We have excessive volatility because it is the interest of trading firms to encourage it, that’s why. And since all of today’s banks have huge trading operations, which generate a large share of their profits in good years, whenever they talk to clients or to the news media, they all encourage volatility. With low volatility, they would soon be out of a job. And before that, their bonuses would evaporate. Again, the question must be asked, is all this volatility helping or hurting the fundamental function of markets (which, contrary to widely held belief, is NOT to make a relatively few traders rich)? If the volatility is harmless—hey, why not? But if it is harmful, if it makes it more difficult for the economy to expand because economic producers cannot raise capital in the markets at fair prices, or savers are afraid to commit their money to economically productive enterprises because of the terrifying lurches in the market, then it should be curbed.

One can argue that the markets ought to be volatile due to the uncertainties of the present economic situation. But the present economic situation has been pretty static for quite a while: there is news flow, but no real change in the outlook, which remains somewhere between very sluggish growth and a modest (but discouraging) further contraction. What real news should induce investors to be 3% more optimistic one day, and 4% less optimistic the next?  The largest part of the market volume is algorithmically driven (HFT alone is  56% according to TABB, an association of quantitative traders, and this does not include the huge volume in other quant strategies involving ETFs and other non-economic market correlations); there are no fundamental convictions involved, nor any view of the markets lasting beyond tomorrow. So what useful function is all this volume serving aside from providing an income to traders? Worse, since many of these quant strategies are zero-sum games, there is no net gain to the economy.

Has anyone done any comprehensive studies of whether all these new forms of trading add to or subtract from the original function of markets? I haven’t seen one; academics just assume that liquidity equals efficiency. Nor have they ever conceded that markets can be hyper-efficient (i.e., over-react), which anyone who has ever been a portfolio manager knows to be a common phenomenon. And everyone loves to forget the great market crash of 1987, which presaged nothing, and where most of the liquidity was provided by computers trying to sell enough options to make up for the gaps down in share prices. (They never could catch up. If the market had been open another hour, it probably would have fallen another 20%.) This form of portfolio insurance is now remembered as a ‘success’ by its academic inventors, but it was a dismal failure for anyone who put any money into it.

One would know none of this from reading the public statements of senior bankers against restrictions on their proprietary trading or any other fundamental changes in the structure of our capital markets. In response to ex-Fed Chairman Volcker’s call for ring-fencing and reduction of these activities, the Administration has been waffling, while the bankers say, ‘Over our dead bodies.’  Many of these same bankers were members of the blue-ribbon Council on Jobs and Competitiveness which recently called for severe curbs on Sarbanes-Oxley’s auditing requirements, and which received President Obama’s unqualified endorsement; this despite the horrendous accounting scandals we have had which defrauded millions of investors of billions of dollars, and precipitated at least one major market decline, as well as making the Great Crash of 2008 possible.  How likely is reform of our markets when both major parties seem to share this Panglossian view that we have the best of all possible capital markets in this best of all possible financial worlds?

I’m afraid that most of this discussion loses sight of the real issues. Liquidity is not an end in itself. Cheap execution is not an end in itself. And I’m afraid that huge bonuses are not the goal of capital markets, either, although they are wonderful to bring home for the trader him/herself. In fact, much of the money made from trading is merely a form of rent extraction, which means it is raising costs for everyone else, there is no net gain, and probably a net loss.

Capital markets exist to bring together natural lenders of money with those providers of goods and services who by their very nature have a constant need for capital. All the rest of our market activity is derivative of this basic function. Savers (investors) have long believed that they can get an excess return on their investments if they invest their money intelligently, and this has given birth to a huge industry in search of these excess returns. Unfortunately, not every technique works consistently, and none works over every time period, so there is a constant search for new techniques. It is in the interest of the general economy that markets allocate money to those investment opportunities which will lead to the greatest amount of net economic gain for their owners, and therefore the highest returns for investors. This is the real meaning of efficiency.

Quantitative techniques are a way of gaming the system so that one tries to get a positive return no matter what is going on in the real world of the economy, by looking at correlative market events having little or nothing to do with the general economy. They are at best, a sideshow to the main event. Unfortunately, because such gains are inherently minuscule (if they exist at all) on any one transaction, they must be multiplied by vast volumes of trading, or by using huge amounts of leverage, to make them worth anyone’s while. This often leads to excess volatility, especially at times when the market lacks clear direction. If there are hidden risks, which were not properly accounted for in the trader’s algorithm, they can cause enormous losses, and perhaps even start panics.

There are always going to be people who are looking for a way to get a free lunch, including those who believe, despite all the principles of science, that there is such a thing as a perpetual motion machine, that it is possible to turn lead into gold, that one can find a chemical or physical reaction which results in a net gain of both mass and energy with no entropy loss, and that it is possible to make money on the stock market without doing one’s homework, and finding something truly undervalued. Historically, in the grand scheme of things, such people were relatively harmless—perhaps they defrauded a few investors, but that was all. Unfortunately, with the vast amounts of leverage now commanded by some traders through the magic of derivatives, this quest for the the gimmick that gives one a free lunch can become very expensive indeed.

Portfolio insurance was a fraud, which directly led to the market crash of 1987. Long-Term Capital Management had run out of gimmicks, so they started gambling on naked risk arbitrages with huge leverage, and caused a market panic in 1997. Collateralized Debt Obligations were a fraud which caused the great credit crisis of 2007, multiplied by the leverage offered by CDS, which accelerated the crisis. All of these quantitative strategies were supposed to make markets more efficient; in the end, they all led them astray. I think that regulators need to stop giving all arguments for increased liquidity a free pass. There is such a thing as excess liquidity, and just as seawater sloshing back and forth on the deck of a Roll-On-Roll-Off auto ferry caused it to sink, excess liquidity careening back and forth within markets causes frightening volatility, scares off investors and borrowers alike and can cause crashes. It needs to be brought back within rational limits.

That is when the real break occurred: Hurd essentially changed the culture of the company by trying to turn it from an engineering-driven hardware product innovator to a lower-cost follower of industry trends. When Hurd had to go, because of personal indiscretions, it seemed natural to the board to ignore corporate culture yet again, and bring in Apotheker, who tried to transform the company into a software house (not surprising given that he came from SAP, one of the leading software producers.) That, too, appears to have been a disaster.

The problem seems to be that this board acts as if they can move the pieces of the company around the board at will, like some sort of demented chess player who thinks he can exchange a bishop for a rook whenever he wishes, and occasionally add some additional squares to the board when he needs the extra room. In real life, you have to work with the material on hand, and changing a corporate culture is a slow and perilous business. Clichés like ‘think outside the box’ and ‘every company needs a radical infusion of fresh blood from time to time,’ are bandied about too casually in many boardrooms, especially by CEOs and ex-CEOs who may have an exaggerated impression of their own ability to exercise their will upon others.

Although we don’t of course know exactly what may have been going wrong inside, it also may not have have helped that the HP board seems to have become as impatient as the stock market. Shareholder-friendly corporate governance is one thing; running a company as if it were a marketing focus group is something else.

Me: Hijacked by whom, exactly? An obsession with board process can be as much of a distraction as one with shareholder ‘democracy,’ regulatory compliance, stakeholder interests or anything else. The point is that a company should be efficiently run, with optimal management of the risks it is running and/or is likely to encounter in the foreseeable future. What else is governance about?

—How about Responsibility, Accountability and Stakeholders Value Creation? Just a thought…

Responsibility—yes, but to whom? Accountability, absolutely—but for what? Stakeholders’ value, surely—but why? For being a good steward of the assets which have been entrusted to you: that you managed them well, and for the future as well as the present time. The three you cite are important, but I see them as means, not ends. Which is why I gave the above, admittedly reductionist formula. The company should be the best manager of the assets it controls (including the portion of people’s lives it affects), and it should attempt to continue to be so for the indefinite future. Since that includes shareholder value in the broadest sense, I don’t think it’s hijacking anything.

—Ends and Means…uuumm I like where this conversation is going. Since Governance is just a means to a end… what is the end?

Good stewardship: sustainable profits for the owners, reliable goods or services for customers, fair and beneficial relationships with the other stakeholders, good economic use of the assets. I think that covers it—no?

—I think you might have missed a bit… commonly known as natural resources, which I would rather call Natural Capital. I wonder though, if the end of Governance is Good Stewardship, what is the end of Business, its purpose?

Business? I would say ‘economic activity’ is the end of business. It’s very neutral, and completely amoral—a good business, a bad business, a criminal business, a profitable business, a tax shelter, a charitable business, etc. etc.

So the purpose of business is generating economic activity? in other words, everyone works just to keep themselves busy so that someone else gets richer? is that what you are saying? that would not make me want to get up in the morning, and certainly not inspire me to work.

In my view, economic activity, like governance, is still a means, not an end. Any other views or suggestions?

People engage in economic activity so that they themselves get richer! Or so that a non-profit can do whatever it does: stage artistic performances, aid the less fortunate, provide for education . . . Or for any of the many other purposes one can think of for a business. Yes, of course it is a means to an end. I didn’t think we were on this site to talk about the Meaning of Life, but if we are, personal benefit, broadly defined, would be part of the reason for human activity, altruism another, and if you believe in God (or any other transcendent principle), serving him (it) would be a third. Obviously, personal enrichment (this includes survival) heads the list where economic activity is concerned, because there the link is most direct.

I suppose what you are saying is, “Why should anyone in a position of power care about good governance, if the only results serve base ends or else accrue to someone else’s benefit?” but that shouldn’t be it. The point is that good governance makes higher returns (including non-economic returns and intangibles, if those are your goal), sustainable. That is, over time, the investments which are necessary to allow any business to function—money, human capital, natural resources, brand equity—will only flow to those businesses which adequately reward them over the appropriate time frame. So you shouldn’t manage the business only for next week, unless your stated goal is to make a quick return and pay off the stakeholders. This is, I think, the logic behind [another member's] point that the goals of governance are variable; they should be consonant with the expectations of those who have invested money, time, effort, and other scarce resources in them. If you are deluding or otherwise disappoint any of these stakeholders, they will sooner or later withdraw their stake, and refuse to support any more of your ventures.

The alternative to this model of governance is really: ‘There’s a sucker born every minute.’ That’s a form of fraud, and I think most of us would agree that it is both socially undesirable and unsustainable as a business model.

Dear Professor C_____:

In response to the question whether it is worthwhile to discuss stock lending practices in the context of a UK consultation regarding short-termism versus a long-term investment perspective, I would summarize the current state of lending activity as follows:

The biggest problem with stock lending in this context of short- vs. long-term perspectives is that it provides a powerful inducement not to vote on issues which are otherwise deemed important by the investor in question—either the asset manager or the beneficial owner.  This can produce conflicts between owners and managers, particularly when a major part of the managers’ business model is built around margins from lending, as it often is with index fund managers. Related issues are that it sometimes interferes with other  engagement activities, may on rare occasions threaten the integrity of the shareholders’ meeting, and that lending is not quite as risk-free as it has often been portrayed to trustees. But the real stumbling block from the viewpoint of the lender is the effect upon voting.

The ICGN Securities Lending Code, which addressed these issues from an international perspective, called for more transparency in lending activity.  In particular, lenders should (1) implement a clear policy regarding these potential conflicts between voting and lending, and make it public, particularly to beneficiaries, (2) that the income from lending be reported separately from investment income, and (3) that all parties to the lending process pledge not to lend shares in suspicious situations, when they have reason to believe that someone is borrowing shares in order to influence a vote.  This third point has been much ridiculed by the agents and custodians, but in fact there have been cases where loans suddenly went ‘special,’ (i.e. someone was suddenly willing to pay a significantly higher margin than usual) with unusual or rigid delivery terms, in the days just before the record date for a controversial vote.  Borrowing shares for the principal purpose of voting them is banned in the US by Reg. ‘T’ and frowned upon in many other markets, but it is not usually illegal, and is in any case difficult to police.  The lending industry operates on the basis of ‘see no evil, hear no evil,’ and this may sometimes be an inducement to overlook the obvious.

In general, our attitude in drafting the Code was that lending is a useful activity which improves market liquidity, but that the tail shouldn’t be allowed to wag the dog. In and of itself, we see nothing wrong with some market participants profiting from a decline in a share’s price:  it is a part of price discovery.  Also, many loans have nothing to do with constructing short positions, but are rather for covering fails and the like, or for creating hybrid hedged positions in which the ultimate borrower may also be net neutral, or even net long.  And although the most frequent function is indeed to construct a short position, often the bet doesn’t work or has only limited effect, and the lender has lost nothing on the capital side either.  But this isn’t always true, of course, and sometimes the short sale might add to the weight of selling putting downward pressure on the share price.

With reference to the UK consultation:  One good thing about the UK which we don’t enjoy in the US or Canada is that the agenda is posted long before the record/reconciliation date, and therefore, investors have an opportunity to recall shares after seeing whether there is anything to be voted upon they actually care about.  One problem however, in the UK, which is not usually a problem over here is that there is normally a totally separate chain of authority for authorizing and transmitting voting instructions from that of portfolio management, including decisions whether a particular vote affects shareholder interests.  The right hand is not normally allowed to know what the left hand is doing. This could be addressed by re-writing the contracts to allow for direct communication between managers and custodians, but to the best of my knowledge, no one has done so.

A problem on both sides of the Atlantic is that lending is more and more being done by third parties, many of whom have authority to lend shares without informing the beneficial owner of specific loans.  Thus, a beneficial owner often gives out orders to vote its shares, not knowing that the majority of them have been lent, and may not be able to be recalled in time.  The procedures involved in the process could use updating, but those most involved are most resistant to any changes in the system, or any further investment in technology.

Since the margins on most loans are very thin, and the construction of short positions by prime brokers is very lucrative, it could be argued that the lenders are throwing away their votes for too little. For this reason, a few asset owners have withdrawn from lending entirely, as not being worth the cost.  But there are many others willing to step into the breach.

A danger particularly of the U.S. system is that lenders always have the temptation to augment their returns by reinvesting the collateral in riskier paper.  This was highlighted by the problems some pension funds had in 2008, when they discovered that their agents had reinvested the collateral from loans in risky and less liquid instruments, and then had to return the collateral on short notice without being able to cash the investments they had made, or only at large losses. Several public pension funds in the U.S. had put some of their collateral into SIVs!  So the riskiness of the portfolio was actually increasing, relative to the equity position.

Another problem to emerge in 2008 was counterparty risk.  Since a loan is essentially a contractual, unsecured agreement with a prime broker (the collateral is posted by the actual borrower, the prime broker acting as its agent),  there is some risk that if the counterparty goes belly up during a loan, part of the transaction may be tied up in bankruptcy proceedings.  In the US this risk has apparently been dealt with by changes in the law to explicitly protect such agreements, but to the best of my knowledge, in the UK it has not.  There were instances of lenders who had ‘their’ shares (i.e., the commitment to buy them back in) frozen for some months after the Lehman bankruptcy, but who still had to return the collateral.

In answer to your students’ question, yes, individual portfolio managers often want to know whether someone is betting against their long positions, especially when these are in mid- or small-cap stocks which may be more easily influenced by a few big shorts.  They sometimes ask to recall, when they know that such shares are being borrowed against their own positions.  However, if the lending institution is on average a long-term holder, they are usually told by their senior managers or trustees that the income is significant, and that over the longer term, the effect on prices is not significant.  They are also told that the process is a ‘riskless’ source of cash income (nothing is riskless, but never mind) and that they should shut up.  The greatest conflict, in my opinion, is not between asset owners and asset managers, but between those (senior managers, directors, trustees, and of course anyone in the lending apparatus) who have an interest in maximizing annual income, and those (portfolio managers, corporate governance staffers, and concerned beneficiaries) who are concerned about the capital return, either directly (the PMs) or indirectly over the long-term (governance types).

Feedback from the other parts of an asset owner or manager would usually act to mitigate some of these problems.  But lending is usually treated separately as a back-office function, and flies beneath the radar of most decision-makers.  Those administering the lending are (a) usually not involved economically with any other part of the investment process, and (b) always rely upon the argument that even a relatively piddling amount is worth vastly more than a ‘worthless’ vote.  Asset owners and especially their trustees have to decide beforehand whether votes (other than on sale of the company) are worth anything to them, and instruct their lenders accordingly.  Most don’t.

I don’t necessarily want to stir up a controversy between active UK lenders and governance advocates, but the share-lenders’ lobby has been very aggressive, and includes several asset owners which otherwise bill themselves as proponents of good governance.  I think many such funds have failed to integrate the issues with potential conflicts to governance policy because internal advocates of lending grossly understate some of the problems.  Indeed, the difficulty with ameliorating many mechanical difficulties which could be solved without suspending most lending activity is because the position of lending advocates is that there should be no encumbrance upon lending at all.

Incidentally, although it won’t provide lenders with substitute income, there is developing an alternative to the stock loan:  the single-stock future, especially when incorporated into an Exchange for Physical contract.  It’s cheaper, simpler, and doesn’t require anyone to borrow stock.  (Disclosure:  I am an independent director of OneChicago, the single-stock futures exchange.)

I look forward to discussing the subject further with you, if you are interested.

Best regards,

Andrew

Many things have been declared ‘dead,’ based on recent experience.  For example, political conservatism in the U.S. was declared dead by the media and most commentators only two years ago; four years before that, liberalism was likewise ‘dead.’  In Europe, socialism was ‘dead’ in 1991; British-style liberal economics in 1997.  The best one can safely say, at least until the dusty coating of history has covered something to a reasonable depth, is that it seems to be ‘moribund.’

Before one declares something called corporate governance potentially in need of a priest to perform the Last Rites, one should define it carefully.  The Cadbury Report defined corporate governance as “the system by which corporations are directed and controlled,” a definition which is frequently employed by other authors.   I haven’t noticed the corporate mode of organization on the wane in our society, and I assume that most if not all of these entities are both directed and controlled, (although occasionally a specific situation gives one pause.)  Companies will continue to need advice in all related areas.  Clearly, the article on the death of corporate governance must be referring to something far more specific.

If the author means to say specifically that shareholder activism motivated by concerns about corporate governance is dead, one must assume either:  that the concerns which once motivated shareholders have been forever remediated, or that these concerns are no longer of interest to shareholders, and are unlikely ever to be of interest again.  I would submit that the first assumption is extremely unlikely, given that no one has succeeded in changing human nature in at least the 5,000 years of recorded history.  The second, if true, is only true so long as the the concerns underlying the first  remain in abeyance and/or fully discounted in share prices.

While there is some evidence, at least in the U.S. and the U.K., that these elements have been fairly well discounted over the past nine years, there is no reason to believe that this is the case because either (a) investors have become permanently more rational, or (b) managers and directors have become permanently less self-interested.  On the contrary, it has been demonstrated that the reason governance issues or the lack of same seem to have been discounted in share prices is because investors became expected to pay attention to them, due to the excess returns gained from paying attention to these issues during the preceding 15 years.  This was thanks to the efforts of corporate governance activists, of proxy advisors, and the occasional muckraking financial news item.  If governance activism is in fact temporarily moribund, then after a while investors will cease paying attention to it, just as at regular intervals they cease paying attention to book value, return on invested capital, or, in bear markets, growth potential.  This means that there would again be an excess return to be made from paying closer attention to these same governance issues:  board independence, transparency, protection from rent extraction, and fair treatment of minority shareholders.

It seems that what the author is decrying instead is the loss of missionary enthusiasm among the first generation of activists, and the decline of a rational link between the governance concerns of investors and the proper management of a business.  It is indeed arguable that the present governance ‘industry’ is a victim of its own successes:   there is increased emphasis upon compliance with increasingly minor infractions, the area has become bureaucratic and legalistic, divorced from investment concerns, exploited by some for purposes entirely contrary to the original intentions attending its foundation, and the whole subject has become overlaid with layers of complex regulation, particularly in the U.S.

However, the U.S. is not the whole world, the new regulations will not cover all possible attempts to circumvent them, the majority of the largest corporations are not the whole of all investible propositions, and investors may be counted upon to ignore or eventually forget all lessons not recently acquired from personal pain.  Corporate governance watchdogs will continue to be needed the same way that police will always be needed; because some individuals will try to cut corners no matter what the environment, and many more will begin to ignore or even participate in whatever is going on whenever it seems that is what most of their contemporaries are doing.

As Prof. Frentrop has demonstrated, governance activism goes back to the first corporation, the Dutch East India Company, and began as early as 1609.  It will be needed in some form as long as some people manage assets on behalf of others.

Larry,

Of course, we never had abuses of power by directors and chief executives before the regulators started empowering shareholders, did we?

The problem of the power of the proxy advisors is analogous to that of the credit rating agencies for only one reason: most institutional investors refuse to dedicate any resources to dealing with these issues, so they outsource it.  If instead of regarding governance issues as a nuisance artificially created by regulators, they attempted to integrate consideration of them into their investment process, they would (a) be capable of making independent judgments rather than merely trying to cover their rear ends by relying solely on someone else’s opinion, and (b) they would then be in a position to make a fuss only about governance issues they themselves deemed substantive—but they would really make a fuss about those.

There is another important analogy with credit rating: as we saw in 2007 – 2008, it wasn’t that the debt ratings were unimportant, it was that they had been corrupted. And they were corrupted because bond investors relied upon somebody’s measure of risk, but refused to pay anything for it themselves. So the issuers paid instead. Similarly, one may argue that the voting recommendations can be important (yes, most of them are routine, but in that case, there’s no controversy), and that they key issue is only whether the system has been corrupted or not. The analogy to the credit rating system would only hold if the companies themselves were paying for the governance advisors’ recommendations. There have been accusations that ISS has some conflicts of interest due to the fact that they also have a consulting service for issuers, but they claim to be careful to avoid those conflicts, and the complaint Mr. Carney is making is that on the contrary, the recommendations are anti-management.  (The other major proxy advisors have no such conflicts in any case.)  For the analogy to hold, one must argue that the credit ratings agencies were an unnecessary nuisance because ratings they had issued on a lot of paper were too low, not that they were in fact far too high.

I agree that it would be better if more investors did some research on these issues and thought for themselves, rather than relying entirely upon third-party recommendations. But they would have to be prepared to spend a bit more on staff dedicated to considering these issues from an investment point of view. As it is, there is an almost total lack of coordination between corporate governance and investing at most institutions in the U.S.  Then, when something that has been flagged for years goes very wrong, the portfolio managers who had ignored the risk run screaming to their lawyers, and a raft of after-the-fact litigation results.   In such cases, any recoveries are paid for by the other shareholders.  Is this really the better way to run this particular railroad?

Another contributor, Douglas Levene, responded to my post by arguing that I had avoided the central issue, that there was no economic incentive for institutions to pay attention to agency costs anyway, and they were only doing a minimal job of it because it had been mandated by regulators.  Again, I think this is a dangerous misconception that needed to be met head on:

Douglas,

You’re assuming that they are correct in believing (if they really believe) that there is no economic incentive for monitoring agency costs. Actually, there are two: one, that more and more of their clients are demanding it; two, that poor governance is a risk factor, and correlates over the longer term with poor (often spectacularly poor) performance.

I know, there are some studies that claim to demonstrate otherwise, but they were, I believe, poorly constructed in two respects. First, they almost always looked for positive correlations between high governance scores and outperformance; governance is not a positive performance factor for the same reason that being law-abiding is not a sufficient reason in itself to hire someone—it’s an important requirement, not a sign of growth or performance potential. Second, most of the studies were event-driven. As with most risk factors, the event does not occur when the risks are first taken, and certainly not when they are ameliorated—they will occur somewhere down the road. As a veteran portfolio manager, I can assure you that plenty of investors who were told they might be supping with the devil, but thought they would have time to get out safely, ended up losing barrelfuls of money.

Meanwhile, there are plenty of other long-term studies which indicate the opposite, beginning with the landmark study of Gompers, Ishii, and Metrick (2003) which demonstrated an 8.5% annual performance spread from S&P constituents over the 1990s between the highest quintile on IRRC ratings, and the lowest.  The sample was re-balanced each year, so that survivor bias should not have been a major factor.  My own examination of the data indicated that about two-thirds of this return came from avoiding the low-rated components, which confirms my view that much of the benefit from governance monitoring is in minimizing risk.

There is another issue: many institutions do not pay for an in-house governance program primarily because their directors or trustees passionately hate the idea. They hate the idea because they are also CEOs and directors of other companies which may at some point be the object of governance concerns. It’s a conflict of interest problem as much as it is a problem of demonstrating and quantifying the economic incentives.

Yes: in an ideal efficient market, higher agency costs will translate rapidly into a higher cost of capital and underperformance. The problem is that this assumes (a) that the market is monitoring those agency costs itself, and (b) that real-life capital markets are efficient. I think we have had enough practical experience with the algorithms of efficient-market theorists  in recent years to demonstrate that markets are far from perfect, or at least that when they do return to equilibrium it is sometimes with a very long lag and often a violent over-correction. As for the market being potentially a sufficient monitor of agency costs, this is contrary to the author’s hypothesis that monitoring these factors is a waste of time.  If  everyone is ignoring them, the invisible hand of the market will have no effect.  It is true that the market could serve this function in theory, (which would create a free-rider problem), but this issue would not be solved by abolishing (or crippling) proxy advisors, nor by recommending that all investors vote blindly with management.

Dear Ms. Holzer:

If you agree with the U.S. Chamber of Commerce that business needs a “level playing field” to offset the ‘case-by-case approach’ of the institutions, I have another wonderful proposition for you:

• • a law that guarantees high voter turnout in U.S. elections by allowing registered voters to have ‘standing instructions’ that their vote should be automatically cast for their affiliated party’s candidate or for the incumbent official.  They could always change their standing instructions to a different set of standing instructions if they bother to, remember to, or are allowed to by the authorities (who, after all, should have the last word).

It is an absolute scandal that voter participation in U.S. elections is so low—bordering on 50%—when it is so much higher in other countries such as North Korea, Iran, or Zimbabwe.  We need to get out more voters to create a level playing field so that our elections cannot be dominated by malcontents and special-interest voters who seek to overturn the established order and create chaos throughout the legislatures and cabinet rooms of our country!

Similarly, If you agree with IBM that ISS and other third-party proxy advisors who have such tremendous influence, but no economic interest in a company should be stopped, I’m sure you would be in favor of a law preventing third parties such as the Wall Street Journal from airing their influential opinions on matters in which they have no direct interest, such as tax policy, monetary policy, and the attitudes towards private property of various foreign powers.  Just think of how much easier it would be for policy makers to operate effectively without all these noisome distractions from uninvolved parties!

Sincerely,

Dr. Andrew Clearfield

President

Investment Initiatives LLC

The problem is, that as trite as it might sound, it is the radical changes in corporate culture at the major financial institutions that created the environment for 2008′s crash. The changes in corporate culture at the investment banks in the late ’80s and early ’90s were palpable. There were always unscrupulous players before, of course, but even before these were caught out, they were usually mistrusted by most of the rest of the industry. Suddenly, over a period of less than 20 years (my impression was that it never took more than about 10 in any given country, with the U.S. leading the way) the ethos became, “Anything goes, if it makes enough money.” The question is, how do you get the genie back in the bottle?

It may be that the only way to stop individuals from reckless behavior, once the psychological barrier against unethical behavior has been broken, is to police them much more closely. This puts an intolerable burden on markets, and on regulators as well. An alternative is to consider a world in which, unlike that of our present financial markets, everyone at a firm knows what everyone else does for a living. This implies smaller, more specialized firms, and partnership-like arrangements. If someone is cutting ethical corners with what is partly your own money, you will try to rein in the behavior, or see that someone else reins it in. As long as it’s someone else’s money, you are far more likely to say, ‘What the hell,’ and let it go.

Such a radical change in market structures and financing may have all sorts of negative implications for growth, which should be studied carefully, before any such radical a reform is contemplated. But it should be considered seriously, because, as behavior within large bureaucracies has always shown (consider government agencies, police states, and the rest), individual responsibility declines in inverse proportion to the size of the organization. If there is only a limited degree of personal (read, ‘economic’) identification with it, then the process accelerates.

WHERE did you get the idea that I see governance as mere compliance???  Compliance is making sure that the laws and regulations have been complied with; by definition, that is backward-looking. Governance is an aspect of risk management, which is inherently forward-looking. Good management manages its risks well; it produces the highest possible returns commensurate with an acceptable level of risk. Bad management is hyper-cautious, or bets the farm on a risky strategy (sometimes both in alternation!)

I think people get hung up on seeing this as a negative, merely because it will only manifest itself to outsiders if the roof falls in. Rather it is, if you will, the exercise of foresight that allows a good strategy to shine through. But governance is not itself the strategy, it is not the growth factor. And you need growth factors as well if the company is to do well.

The issue for investors is that there will be plenty of successful growth strategies that succeed over the short-to-medium term because the company got lucky: if you bought WorldCom in 1994 and sold it in 1999, you did well. AIG shareholders were lucky for years. Their luck ran out because of defects in governance which were visible if one paid attention to them. Spotting AIG early as a high risk saved my clients a lot of money, and I believe that’s where the most demonstrable value-added in governance activity is situated.

Sure, if anybody could have convinced Hank Greenberg twenty years ago to break down the silo structure he had created, and to allow his board to have a succession plan (among other things) you would have saved everyone a lot of money, a lot of jobs, a lot of financial stability. But that wasn’t easy, and Greenberg probably wouldn’t have listened to anyone who tried. So the next best thing is the scolds, who point out the shortcomings, and (mostly) persuade a minority that is willing to listen to stay away from risky practices. Yes, you want the best board possible, but you can’t guarantee that they will all do their jobs properly, so you monitor, and you try to assure that all the structures are working, and to make sure than no one is asleep at their post.

Those who oppose the rights of shareholders to monitor and speak out on governance issues seem to believe that human nature changes when people walk into a boardroom.  It doesn’t.