CHAPTER THIRTY-ONE

The Governance of Corporations

FIFTEEN YEARS AFTER IT was first chronicled, the “unseen revolution” has transformed corporate ownership in the United States and is now visible to all. The 20 largest pension funds (13 of them funds of state, municipal, or nonprofit employees) hold around one-tenth of the equity capital of America’s publicly owned companies. All told, institutional investors—that is, primarily pension funds—control close to 40 percent of the common stock of the country’s large (and many midsize) businesses. The largest and fastest-growing funds, those of public employees, are no longer content to be passive investors. Increasingly, they demand a voice in the companies in which they invest—for instance, a veto over board appointments, executive compensation, and critical corporate charter provisions.

Equally important, and still largely overlooked, pension funds also hold 40 percent or so of the medium-term and long-term debt of the country’s bigger companies. Thus these institutions have become corporate America’s largest lenders as well as its largest owners. As the finance texts have stressed for years, the power of the lender is as great as the power of the owner—sometimes greater.

The rise of pension funds as dominant owners and lenders represents one of the most startling power shifts in economic history. The first modern pension fund was established in 1950 by General Motors. Four decades later, pension funds control total assets of $2.5 trillion, divided about equally between common stocks and fixed-income securities. Demographics guarantee that these assets will grow aggressively for at least another ten years. Barring a prolonged depression, pension funds will have to invest $100 billion to $200 billion in new resources every year throughout the 1990s.

America’s failure, until quite recently, to recognize (let alone address) this power shift accounts in large measure for much of the financial turbulence of the 1980s—the hostile takeovers, the leveraged buyouts, and the general restructuring frenzy. Two problems in particular demand attention: for what should America’s new owners, the pension funds, hold corporate management accountable? And what is the appropriate institutional structure through which to exercise accountability?

Actually, the United States is quite late among developed countries in concentrating ownership of large companies in a small number of institutions. In Germany, the country’s three major banks have long controlled around 60 percent of the share capital of the large companies, partly through direct holdings, partly through the holdings of their customers that, under German law, the banks manage and vote on. In Japan, the majority of large companies are members of a small number (ten at most) of industrial groups, the now-familiar kei-retsu. In a keiretsu, 20 percent to 30 percent of the share capital of each member company is held by the other members and by the group’s bank and trading company, and practically all credit to the member companies is provided by the group’s bank. In Italy, half of the country’s large businesses have been owned or controlled by the state since the 1930s. (IRI, the biggest state holding company, is the second-largest company in all of Europe.) The rest of Italy’s big businesses are under the control of five or six huge conglomerates such as the Fiat Group.

Ownership in the United States is quite different. It is indeed unique. In Europe and Japan, stock ownership is a means to nonfinancial ends. A German bank’s income from the companies to which it is the hausbank comes through commercial relationships rather than through its ownership stake. Deutsche Bank, Germany’s largest financial institution, gets many times as much in fees from client companies for mundane services such as letters of credit as it receives from them in dividends on the shares it holds in them. The keiretsu’s first concern is power—power in the market, power over suppliers and subcontractors, power and influence with ministries and civil servants. As for tangible benefits, a keiretsu company profits far more from the business it gets from the other members than from their dividends. The government holdings in Italy constitute the largest concentration of economic power in any market economy. They serve primarily political objectives. The companies are run to provide jobs in politically important regions, to create lucrative executive positions for the party faithful, and to supply campaign funds for the parties in power.

Neither the German banks nor the Japanese keiretsu nor Italy’s government nor its conglomerates has much interest in share prices or capital gains. They do not intend to sell. The American pension fund, by contrast, has no commercial ties to the companies in which it invests or to which it lends. It is not a “business” at all, but an “asset manager.” There are, as we shall see, important lessons to be learned from developments in Europe and in Japan, both as to what to do and what not to do. But in the United States, the rapid shift of ownership and credit power to these new and quite different owners poses totally new and very different problems.

Pension funds first emerged as the premier owners of the country’s share capital in the early 1970s. But for 15 or 20 years thereafter, the realities of pension fund ownership were ignored. In part this was because the pension funds themselves did not want to be “owners.” They wanted to be passive “investors” and short-term investors at that. “We do not buy a company,” they asserted. “We buy shares that we sell as soon as they no longer offer good prospects for capital gains over a fairly short time.” Moreover, the development was totally at variance with American tradition and with what everybody took for granted—and many still take for granted—as the structure of the U.S. economy. Long after pension funds had become the largest holders of equity capital, the United States was still referred to as the country of “people’s capitalism” in which millions of individuals each owned small pieces of the country’s large companies. To be sure, employees have become the owners of America’s means of production. But their ownership is exercised through a fairly small number of very large “trustees.”

Finally, though, the fog has begun to lift. The trustees of pension funds, especially those representing public employees, are waking up to the fact that they are no longer investors in shares. An investor, by definition, can sell his holdings. A small pension fund may still be able to do so. There are thousands of such small funds, but their total holdings represent no more than a quarter or so of all pension fund assets. The share holdings of even a midsize pension fund are already so large that they are not easily sold. Or more precisely, these holdings can, as a rule, be sold only if another pension fund buys them. They are much too large to be easily absorbed by the retail market and are thus permanently part of the circular trading among institutions.

Ownership in the United States is far less concentrated than in Germany, Japan, or Italy—and will remain far less concentrated. Hence the U.S. pension fund still has more elbow room than the big bank in Germany, the keiretsu in Japan, or the industrial conglomerate in Italy. But some large U.S. pension funds each own as much as 1 percent or even 2 percent of a big company’s total capital. All pension funds together may own 35 percent of the company’s total capital. (For example, pension funds own 75 percent of the equity of the Chase Manhattan Bank.) The 1 percent holder cannot sell easily. And the 40 percent holder, that is, the pension fund community at large, cannot sell at all. It is almost as committed as the German hausbank to a client company or the Japanese keiretsu to a member company. Thus the large funds are beginning to learn what Georg Siemens, founder of Deutsche Bank and inventor of the hausbank system, said a hundred years ago when he was criticized for spending so much of his and the bank’s time on a troubled client company: “If one can’t sell, one must care.”

Pension funds cannot be managers as were so many nineteenth-century owners. Yet a business, even a small one, needs strong, autonomous management with the authority, continuity, and competence to build and run the organization. Thus pension funds, as America’s new owners, will increasingly have to make sure that a company has the management it needs. As we have learned over the last 40 years, this means that management must be clearly accountable to somebody and that accountability must be institutionally anchored. It means that management must be accountable for performance and results rather than for good intentions, however beautifully quantified. It means that accountability must involve financial accountability, even though everyone knows that performance and results go way beyond the financial “bottom line.”

Surely, most people will say, we know what performance and results mean for business enterprise. We should, of course, because clearly defining these terms is a prerequisite both for effective management and for successful and profitable ownership. In fact, there have been two definitions offered in the 40 years since World War II. Neither has stood the test of time.

The first definition was formulated around 1950, at about the same time at which the modern pension fund was invented. The most prominent of the period’s “professional managers,” Ralph Cordiner, CEO of the General Electric Company, asserted that top management in the large, publicly owned corporation was a “trustee.” Cordiner argued that senior executives were responsible for managing the enterprise “in the best-balanced interest of shareholders, customers, employees, suppliers, and plant community cities.” That is, what we now call “stakeholders.”

Cordiner’s answer, as some of us pointed out right away, still required a clear definition of results and of the meaning of “best” with respect to “balance.” It also required a clear structure of accountability, with an independent and powerful organ of supervision and control to hold management accountable for performance and results. Otherwise, professional management becomes an enlightened despot—and enlightened despots, whether platonic philosopher kings or CEOs, neither perform nor last.

But Cordiner’s generation and its executive successors did not define what performance and results produce the best balance, nor did they develop any kind of accountability. As a result, professional management, 1950s-style, has neither performed nor lasted.

The single most powerful blow to Cordiner-style management was the rise of the hostile takeover in the late 1970s. One after the other of such managers has been toppled. The survivors have been forced to change drastically how they manage or at least to change their rhetoric. No top management I know now claims to run its business as a “trustee” for the “best-balanced interests” of “stakeholders.”

Pension funds have been the driving force behind this change. Without the concentration of voting power in a few pension funds and the funds’ willingness to endorse hostile takeovers, most of the raiders’ attacks would never have been launched. A raider who has to get support from millions of dispersed individual stockholders soon runs out of time and money.

To be sure, pension fund managers had serious doubts about many buyouts and takeovers, about their impact on the companies in play, and about their value to the economy. Pension fund managers—especially the moderately paid civil servants running the funds of public employees—also had serious aesthetic and moral misgivings about such things as “greenmail” and the huge fortunes earned by corporate raiders, lawyers, and investment bankers. Yet they felt they had no choice but to provide money for takeovers and buyouts and to tender their shares to them. They did so in droves.

One reason for their support was that these transactions kept alive the illusion that pension funds could in fact sell their shares—that is, that they were “investors” still. Takeovers and LBOs also offered immediate capital gains. And since pension fund portfolios have by and large done quite poorly, such gains were most welcome—though, as will be discussed shortly, they too were more illusion than reality.

What made takeovers and buyouts inevitable (or at least created the opportunity for them) was the mediocre performance of enlightened-despot management, the management without clear definitions of performance and results and with no clear accountability to somebody. It may be argued that the mediocre performance of so many of America’s large corporations in the last 30 years was not management’s fault, that it resulted instead from wrong-headed public policies that have kept American savings rates low and capital costs high. But captains are responsible for what happens on their watches. And whatever the reasons or excuses, the large U.S. company has not done particularly well on professional management’s watch—whether measured by competitiveness, market standing, or innovative performance. As for financial performance, it has, by and large, not even earned the minimum-acceptable result, a return on assets equal to its cost of capital.

The raiders thus performed a needed function. As an old proverb has it, “If there are no grave diggers, one needs vultures.” But takeovers and buyouts are very radical surgery. And even if radical surgery is not life-threatening, it inflicts profound shock. Takeovers and buyouts deeply disturb and indeed alienate middle managers and professionals, the very people on whose motivation, effort, and loyalty a business depends. For these people, the takeover or dismantling of a company to which they have given years of service is nothing short of betrayal. It is a denial of all they must believe in to work productively and with devotion. As a result, few of the companies that were taken over or sold in a buyout performed any better a few years later than they had performed under the old dispensation.

But weren’t takeovers and buyouts at least good for shareholders? Perhaps not. In a typical transaction, shareholders (and this means primarily the pension funds) received, say, $60 for a share that had been quoted on the stock exchange for an average of $40 before the deal. This 50 percent premium is proving to have been an illusion in many cases. Perhaps $25 of the $60 was not solid cash but the value put by the raider or the raider’s investment banker on convertible warrants, unsecured loans, or junk bonds. These noncash nonsecurities, which were bought by many of the same institutions that sold shares, are rapidly losing value. Many pension funds immediately did sell these now-depreciating pieces of paper. But they sold them to other pension funds or institutional investors—there are no other buyers. Thus the net financial value of these transactions to the pension fund community at large remains suspect indeed.

Today nearly all CEOs of large U.S. companies proclaim that they run their enterprises “in the interest of the shareholders” and “to maximize shareholder value.” This is the second definition of performance and results developed over the past 40 years. It sounds much less noble than Cordiner’s assertion of the “best-balanced interest,” but it also sounds much more realistic. Yet its life span will be even shorter than yesterday’s professional management. For most people, “maximizing shareholder value” means a higher share price within six months or a year—certainly not much longer. Such short-term capital gains are the wrong objective for both the enterprise and its dominant shareholders. As a theory of corporate performance, then, “maximizing shareholder value” has little staying power.

Regarding the enterprise, the cost of short-term thinking hardly needs to be argued. But short-term capital gains are also of no benefit to holders who cannot sell. The interest of a large pension fund is in the value of a holding at the time at which a beneficiary turns from being an employee who pays into the fund into a pensioner who gets paid by the fund. Concretely, this means that the time over which a fund invests—the time until its future beneficiaries will retire—is on average 15 years rather than 3 months or 6 months. This is the appropriate return horizon for these owners.

There is, however, one group that does—or at least thinks it does—have an interest in short-term gains. These are the employers with “defined benefit” pension plans. Until now, in a classic case of the tail wagging the dog, the interests of these employers have dominated how the pension fund community approaches its role as owner. In a defined-benefit plan, retiring employees receive fixed annual payments, usually a percentage of their wages during the last three or five years on the job. The employer’s annual contribution fluctuates with the value of the fund’s assets. If in any given year that value is high (compared with the amount needed on an actuarial basis to cover the fund’s future pension obligations) the employer’s contribution is cut. If the fund’s asset value is low, the contribution goes up.

We owe the defined-benefit trust to mere accident. When General Motors management proposed the pension fund in 1950, several powerful board members resisted it as a giveaway to the union. The directors relented only when promised that, under a defined-benefit plan, the company would have to pay little or nothing. An ever-rising stock market, so the argument went, would create the assets needed to pay future pensions. Most private employers followed the GM model, if only because they too deluded themselves into believing that the stock market rather than the company would take care of the pension obligation.

Needless to say, this was wishful thinking. Most defined-benefit plans have done poorly, precisely because they have been chasing inappropriate short-term gains. The other kind of plan, the “defined contribution” plan under which the employer contributes each year a defined percentage of the employee’s annual salary or wages, has done better in a good many cases. Indeed, defined-benefit plans are rapidly losing their allure. Because they have not delivered the promised capital gains, a great many are seriously underfunded. From now on, as a result of new accounting standards, such under-funding has to be shown as a liability on the employing company’s balance sheet. This means that even in a mild recession (in which both a company’s earnings and the stock market are down), a good many companies will actually be pushed to, if not over, the brink of insolvency. And what many of them have done in good years—that is, to siphon off the actuarial surplus in the pension fund and show it as “net income” in their income statement—is unlikely to be permitted much longer.

Company after company are therefore going out of defined-benefit plans. By the end of the decade, they will have become marginal. As a result, short-term gains as an objective for the major owners of American business will no longer dominate. They are already playing second fiddle. Public-employee funds are defined-contribution plans, and they constitute the majority of the biggest funds. Being independent of corporate management, they, rather than the pension funds of private businesses, are taking the lead and writing the new script.

We no longer need to theorize about how to define performance and results in the large enterprise. We have successful examples. Both the Germans and the Japanese have highly concentrated institutional ownership. In neither country can the owners actually manage. In both countries industry has done extremely well in the 40 years since its near destruction in World War II. It has done well in terms of the overall economy of its country. It has also done exceedingly well for its shareholders. Whether invested in 1950, 1960, 1970, or 1980, $100,000 put into something like an index fund in the stock exchanges of Tokyo or Frankfurt would today be worth a good deal more than a similar investment in a New York Stock Exchange index fund.

How, then, do the institutional owners of German or Japanese industry define performance and results? Though they manage quite differently, they define them in the same way. Unlike Cordiner, they do not “balance” anything. They maximize. But they do not attempt to maximize shareholder value or the short-term interest of any one of the enterprise’s “stakeholders.” Rather, they maximize the wealth-producing capacity of the enterprise. It is this objective that integrates short-term and long-term results and that ties the operational dimensions of business performance—market standing, innovation, productivity, and people and their development—to financial needs and financial results. It is also this objective on which all constituencies depend for the satisfaction of their expectations and objectives, whether shareholders, customers, or employees.

To define performance and results as “maximizing the wealth-producing capacity of the enterprise” may be criticized as vague. To be sure, one doesn’t get the answers by filling out forms. Decisions need to be made, and economic decisions that commit scarce resources to an uncertain future are always risky and controversial. When Ralph Cordiner first attempted to define performance and results—no one had tried to do so earlier—maximizing the wealth-producing capacity of the enterprise would indeed have been pretty fuzzy. By now, after four decades of work by many people, it has become crisp. All the elements that go into the process can be quantified with considerable rigor and are indeed quantified by those archquantifiers, by the planning departments of large Japanese companies and by the German banks as well.

The first step toward a clear definition of the concept was probably taken in my 1954 book, The Practice of Management, which outlined eight key objective areas for a business. These areas (or some variations thereof) are still the starting point for business planning in the large Japanese company. Since then, management analysts have done an enormous amount of work on the strategy needed to convert objectives into performance.

Financial objectives are needed to tie all this together. Indeed, financial accountability is the key to the performance of management and enterprise. Without financial accountability, there is no accountability at all. And without financial accountability, there will also be no results in any other area. It is commonly believed in the United States that the Japanese are not profit conscious. This is simply not true. In fact, their profitability goals as measured against the cost of capital tend to be a good deal higher than those of most American companies. Only the Japanese do not start with profitability; they end with it.

Finally, maximizing the wealth-producing capacity of the enterprise also helps define the roles of institutional owners and their relationship to the enterprise. German and Japanese management structure and style differ greatly. But institutional owners in both countries support a management regardless of short-term results as long as the company performs according to a business plan that is designed to maximize the enterprise’s wealth-producing capacity—and that is agreed upon between management and whatever organ represents the owners. This makes both sides focus on results. It makes management accountable. But it gives a performing company’s management the needed continuity and security.

What we have is not the “final answer.” Still, it is no longer theory but proven practice. And its results, to judge by German and Japanese business performance, are clearly superior to running the enterprise as a “trustee” for stakeholders or to maximize short-term gains for shareholders.

The one thing that we in the United States have yet to work out—and we have to work out ourselves—is how to build the new definition of management accountability into an institutional structure. We need what a political scientist would call a constitution—provisions that spell out, as does the German company law, the duties and responsibilities of management and that clarify the respective rights of other groups, especially the shareholders. What we have to do the Germans and the Japanese can show us. How we do it will have to be quite different to fit U.S. conditions.

In both Germany and Japan, managements are supervised closely and judged carefully. In Germany, a senior executive of the hausbank sits on the board of each company in which the bank has substantial holdings, usually as chairperson of the supervisory board. The bank’s representative is expected to move fast whenever management fails to perform to exacting standards. In Japan, the chief executives of the major companies in a keiretsu—headed either by the CEO of the group’s bank or by the CEO of the group’s trading company—function as the executive committee of the whole group. They meet regularly. The top executives of the Mitsubishi group, for instance, meet every other Friday for three or four hours. They carefully review the business plans of each of the group’s companies and evaluate the performance of each company’s management. Again and again, though usually without fanfare, chief executives who are found wanting are moved out, kicked upstairs, or shifted to the sidelines.

The analysis and scrutiny of management’s performance is organized as systematic work in both countries. In Germany, it is done by the sekretariat of the big banks—invented in the 1870s by Deutsche Bank, which modeled it on the Prussian general staff. The sekretariat works constantly on the companies for which its bank is the hausbank and on the board of which one of the bank’s executives sits. Since the bank also handles the commercial banking business of these companies, the sekretariat has access to both their financial and business data. There is no sekretariat in Japan. But the same function is discharged by the large and powerful planning departments of the keiretsu’s main bank and of the keiretsu’s trading company. They too have access to commercial and business data in addition to financial information.

Even the largest U.S. pension fund holds much too small a fraction of any one company’s capital to control it. Law wisely limits a corporate pension fund to a maximum holding of 5 percent of any one company’s stock, and very few funds go anywhere near that high. Not being businesses, the funds have no access to commercial or business information. They are not business-focused, nor could they be. They are asset managers. Yet they need the in-depth business analysis of the companies they collectively control. And they need an institutional structure in which management accountability is embedded.

In an American context, the business analysis—call it the business audit—will have to be done by some kind of independent professional agency. Certain management consulting firms already do such work, though only on an ad hoc basis and usually after a company has gotten into trouble, which is rather late in the process. The consulting divisions of some of the large accounting firms also perform business analysis assignments. One of them, KPMG Peat Marwick, actually offers a systematic business audit to nonprofit organizations, which it calls a resource-development system. And several firms have recently come into being to advise pension funds—mostly public funds—on the industries and companies in which they invest.

I suspect that in the end we shall develop a formal business-audit practice, analogous perhaps to the financial-audit practice of independent professional accounting firms. For while the business audit need not be conducted every year—every three years may be enough in most cases—it needs to be based on predetermined standards and go through a systematic evaluation of business performance: starting with mission and strategy, through marketing, innovation, productivity, people development, community relations, all the way to profitability. The elements for such a business audit are known and available. But they need to be pulled together into systematic procedures. And that is best done, in all likelihood, by an organization that specializes in audits, whether an independent firm or a new and separate division of an accounting practice.

Thus it may not be too fanciful to expect that in ten years a major pension fund will not invest in a company’s shares or fixed-income securities unless that company submits itself to a business audit by an outside professional firm. Managements will resist, of course. But only 60 years ago, managements equally resisted—in fact, resented—demands that they submit themselves to a financial audit by outside public accountants and even more to publication of the audit’s findings.

Still, the question remains: Who is going to use this tool? In the American context, there is only one possible answer: a revitalized board of directors.

The need for an effective board has been stressed by every student of the publicly owned corporation in the last 40 years. To run a business enterprise, especially a large and complex enterprise, management needs considerable power. But power without accountability always becomes flabby or tyrannical and usually both. Surely, we know how to make boards effective as an organ of corporate governance. Having better people is not the key; ordinary people will do. Making a board effective requires spelling out its work, setting specific objectives for its performance and contribution, and regularly appraising the board’s performance against these objectives.

We have known this for a long time. But American boards have on the whole become less, rather than more, effective. Boards are not effective if they represent good intentions. Boards are effective if they represent strong owners, committed to the enterprise.

Almost 60 years ago, in 1933, Adolph A. Berle, Jr., and Gardner C. Means published The Modern Corporation and Private Property, arguably the most influential book in U.S. business history. They showed that the traditional “owners,” the nineteenth-century capitalists, had disappeared, with the title of ownership shifting rapidly to faceless multitudes of investors without interest in or commitment to the company and concerned only with short-term gains. As a result, they argued, ownership was becoming divorced from control and a mere legal fiction, with management becoming accountable to no one and for nothing. Then, 20 years later, Ralph Cordiner’s Professional Management accepted this divorce of ownership from control and tried to make a virtue out of it.

By now, the wheel has come full circle. The pension funds are very different owners from nineteenth-century tycoons. They are not owners because they want to be owners but because they have no choice. They cannot sell. They also cannot become owner-managers. But they are owners nonetheless. As such, they have more than mere power. They have the responsibility to ensure performance and results in America’s largest and most important companies.

[1991]