Excerpted from remarks by John C. Bogle to The Foley and Lardner National Directors Institute on March 10, 2005, in Chicago, Illinois.
The institutionalization of investment has led to a situation in which the guardians of capitalism-its owners-are asleep at the switch. And because of this situation, we find ourselves with: 1) grossly excessive pension return assumptions and earnings management; 2) extraordinary executive compensation-largely through improperly structured stock options-based on peers rather than performance; and 3) focus placed on stock prices rather than corporate values.
In a broader context, each of these problems is a reflection of what has been called a "pathological mutation" in capitalism, in which traditional owners' capitalism-with corporations run in the interest of those who invest their capital, assume the risks and demand the rewards of ownership- has turned into managers' capitalism-with corporations increasingly operated in the interests of management. (The worst form of managers' capitalism, it turns out, is in the mutual fund field, where fund management companies hold virtually total dominion over the interests of almost 100 million fund shareowners. But that's a story for another day.)
What is paradoxical is that this development has occurred despite the emergence of a power block of owners, the proverbial 800-pound gorilla who has the power to sit wherever he wants, whenever he wants, at the board table of corporate America. I refer, of course, to the institutionalization of investment America, in which the largest 100 mutual funds and pension managers alone hold 52 percent of all the shares of stock in the U.S. If you are a director of virtually any of our, say, 5,000 largest corporations, more than half of your shares are likely to be held by these giant institutions.
In fact, the institutional ownership figure rises to something like 65 percent if we include all managers of private and public pension funds, mutual funds, the Federal Thrift Savings Plan, endowment funds of colleges and other nonprofit organizations, trust companies and so on. Hard as it is to imagine, a half-century ago this institutional community barely existed. Then, mutual funds owned less than one percent of all stocks; today, funds own nearly 25 percent. Yet, the institutional gorilla-call him King Kong, if you will-has been conspicuous not by his presence in the corporate governance scene, but by his absence from it. He has made himself known not by his voice, but by his silence.
How many corporations, with their attendant corporate secretaries, or senior officers, or attorneys, or directors, have heard anything from any of these institutions? I don't know the answer, but I do have some impressions that suggest that these owners are passive. For as far as I know:
• No large shareholder has made a single proposal in a corporate proxy statement that was opposed by management;
• No large shareholder has commented in Congress at the hearings for the Sarbanes-Oxley bill;
• No large shareholder has demanded that the Securities and Exchange Commission grant even more substantial access to the proxy process than the extremely limited access presently proposed to permit institutions to nominate corporate directors;
• No large shareholder has urged the Financial Standards Accounting Board to get on with the job of requiring stock options to be expensed; and
• No senior executive of a major financial institution has spoken out on the subject of the rights and responsibilities of shareholders.
And finally, how many investors have expressed concerns to corporate management teams about the issues of stock options, pension return assumptions and the focus on intrinsic value that I've just discussed? My guess is not many.
The evidence is compelling that institutional shareholders-who one would think would be in, well, the vanguard of owners' capitalism-simply don't have much interest in the governance and management of the corporations they collectively control. And it is the lassitude of these owners that has permitted managers' capitalism to sit in the saddle and ride corporate America. As it has been said, "[w]hen we have strong managers, weak directors and passive owners, don't be surprised when the looting begins."
Of course, corporate directors are hardly blameless in this scandal. Too many directors have been placed in positions of awesome power and responsibility without fully recognizing that their fiduciary duty-one could even argue their sole duty-is to act as faithful stewards of the corporation's assets in the service of its owners. Yet the word "stewardship" and the concept of stewardship have been conspicuous by their absence from the governance scene.
In the recent era, lots of our traditional gatekeepers failed to honor their responsibilities-auditors, attorneys, investment bankers, professional money managers, regulators … even our legislators let us down-but corporate directors, given their specific task to "manage the affairs of the corporation," as so many corporate charters say, must bear the final responsibility for the financial overreaching of the recent era.
But, wait a minute. Why should that be? Directors don't even have the final responsibility to protect the interests of the owners. The final responsibility lies with the owners themselves. And if the owners of American business don't give a damn about the affairs of the companies they own, who on earth should? Nonetheless, my bet is that owners- especially institutional owners-will finally stand up and be counted, gradually gaining both the opportunity and the motive to assure that corporations are run in their interests and in the interests of those that they represent.
I am not unaware, of course, that in this age of short-term investing and speculation, most of today's institutional holders of stocks comprise a rent-a-stock industry rather than an own-a-stock industry, and have ignored, even derogated, their ownership rights. They may be stock holders, but with their high portfolio turnover (100 percent or more) and their short holding periods (one year or less), they are not stock owners in the traditional sense. I predict that this will change as these institutions finally come to recognize-or are forced to recognize, be it by law, moral suasion or public demand- their fiduciary duty to the pension beneficiaries and mutual fund shareholders whom they are duty-bound to serve. When they do and this powerful sleeping giant I've described as King Kong awakens, he will properly demand that the corporations he controls respond to his ownership interests.
As James Madison reminded us, "[i]f men were angels, government would not be necessary." And I remind you all that "if CEOs were angels, corporate governance would not be necessary." But of course it is necessary, and directors have a major role to play. The corporate structure is, like our nation, a republic in which voters elect their representatives through a democratic process. Quoting Warren Buffett, there's just one rule for these representatives to observe: "Directors should behave as if there was a single absentee owner, whose long-term interest they should try to further in all proper ways." The board that fails to place that rule at the top of its agenda is making a big mistake. Those who do not accept the ultimate triumph of corporate democracy, however remote it may seem today, will be on the wrong side of history.