Chapter 10

Stakeholders' Roles and

Responsibilities
INTRODUCTION
SHAREHOLDERS
INSTITUTIONAL INVESTORS
MUTUAL FUNDS
HEDGE FUNDS
INVESTOR ACTIVISTS
EMPLOYEE MONITORING
SUMMARY
KEY TERMS
REVIEW QUESTIONS
DISCUSSION QUESTIONS
NOTES

INTRODUCTION
Shareholders and other stakeholders, including employees, customers, creditors,
suppliers, and society, by being attentive and engaged, play an important role in
corporate governance. The discussion in this chapter is based on the modern model
of corporate governance presented in Chapter 2, which suggests that the primary
goal of corporate governance is to provide appropriate mechanisms for ensuring
shareholder value creation while protecting the interests of other stakeholders. The
monitoring function of corporate governance can be achieved through the direct
participation of investors in business and financial affairs of corporations or
through intermediaries such as securities analysts, institutional investors, and
investment bankers. Institutional investors are regarded as important monitors of
public companies, their corporate governance, and their financial disclosures
because they own more than half of all U.S. public securities. Large public pension
funds (PPFs) are also expected to be actively involved in monitoring public
companies because they hold about 10 percent of the total U.S. equity market. This
chapter presents the important role that investors and other stakeholders can play in
improving corporate governance effectiveness.
Primary Objectives
The primary objectives of this chapter are to

 Discuss shareholder responsibilities in monitoring the effectiveness

and validity of corporate governance.
 Provide insight for strengthening shareholder rights.
 Discuss the role institutional investors play in ensuring effective and
responsible corporate governance.
 Provide methods employees can use to participate in the monitoring
of corporate governance.
 Examine activities by investor activists to strengthen corporate
governance reforms.

SHAREHOLDERS
Corporate governance reforms aimed at protecting investors have made the United
States: (1) a nation of share owners, with about 57 million households either
directly or indirectly owning shares through mutual funds or stocks; and (2) a
nation whose capital markets are the deepest, most liquid, and most efficient
worldwide. The second wave of financial scandals of stock option backdating
practices reported in 2006 proves that even four years after the passage of SOX,
investors still need protections and safeguards from corporate malfeasance. Recent
corporate governance reforms have raised investor expectations for corporate
governance, and any attempt to relax or roll back these reforms would be
disappointing to investors and adversely affect their confidence in public financial
reports and the capital markets.
The direct ownership of stocks by American households has decreased
substantially in the past several decades from 91 percent in 1950 to just 32 percent
in 2004, whereas stock ownership for financial institutions has increased
substantially from 9 percent in 1950 to more than 68 percent in 2004.1 Factors
contributing to this change are the move toward institutionalization of financial
markets through financial institutions, privatization of pension plans, and
individual investors' preference toward long-term investments. These changes in
the ownership structure from individual investors to institutional investors have
several profound effects on corporate governance. The formation of institutional
shareholders, including mutual funds and pension funds, has changed the
traditional agency concept of the separation of ownership control from decision
control. Under the emerging agency-dominated investment society, the majority of
individual investors indirectly participate in the capital markets by investing in
pension plans and mutual funds, and then financial institutions acquire stocks of
public companies.
Corporate ownership and types of owners of public companies have significantly
changed during the past several decades. The capital markets are more liquid than
before, which makes stock ownership more liquid. Both individual and
institutional investors can influence the structure of corporate governance.
Regulation of the capital markets and financial reporting is intended to protect the
rights and interests of investors. Active investors, particularly institutional
investors, can play an important role in the efficiency of the capital markets.
Monitoring of managerial decisions by large shareholders is an effective and direct
corporate governance mechanism that can reduce agency costs. Small
individual investors are not effective in directly monitoring management because
(1) the substantial costs of monitoring usually outweigh the small fraction of
benefits (the free-rider problem), and (2) the ultimate decision of small investors to
sell their shares will not possibly have any impact on the company's stock prices
due to the liquidity and efficiency of the capital markets. For large investors,
however, who own a substantial portion of the company's outstanding shares, the
free-rider problem is mitigated, and their decision to sell their shares can have a
substantial impact on the value of the company's shares, which may force its
management to change course. Nevertheless, monitoring by large investors is not
without its costs. Large investors' incentives and interests may be different from
small investors, and they may face the same free-rider problem as small
shareholders.
The division of internal and external equity securities can influence the shape of
the corporate governance structure and the extent of monitoring control within the
company. Management can exert more control over the company's affairs when
ownership is concentrated in the hands of directors and officers, and thus create
fewer opportunities for outsiders (shareholders) to exert control. The absence of
adequate monitoring by outsiders can result in an entrenchment effect, which is
detrimental to the company because managerial actions are not properly monitored
by outsiders. Significant ownership by insiders, however, may provide more
incentive for management attempts to increase its own wealth through maximizing
the company value and thus decreasing agency costs. Blockholdings by outsiders
(typically, the ownership of more than 5 percent of the company's outstanding
shares) can shape the corporate governance structure by determining the level of
monitoring exerted by outsiders (e.g., the opportunity to nominate directors). The
level of blockholdings by outsiders, particularly institutional investors, provides
them with both incentives and opportunities to effectively monitor management
actions.
Outside shareholders own the majority of corporations' outstanding shares.
Typically, individual shareholders own very small fractions of the corporation's
share, which may not give shareholders much incentive or opportunity to
participate actively in monitoring managerial actions and decisions. However,
shareholders with significant ownership positions have more incentives and
opportunities to engage in the monitoring function. Shareowners should be
attentive through their participation in the nomination and election process and
approval of major business decisions. Shareholders of public companies with
dispersed ownership have little, if any, incentives and opportunities to monitor
their company's business affairs and managerial activities. The prevailing plurality
voting system also makes it difficult for shareholders to monitor their companies.
State statutes have traditionally limited shareholder monitoring other than through
electing directors and voting on major corporate issues (e.g., mergers and
acquisitions). Federal statutes have improved shareholder monitoring through the
proxy rules, which allow shareholders to include their proposals in the company's
proxy materials.
Investors should also share some of the blame for reported financial scandals for
their lack of monitoring of their companies' governance. The publicized financial
scandals of the early 2000s originated from the use of aggressive accounting and
earnings management practices of the late 1990s. Financial irregularities and
earnings management practices of many companies such as Waste Management,
Sunbeam, Cendant, Lucent, Xerox, and McKesson definitely sent strong signals of
forthcoming financial scandals. Nonetheless, investors either did not want to ask
tough questions about their governance or did not care as long as the stock prices
were going up. Earnings management practices of prominent companies such as
Tyco, General Electric, and Cisco were reported in the press, but investors did not
raise many concerns about the irregularities of these companies that were making
profit for them. The economic downturn; stock market plunges of 2000 and 2001;
failures of Enron, WorldCom, Adelphia, Global Crossing, and others; and
ineffectiveness of their corporate governance made investors angry when the roots
of these problems traced back to the capital market inefficiency of the 1990s. The
two biggest corporate bankruptcies in U.S. history, Enron and WorldCom, and the
failures of other high-profile companies primarily caused by fraud, which cost
investors and pensioners more than $500 billion, made investors take notice and
demand corporate accountability.
SHAREHOLDER MONITORING
Shareholders of public companies with dispersed ownership have few, if any,
incentives or opportunities to monitor their company's business affairs and
managerial activities. The prevailing plurality voting system also makes it difficult
for shareholders to monitor their companies. State statutes have traditionally
limited shareholder monitoring other than through electing directors and voting on
major corporate issues (e.g., mergers and acquisitions). Federal statutes have
improved shareholder monitoring through the proxy rules, which allow
shareholders to include their proposals in the company's proxy materials. The
effectiveness of the monitoring and control function by investors is determined
based on the interrelation factors of (1) property rights established by law or
contractual agreement that define the relations between a company's investors and
its management, as well as the existence of such relations between different types
of investors; (2) financial systems facilitating the supply of finances between
households, financial intermediaries, and corporations; and (3) networks of
intercorporate competition and cooperation establishing relations between
corporations in the marketplace.
1. Property rights. Investors' influence, monitoring, and control are
significantly affected by the rights set forth by corporate law, articles
of incorporation, and contractual agreements. Property rights
establish the legal relations between a company's investors and
management as well as the relations among different types of
investors (e.g., equity owners, debt holders). Effective property rights
create a well-balanced and proper division of powers between
investors and management in the sense that investors are provided
with adequate control while management autonomy is preserved.
Property rights, particularly corporate law, specifically define how
shareholder rights translate into voting rights in corporations,
including voting rights of shares, rules on proxy votes, voting
thresholds for particular decisions, and investor meeting quorums.
Corporate laws, including state and federal statutes, also establish the
fiduciary duty, structure, role, and composition of the company's
board of directors.
2. Financial system. The financial system provides a means of
financing of corporate ownership that fundamentally constitutes the
supply side of capital markets. The supply side of financial markets is
significantly influenced by regulatory measures, pension plans, and
labor rules.2 Financial systems provide two alternative modes of
financial mediation between households (investors) and
corporations.3 The first mode is bank-based finance, where banks take
deposits from households and channel this savings into loans made to
 companies. The second mode is market-based finance in which
households, directly or indirectly through retirement plans, invest in
equity or debt securities issued by corporations. Household savings
level, time horizons (short term, long term), and types (regular,
retirement) affect the incentives and investment policies of financial
institutions, including pension funds and mutual funds, which in
return can impact corporate governance by providing different types
of financing requiring different reforms of financial and corporate
governance systems.
3. Intercorporate networks. Investor influence in corporate
governance is affected by the patterns of intercorporate
networks.4 Intercorporate networks determine (a) the relation
between the company and other corporations or organizations; (b)
the structure of power and opportunity; and (c) access to critical
resources, information, and strategic decisions. These relations, by
creating a coalition of power and opportunities, can influence
corporate governance and the ways these intercorporate networks are
managed. The nature and extent of corporate control within networks
is affected by state regulation of market competition and antitrust
law. For example, market competition regulations discourage capital
ties between competing corporations, which may force them to
merge. These mergers may reduce the concentration of ownership
within large corporations and strategic interests within corporate
governance.
Strengthening Shareholders' Rights
Shareholders have been inattentive and have not effectively participated in
corporate governance by letting their preferences or voice be heard by the
company's board. The lack of transparency, accountability, and proper
communication between shareholders and the board of directors is perhaps the
most detrimental factor to the effectiveness of corporate governance. Inattentive
shareholders allow the CEO to have significant influence on the election of
directors, their compensation, and their role on the board. When the CEO is given
such an opportunity to shape the board structure, the likelihood of directors
challenging the CEO's preferences or effectively overseeing the managerial
function can be substantially reduced. This perceived compromised boardroom
culture can adversely impact corporate governance.
Access to Information
State and federal laws are aimed at protecting shareholder rights by allowing
shareholders to (1) inspect and copy the company's stock ledger, its list of
shareholders, and certain books and records; (2) approve certain business
transactions (e.g., mergers and acquisitions); (3) receive proxy materials; and (4)
obtain significant disclosures for related party transactions. Shareholders hold the
board of directors accountable for business strategies, performance, and investment
decisions. In the era of IT and the Internet, shareholders should be provided with
timely electronic access to all relevant information in advance of shareholders'
annual meetings. Shareholders should be able to communicate regularly with
corporate directors. Companies are required to provide the following disclosures
with regard to their processes for security holder communications with board
members (1) if there is a process by which shareholders can send communications
to board members, and if not why; (2) if there is a process, a description of that
process and any filters used; and (3) the company's policy on board members
attending annual meetings.
Shareholder Democracy
The relationship between the board of directors and shareholders has received a
considerable amount of attention in the post-Enron era. Accountability and
transparency between the board and shareholders have not been effective in the
sense that the board was not informed of what shareholders were expecting of it,
and shareholders were not aware of the board's activities or its effectiveness.
Shareholders have voting rights to elect directors as their agents; however,
individual directors have no direct responsibility or accountability to shareholders.
Traditionally, public companies have used a plurality vote system to elect
corporate directors. Under a plurality vote system, directors can be elected by the
vote of a single share unless they are opposed by a dissident director. Conversely, a
majority vote system empowers shareholders to elect the most qualified outside
directors. The nominating committee can play an important role in promoting
majority voting and developing an efficient mechanism for shareholders to
nominate or endorse director candidates.
Shareholder Nomination
The process of nominating and electing directors should be fair, candid, and
transparent to ensure the right of every shareowner to meaningfully participate in
corporate governance. Shareowners are empowered under state corporate statutes
to elect directors to oversee management, but in reality, they have no real voice in
the nomination and election process. The real election appears to be cast in the
boardroom due to the fact that even if the majority of shareholders oppose a
corporate-sponsored nominee, that person will still be elected as a director. Thus,
the extent of shareholders' participation in the election of directors is limited to the
rubber-stamp process of affirmation. The requirement for the establishment of a
nominating committee composed solely of independent directors has provided
some structure to the nomination and election process, even though in many cases
independent directors still serve at the will of the CEOs and other executive
directors.
Directors should be elected annually by a majority of the votes cast when state law,
the company's charter, and bylaws permit majority voting. Alternatively, when
state law requires plurality voting for director election, the board can adopt policies
requiring that directors tender their resignation if the number of votes withheld
from the director exceeds the number of votes for the director. If such a director
decides not to tender resignation, he or she should not be renominated after the
expiration of his or her current term. The board should consider shareholder
proposals that receive a majority of votes cast for and against. The nominating
committee should establish procedures to (1) receive shareholders' nominations for
board candidates and proposals for significant strategic decisions, (2) consider
nominees and proposals received from small individual investors, and (3)
communicate with shareowners.
The existing SEC rules allow companies to reject any proposal pertaining to
director election. The U.S. Second Circuit Court of Appeals, on September 5,
2006, issued a ruling that enabled shareholders in its jurisdiction (New York,
Connecticut, Vermont) to nominate corporate directors.5 The SEC has considered
amending its rule governing shareholder nomination of directors in light of this
recent court ruling. Public companies usually send proxy ballots to shareholders,
including the names of directors up for election. A director candidate can be
nominated by a board committee and placed on the ballot. Shareholders, of course,
can nominate their own candidate through separate ballots, which are often a
complicated and costly process. The court ruled that under the existing SEC rules,
shareholders should have access to the proxy for purposes of nominating their
choice of candidate for director.
The SEC issued a proposal, in October 2003, to give shareholders access to the
proxy, but no action has been taken by the SEC to finalize the proposal. Pursuant
to the court decision, the SEC announced that it will recommend an amendment to
Rule 14a-8 under the Securities Exchange Act of 1934 pertaining to director
nominations by shareholders. The decision by the Second Circuit Court of Appeals
is important because (1) it states that shareholders should be able to access the
proxy for the purpose of nominating their choice of candidate for director, which
disagrees with the SEC staff's long-standing interpretation of the proxy rules; (2) a
large number of public companies are subject to the jurisdiction of the Second
Circuit Court of Appeals; and (3) the SEC is expected to revise its proxy rules to
ensure consistent rational application to shareholder proposals. It is highly possible
that the SEC will adopt the rule to allow companies to keep shareholders' director
nominees off corporate ballots. The shareholders' basic ownership rights of having
unrestricted access to company proxies for board elections are not aligned with
other developed countries, which undermines the effectiveness of corporate
governance in U.S. and shareholder democracy.
Shareholder resolutions in 2007 contain several important proposals, including (1)
an advisory vote on executive compensation packages, (2) say-on-pay resolutions
that pressure companies to link their compensation policies to executive
performance, (3) proposals to allow shareholders to run opposing board candidates,
(4) majority votes for nominations and elections of directors, and (5) monitoring of
the company's executive pay and related compensation expenses. Indeed,
shareholder proposals during the 2007 proxy season received majority votes in
favor of “say on pay,” requiring shareholder advisory votes on executive
compensation at several high-profile companies (e.g., Verizon Communications,
Inc.; Blockbuster, Inc.).
SHAREHOLDER PROXY PROCESS
In July 2007, the SEC approved two proposals addressing the shareholder proxy
process. The first proposed rule would require public companies to allow
shareholder access to the company's proxy statements.6 The second proposed rule
would facilitate electronic shareholder forums. Proxy access proposals are
shareholder proposals that enable shareholders to nominate director candidates
who would be named in the company's proxy statement. The SEC has traditionally
allowed companies to exclude such shareholder proposals from their proxy
statements under its Rule 14a-8(i)(8) to avoid contested elections. The U.S. Court
of Appeals for the Second Circuit in AFSCME v. AIG, in September 2006,
questioned the SEC staff's interpretation of Rule 14a-8(i)(8) that suggests that all
proxy access shareholder proposals are excludable from the company's proxy
materials. On July 25, 2007, the SEC reaffirmed its historical interpretation of Rule
14a-8 and approved a proposed rule that would allow the inclusion of certain proxy
access shareholder proposals and would require additional disclosures by
companies and proponents when such proposals are included. The proposed rule
indicates that a proxy access shareholder proposal is not excludable under Rule
14a-8(i)(8) if (1) the shareholder proposal seeks to amend the company's bylaws,
(2) the shareholder proposal is binding, (3) the shareholder(s) submitting the
proposal held at least 5 percent of the company's outstanding shares for at least one
year, and (4) the shareholder(s) submitting the proposal are eligible to and have
filed a Schedule 13G with respect to the company. Unlike a proxy access rule
proposed by the SEC in 2003 that was never adopted, the new proposed rule does
not dictate the terms of proxy access share-holder proposals that should comply
with state law and with the company's charter and bylaws.
The new SEC proposed rule enables companies and shareholders to communicate
in electronic shareholder forums by eliminating possible impediments to such
forums under the SEC's proxy rules. The proposed rule would provide that (1)
public companies and others who set up electronic shareholder forums are not
liable under the federal proxy rules for false and misleading statements
electronically posted by others on such forums, and (2) individuals who post
communications on electronic shareholder forums at least 60 days in advance of a
shareholder meeting who are not seeking a solicitation will not be considered to be
engaged in a solicitation for purposes of the proxy rules. This proposal permits
companies and others to develop their own format, content, and methods of
electronic shareholder forums.
SECURITY CLASS ACTIONS
Private lawsuits are vital mechanisms for enforcing securities laws, compensating
defrauded investors, and improving corporate governance to be used effectively by
institutional investors, particularly public pension funds. The Private Securities
Litigation Reform Act (PSRLA) of 1995 was passed to bring more focus to private
lawsuits by (1) providing more client control of shareholder litigation, (2) ensuring
lawsuits were meritorious and well prosecuted, and (3) encouraging institutional
investors to take charge of private lawsuits regarding securities litigation. Indeed,
shareholder recoveries have significantly increased and attorneys' fees have
substantially decreased since institutional investors have taken the lead on
securities litigation in the post-PSRLA period. Institutional investors often
participate as lead plaintiffs in class action securities lawsuits under the PSRLA,
and as part of negotiated settlements, try to influence corporate governance. For
example, the California State Teacher's Retirement System (CalSTRS) brought a
class action suit against Home-store, an Internet real estate company, and then
settled the suit by (1) obtaining $64 million in cash and stock for shareholders; (2)
demanding that the company agree to appoint a shareholder-nominated director to
the board; and (3) asking the company to ban the use of stock options in
compensating directors, gradually eliminate staggered terms for directors, and
increase the number of independent directors and board committees.7
INSTITUTIONAL INVESTORS
Institutional investors consisting of insurance companies, pension funds,
investment trusts, mutual funds, and investment management groups often hold
substantial outstanding shares of public companies. Institutional investments in the
United States have grown significantly in the past five decades and will continue to
grow as more employees participate in pension funds. Table 10.1 provides types
and definitions of investment funds. Institutional investors may not fully exercise
their corporate governance oversight function and monitoring controls for several
reasons. First, pension fund managers are not typically the ultimate beneficiaries of
the wealth generated by corporations, and they may not have strong incentives to
engage in monitoring of the company's affairs. Second, fund managers may be
reluctant to incur monitoring costs, particularly when other investors will benefit
from such monitoring (the free-rider problem). Finally, institutional investors are
often not long-term investors and may not be motivated to engage in long-term
costly monitoring, instead choosing to divest poorly performing stocks.
Nevertheless, the equity holdings of institutional investors are becoming more
indexed and diversified, diminishing opportunities for an easy exit to divest poorly
performing stocks. This indexing and diversification may result in alignment of the
fund with public interest and market performance as opposed to alignment with a
specific company. In this capacity, institutional investors play an important role in
improving investor confidence and public trust in corporate governance through
their presence and active participation in monitoring public companies' corporate
governance structure.
Table 10.1 Investment Funds and Their Definitions

Term Definition
Hedge High-risk, aggressively managed fund that uses short selling, swaps, derivatives, an
fund techniques to get a maximum rate of return
Mutual Collective investment plan managed by an investment firm that allows its participan
fund portfolio that is diversified into different bonds, stocks, and other securities
Pension Fund established by an organization for the investment of member pension contribu
fund payment of pension benefits to those members who have retired
Source: Global Investor. 2007. Glossary. Available at: www.finance-glossary.com.

Corporate governance structure is affected by large blockholders because they

often have representation on the company's board of directors. Blockholders may
have more incentives than small shareholders to monitor management actions,
primarily because of (1) the size of their holdings, (2) more opportunity for insider
trading, and (3) the greater possibility of presenting a credible takeover threat. The
involvement of large shareholders has the potential to limit agency problems
associated with the separation of ownership and control in public companies.
Institutional investors can play an important role of reducing information
asymmetry between management and shareholders by obtaining private
information from management and conveying that to shareholders and, thus, the
capital markets. The integrity and credibility of such information should be
verified in order to be relevant and useful to investors.
INSTITUTIONAL INVESTORS' MONITORING
The company's board of directors should become familiar with each of their key
institutional investors. Institutional shareholders normally monitor their holdings
by using a screening system based on financial performance (e.g., benchmarks),
identifying problem areas and concerns, and determining causes and effects of the
problems. Although they often do not micromanage their investments, they
monitor their holdings by ensuring that the investee company is well managed and
has a clear and attainable strategy. Institutional investors do not regularly intervene
in the investee company except in rare circumstances. Intervention may occur in
situations where there are concerns about strategy, operational performance,
mergers and acquisitions strategy, inadequate oversight function by independent
directors, reported material weaknesses in internal controls, inadequate succession
planning, noncompliance with corporate governance reforms, inappropriate
executive compensation plans, lack of commitment to SEE issues, material
financial restatements, and corporate malfeasance and fraud.8 Institutional investors
may intervene by (1) having additional meetings with management; (2) expressing
concerns through the company's advisors; (3) meeting with directors, particularly
independent directors, lead directors, or the chairperson of the board; (4)
collaborating their intervening activities with other institutions; (5) making a
public statement in advance of annual shareholder meetings; (6) submitting
resolutions at shareholders' meetings; (7) requisitioning an additional general
meeting, possibly to change the company's board; and (8) meeting with individual
board committees (e.g., audit, compensation, nominating/governance).
The Commission of the European Communities requires institutional investors to
(1) disclose their investment policy and their policy relevant to the exercise of
voting rights in companies in which they invest, and (2) disclose to their beneficial
holders at their request how those rights have been used in a particular case.9 These
requirements are designed to improve both the internal governance of institutional
investors and their participation in the business and affairs of the companies in
which they invest. The commission believes that institutional investors play an
important role in the governance of public companies and fostering this role will
require amendments to a series of European legal texts pertaining to insurance
companies, pension funds, and mutual and other investment funds. Nonetheless,
the commission does not believe that a requirement for institutional investors to
systematically exercise their voting rights is desirable, and thus, institutional
investors may vote in favor of any proposed resolution to fulfill the requirement.
Institutional shareholders play an important role in corporate governance by (1)
exercising their right to elect directors, (2) raising their concerns about the
company's governance by either selling their shares or voicing their dissatisfaction,
(3) improving the efficiency of the capital markets by transmitting private
information they obtain from management to the financial markets, and (4)
reducing agency problems by possessing resources and expertise to monitor the
managerial and oversight functions as well as reduce information asymmetry
between management and investors. The ever-increasing presence of institutional
investors in the capital markets empowers them to influence corporate governance.
For example, institutional investors claim that they have played an important role
in increasing board independence and through close monitoring encouraged
management to focus more on the company's sustainable performance rather than
short-term profit maximization. Institutional investors are not only seeking a more
active role in the nomination process but are also trying to influence the process.
Opponents to institutional investor activism argue that (1) institutional
shareholders' primary role is to manage pension functions on behalf of their
beneficiaries and their monitoring activities detract them from their main
responsibilities; and (2) to credibly perform the monitoring function, institutional
investors should maintain the investment for a sufficiently long period of time and
hold ample shares to reduce the free-rider problem.10
GOVERNANCE OF INSTITUTIONAL INVESTORS
America's one hundred largest money managers now hold about 58 percent of
stocks of public companies in the United States. It is expected that these giant
financial institutions will get actively involved in monitoring public companies'
governance, business, and affairs. These financial institutions, on the one hand, are
agents of individual shareholders with the fiduciary duty of managing these funds
for the best interest of their individual investors (principals). Financial institutions,
on the other hand, own and manage public companies' stocks, which make them
responsible for monitoring public companies' governance. This dual responsibility
of institutional investors as agents of individual investors and principals of public
companies may create conflicts of interest. This real or potential conflict of interest
has, in many cases, caused institutional investors to refrain from active monitoring
of corporate affairs and governance. These conflicts of interest will continue to
exist as long as the ownership society is diminishing and the agency (intermediate)
society is effectively monitoring public companies' governance, affairs, and
business.
Lack of effective monitoring by institutional investors can be attributed to and
explained by several reasons. First, institutional investors, with the exception of a
few (e.g., state and local pension funds, unions, TIAA-CREF), have their own
interests to serve aside from the interests of their investor-principals. For example,
corporate pension plans are often controlled by the company's executives whose
compensation is linked to the reported earnings, and mutual fund managers'
compensation is often not based on the return-on-funds assets. Second, financial
institutions have a tendency and motivation to focus on short-term speculation of
stock price changes rather than long-term investing based on sustainable intrinsic
corporate value. Third, managers of mutual funds and pension plans are less likely
to support a proxy proposal that is opposed by the management of a corporate
client. Conceptually, institutional investors represent small shareholders as
pensioners or beneficiaries. To ensure that institutional investors protect the
interests of their beneficiaries or trustees, they should disclose their corporate
governance and voting policies as well as potential conflicts of interest and how
they manage them.
MUTUAL FUNDS
According to the U.S. Census Bureau, there are more than 2,656 public pension
funds that hold more than 20 percent of publicly traded U.S. equity and, as such,
are considered major shareowners of U.S. capital markets. Many public pension
funds, including CalPERS and the SBA of Florida have received considerable
attention in the post-SOX era for their participation in corporate governance. These
funds have improved the investor monitoring function through shareholder
proposals, support of regulations to enhance shareholder democracy, and
participation in securities fraud actions. Smaller pension funds are not expected to
be actively involved in corporate governance primarily because of substantial
monitoring costs.
Congress passed the Investment Company Act in 1940 to set requirements for
prohibiting investment companies (mutual funds) from engaging in certain
transactions that may create conflicts of interest.11 The Investment Company Act
also requires that a fund's board of directors provide oversight over management to
align management interests with those of shareholders while granting broad
authority to the SEC to provide exemptions to this act (conditionally or
unconditionally) when the exemptions are in the public interest and provide
protections for investors. More than 95 million Americans invest and entrust their
savings in mutual funds, an industry with more than $7 trillion in assets. The rash
of mutual fund scandals in 2003 indicates significant ineffectiveness in fund
governance structures that eroded investor confidence in the mutual fund industry.
In response to those scandals, the SEC has brought enforcement actions against
troubled mutual funds and obtained more than $2.2 billion in disgorgements and
civil penalties, which is being used to compensate injured investors.12 To improve
independent director oversight of mutual funds, the SEC requires mutual funds to
have independent chairs.
The SEC has taken several mutual fund initiatives designed to (1) address late
trading, market timing, and revenue sharing that create conflicts of interest
between management of mutual funds and their shareholders; (2) improve
transparency of disclosures to fund investors; and (3) strengthen the oversight
function of mutual funds by improving their governance, ethical standards,
compliance, and internal controls.
IMPROVING THE OVERSIGHT FUNCTION
In July 2004, the SEC, in a close 3-2 vote, adopted mutual fund governance
reforms that require mutual funds to have an independent chairman (nonexecutive
director) and 75 percent of board members to be independent. The independent
directors must have the authority to hire staff to support their oversight function,
engage in an annual self-assessment, and hold separate executive sessions with the
presence of fund management. On June 29, 2005, one day before William
Donaldson stepped down as the chairman, the SEC preapproved its rule requiring
mutual fund boards to have at least 75 percent of their directors be independent,
including the chairman of their board. The SEC initially approved this rule in 2004,
the U.S. Chamber of Commerce brought a lawsuit against the rule, and the U.S.
Court of Appeals in the last week of June 2005 nullified the rule on the grounds
that the SEC failed to consider the cost to mutual fund companies in complying
with the rule. The four horsemen of mutual fund governance as promoted by the
SBA of Florida are (1) no more than one management company on the fund's
board, (2) independent chairman of the board, (3) dedicated fund staff, and (4)
federal statute of fiduciary duty.13
CHIEF COMPLIANCE OFFICER
The SEC, in December 2003, adopted initiatives that require mutual funds and
their advisors to have comprehensive compliance procedures and to appoint a CCO
to assist the board in improving the governance structure. The CCO is accountable
to the fund's board and can only be terminated by a board decision.
CODE OF ETHICS
The SEC, in July 2004, issued rules that require registered investment advisors to
adopt a code of ethics that sets forth the standards of ethical conduct for each
employee to reinforce ethical behavior and integrity in the investment management
industry. Mutual funds and their advisors should comply with the requirements of
code of ethics.
HEDGE FUNDS
Hedge funds are expected to grow significantly as (1) pension plans and other large
institutions are expected to invest about $4,300 billion in hedge funds by 2008, (2)
large companies such as Weyerhaeuser and Eli Lilly are investing a significant
portion (up to 39 percent) of their pension fund's assets in hedge funds, and (3)
Congress is considering changing the definition of “plan assets” and relaxing the
pension law for hedge funds by raising the limit (up to 50 percent) on how much
pension money a hedge fund can have before it is considered a fiduciary under the
pension law.14
Hedge funds and other private equity investors play an important role in
influencing corporate governance issues by promoting investor protection as their
primary goal. Investors in general, and hedge and mutual funds in particular, can
influence corporate governance by demanding that boards of directors act
independently from management, holding boards accountable for their decisions,
and holding the compensation committee accountable for approving excessive
executive pay. The hedge fund industry accounts for trillions of investment assets.
The SEC rule requires that hedge fund advisors managing more than $25 million
for more than fifteen clients register with the SEC. Some hedge funds have a suit
against the SEC on the grounds that the commission has overstepped its
jurisdiction. The SEC has filed numerous enforcement cases against hedge funds in
connection with their inappropriate fund valuation schemes, insider trading
violations, and failures to supervise the hedge funds. These cases are significantly
associated with violations of rules related to market timing and late trading, which
have victimized both investors and the capital markets. The SEC has recently
aggressively enforced the insider trading laws for insider trading abuses by both
individual investors and market professionals (e.g., a UBS research executive, a
Morgan Stanley attorney).
INVESTOR ACTIVISTS
The monitoring function led, to a great extent, by large and proactive institutional
shareholders has played an important role in improving corporate governance.
Investor activists generally claim that recent corporate governance reforms are not
adequate, whereas others believe these reforms are unfair to those public
companies (e.g., utilities) that are highly regulated and have been in compliance
with applicable laws, rules, and regulations. The rash of financial scandals of high-
profile companies caused investors to be more active in monitoring companies in
which they invested, and they have begun to consider corporate governance
effectiveness in their investment decisions. This well-deserved, long-awaited
investor focus on corporate governance generated a demand for and interest in the
development of ratings metrics or systems that gather, analyze, rank, and compare
corporate governance practices of public companies. National and international
organizations, including ISS, The Corporate Library, Standard & Poor's, Moody's
Investment Service, CoreRatings, and GMI have all developed and published
variations of corporate governance ratings that are often used by shareholders in
assessing their stock returns and by bondholders in determining the costs of
lending.
EMPLOYEE MONITORING
The agency theory aspect of corporate governance focuses primarily on the relation
between investors and management with shareholders considered the only bearers
of residual risk.In modern corporations, particularly in the era of technological
advances, labor resources are becoming an important part of corporate governance
as capital resources. The balance of power and association between property rights
(investor protection), managerial control (management prerogative), and employee
participation rights (labor management and employee protection) can play an
important role in the effectiveness of corporate governance. Employee
participation in corporate governance can influence managerial control and
authority, and can influence employee cooperation in the implementation of
decisions. The shape and extent of employees' participation in corporate
governance is a function of the employee level of investment in the company's
stock through retirement plans and whether their skills are firm specific. In a
situation in which employees invest in skills specific to their company and their
retirement funds and pensions are tied to the company's stock, their incentives to
participate in corporate governance are greater. Alternatively, when employees'
skills are portable across companies and their investments in the company are
insignificant, they may prefer strategies of exit over voice in response to
dissatisfaction and grievances. Thus, employees' interests in corporate governance
are shaped by their economic, investment, and employment ties to the company, as
well as their participation in managerial decisions.
Employees' participation rights can be defined by employment contracts, employer
action, labor law, ownership, or collective bargaining. First, employee participation
may be established by the employment contract in terms of involvement in
decision making. Second, participation may be determined through decisions made
by the employer. Labor law, or statutory law, may also establish participation
rights. Finally, collective bargaining can be an important vehicle for establishing
contractual participation rights. Employee participation can also be established by
direct ownership as shareholders, or through employee share ownership plans
(ESOPs). Employee stock options and other performance-related incentives may
shape employee participation. The financial scandals and bankruptcies of Enron
and WorldCom, which caused significant loss of jobs and employee pension funds,
underscore the importance of employee participation in corporate governance.
EMPLOYEE OWNERSHIP
Employees are one of the important stakeholders of corporations whose
productivity and efficiency contribute to the bottom line of increasing firm value.
Employees are usually paid fixed salaries or wages regardless of the company's
performance (unless there is a threat of bankruptcy or job loss). One way to get
employees more engaged in corporate governance is to link their pay to company
performance through equity ownership plans such as ESOPs. Theoretically,
combining labor capital and equity capital by ultimately moving to employee-
owned corporations can substantially reduce agency costs by empowering
employees and protecting both labor and equity capital. Nonetheless, employees
often (1) do not have the incentive to sustain physical capital, which may cause
inefficiency in the use of both human and physical capital; (2) are motivated to
maximize net revenues per worker rather than to maximize profit, which results in
the inefficient use of resources and production levels; and (3) are risk averse,
prefer a fixed wage, and may be unable to diversify their risks efficiently as
opposed to investors who are more risk neutral and able to diversify their
portfolios. The Enron debacle indicates that employees are motivated to invest in
their company, and when given the incentives and opportunity, they invest to their
maximum financial capacity without diversifying their investment portfolio.
The possible effects of employee ownership on corporate governance depend on
the type and extent of the ownership. First, employee ownership may result in
improved performance by employees and thus increase firm value. Second, in
some industries (e.g., steel, air travel, trucking) employee ownership facilitated
employee or union representation on the board of directors. Nevertheless,
employee stock ownership quite often enables employees to have neither board
representations, nor voting control of their shares, nor the right to decide whether
to tender their shares in the event of a takeover board of directors. Stock held in
profit-sharing trusts, ESOPs, and pension funds are controlled by the trustees,
which entitle them to mirror voting according to employees' wishes.
Employee ownership has significantly increased. Employees can be turned into
share-holders in several ways: (1) buying their company stock as part of a pension
fund or 401(k), (2) participating in an ESOP, or (3) obtaining stock through an
individual reward package. Employee ownership causes employees to feel some
loyalty to the company and may result in a better alignment of their interests with
those of shareholders.
EMPLOYEE ROLES IN CORPORATE GOVERNANCE
Employees contribute to company value creation through the utilization of their
human skills. Employees are often motivated to do the minimum to sustain
continuation of their employment rather than make improvements in their
performance that would result in the maximization of company value. This goal of
company value maximization can be achieved when employees own the company's
shares. Senior executives and skilled employees should be provided with
incentives through compensation plans consisting of restricted stock and stock
options. The employees' total compensation should be divided into (1) performance
of the assigned job, and (2) performance of firm-specific skills. Performance of the
assigned job should be compensated through salary-based pay, whereas
performance of firm-specific skills should be compensated through stock
ownership to encourage employees to devote these skills to the company.
Employees play important roles in corporate governance in a variety of ways. First,
employees, as the most important human capital in the company, work toward the
achievement of sustainable and enduring performance. Second, employees are
regarded as investors by owning corporate shares through their retirement plan,
savings plan, 401(k) plan, or a separate ESOP. Although employees do not have
the legal right of participating in the oversight of retirement plans, they rely on
plan trustees to exercise oversight functions on their behalf. Thus, employees,
through retirement plan administrators, indirectly engage in monitoring their
company's corporate governance. Third, recent reforms empower employees to
participate in the monitoring function by requiring the company's board or its audit
committee to establish whistleblower programs encouraging employees to report
corporate misconducts, fraudulent financial activities, or violations of applicable
laws, rules, and regulations without the fear of retaliation. An effective
whistleblower program should improve corporate governance.
There are several advantages of employee participation in corporate governance.
First, through ownership of company shares, employees have more incentives to
align their interests with those of shareholders. Second, employee involvement in
corporate governance is a learning process for employees to advance their position
and improve the company's operational efficiency. Third, employee participation in
corporate governance can be regarded as an internal mechanism to monitor
managerial performance and prevent management opportunistic conduct. The only
concern is whether employee governance and monitoring conflict with shareholder
governance and monitoring. Academic research suggests that these two forms of
governance are indeed complementary and mutually beneficial in the sense that
cooperative monitoring by both employees and shareholders provides more
incentives for management to align its interests with those of employees and
shareholders.15
EMPLOYEE CLASS ACTIONS
Financial scandals of the early 2000s resulted in several major bankruptcies of
high-profile corporations, including Enron and WorldCom, which caused
employees not only to lose their jobs but also their retirement and savings plans.
Enron employees subsequently brought a class action lawsuit that covers all 20,000
former Enron employees who were participants in or beneficiaries of Enron
Corporate Savings Plan [401(k) plan] from January 20, 1998 through December
2,2001, and who held investments in Enron stock, as well as participants of the
Enron stock ownership plan or cash balance plan. Enron employees sued the board
of directors, board committees, executive and nonexecutive directors, and officers
of Enron on the grounds that they failed to disclose the company's true financial
condition.
In many cases, the settlement of employee class actions suits causes changes in
corporate governance mechanisms to protect employee rights. In 2004, Board
Analyst Alert tracked the association between corporate governance effectiveness
(board effectiveness) and securities claim action suits and found that (1) most
securities class actions were triggered by substantial drops in stock prices or one or
more significant financial restatements by the defendant firm, (2) strong
relationships exist between board effectiveness ratings and the incidence of class
action suits, and (3) high-risk companies were about three times more likely to
become the subject of a class action filing than low-risk companies.16
SUMMARY
In the post-SOX era, institutional investors have continued their monitoring of
public companies and attempted to influence governance of companies in which
they invested by putting forth many proposals intended to improve corporate
governance effectiveness. In summary, an effective monitoring function can be
achieved when shareholders are allowed to (1) vote their shares by proxy
regardless of whether they attend the meetings in person, (2) cast their votes
confidentially, (3) cast the cumulative number of votes allotted to their shares for
one or a limited number of board nominees, (4) approve changes in corporate
policies and practices that may alter their relationship with the company, (5)
nominate directors for election to the board, (6) submit proposals for consideration
at the company's annual meetings, and (7) take legal or seek regulatory action to
protect and enforce their ownership rights. Shareholders have the ultimate power to
exercise control of a company to ensure value creation and enhancement.
The key points of this chapter are

 The monitoring function of corporate governance is the direct

responsibility of shareholders and other stakeholders, and can be
achieved through directparticipation of investors in business and
financial affairs of corporations.
 Shareholders play an important role in monitoring public companies
to ensure the effectiveness of their corporate governance and
strengthen shareholder rights by (1) providing timely access to
information, (2) enhancing shareholders' rights, and (3) promoting
shareholder democracy.
 Institutional investors can play an important role in reducing
information asymmetry between management and shareholders by
obtaining private information from management and conveying that
to shareholders and, thus, the capital markets.
 Employee participation in corporate governance can influence
managerial control and authority, and can influence employee
participation in decision making and cooperation in the
implementation of decisions.
 Institutional investors influence the governance of public companies
in which they invested by putting forth proposals intended to improve
corporate governance effectiveness.

KEY TERMS
blockholding
employee class actions
free-rider problem
institutional shareholder
intercorporate networks
property rights
security class actions
shareholder democracy
REVIEW QUESTIONS
1. What are the interrelation factors on which the effectiveness of the
monitoring and control function by investors is based?
 2. Explain the two alternative modes of financial mediation between
households (investors) and corporations.
3. Discuss the five rules that the Business Roundtable recommends for
fair and respectful treatment of shareowners and their views.
4. What are the policies and procedures that should be established by
the nominating committee to better enhance the viability of
shareholders' nominations?
5. What situations can lead to institutional investor intervention with
the invested company?
6. How can institutional investors participate in the corporate
governance of the company?
7. Explain the advantages of employee participation in corporate
governance.
DISCUSSION QUESTIONS
1. What factors and opportunities have led to the movement of direct
individual ownership of stocks to a more institutional ownership
structure?
2. Should investors share some of the blame for reported financial
scandals for their lack of monitoring of their companies' governance?
Why?
3. Traditionally, the accountability and transparency between the board
and shareholders have not been effective in the sense that the board
was not informed of what shareholders were expecting of it, and
shareholders were not aware of the board's activities and its
effectiveness. What should be done about this communication gap?
Substantiate your answer.
4. Describe the importance of shareholders' proactive participation in
the nomination and election of corporate directors.
5. Do you believe that the extent of shareholders' participation in the
election of directors is limited to the rubber-stamp process of
affirmation? Explain the given statement.
6. Elaborate on the following statement: “In modern corporations,
particularly in the era of technological advances, labor resources are
becoming an important part of corporate governance as capital
resources.”
7. Describe shareholder voting rights and effective ways to exercise
those rights.
8. Discuss shareholders' participation in monitoring their companies'
affairs, decisions, and corporate governance.
 9. Describe how shareholder proposals can influence corporate
governance.
NOTES
1. Bogle, J. C. 2005, October 3. Individual Stockholder, R.I.P. [Opinion]. The Wall Street Journal October 3.
Available at: online.wsj.com/article/SB112829417598858002.html.

2. Jackson, G., and S. Vitols. 2001. Between Financial Commitment, Market Liquidity and Corporate Governance:
Occupational Pensions in Britain, Germany, Japan and the USA. In Comparing Welfare Capitalism: Social Policy
and Political Economy in Europe, Japan and the USA, edited by B. Ebbinghaus and P. Manow. Routlege, London.

3. Zysman, J. 1983. Governments, Markets and Growth: Finance and the Politics of Industrial Change. Cornell
University Press, Ithaca, NY.

4. Windolf, P., and J. Beyer. 1996. Co-operative Capitalism: Corporate Networks in Germany and Britain. British
Journal of Sociology 47(2): 205-231.

5. Pender, K. 2006. Board Drama in East. San Francisco Chronicle September 10, p. F-1. Available
at: www.sfgate.com/cgibin/article.cgi?file=Chronicle/archive/2006/09/10/BUGJ9L1IPA1.DTL.

6. U.S. Securities and Exchange Commission (SEC). 2007, July 27. Shareholder Proposals and. Releases 34-56160
and 34-56161. Available at: www.sec.gov/rules/proposed/2007/34-56160.pdf; U.S. Securities and Exchange
Commission (SEC). 2007, July 27. Shareholder Proposals Relating to the Election of Directors. Available
at: www.sec.gov/rules/proposed/2007/34-56161.pdf.

7. CalSTRs' Ethical Victory. 2003. Financial Times August 25.

8. London Stock Exchange. 2004, July. Corporate Governance: A Practical Guide. London Stock Exchange,
London. Available at: www.londonstockexchange.com/NR/rdonlyres/C450E4FC-89C2-4042-804A-
685855FF217B/0/PracticalGuidetoCorporateGovernance.pdf.

9. Commission of the European Communities. 2003, May 21. Communication from the Commission to the Council
and the European Parliament: Modernising Company Law and Enhancing Corporate Governance in the European
Union—A Plan to Move Forward. Available at: europa.eu.int/eurlex/lex/LexUriServ/site/en/com/2003/
com2003_0284en01.pdf.

10. Gillan, S. L., and Starks, L. T. 2003, August. Corporate Governance, Corporate Ownership, and the Role of
Institutional Investors: A Global Perspective. Weinberg Center for Corporate Governance Working Paper No. 2003-
01. Available at: ssrn.com/abstract=439500.

11. U.S. Congress. 1940. Investment Company Act of 1940. Available at: www.sec.gov/about/laws/ica40.pdf.

12. U.S. Securities and Exchange Commission (SEC). 2005, April. Exemptive Rule Amendments of 2004: The
Independent Chair Condition. A Report in Accordance with the Consolidated Appropriateness Act, 2005. Available
at: www.sec.gov/news/studies/indchair.pdf.
13. State Board of Administration (SBA) of Florida. 2006. Corporate Governance: Annual Report 2006. Available
at: www.sbafla.com/pdf%5Cinvestment%5CCorpGovReport.pdf.

14. Atlas, R. D., and Walsh, M. W. 2005. Pension Officers Putting Billions Into Hedge Funds. The New York
Times November 27. Available at: www.nytimes.com/2005/11/27/business/yourmoney/27hedge.html.

15. Boatright, J. R. 2004. Employee Governance and the Ownership of the Firm. Business Ethics Quarterly 14(1):
1–21.

16. Marshall, R. 2005, April 12. Research Highlights: Board Effectiveness & Securities Class Action Suits.
Available at: www.boardanalyst.com/alerts/alert_classaction_041205.html.