Public Companies and the Shareholder Revolt

By Robert Strauss

It may not be clear at first glance just how well sociologist Michael Useem, one of the Wharton Management Department’s newest acquisitions, fits into the School’s agenda.

Yet Useem — who combines a master’s degree in physics and a PhD in sociology (both from Harvard) with a genius for communicating clearly and a keen interest in how large corporations are organized and managed — has already earned a reputation for excellence in teaching, research and administration.

He developed a new leadership course for Wharton’s Executive MBA program, for example, and has helped shape the MBA Core “Foundations of Leadership” course. His classes on organizational design, business ethics, leadership and management have earned him numerous teaching awards. And he has been cited extensively by both scholars and journalists for his groundbreaking research on corporate governance, leadership and restructuring.

One barely has to scratch the surface of Useem’s busy schedule to see how broadly his academic expertise applies to the real world of business. In February, Useem attended the World Economic Forum in Davos, Switzerland, where he organized a session on “Investor Capitalism and Governance of Global Firms” and hosted a dinner on “Investor Strategies, Governing Boards and Corporate Leadership” for business and political leaders from around the globe.

In April, he spoke at the Mexican Stock Exchange’s annual Securities Market Convention about his new book, Investor Capitalism: How Money Managers Are Changing the Face of Corporate America (Basic Books/HarperCollins), which chronicles the huge increase in the power of large institutional investors — primarily pension plans, bank trusts, mutual funds, insurance contracts and non-profit endowments — to influence the way companies are managed.

That same week, Useem’s views on institutional ownership were cited in a Fortune magazine article titled “Who Owns the 500? You Do.”

He argued for more research on the powers of institutional investors at forums sponsored by the University of Michigan, University of Illinois and Cornell University this spring. This summer and into the fall he is applying his research on leadership and governance to Wharton’s Executive Development Program, special programs for South African managers and officials, and other executive courses in Bangkok, Bombay, San Salvador, Shanghai and Taipei.

Useem first came to Penn six years ago with a joint appointment in sociology and management. He officially transferred his primary appointment from Penn’s School of Arts & Sciences to Wharton last fall.

In addition to Investor Capitalism, Useem has written four other books on different aspects of corporate life, including Executive Defense: Shareholder Power and Corporate Reorganization (1993), Turbulence in the American Workplace (co-authored, 1991), Liberal Education and the Corporation (1989) and The Inner Circle: Large Corporations and the Rise of Business Political Activity in the US and UK (1984).

Indeed, it was during his research on corporate restructuring that the idea for Investor Capitalism first presented itself. “In interviews with senior managers throughout the country, I kept hearing about ‘the demons of Wall Street,’ those money managers and analysts who incessantly emphasize short-term profits and shareholder value,” Useem says. “Clearly there was a force out there I hadn’t appreciated before.”

During this same period, Useem was approached by the Institutional Investor Project — a research initiative organized by the Columbia University Center for Law and Economic Studies and funded by corporations, institutional owners, unions and the New York Stock Exchange — to study the organizational side of institutional investing, what Useem calls “the human element.” The project provided him with access to top executives in 20 large U.S. corporations and 58 institutional investors.

Useem’s sociological research perspective gives Investor Capitalism a unique place among the usual financial and legal studies of corporate governance. He is as interested in the social networks that the new financial world has created as he is in the problems of managing the large firm.

He analyzes, for example, the shadowy relationships that exist between institutional investors and managers and the “gray area” of information trading that results; the subtle social pressures that underlie executive compensation issues; and the dilemmas faced by boards of directors in seeking to understand investor priorities and in emphasizing shareholder value without circumventing or interfering with company management.

“I have been able to observe the networks and culture that define the upper reaches of company organizations,” Useem says. And what he has found is that “relations between money managers and company managers which had once been impersonal and fleeting are now more personal and enduring. New social ties are being added to traditional market ties, which means that capital markets should no longer be viewed as purely economic phenomena.”

From Managerial to Investor Capitalism

As Useem sees it, America’s boardrooms have recently undergone a “quiet revolution” away from managerial capitalism, under which professional executives were firmly in control of many large, publicly-traded companies, to investor capitalism, where institutional investors demand accountability from executives.

For example, institutional investors played a catalytic role in breaking up ITT and AT&T. They pressured Sears Roebuck to sell off divisions unrelated to the company’s core retailing business. And they had an influence on the mergers of Capital Cities/ABC and The Walt Disney Co., Turner Broadcasting System and Time Warner Inc., CBS and Westinghouse Electric Corp. and Chase Manhattan Corp. and Chemical Banking Corp.

From the tobacco to the automobile industries, pension and mutual fund managers have sought to replace the most senior officers of large corporations when their stock prices lagged behind the market. “Today’s kingmakers,” sums up Useem, “are the institutional investors.”

In 1955, institutional owners held a mere 11 percent of the stock of U.S. companies. Today it is more than half. In addition, institutions now hold more than 57 percent of the 1,000 largest corporations, well over $2 trillion in value. The five largest institutional holders — led by Fidelity Investments — control 11 percent of the stock of the 25 largest corporations.

The California Public Employees’ Retirement System, known as Calpers, has $85 billion under management. TIAA-CREF, the Teachers Insurance and Annuity Association-College Retirement Equities Fund, oversees $155 billion. Merrill Lynch presides over $167 billion, Bankers Trust over $187 billion and Mellon Bank over $203 billion. Fidelity, the unequivocal heavyweight, sits on top of more than $435 billion, with better than $56 billion in just one of its funds, Magellan.

For these institutional investors, the last five to 15 years have brought new challenges. In the 1970s and early ‘80s, the common practice for disgruntled investors was to sell their holdings in underperforming companies. These days, it’s not so easy. “Somewhere back in the mid ‘80s, money managers and investment analysts began to appreciate that the sell option was more problematic,” says Useem. “Given the size of the funds and the fact that so much of their money was invested in so many American blue chip companies, there was no place to hide from bad management. Either a manager couldn’t easily get the money out of a poorly managed firm, or there was no better place to put it.”

Money managers’ flexibility was further hindered by the rise of index funds, which lock investors into a set portfolio and therefore preclude selling as a major investment strategy. Big investors realized that the only way to improve stock performance was to improve managerial performance.

“So institutional investors began to experiment with changing management through LBOs and M&As, and then finally said, ‘We have to get in there with both hands and think about strategy and how these companies operate, in a much more aggressive way,’” Useem adds.

At their best, he says, institutional investors provide a “wake-up call” to executives asleep at the switch when rapidly changing markets threaten to undermine out-moded corporate strategies.

At their worst, institutional investors cause such dysfunction within a company that senior managers become more concerned either with their own survival, or with short-term shareholder value to the exclusion of long-term objectives and the needs of the corporation’s other legitimate constituencies.

“As these institutional investors have come to the fore, other stakeholders that traditionally had some voice in company management — such as employees and the community — are forced to the sidelines,” says Useem.

“It’s ironic that pension funds pressure managers to lay off employees as a way to increase shareholder value, because by doing so they ultimately deny employees the opportunity to earn pensions,” Useem notes. Similarly, employees who invest in mutual funds are among those who find themselves out of work when Fidelity and other giants push for huge cuts in expenses, including, most obviously, personnel.

Useem, however, is also quick to commend institutional investors’ success in restoring accountability at the top of the firm. “Managers managing themselves was a poor model,” he notes.

So what is an appropriate way to frame this debate? “I find the concept of mutual gain to be valuable here,” says Useem. “Everyone wants more effective leadership and management inside the firm, although different sides are looking for different outcomes. Investors want more money while employees want more job security and better quality of work life. The challenge is to act in ways that will benefit both constituents.

“If you look at the better managed firms right now, like Motorola, G.E. or Xerox, and you leave aside the question of how they got to this point, you find that, in fact, both sides have been well served. Stockholders are seeing good returns, and employees have more authority to get their jobs done.”

Executive Compensation: Not a Problem

Side by side with recent press stories spotlighting the human costs of corporate downsizing has been a barrage of criticism — from the media, labor and Congress — over the size of CEO compensation, a subject Useem addresses at length in Investor Capitalism.

One might expect institutional investors to join this chorus because executive pay is part of the expense side of the corporate ledger.

Not so, Useem says. “Institutional investors express little concern over the level of pay. Seven figure incomes don’t bother them. Successful portfolio managers and stock analysts themselves often draw pay packages that match the best of the company executives.”

What investors do despise, Useem points out, are high compensation levels displaying little relationship to company performance as measured by company dividends and stock appreciation.

Useem summarizes: “Investors oppose fixed compensation, favor variable compensation, and don’t care about the amount, as long as it varies with shareholder value. Managers of many companies have, as a result, placed more income at risk, put more managers on contingent compensation and linked more of the contingency to expanding shareholder wealth.”

If one reads enough press reports, however, it would appear that executive compensation continually increases even in companies which have performed poorly. That’s true, says Useem, for the following reasons. “If executives are operating in uncharted territory, in a tougher more global environment, then the feeling inside the firm is they ought to get paid more if they do well, and paid less if they do poorly.

“Investors push very hard for contingent compensation also, meaning that executives only get paid if they do well. That translates into stock options. But executives can also then see a lot of money from options simply if the stock market does well. It has done well. So a lot of these CEOs have reaped huge rewards, ironically in part through no work of their own.

“Yet the flip side of this system — if you do poorly, then you don’t get paid more — rarely seems to come into play. That’s because of how stock options work. If you get an option based on today’s stock price, say it’s $50, and you don’t perform well and the stock goes down, once it’s down to $49 the option is worth the same as when it’s down to $25 — which is to say nothing. So if you do a really awful job, there is no proportional down side to it. But investors are onto this problem too, and companies as a result have set up several arcane devices to get around it, like premium stock options (used, for example, by AT&T, The Walt Disney Co., Rockwell International and Time Warner), indexed stock options and restricted stock. The problem is few companies have adopted them so far.”

Social Networks and Insider Information

Even as managers and institutional investors lock horns over such issues as downsizing, stock price and incentive compensation, relations between the two sides are not always antagonistic, Useem points out. And therein lies the potential “dark side” of institutional investing.

Useem is particularly intrigued by the role of analysts in the sharing of information about companies. Experienced analysts, he points out in a section of Investor Capitalism, are valued not just because of their knowledge of a specific company and its industry, but also for information they have about the competition. Yet to get that information, managers must offer information of their own.

“As CEO or CFO of a pharmaceutical company, for example, I would like to hear what industry analysts know, but that comes at a price,” says Useem. “The analysts want to hear what I know as well. So I begin to give them, not inside information, but information in the ‘gray area.’ And then the analyst — whose job it is to develop good sources, contacts and information pipelines — reciprocates by giving me relatively sensitive information that he or she picked up during the last visit to my competitor.

“This inadvertent misuse of information may be a product of the lives these people lead. But I think the potential for a subtle form of corrosion is there in the cozy relationships that involve knowledge which either should be in the public domain or should not be disclosed.”

Companies say they treat all analysts equally, Useem notes, but in reality, that isn’t always the case. Analysts who come on too aggressively or who refuse to correct predictions may get less time and less information from company managers than analysts who are more respectful and responsive.

At the same time, managers and investors have created avenues for “off the record” information, including unstated but well understood rules which require that the source of the information never be disclosed and the data never published.

In the process, Useem notes, both sides resort to a kind of “code” that can be used to change an analyst’s overly pessimistic, or overly optimistic, forecast. An overly optimistic forecast, for example, might inspire an investor relations manager to talk to the analyst about the “tough economy out there,” and expect, with some confidence, that the message has been delivered.

“It’s a good idea for institutional investors and senior executives/managers to communicate and develop an understanding of each other, but you need to remember that each side still has its own very powerful agenda,” says Useem.

Although information trading is consistently denied, for the record, Useem clearly believes the problem is out there and is escalating.

“Just as investors are pressing boards and top managers to be more accountable to stockholders, so also do money managers have to be accountable to the holders of the assets (whether that is a retiree or a mutual fund investor), to the SEC and ultimately to the capital markets at large. Nobody should have an inside edge. The legal system is structured to protect the idea of a level playing field.

“I predict that the SEC will begin to take a look at this whole area in the not-too-distant future,” Useem says.

Toward a New Corporate Board

Investor power, Useem predicts, will probably continue to increase for one to two more years, and then top out, not because institutional investors will hold any fewer shares, but because boards of directors are being restructured to more effectively bring together the voices of management and investors.

“My own preference,” Useem adds, “is that I would like to see a more stabilized dialogue between investors, directors and executives, and then more institutionalized means for other groups — like employees and the community — to be at the table as well.”

Useem views boards of directors as “arbiters,” a role he predicts will increase in the next five years as the focus of the debate shifts away from proxy battles and struggles over ownership and control to a discussion of what makes a “good board.”

Citing one study of 67 semiconductor manufacturers from 1978 to 1989, Useem notes that performance downturns at firms with a powerful chief executive resulted in the dismissal of the CEO’s top managers rather than the CEO; poor performance at firms with a powerful board and active investors led instead — and more appropriately, in Useem’s view — to the CEO’s dismissal.

Already, there has been evidence that boards are becoming more independent of management. A report last year that surveyed more than 1,000 independent and inside directors of the nation’s top public companies noted that three-quarters of those interviewed said their boards set clear objectives for evaluating the performance of the chief executive, and two-thirds said they had formal processes for evaluating their chief executives on an annual basis.

“A good board,” says Useem, “will be one that is similar to or smaller than today’s typical 12-member board (nine outsiders and three insiders), that has some investor voice but is not dominated by outside owners, and that has members who are not beholden to management for their personal livelihood, i.e. not consultants, former CEOs or representatives of outside law firms.

“Research suggests that smaller boards are more effective because they are more likely to establish incentive executive compensation plans, work as teams and assume responsibility for outcomes. There is more pressure on everyone to pull their own weight and to be less ceremonial.”

Institutional investors can play a positive role in this transition. Useem notes that it is not unusual today to see big investors going after poorly performing companies and arguing for a much stronger board, Useem says. “That usually translates into more pressure to get independent-minded directors who can think like big shareholders.”

Another area of interest to Useem is institutional investors’ campaign for increased executive accountability abroad.

Up until the 1990s, American investors generally avoided international investments. Approximately 94 percent of their holdings in 1989 were in financial assets in the U.S. (Japanese investors had 98 percent of their holdings in Japanese securities, and Britain had 82 percent of its holdings in the UK.)

Even though rapidly-growing U.S. international and global mutual funds now hold some $200 billion, and even though some American pension plans like Calpers are expanding international investments to as much as 20 percent of their assets, the ability to influence management of foreign companies hasn’t kept pace, says Useem. “In Asia there were several celebrated — and unsuccessful — attempts to influence company policies. But I think the next decade will be different. Most rapidly expanding mutual funds are now international. Even Japanese investors are finally looking outside Japanese companies, primarily into Asia. The management of Japanese assets are on the verge of being opened up to international money managers. There is movement everywhere and it’s always in the direction of more openness in terms of cross border money management and investment.

“Intensifying pressures for company restructuring, independent boards and improved performance are sure to be felt in the years ahead. In some Latin American and Asian countries, U.S. mutual funds have become major players and have taken over much of the financing role traditionally played by commercial banks and government institutions. They are unrelenting in their demands for consistent performance, as Mexico learned to its dismay in December 1994 when it unexpectedly devalued its currency and investors fled in droves.”

Leadership, Inside and Out

According to Useem, tomorrow’s boardrooms will need a new breed of corporate leader. And Useem thinks Wharton should be at the forefront of educating students to thrive in this new environment.

He is a strong believer in the wisdom of teaching leadership to students. “Leadership skills can be cultivated through the discipline of the classroom. Companies have also been developing their own leadership development programs and demanding more leadership and teamwork skills from the students they are hiring.” Useem has pushed efforts to bring the best from these programs into Wharton’s own leadership courses.

“One way to think about effective leadership,” says Useem, echoing a theme from Investor Capitalism, “is that it has to work well on the inside but equally importantly, it has to work well with outside groups, including board members, government officials and investors.”

The rise of investor capitalism has generated a host of fresh questions, he adds. How can investors, directors and managers best work together? When should each resist or change in response to pressures from the other? What is the impact of joint oversight on corporate performance? Will the short-term demons of Wall Street sabotage long-term company strategies? Can the stressed executive ranks deliver the results demanded?

“While an earlier era allowed executives considerable latitude in setting their own priorities, the era of investor capitalism does not,” Useem notes. “Company executives had long been able to ignore their shareholders; they do so now at their own peril. Money managers and the powers they wield are changing the face of corporate America, and with that has come a demand for company leadership that is as capable of working with analysts and investors as with their troops and customers.”

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