn, is an imaginary animal not found in the real world.

A Ridiculous Solution To A Nonsensical Problem

The favorite solution proposed in corporate governance codes — independent directors — is, in fact, ridiculous.

Not only is there no such thing as an independent director, even if there were, why would anyone want to put such a person in charge of a major corporation?

A director who has never worked for the corporation knows little about the business and less about the character and capacity of candidates for chief executive.

When the criteria for being a director, as suggested by TIAA-CREF, is in part based on race, sex, and age, and, in part, on lack of financial or other relationship to the company or its management, how can investors be served?

All directors without a controlling interest are beholden to someone for their position.

It would seem to be more sensible to seek people with a close knowledge of the business and the corporate culture and to forget the politically correct call for diversity among board members.

Unless a candidate owns a large block of stock, a director must be beholden to someone for his or her job and cannot be independent.

Moreover, the method for nominating directors compromises their independence.

Directors who know nothing about the business would not have time to recruit candidates and would need to depend on recruiters, hired, of course, by management.

There have been suggestions that independent directors be hired and paid by the large pension funds, like CalPERS and TIAA-CREF, and that directors work full time.

Of course, if directors work full time and are paid handsomely, they become indistinguishable from management, and therefore no longer meet the definition of independence.

Fiduciaries With Agendas

Fiduciaries, such as TIAA-CREF and CalPERS, may have agendas that are different from those of the ultimate investors whose interest they represent.

In 2002,the CalPERS board was not composed of successful business people or even experienced portfolio managers.

Union leaders, local politicians, and state employees accounted for over seventy percent of the administrative board of CalPERS.

Following the TIAA-CREF corporate governance guidelines, independent directors are likely to be lawyers or doctors, deans of universities, civil rights leaders, feminists, wives of legislators, representatives of racial minorities, ex-government officials, and environmental advocates.

Is 'Corporate Democracy' An Oxymoron?

The solution to the corporate governance dilemma lies in understanding that the problem arises from inherent problems with the concept of democratic capitalism.

Corporations are not democracies.

Successful owner-managers often appear to be unpleasant autocrats.

The confused political ideology of 'workers' capitalism' and pious calls for 'corporate democracy' have spawned an army of charlatans promoting 'good corporate governance'.

Better protection for investors might be to return control of public corporations to owner-managers.

The basis for corporate reform is more complex that the silly notion of 'independent directors':

Better protection for investors might be to return control of public corporations to owner-managers.

Such an environment was effective in the Brazilian stock market in the 1960s, adequately protecting investors even under a weak court system and before the advent of a securities regulator.

In those years owner-managers treated investors more fairly, even in the absence of a securities and exchange commission, than hired professionals in the American market of the 1980s and 1990s.

However, in the United States, the concept of corporate democracy has deep emotional and political roots.

Reform is unlikely.

For purposes of Capital Flow Analysis, we need to watch the corporate governance movement and look for changes that might signal a shift in executive ethics and corporate behavior.

However, we might reasonably be skeptical that significant improvement will occur.

Government and Corporate Governance

Institutional investors are the today's guardians of the ideals of capitalism, at least with respect to large public corporations.

Andrew Carnegie, in writing The Gospel of Wealth, reminded those that control wealth that they should

'busy themselves in organizing benefactions from which the masses of their fellows will derive lasting advantage, and thus dignify their own lives.'

Those that draft the codes of corporate governance have an opportunity to suggest a higher purpose for corporations than pumping up stock prices for the benefit of speculators.

Sadly, throughout the 1990s, such lofty intentions have not been fashionable.

The corporate governance movement has been bereft of vision and elevated principle.

The corporate governance movement mostly involves organizations associated with government.

For the most part, the corporate governance movement mostly involves organizations that are associated with government.

The codes written by the California pension funds, the various Europe commissions, and the World Bank, are sterile substitutes for traditional capitalist ethics.

There is no call for corporate responsibility to mobilize capital effectively to help humankind move forward.

Instead, the TIAA-CREF guidelines emphasize the importance of diversity, with directors that represent different races, genders, levels of experience, and age groups.

TIAA-CREF favored boards made up people from these highly dissimilar backgrounds, urging them to focus on policies that address issues of the environment, equal employment, and community impact.

The board, they said, should also be concerned with the 'exploitation of non-shareholder constituencies' – whatever that might mean.

Considering that labor union leaders and state politicians dominate the board of CalPERS, this is not surprising.

Enforcers of Political Correctness

The U.S. corporate governance movement, as represented by CalPERS and TIAA-CREF, has a distinct odor of touchy-feely political correctness.

CalPERS has been especially eager to display its power as an enforcer of political correctness.

In 2001, the fund announced on its web site that it had exercised its votes in favor of proposals that advanced the cause of women and minorities, diversity of sexual orientation, environmental concerns, and human rights.

The corporate governance movement has a distinct odor of touchy-feely political correctness.

Presumably, long-term investors will sleep soundly knowing that Exxon does not bar homosexuals from oil rigs and that Home Depot will not torture its shoppers.

CalPERS has been not only eager to display its touchy-feely credentials, but also to lead the movement towards the deindustrialization of the United States.

This shows the weird schizophrenia in liberal politics at the millennium.

Here we see a pension fund, controlled by government employees, local politicians, and labor unions that endorsed investment policies that over the next generation would create jobs abroad and build the tax base in foreign countries.

A Question of Standards

The significance of the corporate governance movement is not that institutional investors actually control great enterprises.

In a practical sense, this is unlikely given the lack of involvement of directors in day-to-day affairs.

Rather the importance is in the standards and general goals that are set for business.

When stock prices are the principal aim, the nation loses a sense of higher economic and moral purpose.

For better or worse, it would seem that the trend towards control of corporations by institutional investors is irreversible and that corporate governance is here to stay, at least in the United States.

Control of public corporations by institutional investors seems to be irreversible.

Portfolio managers are now firmly interposed between the ultimate investor and the corporation and these managers are rewarded for increases in the market capitalization of portfolios that they control.

The corporate governance movement is tightly bound to American liberal politics.

The strange conclusion that one might draw from corporate governance and democratic capitalistic ideology is that today's institutional investors think that Carnegie Steel should have been run by a board that was diversified as to gender, sexual orientation, age, and race, with no knowledge of steel making — rather than by Andrew Carnegie.

The Ultimate Power

Since corporations are creatures of the state, we cannot blame shareholders and fund managers for failure of government to set standards.

In the final analysis, it should not be up to TIAA-CREF and CalPERS to codify the ethics of corporate governance.

Rather, this is the job of the primary stakeholder: government.

In other essays, there is discussion of government motivation with regards to corporations and how government influences policies for issuance of securities, buybacks, and dividends.

All other corporate stakeholders – managers, shareholders, suppliers, creditors, and employees – are subservient to the supremacy of government interests.

July 25, 2020

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