IBC Conference
Corporate Governance -
The Role of the Institutional Shareholder ...
by: Charles Macek

The aim of this paper is to provide you with an improved understanding of institutional investors as intermediaries of household savings and in particular their role in corporate governance.

I will begin with a brief overview of the evolution of the managed funds industry. This will be followed by a brief examination of structural changes occurring in this industry and the forces driving that change. I will then examine the tensions this is creating for the corporate sector with regard to its accountability. In particular, whether organisation are accountable merely to shareholders or to a wider set of stakeholders. In conclusion, I will examine corporate governance from the perspective of its costs and benefits and the challenge it poses for institutional investors.

When one looks at the size, scope, vibrancy and sophistication of the managed funds industry in Australia in 1999, it is hard to believe that the industry did not exist 30 years ago. To go back to the 1960s, investment management was bundled together with risk management typically in a product offered by a life office where frequently the benefits of the product, the expected outcomes, the risks and the costs were not transparent due to inadequate disclosure. The only other avenue for savings was in a low interest bearing account with a bank.

As a consequence, during the 1960s professional funds management organisations, typically subsidiaries of merchant banks arrived on the scene with a simple proposition: Give us a little bit of your money and we will do better than what you are getting at the moment. I'm referring to companies such as Schroder Darling, Rothschild, JP Morgan and Bankers Trust. These organisations subsequently did deliver on their promise and a new industry was spawned, assisted by another group of intermediaries - the asset consultants.

It was in the early 1970s that the first performance survey was developed in Australia, initially as a marketing gimmick to promote an asset consultant. The existence of new managers, challenging the monopoly of the Life offices, contributed to the success of the survey and, in turn, the survey provided a vehicle which legitimised the promise of the new fund managers.

In less than three decades the industry has moved from domination by Life offices to increasing influence by investment managers. This has caused a shift from selling products to developing clients. An oligopoly of sorts has been replaced by a plethora of competitors. Regulation, which previously controlled and protected institutions by restricting new entrants, has been succeeded by deregulation removing the barriers to entry. Within the compulsory superannuation framework which lies at the heart of Australia's retirement and incomes policy exists the paradox of increasing consumer choice.

I now turn to the issue of structural change. There would be few that would dispute the assertion that globalisation and technology are the key drivers of the changes in our businesses, economy and society with which we are struggling to cope.

Globalisation means that we live in a global village and work in a global marketplace. It is the openness of trade in goods and services, which drives this process. This openness reflects the politics, which flow from the end of the Cold War and the adoption of multi-lateral rather than bilateral trade agreements. This removal of many barriers to trade is reinforced by technology in facilitating rapid information flows and cross-border transactions.

People employed in the capital markets - whether in banking, finance or investment - understand the external forces of change better than most. For capital respects no boundaries and is motivated solely by the pursuit of profitable opportunity.

Further, it is also only in the post-Cold War period that we have seen the evolution of computer power. From very large and expensive mainframes with limited functionality to very cheap, incredibly powerful, fast and highly flexible personal computers. Further, all of this improvement has come at a fraction of the original cost. Computing has moved from processing batched data in greater volumes, faster and cheaper to enabling functions and activities to be undertaken differently.

Just think how banking is changing. Rather than a transaction occurring across the teller's counter at the branch between 10.00 am and 4.00 pm, five days a week, we are increasingly using an ATM, the register at a supermarket, a telephone or even the Internet for the same transaction. Further, this access is available 24 hours a day, seven days a week. Lower lending margins (in turn the result of deregulation) which are only partially offset by fees has put extra dollars in customers' pockets as well.

Herein lies a paradox. Whilst technology is destroying some jobs by making certain skills redundant, it is creating new jobs based on different skills or even new industries. This poses a tremendous challenge for policy and regulation. Again, take banking as an illustration. Do we try to preserve yesterday's technology or yesterday's industry structure? In both cases we will fail. In the former, jobs will disappear as consumers vote with their feet.

In the latter, control of a key Australian industry will increasingly pass offshore as regulation prevents domestic banks from acquiring global scale. It is the failure to recognise this, and the rejection of a merger between a major bank and major Life Office, which has seen the transfer of Australia's second largest Life Company into French control. Today it is possible to have a cheque account, a savings account, a mortgage, a loan, superannuation, unit trust investments, a margin lending account and a credit card without any relationship with a bank.

In financial services the impact of globalisation and deregulation has been immense. When I commenced my business career in the late 1960s by joining a Life office they were large, monolithic structures dominated by their field force of tied agents and governed by an establishment board. This combination produced a product-driven culture rather than a customer focus.

In those days institutions focused not on performance but rather on relationships which were occasionally quite cosy because of interlocking directorships. Their investment portfolios were managed largely on their own balance sheet and quite passively. For example, the Australian share portfolio was dispersed, often spread over hundreds of holdings and shares were rarely sold in companies where there was a client relationship or board connection.

The most significant change in the nature of institutional participation in investment markets over the last 30 years is their transformation from owners to agents. This is an issue that is poorly understood by the media, policy makers, and representatives of small shareholders and even regulators. Driven by competition, investor protection regulation, the rise of asset consultants and a more knowledgeable and empowered consumer, there has been a significant decline in the proportion of household savings exposed to the balance sheet risk of investment institutions. This is evidenced by the explosive growth of the managed fund industry shown in Table 1.

The main consequence of this change is that institutions are increasingly managing assets as agents, usually with one or more other intermediaries such as a trustee, an asset consultant or a financial planner interposed between them and the investor. As agents they have become more sensitive to their fiduciary responsibilities. As agents they have become less secure in their tenure. As agents they have become more vulnerable to fashion dictated by other intermediaries.

Their investment behaviour has been influenced by these pressures - especially a shortening of time horizons and a preference for liquid assets. As investors they are global in their perspective and, in turn, are influenced by global developments. Shareholder activism is one consequence of this. This change in institutional behaviour has not surprisingly, led to some tension with the corporate sector.

The joint stock company replaced the family owned company as the dominant means of financing commercial activities during the 19th century as the requirements of the industrial age outgrew the capacity of the family to finance. At that time most investors were individuals who took an active interest in their investments through participation at the AGM. This ensured that the interests of management were aligned with the owners of the business. During the 20th century we have witnessed the separation of ownership and management to an even greater as the scale of business increased. Initially this institutional capital was on balance. Shareholder control was exercised through control of board appointments.

However, over the last 30 years we have seen an unbundling of financial services thereby separating the customer's investment and the capital of their service provider. This changed the role of institutions increasingly to that of fiduciaries. Initially they failed to recognise the implications of this and continued to behave passively other than to control membership of the directors club.

This began to change during the 1980s, initially in the United States. There, the trend towards the appointment of specialist investment managers responsible for a specific asset class or sector, such as equites, started the process. The increasing use of passive equity managers merely tracking the index gave birth to what today we call corporate governance or shareholder activism. For these funds the so-called "Wall Street Walk" - or selling out of poorly managed and performing companies, was not an option if that company was included in the manager's benchmark or index.

The large public sector funds such as CALPERS (the California Public Employees Retirement Scheme) recognised that they had a fiduciary responsibility to their members to improve the performance of their portfolio. This resulted in more active and objective scrutiny of the performance of companies they were invested in. Initially this focus was on American companies, but has since spread to foreign companies (including Australian) held in their portfolio.

Thus active involvement in corporate governance and proxy voting represent a return to the past when boards and management were held accountable to the owners of the business. Just as the move from the agrarian age to the industrial revolution spawned the joint stock company the information age is leading to owners once again exercising their responsibilities. Tension between companies and their owners is inevitable during the transition towards a new relationship. A relationship in which the interests of owners and management become better aligned. With corporate accountability a clear focus the issue is which model should be adopted? The shareholder or stakeholder?

Before I evaluate these two models it is worth examining why the US is winning the global race to succeed in a competitive world. It is my contention that the United States economic performance in the 1990s can be explained by several factors. Firstly, it enjoys flexible labour and product markets. Secondly, it has a deep and sophisticated capital market - a capital market that operates with liquidity across the entire continuum of the risk spectrum. Thirdly, the US success story reflects accelerating innovation, entrepreneurship and rising productivity. Risk taking is encouraged and readily financed. However, to what extent can the US model be transported?

Australia over the last 15 years has had substantial financial and labour market deregulation. Protection in the traded goods sector has also been substantially reduced. Tax reform, after several abortive attempts starting with the Asprey Commission in 1975, is finally likely to see an improvement in Australia's competitive position. Despite this, the performance of Australian companies remains relatively poor on a global comparison with an ROE roughly half that of the US and UK stocks. Yet the competitive pressures are similar around the globe.

In Australia the usual response to the relentless need to compete has been to look for panaceas. In business we call in a management consultant peddling the latest and most fashionable management fad. Often the recycling of an earlier fashion suitably relabelled. If you have worked in a large organisation for long enough you have probably been exposed to all of them. The following is by no means a complete list.

There are at least two other groups without whom business could not even survive, let alone prosper. They are, of course, employees and customers. All companies acknowledge this. Pick up any annual report and it will refer to and thank their employees. Look at any mission statement or strategy review and it will highlight the importance of customers. Do you know any business that does not claim to have a customer focus? Yet too often such sentiments are but hollow words or an organisation's actions and behaviour cannot match its strategic intent due to poor management or culture.

For instance, as business responds to a competitive environment by focussing on costs and downsizing the implicit contract with its workforce breaks down. Morale suffers and there is a lessening of trust and loyalty as employees are forced to manage their own careers. Yet good cost control is essential for competitiveness and hence survival and security for the business. Seemingly this is a paradox. However, we should not confuse efficiency with effectiveness.

Michael Porter states that "operational efficiency is not strategy - it is necessary but not sufficient." Ultimately, growth in revenue and profits are the only path to prosperity.

By now you have probably concluded that I am advocating a stakeholder model for success. Yet as an investment manager, I can tell you from experience that it is not possible to serve more than one master - to manage conflicting performance objectives. So how is this dilemma to be managed?

Fortunately I believe that the answer is simple. There is no fundamental difference between the shareholder and stakeholder models! The shareholder model - of maximising shareholder returns - inevitably leads to a short-term focus on that which is measurable, namely current profits. The stakeholder model can be restated as one of maximising shareholder wealth over the medium to long term. In other words the difference is simply one of time frame and measurement.

Let me give you a simple illustration. Any fool of a manager can maximise this year's profits by taking costs out of the business which flow directly to the bottom line. We can measure precisely the profit improvements from cutting the cost of research, of training, of advertising, of not investing in new plant. But what is the cost of not undertaking research? Could product development suffer? What is the cost of having poorly trained staff? Lost sales? Increased workplace accidents? Increased customer dissatisfaction, perhaps even litigation? What sales do we lose by not promoting our products and services? We can measure the cost of employing people but what is the cost of staff turnover?

It was Einstein who said "not everything that can be counted counts... and not everything that counts can be counted."

The most eloquent case for the stakeholder model has been stated by Sir John Dunlop when he said "that directors are responsible to shareholders for profit in perpetuity; and that this general expression of a principle permits, indeed requires, directors to pay full regard to their employees, to labour relations generally, to the community, to the country, in all their decisions for and on behalf of shareholders."

Authors James Collins and Jerry Porras wrote "Built to Last" in order to examine the secret of successful companies. One of their key findings was that "visionary companies pursue a cluster of objectives, of which making money is only one - and not necessarily the primary one. Yes, they seek profits, but they're guided by a core ideology - core values and a sense of purpose beyond just making money.

Consider the following mission statements - all reflecting the values of their founders rather than the word-smithing of a consultant.

Mary Kay Cosmetics: To give unlimited opportunity to women.

Sony: To experience the joy of advancing and applying technology for the benefit of the public.

Wal Mart: To give ordinary folk the chance to buy the same things as rich people.

Walt Disney: To make people happy.

In other words we need to look at the big picture and not just the bottom line. We need to think holistically as well as analytically. Anita Roddick, who is a staunch advocate for exactly this type of approach, argues that business must stand for more than just making profit. There are two great benefits in doing that. Firstly, the best people will want to work for you. Secondly, consumers will want to support you. Now that has to be good business!

I dare say that Australia's banks would not be held in such low regard by the community if they had adopted such a philosophy.

I now turn to the issue of corporate governance, its objectives, costs and benefits.

In 1997 the ASX prescribed that listed public companies were required to include a checklist of their corporate governance practices in their annual report. A brochure for a leading accounting firm defines corporate governance as "the system or process adopted to direct and manage the business and affairs of a company". In Victoria the recently released report from the Public Accounts and Estimates Committee, Annual Reporting in the Victorian Public Sector defines corporate governance as: "the processes by which agencies are directed and controlled. It encompasses authority, accountability, stewardship, leadership, direction and control".

These definitions and approaches suggest to me that we have further to travel in our understanding of the issue. So what are the underlying issues? Quite simply they revolve around accountability and disclosure. Boards are accountable to shareholders for the company's performance. Disclosure is the means by which shareholders gain comfort that this responsibility is being taken seriously. Companies cannot prosper without the trust and support of their shareholders. Disclosure is the means by which this trust is obtained and maintained.

It is my contention that corporate governance is primarily about attitude - about corporate cultures. It is also about behaviour that reflects an appropriate culture. It is about accepting responsibility for their obligations to all stakeholders. These include shareholders, employees, customers, suppliers, the community, regulators and even the environment. It is only by meeting these obligations that "profit in perpetuity" will follow. It is for this reason that prescriptive approaches are of some concern.

Even good general principles such as those found in the AIMA "Blue Book" need to be interpreted flexibly to reflect differences in specific circumstances. A rules and process based approach lacks this flexibility. Such an approach fails to encourage the appropriate culture and may allow the avoidance of accountability by hiding behind the process.

Corporate governance is and should be about PERFORMANCE and not CONFORMANCE! In other words it is a means to an end not an objective in its own right.

Shareholders by being interested and active participants in monitoring the performance of their investments and questioning the actions of Boards are best placed to achieve this outcome. Regulators, who are monopolist by their very nature, but subject to political and public scrutiny, will often seek comfort in rules and process. Where they are enlightened and avoid an overly prescriptive approach the resultant vacuum is usually hijacked by a legalistic approach.

This is evidenced in prospectuses and information memoranda. In the production of these documents the overriding objective is to minimise the risk of litigation and maximise the defence of any litigation. Helping the intending investor to make an informed decision is a secondary goal. The investor is simply drowned with information whilst starved of knowledge. Who benefits from a 200-page prospectus which no one reads?

Providing there is appropriate disclosure, transparency and choice, informed investors operating in a free market are the best regulators. "Caveat emptor" recognises responsibilities whilst overly protective regulation presumes only the existence of rights.

Getting it right in our approach to governance is both necessary and yet difficult. This is best illustrated by the examining the simple proposition that the interests of management and owners should be aligned. It is in response to this goal that executive compensation has become more performance driven. Yet too often these schemes are poorly designed by simply rewarding executives for a rising sharemarket. Moreover, the magnitude of the current bull market has delivered financial returns to salaried executives beyond the dream of all but a few successful entrepreneurs who have to risk everything and not just their reputation.

The widening gap between employees and senior executives is unsustainable and unlikely to survive beyond the next bear market.

Overseas experience has demonstrated a close link between companies that adopt good governance practices and their performance. Globalisation of markets ensures that these policies and activist shareholders will become an increasing feature of the Australian landscape.

Indeed at their AGM in July 1999, the International Corporate Governance Network (ICGN), which represents $6 trillion of institutional investor capital unanimously adopted a practical ten point "working list" in response to OECD Global Governance Principles adopted earlier in the year.

The ICGN approach acknowledges that "the overriding objective of the corporation should be to optimise over time the return to its shareholders…the corporation should endeavour to ensure the long-term viability of its business, and to manage effectively its relationship with stakeholders".

The other points of focus in the working kit relate to:

The external factor is the result of traditional "gatekeepers" such as trustees, asset consultants and financial advisers now being subject to the same competitive pressures faced by investment managers. This leads to the tyranny of relative performance with all intermediaries chasing recent past performance. Fewer than half of all trustee- administered funds have a corporate governance policy. Large managers incur substantial regulatory compliance costs with little competitive advantage as asset consultants and their clients chase investment performance.

Fortunately, technology should enable appropriate policies, especially with respect to proxy voting, to be implemented at a more affordable cost in the future. These forces lead to the short termism much bemoaned by corporations. It also leads to an increasing premium for liquid investments with the premium paid by investors who should have a long-term horizon and less need for liquidity.

Unless institutional investors take the lead on proxy voting they may find regulators or their clients imposing more prescriptive and costly solutions upon them. As professionals, institutional investors are best placed to judge the impact of corporate policies and Board performance on shareholder wealth.

The internal factor is the increasing contact which investors have with boards and senior management of companies in their portfolio. A 1999 questionnaire on the frequency of informal contact from institutional investors indicated that 77% of companies reported quarterly contact with investors compared with 56% in 1998.

Whilst counter intuitive this is a dangerous practice for institutions. Firstly, it is no substitute for proxy voting. Secondly, it is likely to lead to a backlash from small shareholders and regulators. The absence of proxy voting reinforces the perception that this practice is a cosy arrangement for Boards and discriminates against small shareholders.

Yet it would be a tragedy for all investors regardless of whether a professional investor manages their funds, or whether they invest directly with the advice of a stockbroker, if professional analysts had less access to companies. This would result in a less well-informed market if professionals did not have appropriate insights and understanding of corporate strategies upon which to base their recommendations to investors.

To conclude, this paper has aimed to provide a better understanding of the role of institutional investors and the pressures they face. It has also aimed to improve our understanding of the complexities surrounding the issue of corporate governance. However, my prime goal has been to stimulate your thinking.

I would like to leave you with some overriding messages:

Globalisation and technology ensure that good corporate governance will remain as an important issue. Only those who play by the rules will receive access to global capital.

After initial discomfort and resistance, Australian corporates have lifted their game. It is now up to institutional investors and trustees to lift their performance and provide leadership for further improvement by corporates.

As we move through the present transition tensions between companies and their owners are inevitable. However, a new relationship in which the interests of owners and management become better aligned is emerging. In turn, the informed consumer will force the corporate sector to include the community as a stakeholder in the business. A partnership which will prove to be in the best interest of shareholders.

Our understanding of good governance will evolve from focus on process to evaluation of outcomes. Performance not conformance! Culture not process! Ultimately good governance includes ethical behaviour if we seek profits in perpetuity.