Two Cultures Shaping the Corporate

Governance Debate

Donald G. Margotta
Northeastern University

Objectives of This Research (1)

Determine

alternate explanations to why

shareholders and managers disagree on
certain corporate governance issues

Takeover defenses
Capital structure
Corporate strategies

Usual

explanations involve agency issues

Perhaps here too, but different meaning of agency

Objectives of This Research (2)

Suggest

SEC initiative to address conflicts of

interest identified here.

Snow, C.P. The Two Cultures

It was through living among these groups ... that I

got occupied with the problem of what ....I christened
to myself as the two cultures.

For constantly I felt I was moving among two groups

- comparable in intelligence ... who had almost
ceased to communicate at all ...
Snow, C.P. (1961) The Two Cultures and the Scientific Revolution,
Cambridge University Press, NY

Two Cultures in the Corporation

Corporate

Managers

Live in a culture shaped largely by legal

responsibilities and legal theory

Institutional

Shareholders

The major owners of large corporations and live in

a culture shaped largely by finance theory

Sources of Governance Conflicts (1)

Finance

Theory View (agency issues)

Managers attempt to enrich themselves at

shareholder expense. For example:
Adoption

of poison pill takeover defenses

Adoption of state takeover laws
overly conservative balance sheets (Motorola)

Sources of Governance Conflicts (2)

Two

Cultures View

Managers have a duty to work in the best

interests of the corporation
poison

pill takeover defenses protect the corporation

state takeover laws protect the corporation
conservative balance sheets protect the corporation

Definition

of best interests of the

corporation undefined

Nature of Governance Issues (1)

Compliance

Issues

Board structure, board duties

Control of potentially illegal activity
Accountability

Sarbanes-Oxley

Issues (2002)
---------------------------

None

of these are discussed here

Nature of Governance Issues (2)

Focus

here on legal, but controversial issues

Takeover defenses (poison pills, state laws)

Corporate strategies (e.g. Kodak)
Capital structure / bankruptcy (e.g. Motorola)

Why

managers and shareholders disagree?

Why Focus on Institutional Investors?

There

are others beside institutions who may

have their own distinct cultures and conflicts
with the corporation

Corporate acquirers
Risk arbitrageurs
Short sellers

Why Focus on Institutional Investors?

They

are largest owners of corporate stock

Their diversification is key to the discussion
They are the leaders in urging changes in
corporate governance practices

Diversification is Key
Diversification

of institutional investors is key

because it changes the way they view risk
That differentiates them from corporate
managers and undiversified shareholders

Diversification: Good for Investors (1)

MPT

Developed by Harry Markowitz (1952)

a breakthrough in finance theory

lead to 1990 Nobel Prize in Economic Sciences
shared with co-recipients Merton Miller and
William Sharpe
Portfolio Selection,

J. of Finance, 7, Number 1, 77-91

Diversification: Good for Investors (2)

The impact of MPT is underscored by the fact that it

has lead to indexing of most of the money in
managed stock funds
Carleton et al. (1998) find that TIAA-CREF, the
largest private pension fund in the U.S., indexes 80%
of its domestic equity portfolio
Carleton, Nelson, Weisbach (1998), The Influence of Institutions on Corporate
Governance through Private Negotiations: Evidence from TIAA-CREF, J. of
Finance, Vol. 53, August 1998

Diversification: Good for Investors (3)

MPT

shows that diversified portfolios are the

most efficient ones

through

diversification investors can

eliminate virtually all company specific risk

Diversification: Source of Conflict (1)

However,

by eliminating company specific

business risk, diversified shareholders more
concerned with performance of portfolio
than with individual stocks in the portfolio.
On some issues this puts diversified
investors in conflict with managers who are
concerned with specific company risk

Diversification: Source of Conflict (2)

Managers

have a legal duty to act in the

interests of one corporation, not in the
interests of a portfolio of stocks.
Block (1987): at least 30 states codified
fiduciary duty statutes: A director shall
discharge his duties as a director... in a
manner he reasonably believes to be in the
best interests of the corporation.

Evolution of Corporate Control (1)

Figure 1
Pre-Berle and Means Model
Undiversified
Owner-Manager

Corporation
Business Risk
Market Risk

Evolution of Corporate Control (2)

Figure 2
Berle and Means Model
Undiversified
Owners

Undiversified
Manager

Corporation
Business Risk
Market Risk

Evolution of Corporate Control (3)

3

Figure 3
Modern Portfolio Theory
Model
Diversified
Owners

Market
Risk

Undiversifie
d Owners

Undiversifie
d Manager

Corporation
Business Risk
Market Risk

Others on Institutional Holdings (1)

Horrigan:

ethical perspective.
Applies Kants categorical imperative
Concludes that investors may act unethically
in adopting a MPT perspective
Horrigan, James O. (1987), The Ethics of the New Finance,
Journal of Business Ethics 6, 97-110

Others on Institutional Holdings (2)

Deakin: diversified institutional investors are more

likely to engage individual companies to try to
improve performance
Black: suggests that institutional holders can play a
constructive monitoring role
Deakin, Simon (2005), The Coming Transformation of Shareholder
Value, Corporate Governance, V. 13, Number 1, January 2005
Black, Bernard (1992), The Value of Institutional Investor Monitoring:
The Empirical Evidence, UCLA L. R., V. 39, N. 4, 895-939

Others on Institutional Holdings (3)

In 1968, Congress directed the SEC to conduct a study of

institutional investors and their impact on the securities markets.

Congress was concerned that the growth in securities held by

banks, insurance companies, and pension funds, might result in a
concentration of economic power by a few institutional traders not
only over markets, but over the managements of the companies
whose stock they held, and indeed over American industry itself.
Structure of Corporate Concentration: Institutional Shareholders and Interlocking
Directorates among Major U.S. Corporations, Committee on Governmental Affairs, U.S.
Senate, December 1980, page 2 (approximately 3,000 pages).

Others on Institutional Holdings (4)

Voting Rights in Major Corporations (Sen. Doc. 95-99, June 1978) and Interlocking
Directorates Among the Major U.S. Corporations (Sen. Doc. 95-107, June 1978)

"Corporate Ownership and Control," Senate Comm. on Government Operations,

Subcomm. on Reports, Accounting and Management. Nov. 1975, Sen. Doc. 94-246,
94th Cong., 1st Sess. Public Law 94-29, 1975.

Disclosure of Corporate Ownership (Sen. Doc. 93-62, March 1974), Senate

Committee on Government Operations, Sub-Committee on Intergovernmental
Relations and Subcomm. on Budgeting, Management and Expenditures,1974

"Institutional Investor Study Report." Securities and Exchange Commission, 1971.

House Doc., 92-64 92nd Cong., 1st Session. 1971

Others on Institutional Holdings (5)

"Commercial Banks and Their Trust Activities: Emerging Influence on the American
Economy." Subcomm. Print, House Committee on Banking and Currency, 90th
Cong., 2d Sess., July 8, 1968. (Patman Subcommittee Study).

Temporary National Economic Committee (TNEC), "Investigation of Concentration of

Economic Power." Distribution of Ownership in the Largest Non- financial Corps
(Monograph 29), S. Doc. No. 35, 77th Cong., 1st Sess. Created by a joint resolution
of Congress on June 16, 1938. "Many of the investment problems of nation arise out
of the concentration of investment funds and their control in few hands." (Page 91)

Investigation of Concentration of Control of Money and Credit." House Committee

on Banking and Currency. H. Rept. No. 1593, 62nd Cong. 3d Sess. Feb. 28, 1913.

Conflicts of Interest in the Corporation (1)

Manager

/ Shareholder

Potential conflicts long recognized

And

demonstrated in illegal activities

Not demonstrated in strategies discussed here

Diversified

Shareholder / Corporation

Takeover Defenses
Bankruptcy
Product Strategies

Conflicts of interest (2)

Diversified Shareholders and Takeover Defenses
The primary argument being made by the
proponents of these proposals (anti-poison pill proxy
proposal), and an argument generally supported by
institutional investors based upon their proxy voting
guidelines, is that poison pills entrench management
and discourage takeover offers for the company.
SharkRepellant.com website, February 8, 2005

Conflicts of interest (3)

Diversified Shareholders and Takeover Defenses
The

State of Wisc. Investment Board (SWIB)

opposing Champions poison pill is typical of
such proposals and states that a pill effectively
precludes a hostile takeover and thus allows
management to take stockholders hostage.
Champion International proxy statement, 5/17/90, page 10

Conflicts of interest (4)

Diversified Shareholders and Takeover Defenses
Champion

responded to SWIB saying a pill

enables the board to respond in an orderly and
considered manner to an unsolicited bid. It puts
the board in a better position to deflect unfair
offers, such as coercive, partial, or two-tiered
bids ... And it puts the board in a better position
to negotiate a higher price for shareholders.
Champion International proxy statement, 5/17/90, page 11.

Portfolio Returns: wo / w Pill

Portfolio I: w/o
Co. A 8%
8%
Co. B 8%
8%
Co. C 8%
8%
Co. D 8%
8%
Co. E 40%
Acqd
Co. F 40%
Acqd
Co. G 40%
Acqd
Co. H 40%
Acqd
Co. I 40%
Acqd
Co. J 40%
Acqd
Avg: 27%
18%

Portfolio II: with

8%
8%
8%
8%
60%
60%

A
A
A

Conflicts of interest (5)

Diversified Shareholders and Takeover Defenses

Friedman Billings Ramsey analyst David Hilal (MSFT / YHOO)

18 of Yahoos top 25 shareholders 42% of Yahoo shares own more

shares of Microsoft, which tilts their interests toward MSFT

those 18 shared holders hold 4.4 MSFT shares for every one of Yahoo

If MSFT were to raise the offer by $3, and this negatively impacted its
own shares by at least $0.68 (which we think possible), then these
shareholders would be net losers

He concludes those 18 may not want a bigger offer for that reason
WSJ, 2/28/08, Courtship of Yahoos Jerry Yang, Heidi Moore

Conflicts of interest (6)

Diversified Shareholders and Bankruptcy
The

bankruptcy of an airline company, for

example, might be a disaster for its employees
and managers who lose their jobs but a matter
of indifference to its investors who own shares
in other airline companies that obtain the
bankrupt company's routes.
Fischel, Daniel (1985), The Business Judgment Rule and the Trans Union
Case, Business Lawyer, v. 40, August 1985, 1437-1455, at page 1442.

Conflicts of interest (7)

Diversified Shareholders and Competitive Strategy
Explaining

Kodaks decision to devote more

resources to digital photography CEO Daniel
Carp said, We are acting in the knowledge that
demand for traditional products is declining,
especially in developed markets.
Wall Street Journal, September 26, 2003

Conflicts of interest (8)

Kodak shares dropped $4.84 per share, or 18% on the

day following the announcement
trading volume of approximately 37 million shares, ten
times the average daily volume,
one day loss of approximately $1.4 billion in market
value based on 287 million shares outstanding.
Several analysts and large investors questioned Kodaks
strategy when rivals such as Canon and Sony were far
ahead of Kodak in digital photography.

Conclusion
Diversification:

optimal investment strategy

Not necessarily best for exercising control

because it creates conflicts of interest between
the diversified shareholder and
The

non diversified shareholder

The corporation itself
Management and directors of the corporation

Resolution (1)?
Change

fiduciary duty statutes to say

directors have a duty to work in the interests
of diversified shareholders (unlikely)
Identify specific issues where conflicts of
interest exist with the corporation and limit
voting on such issues to shareholders who
do not own shares in competing companies.

Resolution (2)?

SEC already makes judgments identifying

governance issues that can be voted on
Allows companies to omit shareholder proposals if
they deal with operating decisions or elections
Having the SEC make judgments on whether issues
represent a conflict of interest for some would not be
a significant extension of its current responsibilities

Resolution (3)?
Limiting

voting based on conflicts of interest

is not unusual

Del. et al. disallow director shares in determining

control share exemption
Ohio disallows arbs (>$250k) from vote
35 states completely strip an acquiring person
(20% owner) of their votes.

Example: SEC Prop. 14a-11 (2003)

would

give certain large shareholders the

right to directly nominate directors
supported by large institutional shareholders
such as the CalPERS (originator)
opposed by major business organizations

SEC Prop. 14a-11 (2)

Example

of a potential conflict of interest

Avoid largest shareholders of GM
nominating directors to Ford
require shareholders who want to nominate
directors, or vote, certify that they do not own
significant amounts of a competitors stock
Impose a duty of loyalty on shareholders who
seek to exercise control

Dm notes
Intro:

arose from corp. gov. meeting

Perhaps others will follow
Not empirical, but has empirical implications
May offend some finance people