Reforms in Money Management and Corporate Governance

Over the last few weeks Carl Icahn, the billionaire financier, and John Bogle, who founded the hugely successful Vanguard group of investment funds, have offered some related ideas to improve the financial system.

Icahn wants a national law that takes power from the management of public companies and gives it to owners. The means to this end would be a federal law that permits shareholders to change the state in which the company is incorporated. Corporate law is mainly determined at the state level, with each state having a more or less different legal regime in place. Currently, Delaware law gives exorbitant power to managers of publicly traded companies at the expense of shareholders. Therefore, most of these companies have been registered (by management) in Delaware. And under current state law the approval of the incumbent board of directors is necessary to change the jurisdiction of incorporation. Given the incestuous relations between managements and boards, the boards choose to remain in Delaware. But, there are states with much more shareholder-friendly corporate laws. Icahn insists (rightly, in my opinion) that shareholders, being the owners of the company, ought to have an unimpeded choice in this matter of jurisdiction. The economic assumption underlying Icahn's shareholder rights campaign is that shareholders, rather than managers, have such incentives as will lead them to maximize corporate profits and optimize the risk/reward ratio in corporate decisionmaking. After all, shareholders benefit from success and suffer from failure. Managers benefit disproportionately from success, but do not necessarily suffer losses from failure since (with the connivance of corrupt boards) their compensation is so often contracted at a high rate in the event of failure and at an obscenely high rate in the event of success. Delaware law, largely through the "business judgment" rule, leaves managers largely unaccountable. Corruption and incompetence result.

Bogle wants a national fiduciary law imposed on money managers that requires them to put investors' interests first. It would entail active engagement by institutional investors in those companies in which they hold stakes; and these investors control 70% of the shares in large public companies, making them a potentially significant force in holding managers and boards to account. It would also mean an end to publicly traded money management firms because they have irresolvable conflicts of interest--the fiduciary responsibilities they owe to their shareholders conflict with those owed to their investors. Over the last few years, these funds paid no heed to the risks of their investments in financial companies--over which, collectively, they had effective control as majority shareholders. They seemed unaware that their clients, the investors in their funds, faced normal investment incentives (the possibility of profit or loss), whereas the management of these financial companies had quite different incentives. If they made profits they won big; but, if they lost money, well, it was only other people's money. Result: financial companies followed the trace of their incentives and took risks that benefited management, but were sub0ptimal for shareholders. Also, the money managers themselves had incentive structures that did not align with their investors'; once again this created suboptimal investment strategies. This idea of emphasizing the fiduciary duty of money managers to increase their activism in overseeing their investments is obviously similar to Icahn's focus. But, Icahn just wants to open the door to activism and facilitate would-be activist shareholders; Bogle seems to think he can pressure reluctant money managers into this sort of activity (one which many of them are probably incompetent to execute and which most are inexperienced in pursuing). Icahn's approach looks more likely to have an impact, but Bogle's certainly would not hurt and might even have a gradual effect through altering investors' expectations of money managers and focusing their attention upon a new way to compare the achievements of different money managers.
Bogle also notes that most investment funds overcharge their investors. This is true, but it is also a function of the free market in action. After all, a presuppostion of the existence of the fund industry is that different funds achieve different performance. Is it not reasonable that high-performing funds should charge more for superior service? In reality, there is limited correlation between the level of charges and the level of performance. But, people who fail to realize this are stupid and natural selection will take care of them (that is, the amounts invested by the stupid will on average earn smaller returns than those of the intelligent, relegating to the stupid, over time, an ever declining share of total investments). The only necessary or desirable regulation of fee structure is that which ensures clarity and transparency.

The best funds are those in which the management of the fund has essentially the same incentives as the investors--because the management is substantially invested in the fund and expects most of its return to come in the form of return on its investment, rather than in the form of fees or performance bonuses. This description fits Berkshire Hathaway and probably the majority of the most successful hedge funds. A recent paper in the Journal of Finance, "Role of Managerial Incentives and Discretion in Hedge Fund Performance", found that the three key characteristics of hedge funds that are positively associated with high returns are managerial ownership, a well-designed structure of pay for performance provisions that is hard to cheat (like high-water mark provisions), and, when the other two factors are present, managerial discretion. Index funds are a reasonable alternative to one of these managed funds since they avoid the conflicts of interest and offer low fees. On the other hand, if the rule of the day is an ill-regulated financial system with misplaced incentives, the index funds will still suffer from the resulting underperformance of the market and the economy.