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To encourage fund managers to act solely in the interests of shareholders, activists want their proxy votes disclosed.
Ronald Fink, CFO Magazine
October 1, 2002
While federal investigators focus on conflicts of interest at the heart of the darkness created by former Enron CFO Andrew S. Fastow, Congress has moved on to interwoven interests of other corporate insiders. But one group of market participants, institutional investors, has all but escaped notice--until now. Corporate-governance watchdogs and shareholder activists are calling on regulators and lawmakers to look into possible conflicts of interest on the part of fund managers.
For evidence they point to recent proxy contests, at such companies as Bank of America, Halliburton, and Hewlett-Packard, in which fund managers have sided with corporate management on shareholder resolutions whose passage might have benefited plan participants. The critics contend that when push comes to shove, fund-management groups often vote the interests of their corporate parents--the banks and insurers that do business with the companies in question.
Both mutual funds and corporate retirement plans are often managed by subsidiaries of commercial and investment banks and insurance companies. Thus, while fund managers are paid by their employers to judge the performance of corporate managers, the banks and insurers that own the fund companies are paid by some of the same corporate managers for securities and loan underwriting as well as other financial services.
Some institutional investors, including those that manage large pension plans, such as the California Public Employees' Retirement System or TIAA-CREF, have avoided trouble, thanks to tight restrictions on their ability to act against the interests of plan participants. But mutual fund companies often lack such restrictions and so may take actions that conflict with the interests of plan participants.
Take, for example, Putnam Investments, the investment-management subsidiary of professional services provider Marsh & McLennan. In 2001, Putnam voted its proxy against resolutions favoring the use of performance-based stock options at such companies as Bank of America, Halliburton, and Office Depot. A Putnam spokeswoman wouldn't comment on its individual votes in these cases, but said the fund company generally votes as an interested shareholder and takes its fiduciary responsibilities "very, very seriously."
Or consider the acrimonious proxy battle earlier this year between Hewlett-Packard Co. and board member Walter B. Hewlett over the proposed acquisition of and merger with Compaq Computer Corp. After a shareholder vote in favor of the deal last March, Hewlett filed suit, charging that HP improperly coerced the parent company of Deutsche Bank Asset Management, which had voted its HP shares against the deal, to switch its vote before the polls closed.
The plaintiffs alleged that after selecting Deutsche Bank to help arrange a multibillion-dollar credit line only to see the fund managers vote against the deal, HP management offered the bank other business in exchange for a change of heart. As evidence, Hewlett's lawyers submitted a tape of a voice-mail message from HP purporting to show CEO Carly Fiorina instructing CFO Robert Wayman to offer such business to Deutsche Bank if its fund managers switched their votes. Then, according to the complaint, Fiorina held the proxy polls open until the fund managers switched their votes to HP management's side. (A spokesman for HP denies the charges; Deutsche Bank declined comment.)
Last April, a Delaware court ruled in favor of HP. It dismissed Hewlett's claim that the company's dealings with Deutsche Bank amounted to vote buying, because it said the evidence was circumstantial. But critics have lambasted the decision, with some finding the Department of Labor's decision not to intervene particularly outrageous.
"It makes your stomach turn," says Robert Monks, a shareholder activist and former DOL official credited with bolstering employee pension protection when he issued an opinion letter in 1990 stating that money managers must act "solely" for the "exclusive benefit" of plan participants. Monks calls HP's actions in the proxy battle nothing less than "a bribe."
Nell Minow, Monks's partner at The Corporate Library, a Web site devoted to corporate governance, testified before a recent congressional hearing that the outcome of the case reflected the "corrupt" state of the U.S. financial system. Although the House and Senate have been examining conflicts of interest in the banking industry, they have shown little interest so far in this one.
Show Us the Votes
The Securities and Exchange Commission has shown little interest as well. Indeed, the SEC has yet to take action on a long-standing petition by the AFL-CIO, which is supported by Monks and Minow, to require disclosure of proxy votes by companies that sponsor mutual funds. Monks says such disclosure is "essential" to promote better corporate governance.
The SEC, to be sure, is investigating the issues surrounding disclosure of the proxy-voting procedures of such investment companies, but that requirement will likely stop far short of mandating disclosure of the actual votes. In a letter dated last February 12 to another petitioner, SEC chairman Harvey Pitt explained that the commission typically defers to state authorities on issues relating to corporate governance, though he noted that the SEC does step in when cases raise questions having to do with the antifraud provisions of federal securities laws.
Didn't the HP proxy battle raise just such questions? "I can't say we're unaware of the allegations in the case," says Douglas Scheidt, chief counsel of the SEC's investment management division.
In any case, Monks isn't alone in citing the case as an example of why disclosure of money managers' votes is needed. "It is well past time" that the SEC act, says Jamie Heard, CEO of proxy advisory firm Institutional Shareholder Services, in Rockville, Maryland. (Ironically, ISS backed Fiorina's plan to merge with Compaq, a decision widely seen as swinging the institutional vote in HP's favor.)
A legitimate obstacle to disclosure arises from the market power wielded by larger fund groups. For example, Fidelity Investments funds are often such big holders that to disclose a proxy vote could tip their hand on future trading decisions. "A lot of people would like to pick our brains," says a Fidelity spokesman, who is quick to add, however, that Fidelity criticizes management in private.
Yet the fact remains that groups like Fidelity earn substantial fees from 401(k) plan administration and record-keeping for many of the companies whose shares they hold. While these 401(k) services are often unprofitable, they are seen as an effective loss leader for asset management. In any case, others point out that proxy disclosure by institutional investors isn't necessary to ensure that plan participants' interests are served, since money managers effectively vote with their feet. "We sell companies we don't like," notes Harold Bradley, president of American Century Ventures, a unit of American Century Investments, in which J.P. Morgan Chase & Co. has a substantial, largely nonvoting, equity stake.
In fact, the compensation of many fund managers is based on how they perform in comparison with their peers, and the benchmarks involved are based on quarterly results. Monks contends that a system that encourages fund managers to trade based on short-term performance ignores the interests of longer-term investors as well as those of nonshareholding stakeholders, including customers and taxpayers, and ultimately leads to exactly the kind of crisis of confidence currently plaguing the markets. But the SEC is unlikely to do more on this front than issue a set of best practices based on an informal survey of proxy-voting procedures and disclosure now being undertaken by the staff. Anything more than that, says a former SEC official, "would be very surprising."
To be sure, Paul Roye, director of the SEC's division of investment management, recently added his voice to those urging institutional investors to become more active shareholders. But there's still more talk than action from the SEC here.
At this point, activism on the part of institutional investors is still most likely to come from a few iconoclasts. Yet there are signs of increasing activity among other, historically less aggressive institutions. Fidelity, Capital Group, and Barclays Global Investors, for instance, recently joined a highly publicized campaign by a multinational group of pension funds known as the International Corporate Governance Network to convince corporate managers to change their compensation practices.
One can't help but wonder, though, whether activism by such managers is likely to be limited by their parent companies' interests, particularly since "Chinese walls" have proven so permeable in other arenas. Barclays's fund managers, for instance, may be no less appalled than other investors at Enron's abuse of special-purpose entities. Yet in late 1997, their affiliate, Barclays Bank, extended a collateralized loan masked as equity to Chewco, an off-balance-sheet partnership controlled by Fastow protégé Michael Kopper. The transaction violated GAAP and ultimately helped speed the demise of Enron.
(Linda Selbach, proxy manager of Barclays Global Investors, insists that the conflicts facing her firm's parent company have not interfered with the subsidiary's ability to fulfill its fiduciary responsibilities. "We're separate," she points out.)
More dissidence from fund managers, of course, is hardly a welcome prospect for CFOs. Who wants their actions subject to more criticism and second-guessing? But the meltdowns of Enron and WorldCom clearly illustrate the value of checks and balances in the capital markets. And while corporate reformers contend that activism on the part of institutions is a critical component, they say it won't come about without public disclosure of proxy votes by those institutions.
Ronald Fink is a deputy editor at CFO.
Key evidence submitted by Walter B. Hewlett's lawyers to back his claim that Hewlett-Packard Co. bought Deutsche Bank's votes in the proxy battle over the Compaq Computer Corp. acquisition and merger this year didn't convince the Delaware Chancery Court. According to an excerpt of the voice-mail message cited in the court's opinion in the case brought by Hewlett against HP, CEO Carly Fiorina told CFO Robert Wayman the following two days before Deutsche Bank Asset Management switched millions of votes in favor of the deal: "...the suggestion is that you call the guy at Deutsche again first thing Monday morning. And if you don't get the right answer from him, then you and I need to demand a conference call, an audience, etc., to make sure that we get them in the right place...get on the phone and see what we can get, but we may have to do something extraordinary...to bring 'em over the line here."
While the court decided this evidence was circumstantial, it noted that the circumstances surrounding the subsequent conference call "raises...questions about the integrity of the internal ethical wall that purportedly separates Deutsche Bank's asset management division from its commercial division." Critics say that's putting it mildly. -- R.F.