Corporate Governance Failures Corporate Governance Failures The Role of Institutional Investors in the Global Financial Crisis Edited by James P. Hawley, Shyam J. Kamath, and Andrew T. Williams UNIVERSITY OF PENNSYLVANIA PRESS PHILADELPHIA Copyright ᭧ 2011 University of Pennsylvania Press All rights reserved. Except for brief quotations used for purposes of review or scholarly citation, none of this book may be reproduced in any form by any means without written permission from the publisher. Published by University of Pennsylvania Press Philadelphia, Pennsylvania 19104-4112 www.upenn.edu/pennpress Printed in the United States of America on acid-free paper 10987654321 Library of Congress Cataloging-in-Publication Data ISBN 978-0-8122-4314-7 Contents 1 Introduction James P. Hawley, Shyam J. Kamath, and Andrew T. Williams 2 Beyond Risk: Notes Toward a Responsible Investment Theory Steve Lydenberg 3 The Quality of Corporate Governance Within Financial Firms in Stressed Markets Robert Mark 4 Chasing Alpha: An Ideological Explanation of the Catastrophic Failure in the U.K.'s Financial Services Industry Philip Augar 5 Corporate Governance, Risk Analysis, and the Financial Crisis: Did Universal Owners Contribute to the Crisis? James P. Hawley 6 Great Expectations: Institutional Investors, Executive Remuneration, and ``Say on Pay'' Kym Sheehan 7 Against Stupidity, the Gods Themselves Contend in Vain: The Limits of Corporate Governance in Dealing with Asset Bubbles Bruce Dravis vi Contents 8 Real Estate, Governance, and the Global Economic Crisis Piet Eichholtz, Nils Kok, and Erkan Yonder 9 The Sophisticated Investor and the Global Financial Crisis Jennifer S. Taub 10 The Role of Investment Consultants in Transforming Pension Fund Decision Making: The Integration of Environmental, Social, and Governance Considerations into Corporate Valuation Eric R. W. Knight and Adam D. Dixon 11 Funding Climate Change: How Pension Fund Fiduciary Duty Masks Trustee Inertia and Short-Termism Claire Woods Notes List of Contributors Chapter 1 Introduction James P. Hawley, Shyam J. Kamath, and Andrew T. Williams Background In late 2008 and early 2009, the subject of financial risk was widely debated and discussed among academics and practitioners, in the business press and on blogs, and among the general public, as well as in the U.S. Congress and parliaments abroad. Yet some of us were struck by how little serious atten- tion (indeed, how little attention of any sort) was being paid to the relation of corporate governance to financial risk, especially the role (or lack thereof) of large institutional investors who have dominated corporate gov- ernance activities globally over the past two decades or so. Institutional investors (public and private pension funds, mutual funds, and, in some countries, banks) have long since become the majority holders of not only public equity but other asset classes as well (e.g., bonds, hedge fund and private equity investments, real estate).1 In prior work two of us (Hawley and Williams) have characterized these large investors as ‘‘univer- sal owners’’ (UOs) because they have come to own a representative cross section of the investable universe, having broadly diversified investments across equities and increasingly all other asset classes.2 One consequence of UOs dominating the global investment universe is that their financial and long-term economic interests come to depend on the state of the entire 2 Hawley, Kamath, and Williams global economy. This contrasts with earlier periods of financial history (es- pecially in common law countries where institutional investors were the rare exception rather than the rule prior to the 1970s) that were dominated by less diversified individual and family owners. Additionally, UOs have come to be the conduits for the majority of the working and retired popula- tions’ savings and investments in many countries, also a historically un- precedented development. Since UOs have broadly diversified financial and economic interests (and indeed, the majority of them are fiduciaries to individual pension fund beneficiaries and retirement investors), it would be logical and, in our view, a fiduciary obligation to closely monitor the behavior of the firms they own. During the past few decades such monitor- ing became more common of individual firms but of individual firms only. Such monitoring was especially directed at firms with poor corporate gov- ernance and poor (relative to their benchmarked peers) economic and fi- nancial performance. In fact, growing corporate governance activism since the late 1980s and early 1990s by some UOs (mostly public pension funds, trade union funds, and some freestanding large investors, e.g., TIAA-CREF in the United States, USS and Hermes in the United Kingdom) has indeed led them to monitor and attempt to change the way in which firms operate (through focus on proxy voting processes, staggered boards of directors, division of CEO from board chair, top executive pay linked to clear performance standards). Varying by country, corporate governance activist UOs have achieved some significant reforms—putting a reform agenda both before the investing public and on the table of the political process while having some impact on how firms’ governance structures operate. In spite of this sea change in both ownership and firm-specific monitor- ing and corporate governance actions, missing was a program among al- most all UOs prior to the financial crisis, and often in its early days as well, which would have monitored the various warning signs of financial danger and then developed actions to mitigate damage, both to their own portfo- lios and systemically. Additionally, the three editors of this volume came to ask ourselves whether, and if so to what extent, the various ways large UOs operated might have, unwittingly, contributed to the financial crisis itself, not necessarily as a primary cause, but as a potentially important factor. In our discussion with various UOs, with academics, policy analysts, and others, we concluded that the time was ripe for a candid discussion of these questions. Introduction 3 Thus, we organized a by-invitation-only meeting of academics, policy analysts, and UOs for a candid, off-the-record two-day conference entitled ‘‘Institutional Investors, Risk/Return, and Corporate Governance Failures: Practical Lessons from the Global Financial Crisis.’’3 All but one of the chapters in this book are revisions of presentations at that conference. An additional chapter was solicited from a participant in the conference who has written widely on risk and who has had a long career as a self-described ‘‘risk quant’’ (Robert Mark). We described the background of the conference as follows in our call for papers: The current financial crisis has, as part of its origins, a variety of corporate governance failures. Most obvious are misaligned compensa- tion arrangements that incentivized extreme risk (while not punishing failure). Less examined is the role of large, supposedly sophisticated institutional investors (universal owners) in the crisis. Their role is likely one of unconscious commission as well as of omission. Commissions include, for example, both direct and indirect exposure to extremely complex financial instruments (e.g., credit default swaps) through in- vestment in hedge funds and private equity funds, as well as more tradi- tional equity investment in large financial institutions. In particular, the pursuit of ‘‘alpha’’ often coupled with leverage to magnify returns may have led institutional investors to pursue investment strategies that proved to be particular risky, and significantly contributed to the growth of these risky markets. Omissions include, for example, neither having nor considering having a risk monitoring system in place to monitor such investments based on what are now relatively well- established corporate governance principles and best practices. The objective of the conference was to investigate the role of corporate governance failures, gaps, oversights, and missed opportunities leading up to and during the current global financial crisis as well as to consider and develop proposals to mitigate these failures in the future. The problem may have been that institutional investors accepted high returns in the financial sector without adequately investigating the basis for the returns and asking the question about whether they were sustainable or might pose systemic risk. There may be an important parallel to the over- performers of the late 1990s, Enron, WorldCom, and so on, that were much 4 Hawley, Kamath, and Williams admired for their performance, but where performance was built on an unsustainable business model, often not adequately transparent. Addition- ally, there has not typically been concern for systemic risk, which has re- sulted from the piling on of multiple firm, sector, and financial instrument risk. Also, the apparent acceptance of a significant degree of lack of transpar- ency, especially in the financial sector and among the majority of alternative investments, violated a core concept of corporate governance advocated by universal owners and others: that transparency is critical to accountability, which in turn is critical to a well-governed firm in relation to its owners. Transparency, accountability, and good governance generally add value. Lack of these was toxic. In addition to considering the widespread failure of most mainstream investors, government agencies, and central banks to both foresee, and when warning flags were