Professor Jim Hawley Director, Elfenworks Center for the Study of Fiduciary Capitalism And

1. Corporate Governance, Universal Ownership and the Current Economic/Financial Crisis:A Conversation with Professor Jim Hawley Director, Elfenworks Center for the Study of Fiduciary Capitalism And Professor Andy Williams Graduate Business July 2010 1 Hawley/Williams-Elfenworks Center www.fidcap.org

2. Road Map Introduction Fiduciary Capitalism / Universal Ownership Corporate Governance I, II and III Universal Owners and the Economic/Financial Crisis Conclusion – Q and A 2 Hawley/Williams-Elfenworks Center www.fidcap.org

3. Roots and Perspective: An Approximate Chronology • Ethical Investing to Influence Corporate Behavior--SRI (socially responsible investment) • Corporate Governance • Responsible Investment • Fiduciary Capitalism • Universal Owners • Reemergence of ‘ethical’ investing in Europe, UK and US • Often called: sustainable or responsible investment Hawley/Williams-Elfenworks Center www.fidcap.org

4. Background: Roadmap • Fiduciary Capitalism • Universal Owners • The ‘Modern’ Corporation…….. • …………And Adam Smith 4 Hawley/Williams-Elfenworks Center www.fidcap.org

5. Adam Smith, the Corporation, Nature of Private Property, and the Agency Problem “The directors of such companies [joint stock companies] however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery [partnership] frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honor, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” (Emphasis added.) 5 Hawley/Williams-Elfenworks Center www.fidcap.org

6. Managerial Capitalism • Berle/Means, Chandler and others: • “private property” has changed with the rise of the modern firm. • Ownership and control are separated in the modern corporate form • “Private property” in a new form; not your basic Adam Smith’s (or Karl Marx’s) capitalism • Markets are typically not laissez faire; large firms have traditionally internalize markets (vertical integration and/or tight subcontracting; alliances, R and D sharing, etc) 6 Hawley/Williams-Elfenworks Center www.fidcap.org

7. The ‘Modern’ Managerial Corporation • Logic of public equity markets and professionalization of management leads to separation of ownership and control • Separation leads to the agency problem • How to constrain managerial opportunism? • Growth of institutional ownership and the concomitant decline of individual ownership presents challenges and opportunities. • The rise of fiduciary capitalism-- 7 Hawley/Williams-Elfenworks Center www.fidcap.org

8. What is Fiduciary Capitalism? • Institutional ownership dominates • Also called Pension Fund Capitalism (Clark) • Financially Intermediated Society (Bogle) • La République des actionnaires (Gomez) • The New Capitalists-Citizen Investors (Davis, Lukomnik, Pitt-Watson) 8 Hawley/Williams-Elfenworks Center www.fidcap.org

9. Fiduciary Capitalism:Why the Adjective ‘Fiduciary’? • Describes and recognizes a changed ownership structure • Institutional Investors • Nature of institutional ownership in many countries-fiduciary or fiduciary-like • Duty of Loyalty • Duty of Care • Other emerging duties: • Impartiality • Short term/long term • Ethical • best interests of investors/beneficiaries • An ownership revolution and its implications • U.S. as an example…. 9 Hawley/Williams-Elfenworks Center www.fidcap.org

10. The Rise of Institutional Ownership in the United States: 1945 - 2008 10 Hawley/Williams-Elfenworks Center www.fidcap.org

11. Main Types of Institutional Ownership • Local/regional Pension Funds • Public; corporate; hybrid • Sovereign Wealth Funds • Sovereign Pension Funds • Mutual/Unit Funds • Universal Banks • Insurance Firms 11 Hawley/Williams-Elfenworks Center www.fidcap.org

12. Fiduciary Obligations, Law and Ownership Structure • Common law countries (vs. civil law) • Equity market financing (vs. bank) • Emergence of non bank, non equity financing • E.g. commercial paper • Diversified ownership (vs. bloc) • Post 1970: institutional ownership vs. individual (and controlling blocs; main banks, etc.) 12 Hawley/Williams-Elfenworks Center www.fidcap.org

13. Implications of Institutional Ownership / Fiduciary Capitalism • Professional Ownership • Universal Ownership • Universal Monitoring 13 Hawley/Williams-Elfenworks Center www.fidcap.org

14. Implications of Professional Ownership • A professional owner is a fiduciary, at minimum: • Duty of loyalty • Duty of care • All of the rights and responsibilities of ownership except the right to the profit (or loss) from investment decisions • Implies “active ownership” – Avon Letter, U.S. Dept. of Labor, 1984. 14 Hawley/Williams-Elfenworks Center www.fidcap.org

15. Emergence of Universal Owners • A Universal Owner owns equity, debt and other assets representing a broad cross section of the economy. E.G. CREF and CalPERS in US, USS in England and The Government Pension Fund – Global in Norway. • A Universal Owner’s return depends on the performance of the economy as a whole as much as on the performance of individual companies. • Why? • Diversification Strategy • Index Strategy Hawley/Williams-Elfenworks Center www.fidcap.org

16. Sea Change in Ownership Underlying UO’s • Common law countries UO’s are fiduciaries for a large proportion of employees and investors • 60% or more of the adult population--U.S., Canada, UK, Netherlands (civil law) • Examples: countries where UO’s are emerging • Some are sovereign wealth or pension funds; others not • France • Ireland • China (?) • Japan • Norway is a special and influential case • Most other countries UO’s are few, ownership dominated by families, managers and/or governments 16 Hawley/Williams-Elfenworks Center www.fidcap.org

17. Implications • Economic interest in externalities • Negative or positive impact on ‘third parties’ not party to a contract. • They are partially internalized by a UO • Global Climate Change • The Mother of all Externalities • Public Health and Education • Clean Drinking Water • Etc. • Long-term perspective – Sustainability • Particularly for pension funds 17 Hawley/Williams-Elfenworks Center www.fidcap.org

18. UO’s • Due to internalizing externalities, the performance of the whole is great than the sum of its parts. • Calculate performance holistically, not only on a firm by firm (smoke stack) basisCHALLENGE/OPPORTUNITY #1 • Have a quasi-public policy interest given investment-return horizon and investment diversityCHALLENGE/OPPORTUNITY #2 18 Hawley/Williams-Elfenworks Center www.fidcap.org

19. A Closer look at Externalities: Pecuniary and Non Pecuniary • Externalities: affect return on investment by imposing costs or returning benefits to firms which are neither typically accounted for or controlled. • Pecuniary: create costs or benefits that are measurable in monetary terms. • E.g. dumping effluent by an upstream plant. • Non Pecuniary: create costs or benefits not directly and initially measurable in monetary terms, but may have important economic consequences. • E.g. lost future productivity of a child who labors in a factory rather than going to school. 19 Hawley/Williams-Elfenworks Center www.fidcap.org

20. Logic of Universal Ownership • Most universal owners cannot or do not sell; they are indexed or shadowed indexed. • If they sell (many do for relatively short term perceived gains) they still hold very diversified assets across asset classes • Most universal owners’ portfolios mirror each other • Thus, they cannot sell without fear of market disruption (and therefore loss) • Consequently, the importance of non-market means of influencing firms—corporate governance activism—Engagement – using “voice” rather than “exit” 20 Hawley/Williams-Elfenworks Center www.fidcap.org

21. Logic continued • Since they cannot sell they must care • Care • Not only focusing on individual firm performance and behavior, • BUT on the interactive externality effects within a universal owner’s portfolio. • Secondarily link: Risk • Related to norm shifts and the various types of contingent liabilities norm shifts often create. 21 Hawley/Williams-Elfenworks Center www.fidcap.org

22. Logic continued • Furthermore, major agency-governance concerns • Internal (vis à vis to whom they are loyal and their internal investment managers) • External (vis à vis their investment chain/external managers/consultants) CHALLENGE/OPPORTUNITY #3 22 Hawley/Williams-Elfenworks Center www.fidcap.org

23. What’s Unique #1 • Large funds • Increasingly concentrated • Largest 100 U.S. fiduciary institutions hold over 60% of all publicly traded equity; • Indexed (actual or shadow) • Too big to sell- Must care (Hirschman’s voice) • Not a stock picker 23 Hawley/Williams-Elfenworks Center www.fidcap.org

24. What’s Unique #2 • A long term investor (or should be) • Corporate governance/engagement/voice--is key. • Long-term economic performance is governancegoal • Is a governance activist of necessity--Or fiduciary duty should obligate it to be 24 Hawley/Williams-Elfenworks Center www.fidcap.org

25. In Sum:The concept fiduciary capitalism captures these trends • Ownership sea change • Broadly diversified across most asset classes • Large scale, long-term focus (or should be) • Highly diversified, therefore internalizing many externalities • The agency problem is manifest in the investment chain, and perhaps internally • A corporate governance activist because large-scale exit blocked • Voice (governance) the alternative • Corporate governance goal: Long-Term Performance 25 Hawley/Williams-Elfenworks Center www.fidcap.org

26. Corporate Governance Stages I and II • CG I: focus on accountability, with some improvements in transparency • On-going, far from complete (e.g. CEO ‘pay for performance’; realistic performance measures; board independence; separation of chair from CEO) • Significant globalization • CGII: Includes accountability but increased focus on transparency • Incorporation of ‘ESG’ (Environment, Social, Governance) and ‘Principles of Responsible (sustainable) investment’ • Significant globalization 26 Hawley/Williams-Elfenworks Center www.fidcap.org

27. Corporate Governance Stage III • A response to the financial crisis • Additional concern with ‘sustainable’ finance and ‘sustainable economy’ • Increasingly focused on: • What should be ‘proper’ role of financial sector globally • What can/should UO’s do to achieve this role • Only recently emerging Hawley/Williams-Elfenworks Center www.fidcap.org

28. UO Examples and Some UO Type Activities • CalPERS/CalSTRS/NYcers - US • Environmental Initiatives; Investor Climate Change Network; Carbon Disclosure project (represents/tracks assets of ~$35 trillion) • Hermes-UK • “Don’t rob Peter to Pay Paul” (Principle 10) • Pharmaceutical Shareholders Group; Enhanced Analytics Initiative • Fonds de Réserve pour les Retraites -France • Searching for ‘extra-financial’ factors which influence value • Caisse de Dépôt et Placement du Quebec-Canada • Interest in UO implications • Many UO’s support various aspects of proposed financial reforms (U.S., Canada, UK, EU) • Norwegian Government Pension Fund: an SRI fund? 2008-2010 focus on: • Child labor in developing countries • Political lobbying by firms they own/environmental issues 28 Hawley/Williams-Elfenworks Center www.fidcap.org

29. A UO Investment Implication • Searching for “Alpha” but perhaps long-term finding Beta? • ‘Alternative investments’, asset diversification and benchmarked returns • Raising absolute returns means increasing productivity: total market ‘real’ (not ‘just’ or ‘only’ financial return • That is, increasing economic welfare, market efficiencies. • Must find a way to incentivize increased this type of absolute, long-term return • Implies new benchmarks for the internal and external investment chainCHALLENGE/OPPORTUNITY #4 29 Hawley/Williams-Elfenworks Center www.fidcap.org

30. Transparency Focus • In three areas: ESG – separately and interactively • Environmental (new) • Social (new) • Governance --established in principle • Some in practice • Macro failure (e.g. Enron, current financial crises) • E deals with externalities • S deals with risk (market, reputational, regulatory, political, etc) and some non-pecuniary externalities (e.g. child labor) 30 Hawley/Williams-Elfenworks Center www.fidcap.org

31. Materiality Focus • ESG brings elements of socially responsible investment (‘ethical investment’) to mainstream institutions • Viewed in terms of risk and opportunity • Not ‘ethical’ per se, nor political nor moral • Significant evidence for correlation between E and G and performance (S more difficult to study/quantify) 31 Hawley/Williams-Elfenworks Center www.fidcap.org

32. Institutional Example: U.S. TIAA-CREF • Environmental and Social issues begin to look like governance did 10 years ago • TIAA_CREF: corporate boards should track and disclose S and E issues • Engagement on: • environment • human rights • Labor conditions (e.g. ILO standards) • product responsibility and society (minimize/eliminate negative impacts on communities) 32 Hawley/Williams-Elfenworks Center www.fidcap.org

33. Analytical Example: Trucost and CalPERS/STRS-Utillities and Carbon • Carbon adjusted rate of return (CARR) • TruEVA: weighted avg. cost of capital including cost of carbon externalized on firm-by-firm basis • Of largest 25 U.S. utilities, only 6 had positive TruEVA • A measure of firm/sector risk but also of costs externalities. • Next step: measure how externalized costs are internalized, by firms/sectors. • What is nature and size of value destruction? • Specifically on whom? 33 Hawley/Williams-Elfenworks Center www.fidcap.org

34. Externality Costs of…. Hawley/Williams-Elfenworks Center www.fidcap.org

35. Internalization of Externalities in Portfolios • Flow through costs of externalities to equity portfolios Hawley/Williams-Elfenworks Center www.fidcap.org

36. A UO Perspective Expands the Business Case for Responsible Investment (RI) • Emergence of ESG and RI: Materiality • Ways and means to bring the ‘not yet financial’ or ‘emerging financial’ (‘extra financial’) into the bottom line. E.g. • Market pricing of governance • Climate risk (and opportunity) • Principles of Responsible Investment and the Freshfields Report • PRI: ~ $24 trillion and over 300 signatories (July 2010) • Watson Wyatt: sustainability as substitute for SRI? 36 Hawley/Williams-Elfenworks Center www.fidcap.org

37. A Closer Look at Market and Public Policy Implications • Universal owners cannot avoid externality effects as they own the economy and do not stock pick. • If they stock pick and have high turn over, they still own the economy over time • Fiduciary duty should mandate identifying and accounting for interactive externality effects on an investor’s portfolio. • Fiduciary duty and due diligence should mandate consideration of what actions (if any) would in the long-term result in minimizing negative and maximizing positive externalities. • The value of a universal portfolio would increase due to the growth of productivity in the economy. Hawley/Williams-Elfenworks Center www.fidcap.org

38. Further Implications of Universal Ownership • Strong interest in market wide policies • Accounting standards • Rating agencies • Security regulation • Governance structures (e.g. incentive systems, board composition/structure) • Financial regulation • A quasi-public policy interest in efficient macro economic policies • Free Trade • Effective Education • Health Care • Regulatory and deregulatory activities and policies • Bubbles 38 Hawley/Williams-Elfenworks Center www.fidcap.org

39. The Recent Economic Crisis • Origins • Low interest rates early in the decade • Chasing yield in the housing market >securitization in many forms • But not just a U.S. crisis in origin • Chasing ‘alpha’ and ever higher yields • Financial Innovation – e.g. Collateralized Debt Obligations (CDOs) • Misaligned Incentives • Excessive reward for short-term risk taking • Regulatory failures • Due in part to lobbying by financial firms • Faith in self-regulating/correcting financial markets with minimal regulation/supervision. • Toxic assets and economic meltdown 39 Hawley/Williams-Elfenworks Center www.fidcap.org

40. Impact on Institutional Investors • Big • Government Pension Fund – Global in Norway • Market value • December 31, 2008: 2,275 billion NOK • Return for the year • Overall: -23.3% • Equity Portfolio: -40.7% • Fixed Income Portfolio: -0.5% 40 Hawley/Williams-Elfenworks Center www.fidcap.org

41. Another Example • California Public Employee Retirement System (CalPERS) • Assets at year end 2007: $253.0 billion • Assets at year end 2008: $183.3 billion • % decrease: -27.5% - much greater in the equity portfolio alone • Assets at year end 2010: $207.1 billion • % decrease: -18% -- 3 years after the beginning of the financial crisis 41 Hawley/Williams-Elfenworks Center www.fidcap.org

42. Institutional Reaction • To use Corporate Governance tools to express displeasure at past policies and to try to influence future policies. • An Example: Bank of America • CalPERS holds 22.7 million shares • Decided to vote against all board members • “The entire board failed in its duties to shareowners and should be removed,” said CalPERS Board President Rob Feckner.  April 29, 2009 • Result – Kenneth Lewis was removed as the Chairman of the Board, but continues as CEO Hawley/Williams-Elfenworks Center www.fidcap.org

43. Universal Owner Response • Since universal owner returns depend on the performance of the economy as a whole universal owners have to take a holistic view of the economy • Monitor for Systemic Risk • Accounting • Financial • Regulatory • Etc. • But can UO’s impact firms’ and sectors’ behavior? • If not (and many think they can’t), then….. • Lobby government and regulators for better policies 43 Hawley/Williams-Elfenworks Center www.fidcap.org

44. Further Response • Outlier Monitoring: Hyper Performers Complement to programs that monitor underperformers. • If it is too good to be true, it probably is! • The New Economy, circa 2000 • Enron / World Com • The New Finance, circa 2006-7 • Financial Innovation • Bear Sterns • Lehman Brothers • AIG • Etc., Etc, • Problem of assuming ‘rational economic persons’ • The ‘animal spirit’ problem (Keynes) 44 Hawley/Williams-Elfenworks Center www.fidcap.org

45. Conclusions • Institutional Investors in general and Universal Owners in particular must be active to protect their interests and to fulfill their fiduciary duty to their beneficiaries. • Universal Owners need to pay particular attention to externalities among firms in their portfolios 45 Hawley/Williams-Elfenworks Center www.fidcap.org

46. Corporate Governance, Universal Ownership and the Current Economic Crisis:A Conversation with Professors Jim Hawley and Andy Williams July 2010 46 Hawley/Williams-Elfenworks Center www.fidcap.org