This edition of KLD Newsline focuses on the significance of regulations issued on January 23, 2003, by the US Securities & Exchange Commission (SEC).

          Responding to a petition by Domini Social Investments and two labor organizations, the Commission now requires mutual funds and investment advisers to disclose their guidelines for voting in corporate elections and, then, how they actually voted. Until now, only some social mutual funds and the California Public Employee Retirement System (CalPERS) did this.

          The SEC regulations apply to approximately 3,700 mutual funds and 6,200 investment advisers who have the power to vote in corporate elections shares they hold on behalf of clients. But the new rules affect tens of millions of mutual fund shareholders and investment management clients.

          More importantly, the new rules open corporate elections to stakeholders. Stakeholders will now be able to see how mutual funds vote and why. With that information, they can affect outcomes.

         
Share Ownership & Voting

          The owners of corporations – their shareholders – have the right to vote to elect directors, alter the company’s structure, change executive compensation, require reports from management and the like.

          Publicly traded companies conduct elections by proxy since gathering thousands of stockholders from around the world isn’t practical. Share-holders receive a ballot which includes authorization to an agent – the proxy – to vote the shares as the ballot indicates. Hence, the whole procedure is referred to as “proxy voting”.

         
The New Regulations

          Domini Social Investments, with the AFL-CIO and the Teamsters Union, triggered the process leading to the rules. They asked the Commission to require all mutual fund companies to do what it and a number of other social funds already did: report to their clients and the public:

• their policies and procedures for voting in corporate elections; and
  
• how they actually voted on each issue at each company.

          The SEC’s new rules on proxy voting ended the era when advisers and mutual funds and pensions could ignore proxies or just vote with management. By defending their regulations in terms of fiduciary responsibilities, the Commission foreclosed the possibility of resuming that practice.

          More importantly, the SEC extended share voters’ and stakeholders’ ability to exercise supervisory control over publicly traded corporations. And most importantly of all, the Commission has required advisers and mutual fund companies to look at publicly traded corporations in all their aspects, not just their financials.

          This article describes the scope and practical implications of the new rules. It focuses on two crucial changes reflected in the SEC’s redefinition of “fiduciary duty” and “corporate governance”.

         
Who the New Rules Directly Impact

          The media have focused on the regulations’ impact on approximately 3,700 mutual funds which all – save the social funds – opposed the new reporting requirements. But, the SEC imposed similar (not identical) requirements on the 6,203 registered investment advisers who have authority to vote clients’ shares.

          To grasp the full implications of what the Commission has done, one has to read together the SEC’s rationales for the two sets of regulations.

         
New Fiduciary Duty

          “Under the Advisers Act, ... an adviser is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting.” The breadth of the Commission’s assertion signals its significance.

          It might have limited the duty to those aspects of proxy voting that affected financial performance – something, arguably, the Department of Labor has done (see the following article). The SEC’s formulation applies to anything that can appear on a proxy ballot, from the election of directors to social issues.

          As the next article discusses, this change has a history. But for the first time – the very first time – a regulator has put the force of law behind the idea that advisers and investment companies have fiduciary duties as to proxy voting.

         
The New Duty to Monitor

          As noted earlier, the advisor and mutual fund regulations aren’t identical. The adviser rules are more vague on what an advisor must do than are the mutual fund rules: “The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies.”

          “To monitor corporate events”: What does that mean for an adviser?

         
What Advisors & Funds Must Monitor

          The Commission’s rationale for its mutual fund regulations may answer that question:

“The following are examples of specific types of issues that are covered by some funds’ proxy voting policies and procedures [i.e., the social funds’] and with respect to which disclosure would be appropriate:

         
• Corporate governance matters, including changes in the state of incorporation ... and anti-takeover provisions such as staggered boards...;
  
• Changes to capital structure...;
  
• Stock option plans and other management compensation issues; and
  
• Social and corporate responsibility issues.”

          The right to vote in corporate elections has value to an actual or beneficial owner of shares.

          Today, that proposition seems not debatable. But two decades ago, few thought, to the extent voting rights had worth, it was great enough to require the protection of the fiduciary standards applied to assets under management.

          The path that led to the Securities & Exchange Commission’s assertion of a fiduciary duty to “monitor events” at corporations and to vote and report to clients across the range of proxy issues starts more than three decades ago. It is worth retracing part of that trail.

         
The Department of Labor & ERISA

          Twenty years ago, Robert A.G. Monks was one of the very few who took the position that proxy voting rights had such value for a shareowner that pensions had fiduciary duties as to them.

          At the time, Monks was an assistant Secretary of Labor in charge of pensions subject to the Employee Retirement Income Security Act (ERISA). In that capacity, he wrote an opinion letter that had the effect of requiring ERISA funds to vote their proxies in the best financial interests of their beneficial owners. From that letter the SEC’s rules grew.

          To that time, proxies had little practical value. They always had, however, a theoretical, civics-class value.

         
Gadflies & Activists

          Until the advent of SRI, virtually all managers and investors observed the “Wall Street Rule”. The SEC summarized it in the rationale for its mutual fund rules as “an investor should either vote as management recommends or, if dissatisfied with management, sell the stock.”

          Apart from shareholder gadflies, such as the Gilbert Brothers from the 1950s into the 1980s, and shareholder activists, such as the Interfaith Center on Corporate Responsibility (ICCR) after 1971, almost no one contested the “rule”.

          Building on experience that dated to the 1960s, shareholder activists used proxy resolutions in the 1980s and 1990s to focus attention on critical issues ranging from South Africa to nuclear power. These resolutions never won. But they did publicize issues and mobilize constituencies. More importantly, shareholder resolutions brought managers to the table.

         
The New Shareholder Activists

          Robert Monks and his successors at Labor had dragooned the pension funds into proxy voting. The funds focused on corporate governance because, in their view, it related to stock price and hence the value of their portfolios.

          With the successful end of the South Africa campaign in 1994, this focus – something the pensions shared with the Gilbert Brothers – became the norm for shareholder activism. The social issue activists fought on. But the term “shareholder activists” fixed itself to the public pension funds concerned solely with governance issues which usually related to short-term performance.

         
Maximizing Shareholder Value

          The ascendancy of the corporate governance activists in the late 1980s and early 1990s coincided with the rise of the notion of maximizing shareholder value. The two became identified as one.

          “Vulture capitalists” and “corporate raiders” furthered their aims by leading proxy fights over corporate bylaws that prevented hostile takeovers or looting in the guise of refinancings – all in the name of increasing share worth. The media linked these fights to people named Milken and Pickens. By voting with them, institutional investors probably helped them along. But their votes were secret.

          In this guise, “corporate governance” led to a further emphasis on short-term financial performance. It also meant that whatever made it easy to leverage or flip the corporation became a good. Uncooperative companies, like Champion International, found their executive and directors’ compensation plans under attack.

          All the while, social issue proxy activists continued to raise questions about their companies’ environmental and human rights performance. Some paid attention to the more constructive governance issues and supported them.

         
Systematizing Proxy Voting and Reporting

          In this period, the social mutual funds developed systematic approaches to proxy voting and reporting. In 1995, KLD prepared the first comprehensive proxy voting guidelines for the Domini Social Equity Fund. The Fund made them available to its clients and the public, eventually publishing them on its website. Other social fund families soon followed suit.

          In 1999 Domini was the first mutual fund to report its proxy votes. And again, other social funds, such as MMA Praxis and Pax World, followed. But Domini was not the first institution to report its proxy votes. Credit for that goes to CalPERS, which beat Domini by a few weeks.

          The experience of the social fund families in developing policies and procedures and reporting votes proved to the SEC that other fund families could do the same things without undue expense.

         
The New Definition of Corporate Governance

          By 2000, “corporate governance” taken on a new, broader meaning – one that included how a company actually operated. (For a more complete discussion, see the preceding article.) In 2001, corporate governance pioneer CalPERS signaled that it would begin looking at human rights issues.

          CalPERS’ emergence as a social issues activist confirmed the confluence of corporate governance and broader issues – which social investors had argued for all along. On January 23, 2003 the SEC put its imprimatur on the new definition.

         
Emerging Shape of Corporate Reform

          Just 15 months ago, only a dreamer would have predicted passage of the Sarbanes-Oxley corporate reform bill or of the McCain-Feingold bill on campaign finance reform, much less the SEC’s proxy voting regulations. So forecasting the short-term course of corporate reform is chancy.

          It seems likely, however, that the departure of Harvey L. Pitt as SEC Chair will mark the beginning of a quiet regulatory era.

          His successor, William H. Donaldson, is in every sense a return to the old school. Like Mr Bush, he has a Yale undergraduate and a Harvard Business School degree. Both belong to Skull & Bones, a Yale secret society.

          Donaldson is 71, 12 years older than Pitt. He lacks Pitt's decades of experience with regulatory tools. And his history as head of the New York Stock Exchange shows him a cautious administrator aligned with traditional Wall Street.

          Still, the experience of the last 15 months.... All it is safe to predict is that more change will come before the next presidential campaign starts in earnest in January. Perhaps much more.

          The preceding articles take as a given that the Securities & Exchange Commission (SEC) acted in the public interest when it issued the new proxy regulations. But did it? Some leading figures in the mutual fund industry have doubts KLD does not share.

         
The Vanguard-Fidelity Position

          On January 14, the Wall Street Journal carried an op-ed piece by Vanguard Chair John J. Brennan and Fidelity CEO Edward C. Johnson III. Of the SEC’s proposed regulations, they wrote, “The threat is so severe that we, the leaders of the fund industry’s two largest competitors, come together now, for the first time ever, to speak publicly against it.”

          Normally, it is best to forget the cries of the about-to-be-regulated once they are.

         Not this time. For Messrs Brennan and Johnson’s are right in their central point:

“Simply put, we believe that requiring mutual-fund managers to disclose their votes on corporate proxies would politicize proxy voting. In case after case, it would open mutual-fund voting decisions to thinly veiled intimidation from activist groups whose agendas may have nothing to do with maximizing our clients' returns.”

Brennan and Johnson suggest:

         “Instead of all the regulation, why not simply enhance the proxy oversight role of mutual fund boards? Ensure that they hold their companies to clearly established proxy voting guidelines. Let them see that fund managers’ votes are consistent with the company’s guidelines – subject to SEC examination.”

Two arguments cut against this proposal.

“These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. When you are seeking investment help your-self, those two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic.”

“The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate govern-ance at a given company, simply by withholding their votes for directors who were tolerating odious behavior. In my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved.”

         SEC Proxy Voting Regulations & Explanations

         Securities & Exchange Commission, “Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies” (Jan. 31, 2003), 17 CFR Parts 239, 249, 270, and 274 [Release Nos. 33-8188, 34-47304, IC-25922; File No. S7-36-02], RIN 3235-AI64 http://www.sec.gov/rules/final/33-8188.htm

         Securities & Exchange Commission, “Proxy Voting by Investment Advisers” (Jan. 31, 2003), 17 CFR Part 275 [Release No. IA-2106; File No. S7-38-02], RIN 3235-AI65 http://www.sec.gov/rules/final/ia-2106.htm

         John J. Brennan & Edward C. Johnson 3d, “No Disclosure: The Feeling is Mutual”, Wall Street Journal, January 14, 2003. http://online.wsj.com/article/0,,SB1042509880551133904,00.html

         
Corporate Governance

         Warren Buffett, Letters to Berkshire Hathaway Shareholders. Http://berkshirehathaway.com/letters/ Buffett’s 2002 letter invites readers to compare his 1993 comments on corporate governance. Take up his invitation.

         Corporate Governance net. http://corpgov.net/

         The Corporate Library http://www.thecorporatelibrary.com/

         Vepa Kamesam, “Inaugural Address”, Programme on Governance in Banks & Financial Institutions, Administrative Staff College of India, Hyderabad, Nov. 22, 2001. Http://www.indiainfoline.com/nevi/cogo.html

         Robert A.G. Monks & Nell Minow, Power & Accountability (New York: HarperCollins, 1991). http://www.thecorporatelibrary.com/power/index.html A must read for those interested in the role of financial institutions in corporate reform. One need not agree with the authors to come away from the book with fresh perspectives and insights.

         
General Background

         Stuart Banner, Anglo-American Securities Regulation: Cultural and Political Roots 1690-1860 [1998] (Cambridge, UK: Cambridge Univ. Press, 2002). “The more things change....” A brilliant book that puts securities regulation into its historical context.

         Adolf A. Berle & Gardiner C. Means, The Modern Corporation & Private Property [1932] (New Brunswick, N.J.: Transaction Publishers, 1991). Note in particular Berle’s 1967 introduction. A remarkable view from the midpoint between the New Deal and the new conservatism. Wildly wrong in its optimism, but spot on on the trends.

         Louis D. Brandeis, Other People’s Money and How the Bankers Use It (New York: Frederick A. Stokes, 1914). Sections on conflicts of interest, interlocking boards, value of transparency could have been written today.

         Walter Werner & Steven T. Smith, Wall Street (New York: Columbia Univ. Press, 1991). Note the criticism of Berle & Means’ assertion that ownership and control once were united in publicly traded corporations.

         
SEC’s Direction in the Post-Pitt Era

         Pitt and Donaldson biographical information. http://www.sec.gov/about/commissioner/donaldson.htm and
http://www.sec.gov/about/commissioner/pitt.htm Note omission of corporate names from both bios, especially that of Donaldson’s last employer. Also note the contrast in educational backgrounds.

         Gary Weiss, “Just a Minute, Mr. Donaldson”, Business Week, Feb. 10, 2003, p. 66.

         
Acknowledgments

          For their assistance in the preparation of these articles, KLD wishes to thank James Coats, Liz Umlas and Larry Lawrence of KLD, Adam Kanzer of Domini Social Investments, James McRitchie of CorpGov.net, and Tim Smith of Walden Asset Management.

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