John C. Bogle’s “The Battle for the Soul of Capitalism”

Despite the ideological trope that capitalism is somehow the natural
state of human economies, and that any government regulation risks
causing the ‘invisible hand’ of the market to bitch-slap us all, the
truth is that capitalism depends entirely upon a very complex body of
law and social norms. Without the proper legal incentives to channel
self-interest into benefiting society, Wall Street begins to behave
like La Costa Nostra with better tailoring.

In the aftermath of the massive corporate failures that have
characterized the past several years, it is easy to overlook that those
failures where not due mainly to criminals doing illegal things, but to
ethical people doing business as usual. Enron, WorldCom, Tyco, Global
Crossing and other now infamous business failures were only the
rottenest apples in a bad barrel; not aberrations, but an extreme
example of what we have allowed to become quite representative examples
of the massive and widespread failure of corporate governance.

The principle of effective control of the corporation by owners that underpins capitalism has failed in the American equity culture. Alan Greenspan diagnosed the problem with corporate governance as the ascendancy of the imperial CEO. Boards of Directors, rather than representing the interests of owners, have been captured, along with independent auditors, by managements that are free to enrich themselves shamelessly at the expense of owners.

60% of mergers and acquisitions (M&A) activity results in a long-term loss of shareholder value, even as they brings great rewards to the responsible executives – even if the M&A proves ultimately disastrous. CEO compensation packages, grown to absolutely shameless proportions, are completely uncorrelated to corporate performance. Self-dealing and obvious conflicts of interest have become the operating norm. The few strong institutional voices that could readily act to represent the shareholder’s interests, such as fund managers, pension managers, and other institutional investors, analysts and auditors, are intimidated and bought off by conflicts of interest and legal incentives to ‘go along to get along’. In an environment where a corporation’s short term performance, even at the cost of its long-term financial health, has become the primary motivator of the market, and management has become completely untethered from effective shareholder control, except perhaps in the most spectacular fiscal meltdowns, this little book from John C. Bogle, the venerable founder of the Vanguard group of funds, comes with a simple message about how to address the problem:

Capitalism cannot survive without strong owners.

At the root of the complex scandals, accounting fraud, and executive malfeasance is a simple and elegant explanation: America’s corporate owners now longer have control over their corporations. Fixing that problem is a complex legal issue, but any solution must be judged by how effectively it addresses that deficit of accountability to owners.

For Bogle, the challenge is locating agents who can act effectively and without a conflict of interest on behalf of the owners of corporate American. Because the structure of ownership has changed so radically, with institutional investors now controlling more than half the corporate equity in the country, the obvious solution is empower the professional managers of our vast institutional pools of equity to act in the interest of owners. The real trick is eliminating conflicts of interest (such as ownership of equity funds by commercial banks and management domination of fund Boards) and creating the right legal environment to encourage activist ownership, rather than passive ratification of management decisions.

Only when we fix that broken system of corporate governance that makes management accountable to essentially no one, can we say that we have addressed the challenge of the Enron Era. Sarbox was a good start in creating more transparency in financial disclosures by corporate management, but did absolutely nothing to address the root causes of why management has such strong incentives to misstate their financial positions in the first place, or why owners have failed to themselves bring managements to heel.

Bogle cites as an excellent summation of his thesis, and as a brief overview of the sorts of reforms of corporate law that are needed, a monograph by Sykes and Monks first published by the Center for the Study of Financial Innovation entitled “Capitalism without owners will fail: a policymaker’s guide to reform” (PDF). Monks and Sykes make several concrete proposals for legal reform to address the governance failure of contemporary corporations:

• All fiduciaries (those who hold securities on behalf of others – pension fund managers, investment managers, etc.) must be legally required to act solely in the long-term interest of their beneficiaries;

• Institutional shareholders must be made responsible for exercising their votes in an informed and sensible manner;

• Shareholders must nominate at least three non-executive directors for each publicly traded company;

• Non-executive directors must have real control over the audit and remuneration committees – which implies that auditors and remuneration consultants must be appointed by, and responsible to, the non-executive directors, and must have no other business with company;

• Properly remunerated (and funded) non-executive directors must have access to independent advice on all significant M&A activity so that they can genuinely represent the interests of shareholders.

These are the main points of the monograph and the main suggestions of Bogle’s book. There is a lot more in both tracts for any policymaker concerned about better corporate governance and how to approach the politically underutilized issue of the massive defrauding of American shareholders by corporate malfeasance. This issue is one that I believe presents a clear opportunity for Democrats to take the high ground and also appeal to business and investment professionals, who know that such reforms are sensible and necessary. Far from being anti-business, using such reforms as the basis of a Democratic pro-business agenda would be immensely popular, both with the average person with a 401(k) or a pension, and with the business community.

Unfortunately, Democrats, when they address these issues at all, tend to focus on criminal indictments, cronyism, lobbying abuses, and outrageously disproportionate executive compensation. Well and fine, but these issues are generally handled poorly. By dwelling on the criminality of individual managers, it tends to paint all of corporate America with the same brush; is it any wonder that many in the business community regard the Democratic Party with suspicion and votes Republican? Such a focus on criminality also misses the point, which is that it is the institutional incentives encoded in our laws that are driving ethically questionable and illegal behavior. Democrats’ focus should be on our duty and need to change those incentives.

Dwelling on executive pay generally brings up a call for limiting executive compensation in an arbitrary or absolute fashion. This is a big mistake. It may have some facile populist appeal to say that the CEO should only make X times the pay of his lowest paid employee, or some such formula, but it is divisive and unrealistic. Much better to encourage reforms which encourage incentive pay that aligns the interests of CEOs with the long-term, sustainable growth of their company in relation to average performance in their sector. Incentives could also be encouraged to reward CEOs who keep jobs in America and who give their workers better benefits and higher pay. Americans believe in extraordinary reward for extraordinary work; Democrats should be for ensuring that extraordinary pay only comes from extraordinary results for shareholders and also for society.

Democrats should denounce even the appearance of impropriety in lobbying and awarding of government contracts. If we have to burn a few of our own to do it, so be it. Democrats must be the party of integrity in the coming cycle; if we do not own that issue, we own nothing. The coup of 1994 was predicated upon a pledge to clean up Congressional ethics. Just over a decade later, the GOP is far worse than what they replaced. The issue of corporate governance, while seemingly dry and removed from people’s lives gives Democrats an opportunity to both do what is right and needed, but also can be used as a very effective means of talking about more general issues of ethics.

The framing of this entire complex issue is actually surprising easy: Democracy. It is really easy to understand and elaborate on this issue if it framed as a failure of democracy. Call it corporate democracy, ownership democracy, enfranchising owners, etc. This frame allows it to be easily related to the current crisis in our political system. The Board is Congress and the CEO is the President. The later has too much power and is abusing it to the detriment of the citizens (shareholders). We need democratic (and Democratic) reform to give the shareholders (citizens) a stronger voice on the Board (in Congress). When democracy is shoved aside, and excessive control and secrecy is granted to CEOs (or Presidents) then bad things happen to shareholders and pensioners (or citizens), like A&M activity that destroys value but enriches management (no-bid contracts to cronies), and abuses of power like massive compensation without reference to performance and cooking the books (or illegal wiretapping and secretly spending a billion dollars on propagandizing the American people). Citizens/Shareholders can achieve the aim of restoring democracy (corporate or political) by voting for Democrats and against the abusive CEOs (Bush and his Republican cronies). If there is a single politician out there who cannot do wonders with such material in a stump speech to both average people and the Chamber of Commerce, they need to pick their hats up out of the ring and stop wasting their time.