"Somebody's Gotta Keep an Eye on These Geniuses"

What We Must Do to Restore Owners Capitalism

John C. Bogle

By John C. Bogle

John C. Bogle, the founder and former CEO of The Vanguard Group, gave the keynote speech at this year's Directors' Summit -- a joint initiative of Executive Education at the School of Business and the State of Wisconsin Investment Board that examined issues in corporate governance from the viewpoint of institutional investors. Below is an excerpt of his remarks.

Something has gone profoundly wrong with the very system that we have come to know as American capitalism. The root causes of the disease are deep, and the remedies that are required to cure it will not be easy to come by.

During the 1990s, our system of corporate governance broke down. Too many boards failed to adequately exercise their responsibilities to oversee management, and rare was the institutional investor that exercised its responsibilities of corporate citizenship and demanded that oversight. When the owners of corporate American don't care about governance, who on earth should care?

What's to be done? Writing in The New Yorker, business columnist James Suroweicki gave us an amusing but perceptive answer. He used the example of the 1956 movie, "The Solid Gold Cadillac," in which Judy Holliday played Laura Partridge, a small investor whose continual harassment of the board finally gets the company to put her on the payroll as its first director of investor relations. She quickly uses the position to organize a shareholder revolt that topples the corrupt CEO. As Suroweicki concludes: "American companies are the most productive and inventive in the world, but a little adult supervision (by the owners) wouldn't hurt. Laura Partridge had it right a half a century ago: 'Somebody's gotta keep an eye on these geniuses.'"

Under our governance system, the board of directors is the first "somebody" to hold management responsible to represent the interests of shareholders. And when the directors don't fulfill that responsibility, the second "somebody" must hold them accountable: the shareholders themselves. Shareholder involvement in corporate governance can provide the necessary "adult supervision" required to move us away from the existing system of managers capitalism that we never should have allowed to come into existence in the first place, and to return us to owners capitalism, where we began all those years ago, a system in which trusting and being trusted created a virtuous circle of progress.

That transmogrification of a system of owners capitalism into a system of managers capitalism required only two ingredients: the diffusion of corporate ownership among a large number of investors, none holding a controlling share of the voting power; and the unwillingness of the agents of the ownersÑthe boards of directors-- to honor their responsibility to serve, above all else, the interests of their principals --the shareowners themselves.

When most owners either don't or won't or can't stand up for their rights, and when directors lose sight of whom they represent, the resulting power vacuum quickly gets filled by corporate managers. Little good is likely to result when the CEO becomes not only boss of the business but boss of the board, erasing the "bright line" that common sense tells us ought to exist between management and governance. Put more harshly, in a quote that I came across last spring, "when we have strong managers, weak directors, and passive owners, don't be surprised when the looting begins."

Yet the cause is not lost. Institutional stockowners, working in concert with corporate directors, can root out the problems that plague our system.

Please consider with me these eight ideas of "What We Must Do To Restore Owners Capitalism."

1. Encourage Corporate Citizenship. The only way that investors--and particularly institutional investors--will become better owners is if we at last return to behaving as responsible corporate citizens, voting our proxies thoughtfully and communicating our views to corporate managements.
2. Clearly Separate Ownership from Management. We need to recognize the bright line between directing--the responsibility of the governing body of an institution--and managing--the responsibility of the executives who run the business.
3. Return to a Long-Term Focus. Owners and managers must unite in the task of returning the focus of corporate information to long-term financial goals, cash flows, intrinsic values and strategic direction. Quarterly "earnings guidance," pernicious yet still omnipresent, should be eliminated. So should efforts to meet financial targets through creative accounting techniques.
4. Fix the Stock-Option Mess. I expect that, at the end of the tedious process followed by the Financial Accounting Standards Board, Generally Accepted Accounting Principles (GAAP) will require that the cost of fixed-price stock options be expensed, putting them on an equal footing with other stock-based compensation. But directors and owners should not be fooled into awarding such options. They are fundamentally flawed: Options are indifferent to dividends; their prices are not adjusted for the cost of capital; they don't relate rewards to the performance either of peers or of the stock market itself (indexed options); they pay off for raising momentary stock prices rather than building enduring corporate values and cash flow; and they rarely require that the optionees hold their stock, once purchased, for the long-term.
5. Let the Sunlight Shine on Accounting. Given the enormous latitude accorded by GAAP, owners must demand, and managers must provide, full disclosure of the impact of significant accounting policy decisions. Indeed, maybe we ought to require that corporations report earnings not only on a "most aggressive" basis, (presumably what they are reporting today), but on a "most conservative" basis as well.
6. Bring Back Dividends! History tells us that higher dividend payouts are actually associated with higher future returns on stocks. Yet despite the evidence that earnings retention leads to counterproductive capital allocations, the dividend payout rate has been declining for years. To state the obvious, investing for income is a long-term strategy and investing for capital gains is a short-term strategy. It is high time that owners and managers unite to bring a new focus on the issue of dividends.
7. Reform the Fund Industry. It will take a mutual fund industry focused on stewardship and long-term investing to act as responsible corporate citizens. But unlike corporate America, ownership is so diffused that there is no natural bloc of giant owners to lead the way. So we must build a shareholder-oriented board structure, dismantling today's incestuous conflict between managers and shareholders
8. "Institutions of the World, Unite!" At least since 1998--long before the recent spate of corporate and mutual fund scandals--I've been calling for mutual funds and other private institutional investors to make their will known by taking an active, even collective, role in governance. Index funds--the consummate long-term investors, who simply buy and hold the stocks in their benchmark portfolios--now represent 12 percent of mutual fund assets and an estimated 25 percent of pension fund assets. Such funds, joined by the active managers who eschew a short-term focus could constitute the core of a federation of long-term investors.

The "bad apples" have illuminated a whole host of weaknesses in the troubled barrel of capitalism. They've given us the opening to fix the system. Let's take it.

Yes, "somebody's gotta keep an eye on those geniuses." If the corporation's directors don't do it, why then, the owners must. It is as simple as that.

John Bogle's entire keynote speech is posted at www.uwexeced.com/directorssummit.