Seventy years ago, Adolph Berle and Gardiner Means published an extremely influential book, "The Modern Corporation and Private Property." In it, they argued that there had been an important shift in the American economy over the previous several decades. Corporations, with managers distinct from their owners -- the shareholders -- had come to dominate business affairs. Previously, most businesses had been run by the same people who owned or had a significant ownership interest in them.
The basic problem Berle and Means saw is this: Shareholders own the corporate assets, but they do not control them. Managers control them, but do not own them. Thus managers have a tendency to take advantage of disconnected owners by rewarding themselves excessively -- giving themselves money that rightly belongs to the shareholders -- and operating corporate
businesses inefficiently; that is, not maximizing profits.
Adam Smith had similar concerns about corporations in his time. Even in the late 18th century, he saw managers take advantage of detached owners for their own benefit. In "The Wealth of Nations," Smith said this about corporate managers: "Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honor, and very easily give themselves dispensation from having it. Negligence and perfusion, therefore, must always prevail, more or less, in the management of the affairs of such a company."
Shareholders depend on a corporation's board of directors to look out for their interests. Boards hire and fire senior management, set their compensation, review important management decisions and bear ultimate legal responsibility for everything the corporation does.
Unfortunately, it is increasingly clear that corporate boards are not doing their job. Many board members are also part of management. So-called independent members are usually named to the board by management, often serve on the boards of several corporations simultaneously and seldom take the time to seriously oversee corporate operations. In short, too many boards are simply rubber stamps for management.
Most shareholders are really not able to look out for their own interests. Large corporations today have millions of shareholders, and no one may own more than a few percent of total shares. It is far easier to just sell the shares of a company one is dissatisfied with than to engage management and call them to task for poor performance.
Moreover, should a shareholder -- even a large one -- attempt to take action, he finds that the deck is heavily stacked against him. In recent testimony before the Senate Banking Committee, Sarah Teslik of the Council of Institutional Investors noted some of the ways managers avoid accounting to shareholders:
-- Annual meetings can be held in hard-to-reach places at inconvenient times. She notes that companies have been known to hold such meetings in small towns in Alabama with no airport on Friday afternoons before major holidays.
-- Managers can call off shareholder votes, even on the day of the vote, if they think they might lose.
-- Managers can simply ignore the results of a vote even if they do lose.
Teslik also cites Securities and Exchange Commission rules that make shareholder challenges to management extremely difficult, and New York Stock Exchange rules that rig shareholder votes in favor of management.
To her credit, however, Teslik puts much of the blame for this situation on those she represents: big institutional investors. Members of her organization control some $2 trillion in corporate equities but have failed to adequately exercise the oversight responsibility that these assets bring with them.
In Teslik's words, "Accountants sign off on financials that trick investors
because we let them. CEOs pay themselves hundreds of millions of dollars, even when they bankrupt their companies, because we let them. Boards look the other way because we let them."
The solution to many of today's corporate problems, such as those at Enron, is for boards to become more responsive to shareholders. This is best done, Teslik believes, by easing government rules that make it hard for large shareholders, such as mutual funds and pension funds, to gain seats on corporate boards. These large institutional investors, which now own more than 50 percent of all stock, can look out for small investors far better than the SEC because their interests are the same.
Empowerment of institutional investors, I believe, is the answer to the agency problem posed by Smith, Berle and Means. As more and more corporate shares are owned and controlled by them, they can and should take more responsibility for ensuring that managers work on behalf of those who actually own the corporation, instead of looking out only for themselves. Greater activism by institutional investors will do far more to prevent future Enrons than government regulators can.
Note: Teslik's testimony may be found at: baking.senate.gov/02_03hrg/032002/teslik.htm