Electronic copy available at: http://ssrn.com/abstract=2249872

Short-termism of Institutional Investors and the

Double Agency Problem

Inaugural lecture

Given in abbreviated and modified form during the acceptation of the

office of professor in Corporate Governance & Capital Markets at

Nyenrode Business University on 25 June 2012

By

Prof. Dr. Paul Frentrop

Electronic copy available at: http://ssrn.com/abstract=2249872

2

Copyright 2012 Paul Frentrop

ISBN/EAN 978-90-8980-039-8

Nothing in this publication may be reproduced without the written permission of the

author.

Index of contents

Short-termism of institutional investors and the double agency problem 1

Index of contents 3

1 Preface 5

2 The publicly traded company 10

3 The advent of the institutional investor 20

4 What does the long term mean? 29

5 The first agency issue 37

6 The second agency issue 43

7 Conclusion 51

Appendix: The long debate on the short term 61

Literature 73

4

I have always been conscious of the fact that every guilder we spend as a

government, we take from people, and that we should not spend their

money lightly. [] One should use public resources as a gentleman would

handle someone elses money, that is, even more carefully than his own

money. Willem Drees.1

1 Drees. Zuinigheid. CD 2, no. 4.

1 Preface

A hundred years ago, in May 1912, the US House of Representatives

appointed a special committee named the Pujo committee after its

chairman. Its aim was to investigate the influence of large financiers, who, it

was feared, controlled the major part of the American business community.

This Money Trust had to be brought down. And that is precisely what

happened.2

Do we need a similar committee in the Netherlands? After all, nowadays

board members of publicly traded companies are complaining that the

constant pressure from investors who are exclusively focused on the

quarterly figures is keeping them from making long-term investments.3 And

in some cases, such opinions from managers reach the world at large.

This took place, for example, in 2006, when Henk van der Kolk, the

chairman of Dutch trade union FNV Bondgenoten, said that in actual

practice he noticed that as a result of the threat of takeovers companies

were induced to place greater focus on the near term: I hear this from

captains of industry at Philips, Akzo and Unilever. The power relations have

drastically changed. Board chairmen allow their policies to be guided in part

by the possibility that their organisation will become an acquisition target.

They want to increase shareholder value as quickly as possible. And before

you know, this has a negative impact on the investments in innovation and

research, which are precisely what fosters long-term business continuity.4

Van der Kolks opinion was backed up by Aad Jacobs, a former investor

and at the time the Chairman of the Supervisory Board of Royal Dutch

2 The findings of this committee were presented in a series of articles by Louis Brandeis, which were bundled in a 1914 publication entitled Other Peoples Money and how the bankers use it. 3 Culpepper (2011) provides insight into the way in which such topics are introduced into the political debate. 4 NRC Handelsblad, 26 August 2006. FNV Bondgenoten introduced a plan consisting of seven points that were to stop the practice of stripping, plundering and demolishing companies. Partnoy and Thomas (2005) illustrate that this was a period in which American hedge funds became increasingly active in enforcing changes in corporate governance.

6

Shell and VNU. In Jacobss view, the new breed of active investor placed

too much focus on the near term [..] and the parting with long-term

shareholders would put prudent entrepreneurship under pressure. That

said, anyone will react testily when called a short-term investor. If you ask

fund managers, they all consider themselves to be long-term investors. But

in the meantime, they only keep shares in their portfolio for a few months

on average. And they will drop their stake in a company at the least sign of

adversity. The quarterly performance is sacred. 5

One of the lessons that the Dutch Socialist Party (SP) derived from the

credit crisis in 2008 was the following: The excessive power of

shareholders should be drastically curbed. On average, shares now change

hands within the space of a single year. Shareholders focus too much on the

near term. The power of shareholders, which was radically expanded in

2004 as a result of the modification of the Structuurwet [Dutch Two-Tier

Entity Act], should now be fundamentally limited. 6

In December 2011, Antony Burgmans, the chairman of the Banking Code

Monitoring Committee, asked the Dutch Central Bank (DNB) to organize a

debate on the question of whether banks require additional protection

against shareholders who are focused on the near term. Can we ignore this

many worries? Do investors represent a liability as a result of their short-

term inclinations?

At the same time, many people are of the opinion that major investors

should, on the contrary, interfere more in the policies of enterprises.7

Perhaps because interfere has pejorative connotations, they use the term

engagement. Led by their engagement, investors should encourage

companies to improve their behavior with the regard to the environment,

social issues and governance.

5 Financieele Dagblad, 15 February 2006. 6 As early as 27 October 2008, the SP presented the report Lessen uit de Kredietcrisis [What the credit crisis has taught us], written by Agnes Kant and Ewout Irrgang, then financial chairman and spokesman for the SP parliamentary fraction, respectively. It is obvious why the SP was able to derive that many lessons so quickly: the socialists had been waiting continuously for the predicted crisis in the capitalist system to occur. 7 On 9 January 2002, in a speech entitled Institutionele beleggers en corporate governance: belegger of aandeelhouder? [Institutional investors and corporate governance: investor or shareholder?] at a symposium of Stichting Corporate Governance Onderzoek voor Pensioenfondsen [Corporate Governance Research for Pension Funds Foundation], Dutch Finance Minister Zalm urged insurers and pension funds to exert their control rights more actively.

In the United Kingdom, this obligation has already been laid down in the

Stewardship Code (2010). In the Netherlands, the investors platform

Eumedion regards this as a best practice for its participants (2011). All

around the world, investors are signing agreements stating they will fulfill

the PRI principles of the United Nations, which were drawn up in 2005. In

doing so, they commit themselves to being an active owner of the

company rather than a passive shareholder.

It seems there is a certain ambiguity at issue here. Are investors involved

too much or too little in corporate policymaking? The Dutch House of

Representatives knows how to handle this type of paradox. For years, it has

taken the view that short-time investors should be kept at bay, if not

penalized, while long-term investors should be rewarded.8 Short term is bad

and long term is good seems to be the political motto.

It is a duty of the academia to put commonly held assumptions to the test.

In general, shareholders do not have much say at publicly traded companies,

and so far no clear-cut empirical answer has been given as to whether they

foster short-term thinking.9 It is also difficult to determine the nature of the

interaction between the management of companies and shareholders.

What happens on the stock exchange, however, is visible at a glance.10

Shares are changing hands much faster than in the past. On various stock

exchanges worldwide, between 1991 and 2009 turnover increased from 1.7

to 9.9 times more quickly than the price of the shares.11 This development

is due in part to their use of new technological capabilities.12 Or can this

perhaps also be attributed to new behaviors of existing shareholders? In the

1940s, American investors held on to their shares for seven years on

average, and this term would hardly change until midway through the 1970s.

From that point onwards, the retention period progressively decreased. By

the time of the stock market crash of 1987, this period had already

diminished to less than two years. Around 2000, the threshold of one year

8 See Appendix. 9 Dent (2010) does not think this is the case; Haldane (2011) suggests that it is. 10 Although we no longer have a full view of all the trading on stock changes. Part of it takes place via private trade exchange platforms and dark pools. 11 OECD (2012). 12 High Frequency Trading represents an estimated 30 40 % of the European stock trading market (Haldane, 2010) and more than half the trade volume in the United States, compared with 26% in 2006. (research by the Tabb Group, cited in Wall Street Journal Europe, 10 May 2012).

8

was broken, and in 2007 the average period that a stock would not change

hands in the United States remained stable at seven months.13

For Dutch investment funds that publish their turnover figures, turnover

velocities strongly vary, but on average they retain stocks in their portfolio

less than a year.14 Pension funds do not publish the retention periods for

shares, although it seems likely that in the forty years that an employee

accumulates his pension, the pension funds portfolio will be completely

change at least eight times.15

Turnover velocity of domestic shares in %

16

1995 2000 2005 2009 2010

NYSE (USA) 55.5 87.7 99.1 158.7 130.2

Nasdaq 228.1 383.9 250.4 492.3 340.4

NYSE (Eur)17 43.5 97.6 112.8 83.9 76.5

London SE 40.5 69.3 110.1 91.1 76.1

Tokyo 26.0 58.5 115.3 119.7 109.6

Hong Kong 34.3 60.9 50.3 79.0 62.2

Small wonder, then, that references to increasingly short-term thinking find

fertile ground. The directors of listed companies say, what business do I

have with shareholders who will be gone next year?

But how does stock trading relate to enterprise policy? How does the

increased stock trade impact companies, institutional investors and

corporate governance (the interaction between the two)? Is it true that

institutional investors are increasingly focused on the near term? And if so,

does this make companies less inclined to make long-term investments? In

13 Haldane (2010). 14 Looking at more than 50 stock funds of ING(L), the Invest Europe Opportunities Fund reports turnover of 479 per cent for 2011, while the Japan Fund has a yield of less than 2 per cent. Approximately half the ING (L) funds have turnover of over 100 per cent. 15 Slager (2012). 16 Source: www.world.exchanges.org/statistics. It should be noted that the data on stock trading requires further analysis. For instance, in 2010 trading at the London Stock Exchange represented 1,976 billion Pounds Sterling, as compared with 1,952 billion Pounds Sterling last year. Combined with the trading at the PLUS Market as well as various Multilateral Trading Facilities, the value of the stock trading in London represented 3,340 billion Pounds Sterling in that year. (Source: Trends in UK Financial and Professional Services, www.thecityuk.com) 17 The data up to and including 2000 apply to the Amsterdam exchange.

that case, should policy be created to counter this trend? These are

questions that will we will delve into in this discussion.

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2 The publicly traded company

I recently read about a small Somali town named Harardhere that features a

exchange where people can buy and sell shares in planned pirate ventures.

There is a lively trade. The financiers and their political allies eventually

receive half the ransom, which amounts to between 3 and 5 million Euros

per vessel. The other half of the ransom is divided among the crew (30 per

cent), the ground troops (10 per cent) and the local warlord. [..] And there is

a incentive prize in the form of a single passenger car. This is the usual

reward for the pirate who is the first to board the targeted ship.18

Those who are surprised to hear that stock trading takes place in such a

seemingly remote location will know what the king of Hispania felt four

centuries ago when confronted by the flourishing stock trading in the

remote city of Amsterdam, where the Dutch East and West Indies

Companies brought ashore the goods they had seized, for the benefit of

their shareholders and the local warlord a certain Maurits, the son of

William of Orange.

What we see happening in Harardhere in 2012 and what has been going on

in Amsterdam since 1602 is the creation of the publicly traded company.

The stock market and this company are not separate phenomena.

Companies (organizations) can spontaneously create a capital market

(institution), just as the foundation of football clubs results in a football

league and subsequently a market for players and coaches.

It is a misconception to regard the stock exchange and companies as

opposites. It is not as if industrious producers in cities and villages create

long-term value by manufacturing sustainable goods while speculators on

the exchange floor rush companies to a certain death in their relentless hunt

18 Elsevier 2 April 2012.

for short-term profit. On the contrary: listed companies and the capital

market share as much of a symbiosis as flowers and bees. Stock exchanges

help listed companies and vice versa.

If stock trading was not possible in Harardhere, the lives of pirates would

be much more difficult. It would cost would-be pirates substantially greater

effort to collect the funds required to purchase of a vessel and weapons

from friends and acquaintances if the latter did not know they can monetize

their stakes at any given moment, even before the pirates set sail or while

they are still at sea.

Once a pirate has collected the required funds and starts looking for a

vessel, a crew and ammunition, the capital market will remain of use to him.

Lets say that one of his friends has invested a hundred Euros and suddenly

falls ill or gets hurt (which I presume is a likely risk in a place like

Harardhere). He now has to buy medication and needs his money back.

Even a hardened pirate will not refuse such a request, but will then fall a

hundred Euros short, which may jeopardize his entire expedition. However,

thanks to the stock market, the company (pirate) does not have to return

the money. The unfortunate investor can simply sell his share to another

investor, while the capital invested in the company remains unchanged and

the pirates venture can continue.

The ability to trade shares allows companies to invest over a longer term

than the investment horizon of every participating shareholder. The capital

market offers investors liquidity, without any cost to the company.

The investment horizons of shareholders are no longer relevant. There will

be shareholders who quickly sell their shares because they need the

money for other purposes, or because they have found a better investment

for their funds. There will be shareholders who will refrain from buying or

selling for a long period. In short, there are short-term investors and long-

term-investors among the shareholders. The great thing about publicly

traded companies is that they cater to both types of investors through the

capital market. People are free to buy or sell shares, with no detriment to

the company. The composition of the general meeting of shareholders may

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constantly change, while the company can simply continue to execute its

strategy.

In this light, it is surprising that people fear the influence of short-term

shareholders. After all, publicly traded companies are intended for

shareholders with an investment horizon that is shorter than that of the

company.

The number of shareholders

In the 21st century, which started off with WorldOnlines IPO and that

recently bought us that of Facebook, it is only natural that people should

think companies only go public because the founders, their inheritors or

private equity parties want to cash in. However, 21st-century Harardhere

and 17th-century Amsterdam teach us otherwise. Publicly traded companies

are spontaneously created when a company in this case a family company

active in the field of piracy attracts a large number of shareholders. It is

irrelevant whether the company has sought out these investors because it

needed plenty of capital to buy a ship or that the number of

shareholders has grown because the pirate fathered a great many sons.

If the number of shareholders exceeds a certain threshold, the nature of the

company19 will change and its stocks will be traded. After its foundation in

1602, the Dutch East India Company attracted 1,200 shareholders in a very

short period, which quickly resulted in the trading of its shares. The British

East India Company, which was founded in 1600, only had 200

shareholders, as a result of which its shares were not traded in London.20

It is impossible to exactly determine the critical threshold at which stock

trading arises. However, at a certain moment there will be enough

shareholders who want to monetize their stake. We still see this with family

companies, who will have hundreds of third-generation shareholders before

their IPO takes place. And in the United States, shares in high-tech

companies are already traded before the IPO. Oftentimes this is the case

19 In which supervisory directors will become active, Den Boogert (2005), and agency issues will arise, which we will discuss in further detail later. (p. 36) 20 Frentrop (2002), Harris (2004). London investors had to wait for their money until the fleet returned and the ships and their cargoes were sold. They could then decide whether they would invest in a new journey to the East.

because employees have received shares as a bonus, but are in need of

cash.21

In the United States, the Exchange Act 1934 requires companies with more

than 500 shareholders to register as a public company and to publish their

results each quarter. In March 2012, this threshold was increased to 2,000

through the new Jobs Act. These numbers remind us of the Dutch East

India Company from four centuries ago. I dare say that if there is indeed a

flourishing trade in pirate shares in Harardheere, more than 200 people will

participate in the financing of a single pirate venture.22

In short, if the number of shareholders rises above a certain threshold, trade

in the companys stock will arise, thus creating an official or unofficial

capital market. The benefits of such a market are not limited to the

company, as described above. The market offers anybody who is interested

and has the necessary resources the possibility to take part in the

company value creation process.

Social value

In a system of business-centered production, companies create affluence

in the first instance for the people who work there, but also for their

shareholders. Without publicly traded companies there would be few

shareholders. Listed companies, which are characterized by their large

numbers of shareholders, offer a large part of the population direct access

to value creation through business-centered production. The advent of the

publicly traded company in the 20th century disproved the 19th-century

Marxist fear that a small elite of entrepreneurs would eventually control all

means of production. Publicly traded companies are socializing machines.

They work even better than regular companies. Through the capital market,

they voluntarily distribute income and capital in a way that is at least as

effective as the imposition of taxes by governments.

21 In 2010, American companies financed with venture capital typically existed 9 years before their IPO, as opposed to 4 years in 1999 (source: National Venture Capital Association). This longer period may be the result of bad experiences during the tech-wreck of 2000-2002. However, it does offer new opportunities for investors specialising in pre-IPO trade (Wall Street Journal Europe, 12 April 2012) as well as investment funds, which often invest 15 per cent of their capital in private companies. That does in fact result in new issues, as became apparent during Groupons IPO in 2011. A year earlier, Fidelity, T. Rowe Price, Capital and Morgan Stanley Investment Management had bought $450 million in shares, to which each attributed a highly different value in their accounts. 22 In which case I also assume that people will not entrust a single pirate with all their money, but rather distribute their investments among various pirate ventures.

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Unfortunately, this process is insufficiently visible. Publicly traded

companies do report their number of employees, but do not state the

number of shareholders because they have no way of telling. One can

observe, however, that the ratio between employees and shareholders is

changing. Industrial enterprises with hundreds of thousands of laborers can

be found in China, but are increasingly scarce in the West. As a result of

technological developments, companies outsource more and more of their

production process,23 or are able to create major added value with just a few

employees. During its IPO in 2012, Facebooks value was estimated to be

over $100 billion, while the company only had 3,000 employees.24 On the

capital market, high-tech companies rank among the most valuable

organizations, but on the labor market they are very minor players in

comparison with, say, the service industry.

Number of employees by the end of 2010

Selected stocks Ten largest publicly listed American employers

Microsoft 93,000 Wal-Mart 2,100,000

Intel 79,800 IBM 436,000

Cisco 65,550 UPS 400,000

Apple 34,300 McDonalds 400,00025

Amazon.com 24,300 Target 355,000

Google 19,385 Kroger 338,000

Total 316,785 Hewlett-Packard 324,000

Sears 312,000

Of which in the US 212,485 PepsiCo 294,000

Bank of America 288,000

In the first place, companies offer their employees affluence in exchange for

labor. But publicly traded companies do more than that. They not only

offer their employers a salary, but also and increasingly ensure the

pensions of other people who are shareholders through their pension fund:

The fact is, corporations increasingly are vehicles for providing retirement income. 26

23 Davis (2011) p 1136. With a workforce of 800,000, Hon Hai Precision Industry is the worlds largest industrial employer. 24 A month before the IPO, this number had increased with 11 per cent following the acquisition of Instagram. Facebook paid $1 billion in (predominantly) shares for this company, which had been founded just 2.5 years earlier. 25 1.7 million including franchisees. As far as is known, there are only two organisations in the world who employ more people than Wal-Mart. These are the American army (3.2 million) and the Chinese army (2.3 million in 2008). 26 Richard J. Mahony in: Who really owns corporate America?(1996). This quotation was already included in Corporate Governance in Nederland. De Veertig Aanbevelingen [Corporate Governance in the Netherlands. The Forty Recommendations] (1997), the first report on corporate governance in the Netherlands.

This observation has lost nothing of its power. For instance, in February

2012, the Kay Review of UK Equity Markets and Long-Term Decision

Making prefaced its interim findings with the statement that Equity markets

are principal means by which savers can contribute to, and share in, the success of British

business. Many people who know nothing of the stock exchange participate in equity

markets through their pension funds and other vehicles of long term investment.27

With the current issue of ageing, in view of the public benefit we should

wish for an increase in the number of publicly traded companies in which

employees of other companies can invest through their pension fund.

However, in these parts this does not seem the case quite on the

contrary!

Are publicly traded companies in danger of extinction?

Virtually everything you see, hear or read in the news about the business

sector is related to publicly traded companies, which as a consequence form

the basis of virtually every political discussion on the business community.

However, in fact there are only few companies that are at liberty to trade

their shares, which is a characteristic of publicly traded companies.

In the Netherlands, in 2010 CBS [Statistics Netherlands] counted more than

860,000 businesses. Of these companies, over 220,000 were private limited

liability companies, while less than 800 had the shape of a public limited

liability company. Approximately 12 per cent of the latter companies are

publicly traded companies. In the Netherlands, this amounts to

approximately a hundred companies, or 0.0125 per cent of the Dutch

business community. Despite all the publicity that publicly traded

companies generate in terms of headlines, they constitute an almost

homeopathic part of the business community.28 For the sake of

comparison: private equity funds alone invest in ten times as many Dutch

companies as are publicly traded (almost 1,100).29

On a worldwide level, there were 48,744 publicly traded companies at the

end of 2011. What is striking is that these companies seem to exist in

27 Kay Review, Interim report, February 2012. 28 Although publicly traded companies on average are much bigger in size than their unlisted counterparts. 29 According to the Ondernemend Vermogen [Entrepreneurial capital] study by the Nederlandse Vereniging van Participatiemaatschappijen [Dutch Association of Venture Capital Companies].

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colonies: only seven countries accommodate half of all publicly traded

companies. The top twelve countries represent two thirds of the total

number of publicly traded companies. The size of these colonies has little to

do with the size of the economy. For instance, since 2009 India has had

more publicly traded companies than the United States, while Pakistan has

more than Germany.30

Number of publicly traded companies at year-end 2011

31

1 India 5,112 7 UK 2,001

2 United States 4,171 8 Australia 1,922

3 Japan 3,961 9 South Korea 1,792

4 Canada 3,932 10 Hong Kong 1,472

5 Spain 3,241 11 Serbia 1,323

6 China 2,342 12 Romania 1,267

If we limit ourselves to companies listed in decent countries (defined as

countries that offer shareholders adequate legal protection)32, the worldwide

number of companies that allow shareholders to more or less buy shares

with peace of mind would amount to 16,689. Considering the fact that the

number of polar bears in the Arctic is estimated to be 30,000 and that they

are considered by many to be a species threatened with extinction, we

cannot take the continued existence of the publicly traded company in the

longer term for granted.

This is all the more so because the number of publicly traded companies is

decreasing in Europe and the United States. In December 1998, the Dutch

Monitoring Commissie Corporate Governance [Corporate Governance

Monitoring Commission] wrote a letter to exactly 208 public companies for

its first research study. Nowadays, this only requires half the number of

letters.

30 Davis (2011) p 1135. 31 World Bank, World Development Indicators, Listed Domestic Companies. 32 Defined as countries with a score of 7 or higher in Transparency Internationals Corruption Index (2011) of Transparency and a score of 7 or higher in the Minority Investor Protection rankings of World Bank and IFC.

Development of the number of publicly traded companies33

1988 2000 2011 2000/2011

The Netherlands 232 23434 108 - 54 %

Belgium 186 147 158 - 19 %

France35 646 808 893 + 11 %

Italy 211 654 287 - 56 %

Germany 609 1,022 670 - 37 %

Switzerland 161 252 246 - 2 %

UK 2,054 1,904 2,001 + 5 %

USA 6,680 7,524 4,171 - 45 %

Australia 1,380 1,330 1,922 + 44 %

Japan 1,967 2,561 3,961 + 55 %

Hong Kong 282 779 1,472 + 89 %

China 0 1,068 2,342 +119%

In 1989, Michael Jensen predicted that American public companies would

become extinct. Following his prediction, their number grew by a third,

which led him to revise his opinion in 1997.36 However, between 1997 and

2009 the number of publicly traded companies decreased by half. Jensen

must be scratching himself behind the ears.

In 2002, I concluded my doctoral thesis with the warning that the continued

existence of publicly traded companies with a distributed share capital

should definitely not be taken for granted.37 Ten years later, just before I

finished this document, British magazine The Economist published a

briefing entitled The endangered public company.38 If the continued existence

of publicly traded companies will indeed come under threat, this would

mean a material shift in the economic order that was created in the latter

half of the 20th century around large enterprises with freely negotiable

shares. Lets investigate whether this development can be attributed to

institutional investors who, in their hunt for short-term profit, may not be

33 World Bank, World Development Indicators. 34 By the end of 2000, CBS counted only 143 public companies active outside of the financial sector. 35 On 22 September 2000, the exchanges of Paris, Brussels and Amsterdam merged to create Euronext. This is all the more striking because since that date, the total number of Belgian and Dutch public companies has halved in comparison with the number of French publicly traded companies. 36 Michael C. Jensen (1989) Eclipse of the public corporation. Harvard Business Review (67) p. 60 70 (Revised, 1997). 37 Frentrop (2002), p 408. 38 The Economist. (19 May 2012), pp 25 -27.

18

properly fulfilling their duties as shareholders.39 Because, as Dutch Finance

Minister Nelissen stated more than century ago in 1910, A healthy business

community cannot exist without the interest and co-operation, within the

circle of their competence, of the shareholders proper.

39 And leaving aside the question of whether this is the result of the increased regulation.

20

3 The advent of the institutional investor

Today the key agents in the investment chain

are professional asset managers.

Kay Review Interim Report, February 2012

Contrary to publicly traded companies, the number of institutional investors

is growing exponentially. While there are just over a hundred public

companies in the Netherlands, there are currently no fewer than 1,472

investment organizations.

One of the most striking developments with regard to the availability of

resources since the Second World War is the continued shift from private to

institutional investors, wrote Jaap Koelewijn almost twenty years ago.40 In

its report on 1997/1998, the Bank for International Settlements (BIS)

described the collectivization of asset management as one of the most far-

reaching changes in the capitalist financial system of the last few decades.

This movement started around 1980 and has lost none of its force since.

This particularly applies to the Netherlands, where citizens are feeling the

pressure from fiscally stimulated debts and mortgages, while the

investments of institutional investors keep growing more quickly than the

gross national product, particularly with regard to fiscally stimulated pension

savings.

In 1990, the volume of these investments equaled 119 per cent of the

Dutch GDP. In 2000, this amounted to 199 per cent, and in 2010 the

40 Koelewijn (1993).

investments represented 255 per cent of the GDP, the equivalent of 1,500

billion Euros.41

The advent of institutional investors in countries such as the United

Kingdom and the United States since the 1980s has been exhaustively

documented as well.

So what is an institutional investor? In the framework of the long-term

approach, it would seem a good idea to first remind ourselves of a

definition dating back to the time before this phenomenon was introduced.

In 1981, on the occasion of the 100th anniversary of one of the oldest

institutional investors in the Netherlands, the Rijkspostspaarbank, its

director delivered a speech before the attendees which he entitled Van

institutionele belegger naar rentemargebedrijf [From institutional investor

to interest margin company]. During this speech, he argued, We promote

savings through deposit books, which has resulted in the accumulation of

funds. And these funds, after all, have to be invested. Therefore, I would

define an institutional investor as follows: an organisation that regards the

investment of funds on the capital market as a necessary evil that is

associated with its principal duty.42

Nowadays, investing has grown from a necessary evil to a commercial

activity that allows a lot of people to make a living. CBS [Statistics

Netherlands] defines an institutional investor as an organisation that

disposes of funds that have to be invested. It distinguishes these

organizations into three types: pension funds, insurers and investment

organizations.43

According to the Dutch dictionary Van Dale, the phrase dispose of used

by CBS means to obtain the authority to use something at ones own

discretion. This power of disposal leaves aside whether the money that

institutional investors dispose of is also the property of the investor. In a

strictly legal sense, this is usually the case. For instance, pension funds are

41 CBS (2011). 42 He continues, And this principal duty in those days was clearly to promote and facilitate savings through the ubiquitous apparatus of post offices. The concepts of client and market share hardly existed at the time. 43 In this connection, it should be noted that open-end investment funds actually constitute a different breed of institutional investor. After all, their capital can be claimed by its shareholders any day. In the United Kingdom, the public seems to acknowledge this. In that country institutional investors are regarded as primarily pension funds and life insurance companies. (Paul Myners, Institutional Investment: a Consultation Paper, May 2000).

22

the owners of the funds they manage.44 Nevertheless, many entitled parties

regard the pension capital as their money.

This ambiguity is reflected in the definition of institutional investors used by

the OECD: institutions which collect funds from investors to invest on their behalf but

in the name of the institution. They are thus an owner but not a final, beneficial

owner.45 In this framework, I would venture to define institutional investors

as managers of other peoples money.

What do institutional investors do with other peoples money? Lets first

return to yesteryears approach: With regard to our investment policy, we

determined the need to achieve shorter terms [with a view to increasing the

interest on savings accounts PF], and real estate was the first thing to go

[..] Stock investments were also seen to offer a suboptimal match with the

passive operations and kept at a low level. I will not go into the social and

perception consequences for our organisation, but you can imagine that the

departments involved still suffered from this despite their major

understanding, commented the director of the Rijkspostspaarbank in 1981,

who still simply invested his funds in government bonds.

He was the last institutional investor to think like this. Since the 1980s, an

increasing portion of this growing institutional capital is invested in the

shares of publicly traded companies. This growth in institutional capital,

combined with the shift towards shares, has made institutional investors the

most important shareholders of public companies. Between 1980 and 1996,

institutional investors doubled their market share in publicly traded

American shares.46

To the best of my knowledge, no-one disputes the estimation that 80 per

cent of all shares listed at American and European exchanges are now in the

hands of institutional investors. This implies that in the past forty years,

shareholders of public companies have changed from affluent private

individuals who invested their own money into managers of other peoples

44 Maatman (2004) p 7. 45 OECD (2011). In other words, the OECD does not consider banks to be institutional investors, but it does regard the banks asset manager as an institutional investor. 46 Gompers and Metrick (2001).

money and who, as mentioned earlier, can be distinguished into three

subcategories: insurers, investment funds and pension funds.

Depending on the national regulations, insurance companies traditionally

invested part of their reserves in shares. Stock investment funds were

introduced approximately 90 years ago, but remained limited in size for a

long period.47 Their growth took off in the United States and was

additionally fuelled by a change in tax legislation in 1981, which allowed

companies to offer their employees 401(k) plans as an addition to and

eventually replacement of traditional defined benefit pensions. Private

individuals invested their money in investment funds on a massive scale.

Whereas in 1983 twenty per cent of all American households invested their

money in the share market, by 2001 this number had increase to more than

50% through investment funds.48

In 1989, the investments of American investment funds for the first time

exceeded the milestone of $1,000 billion. By the end of 2010, almost 8,000

investment funds had been registered in the United States. Collectively, they

managed $11,821 billion.49 The United States represent approximately half

of the capital of investment funds, which, however, can also be found in

other parts of the world. Just like publicly traded companies, investment

funds have a tendency towards clustering, albeit in very different locations.

In Europe, they are predominant in Luxembourg, where by the end of 2011

almost 4,000 funds managed a total of 2,096 billion Euros.50 Approximately

10,000 investment funds have registered offices in the Cayman Islands.

Collectively, they managed $1,561 billion.51

Pension funds are latecomers to the share market. It was not until 1980 that

they substantially expanded their investments in shares.52 Corporate pension

47 As with so many developments in the financial sector, there is occasion for some Dutch national pride. Adriaan van Ketwich, who in 1774 invited investors to take part in Eendragt Maakt Magt to offer investors with limited means the possibility of greater diversification, can be regarded as the first provider of investment funds. (Slot, 2004, based on Berghuis, 1967). 48 A development that, according to Davis (2011), has contributed to a broad support for thinking in terms of shareholder value creation as a business objective. 49 2011 Investment Company Fact Book (www.icg.org). 50 Source: Commission de Surveillance du Secteur Financier (CSSF) website. 51 At year-end 2009, according to the Cayman Islands Monetary Authority (CIMA). 52 In 1954, the pension fund of Imperial Tobacco at the time the largest British pension fund was the first to decide to invest in shares in addition to bonds. Gradually, the allocation standard became 60/40 for bonds/shares.

24

funds spearheaded this development; the others followed in their

footsteps.53

In the Dutch context, this group of organizations is of special importance.

While in other developed countries insurers, investment funds and pension

funds approximately have the same size in terms of invested capital54, in the

Netherlands pension funds are the largest institutional investors. Research

by the Dutch central bank DNB55 shows that in the Euro zone the

Netherlands has the relatively largest pension sector with 1,200 billion

Euros in pension capital (the same amount as Italy, Spain and Belgium

together).56 Sixty per cent of this capital is invested abroad. What is relevant

to our discussion is that towards the end of 2011, Dutch pension funds had

invested almost half their total capital in shares of national and (mainly)

foreign public companies.57

A difference between pension funds and other institutional investors is that

pension funds generally keep very a small stake in a single company (less

than 2 per cent of the total number of shares). Insurers traditionally take

larger stakes (5 - 10 per cent). In the United States, as a result of the large

flow of capital to a limited number of large investment funds, some of these

funds hold much greater stakes in companies. For instance, at the end of

the 1990s, Fidelity was the largest shareholder in 1 out of 10 of American

companies, often with a stake of 10 - 15 per cent or higher.58

Since the beginning of the 1980s, the worldwide stock markets have been

marked by this shift from private to institutional investors. On the one

hand, institutional investors took over the role that private investors had

played in the past. This particularly applies to investment funds.

Institutional investors also brought new capital to the share market on

behalf of people who would never have thought of entering that market.

This is particularly true for pension funds.

53 In his column in Dutch newspaper NRC Handelsblad of 19 July 1997, entitled ABP laat 12,5 miljard liggen [ABP leaves 12.5 billion untouched], Eduard J. Bomhoff still argued it was a shame that Dutch pension fund ABP only invested 18 per cent of its capital in shares, while the pension funds of Shell, Unilever and IBM had already allotted half or more of their capital to shares. 54 Since pension funds also invest in investment funds, a certain amount of double counting may be involved. 55 Statistisch nieuwsbericht, 25 August 2011. 56 By the end of March 2011, when France had amassed 1,980 billion Euros in pension capital and Germany 1,909 Euros. 57 Dutch pension funds are not the largest shareholders in Dutch companies. They prefer to invest in businesses abroad. 58 Davis (2011) p 1131.

When the stock market was being institutionalized, however, other, related

developments took place in this market. Internationalization is one of those

developments. Institutional investors are more inclined to invest abroad

than private investors. Added to which, the advent of computers enabled

larger trading volumes as well as the use of share derivatives.

The data sets and computational power that computerization brought also

facilitated the introduction of scientific thinking about stock trading.

Whereas private investors could still simply pick the companies they liked,

institutional investors needed convincing argumentation with regard to their

choices in investing other peoples money. By now, this demand has been

amply catered for. When the Nobel Prize was awarded to Merton Miller,

Harry Markowitz and William Sharpe in 1990, this underscored the fact that

investing had become a scientific endeavor. Investors defined return

requirements, identified risks and calculated the required level of

diversification. 59 Partly as a result, institutional investors, contrary to private

investors, do not primarily focus on the companies in which they hold

shares. Their principal concern is the development of their investment

portfolio, in which shares of various different companies have been brought

together based on predefined criteria.

From a conceptual and emotional point of view, the ties with public

companies have become looser. This applies all the more to institutional

investors that seek to achieve their return based on momentum or quant

strategies, which are in turn based on the behavior of other investors. To

them, trading volumes and movements in the share price are the only things

that count. The underlying business performance of the public company is

as good as irrelevant to them. An anecdote from 1991 will serve to illustrate

this trend.

In a year in which the role of institutional investors was given a great deal of

attention as a result of the merger between Nationale Nederlanden and

NMB-Postbank, Pieter Korteweg, then chairman of the policy committee

of the Robeco Group, told a reporter of Dutch newspaper NRC

Handelsblad60, With Robeco leading the way, they have been able to push

59 Bernstein (1992) offers an overview. 60 In casu the undersigned.

26

through an improvement in the stock dividend ratio. And little has been

heard from them since. In some quarters, people expect that such

institutions will increasingly make their presence felt in similar scenarios in

the future. However, I do not share this expectation. Institutional investors

generally have a limited staff who often manage a substantial range of

individual funds. The possibilities of interfering in the policies of the

underlying companies, other than exerting a marginal influence, are simply

lacking. For this reason, people vote with their feet. And if on top of this

both merger partners are included in the investment portfolio, the lust for

action becomes even more limited. Scientific investment entails a

disciplined management of investment risks, in such a way that the targeted

return is obtained with the lowest possible risk. This implies a certain

disloyalty with regard to the companies in which they invest. Im not

making a value judgment here; Im just making an observation.

Others hoped for the opposite. In the future, the ties between enterprises

and their long-term shareholders will become stronger. In their capacity of

long-term shareholder, institutional investors will adopt a more active

approach. This statement is taken from the beginning of the Minimum

code of conduct van Nederlandse institutionele beleggers [Minimum code

of conduct of Dutch institutional investors], which was drawn up in 1992

by the Vereniging van Effectenbezitters (VEB), a Dutch investors

association that represents individual shareholders in the Netherlands.

So far, Korteweg has been proven right. As other peoples money was

invested in stocks rather than ones own money, shareholders became more

disloyal. By now, easily 80 per cent of the shareholders of publicly traded

companies are disloyal shareholders. We are not just talking about the sick

friend of the pirate from Harardhere who is in need of cash in the short

term. It is more like four fifths of the inhabitants of this enterprising city

near the Indian Ocean suddenly claim they have fallen ill. Does this hamper

the outlook for piracy? Is it true that, as a result of the institutionalization of

share ownership, managers of public companies are less able or willing to

focus on the long term? And what do we actually mean by the long term?

28

4 What does the long term mean?

Publicly traded companies were created precisely to enable companies to

operate for a longer term than shareholders can go without their money.

The fact that shareholders are nevertheless accused of a short-term

approach is all the more striking because none of the stakeholders 61 of a

company are in actual practice as inclined to wait for long-term success as

shareholders provided the companys shares can be traded. This was

already true of the Dutch East India Company, and it still is, as will be

borne out by the following examples.

On 13 March 1986, the day on which Microsofts shares were traded on

Wall Street for the very first time, the companys market value amounted to

$780 million. In the years that followed, increases in the share price turned

four employees into billionaires and made approximately 12,000 other

employees millionaires. However, the investors who bought their shares did

not receive a penny from the company for seventeen years. In 1990,

Microsoft was able to launch Office, followed by its new version of

Windows in 1995. In 2000, CEO Bill Gates was able to resign as a

chairman, and in 2011 the company was able to launch Windows XP. All

this happened without shareholders asking for a return on their investment.

Investors who were in need of money were able to find sufficient other

investors in the capital market who were prepared to buy their shares in the

hope of a return in the long term. On the stock exchange, Microsoft

became the company with the highest market value. It was not until 2003,

no less than 17 years after its IPO, that Microsoft started paying dividend,

and a modest one at that.

61 I hesitate to use this term, bearing in mind the late Harry Hone, who, in a footnote to his inaugural speech, finished off this concept in a few short strokes. He started out with a reference to Het Foute Woordenboek van de Nederlandse Taal, a dictionary containing the origin and usage of irritating, scary, ugly and ridiculous words of today for the Dutch language. For each letter in the alphabet, the booklet offered a blank page where readers could write down their own dodgy words. Hone confessed that for the entry S he wrote down the word stakeholder, with the following explanatory note: Stakeholders: a term often coined in circles of the VEUO [Dutch Association of Listed Companies], mainly to bring shareholders down a peg. [..] Word category: obscuring language; Usage value: 0. (Hone, 1996).

30

Turning to the Netherlands, ASML is a similar example. Its major

shareholder Philips had nearly gone bankrupt, and for this reason ASML

went public in 1994. It was not because the company needed the money

itself.62 In the prospectus, ASML emphatically stated that it had no

intentions to pay out dividends. Nevertheless, the IPO turned out a success.

For years on end, the company was able to grow in highly volatile markets,

without shareholders demanding anything in return. It was not until 14

years later, in February 2008, that ASML paid out very modest dividends.63

In the meantime, not a single shareholder complained.

On the capital market, these companies found shareholders with a long-

term vision. A vision, moreover, that was longer than that of non-family

shareholders of private companies. The average company is owned by a

private equity fund for a duration of 5 years, according to the Nederlandse

Vereniging van Participatiemaatschappijen (Dutch Association of private

equity funds or NVP).64

These examples serve to illustrate that terms such as flash capital are often

used too casually. It is not just successful companies that have patient

shareholders. When public companies are not successful, it is precisely the

shareholders who show themselves prepared to keep an eye on the long

term. In the past few years, companies that ran into trouble, such as KPN,

Ahold, ING, Heijmans, TomTom and Wavin, were able to reinforce their

capital bases through substantial rights offerings when this was found

necessary. BPs shareholders showed themselves prepared to forfeit their

dividends until the scope of the environmental damage from an accident in

the Mexican Gulf was clarified.65

Stakeholders and the long term

Nevertheless, trade unions in particular are convinced that the lust for

short-term profit of shareholders is detrimental to the long-term interests of

62 Of the revenues of approximately 300 million Dutch guilders, 220 million went to Philips and 80 million to ASML, which used the funds, among other things, to pay back a 36 million guilder loan from Philips. 63 A salacious detail: in December that year, ASML received government support. As a result of the sudden drop in demand, the company requested labour time reduction for 1,100 of its 7,000 employees. They received 70 per cent of their salaries from UWV, the Dutch Social Insurance Authority. ASML only had to pay 30 per cent. 64 According to the 2010 edition of the annual Ondernemend Vermogen [Entrepreneurial Capital] study by NVP. That said, the same study for 2011 states, On average, venture capital associations participate in companies for between 5 and 7 years. 65 The company had sufficient funds to pay out dividends, but temporarily refrained from doing so under pressure from the US government. Incidentally, BPs then CEO Bob Hayward is the author of the quotation (from two years earlier) ., I pay taxes so I dont go to jail. I pay dividends so I dont get fired.

the other stakeholders. But are employees in fact more focused on the long

term than shareholders? This is not evident at all. Shareholders are often

prepared to go without dividends. On the contrary, employees insist on

receiving their monthly wages, even when the company is in turmoil.

Added to which, the notion that employees spend their entire working lives

at a single organisation no longer matches actual reality.66 Employees are

free to terminate their employment contracts at any given moment67, and

are increasingly exercising this right. On average, Dutch employees remain

in service with the same employer for a period of seven years.68 They are

monogamous at each different stage, but switch from social partner five to

six times in their professional lives.69

Chairmen of Boards of Directors at public companies stay on board for an

even shorter time.70 In 1995, the CEOs who left the worlds 2,500 largest

enterprises had fulfilled their role for slightly under ten years on average. In

2000, this period had been reduced to slightly over eight years. By 2009 the

average period had dropped to six years.71 However, the long-term

component of the remuneration for board members still has a safety

margin. This usually consists of an additional period of three years. Board

members who brush aside critical feedback from shareholders with the

statement that they are free to sell their shares if they do not like the

company policy do not always seem to be aware of these periods or the

respective powers.72

66 Jobs are created and destroyed. The small difference between the two is what we call prosperity, wrote Holman Jenkins (Wall Street Journal Europe, 16 January 2012) in reference to studies by Steven J. Davis and John Haltiwanger, which demonstrated that in the period from 1977 to 2005, an annual 15 per cent of all jobs in the United States disappeared, while the total number of jobs during the same period grew by 2 per cent annually. 67 One of the most important triumphs of Western society. The only sector in which this right still cannot be effectively exercised is the most recently legalised business sector in the Netherlands, namely prostitution. 68 Since the second quarter of 2004, the number of Dutch employees with flexible employment contracts has been rising more sharply than the number of employees with fixed contracts. 69 In Werk maken van baan-baan mobiliteit [Working on job-to-job mobility](Recommendation no. 2011/05 of 15 April 2011), SER [The Dutch Social and Economic Council] states that the labour market has become more dynamic since the 1990s: Job switching has become more common; the number of career switchers has structurally increased. According to SER, on an international level the Netherlands takes up a mid position in terms of job-to-job mobility. SER was unable to tell whether people changed jobs too much or too little. 70 As a result of amendment X to the proposal for the Wet Bestuur en Toezicht [Management and Control Act], which resulted from the discussion on the compensation of board members and the redundancy pay in particular, board members are no longer considered employees. 71 Karston et al. and Favaro et al. via Haldane (2010). 72 A clever rejoinder is given by Graham (1949) p 2.09, who cites Luke (16:1-2): And he said also unto his disciples, There was a certain rich man, which had a steward; and the same was accused unto him that he had wasted his goods. And he called him, and said unto him, How is it that I hear this of thee? give account of thy stewardship; for thou mayest be no longer steward.

32

In general, bankers also tend to adopt a short-term view, something that

becomes apparent when an interest or installment payment is one day late.

In emergencies, bankers are sometimes willing to help out their clients, but

only in the short term. The additional credit will have to be repaid as quickly

as possible with the shareholders money.73

Suppliers insist on being paid in time, but are sometimes of a mind to allow

a payment extension in view of the long-term relationship. Buyers are

sometimes prepared to participate in the investment, but not if they are

consumers.74

For the time being, we estimate the long term at 7 years for employees, 6

years for board members and 5 years for shareholders in non-listed

companies. And it is with some surprise that we observe that in the

corporate governance debate supervisory directors are no longer considered

independent if they hold their position for longer than two 4-year terms.

Recently, the same maximum period was recommended to ensure the

independence of auditors.75

In the midst of so many short-term relations, it is almost a miracle that

public companies manage to survive in the long term. But how long do

companies actually exist?

Companies

Originally, public companies were founded for a certain period, which was

laid down in the articles of association and on average amounted to over 30

years.76 However, more or less tacitly the idea has taken hold that

companies should live forever that they should strive for continuity. It

does not seem unlikely that the advent of permanent employment contracts

has given rise to this idea.

73 Hilferding (1910) already called this one of the strong points of listed companies. They are more effective than private companies in attracting new capital and will therefore be able to obtain more credit. 74 Something that editorial boards of newspapers tend to overlook when they assume that one of their publications can be kept alive through financing from readers. 75 In 2010, when the new British Governance Code proposed annual reappointments of board members as a best practice in 2010, the investors Hermes, USS and Railpen sent companies a letter with a request to deviate from this best practice out of fear that this would create a short term culture. 76 Frentrop (2002) pp. 198 - 202.

That said, companies are organizations with specific objectives. In a

changing world, neither organisms nor organizations exist eternally. Of all

the worlds organizations, it is probably the Catholic Church that holds the

record, and nation states are also organizations with high longevity (even if

it is often overestimated). On average, companies have a shorter life

expectancy than people.

Although some small family companies refer to a foundation date in a

distant past, large corporations seem to have a longer lifespan than their

smaller counterparts. For instance, from 1930 up to now, the top five

Dutch companies has remained unchanged: Royal Dutch Shell, Philips,

Unilever, Akzo and DSM.77

Looking at the largest British, French and German corporations of the

tumultuous 20th century, which was characterized by World Wars, one will

observe that the chances of survival of companies are smaller than those of

soldiers. Between 1907 and 1989, 37, 42 and 19 per cent of companies

survived respectively, i.e. 24 British companies, 9 French companies and 10

German companies.78 Of the companies that were founded between World

War I and 1929, 56%, 46% and 35% survived, respectively.

We should not be surprised that companies go under. After all, that is how

the market mechanism works. Companies do their utmost to eradicate the

competition and are surprisingly effective in doing so. During this struggle,

the customers and society benefit, and afterwards the legislators must

ensure the oligopolies keep on fighting. To give an example: in 1902 there

were 9,000 telephone companies in the United States, while the Dutch

regulator OPTA now has to protect the Dutch telecommunication market.

An interesting study into the lifespan of American companies concludes

that their life is short and brutal. Large corporations live longer than small

businesses, but even their lifespans are shorter than that of the average

person. Of those that manage to survive the first 20 years, only 0.1 per cent

will be able to survive the next 20 years.79

77 AWT (1993). 78 Casis (1997), 104. Survival is defined as remaining both independent and large in size. 79 Stubbart and Knight (2006)

34

If a country anywhere in the world had this type of mortality rate, large-

scale international aid would be organized immediately.

That said, I am not so much concerned with the question of how old

companies can become. What is relevant to this discussion is the more

specific question of how long a company can survive in the shape of a

publicly traded company, i.e. with a large number of shareholders.

From this perspective, the outlook becomes rather gloomy. Of the 12

companies that formed the Dow Jones Industrial Average in 1896, which

was then published for the first time, only one still forms part of the index:

General Electric. The developments have been very quick, particularly in

recent years. Of the 30 companies that were included in the Dow Jones

average for 1930, six decades later, in 1987, just over half still formed part

of this elite. And two decades later, in 2009, only three of these companies

were left: General Electric, Chevron and Exxon.

If we turn to the United Kingdom, of the 30 companies that made up the

first FT 30 share index in 1935, only six were still in existence in 1996. In

the same year even before the dot-com bubble typically only one third

of the 2,700 companies listed at the New York Stock Exchange were listed

for a period longer than 10 years.80

Incidentally, one should bear in mind that companies have a long if not

the longest existence before their IPO. In 1996, the average age of the 30

companies included in the Dow Jones Industrial Index was no less than 103

years. In the Netherlands, Ahold celebrates its 125th anniversary in 2012

after Albert Heijn took over his fathers grocery shop in 1887. During the

first half its existence, the company was able to grow without being listed. It

was only after the founders death in 1945 that the shares were publicly sold

on the stock exchange (in 1948).

Perhaps a listing should be regarded as the final stage in the lifecycle of a

successful business. After all, companies are only suitable for a listing if they

are able to demonstrate a track record of increasing cash flows for

consecutive years. This implies that the company operates in a market with

80 According to NYSEs CEO Richard Grasso. Wall Street Journal, 28 May 1996.

moderate competition and/or high market entry thresholds. But even this

peace and quiet never lasts very long.

If we look at the 30 companies that were active shares on the Amsterdam

stock exchange at the end of 1985, we see that by now half of them are no

longer listed.81 If we look at the companies with less actively traded shares,

the carnage has been considerably greater since 1985. Twenty-seven years

later, only a few of them are still listed82 (see page 18).

Long term, but no continuity

The fact that listed companies do not live forever makes the continuity of

the business as a guideline for board members neither reasonable nor fair,

and, just like the objective of doctors to keep patients alive, eventually

untenable.

Shareholders know this, but managers act as if the eternal life is attainable.

As far back as 14 years ago, Rietkerk beautifully formulated this aspect of

corporate governance, and I will gladly quote him in full:

The objective of continuity is very popular at public limited companies.

People use the term to indicate that the company should be able to

continue to exist in the long term. In the 1960s and 1970s, when profit was

a dirty word, people tended to emphasize the objective of continuity as a

gesture towards the employees. The preservation of employment was their

direct interest and, moreover, an aim that was generally accepted by society.

It implicitly suggested that the continuity of the business would keep

employment at a regular level. It goes without saying that this was a false

suggestion. After all, profit was needed to ensure continuity. Thus, the true

nature of the beast was maintained. With a view to public acceptation,

profit was promoted from an end in itself to a means to an end. However,

this transformation does not have a material significance. After all, it is not

the continuity of the organisation (the company) that is relevant, but the

continuity of economically profitable activities. From the point of view of

business economics, continuity is a result of the economic feasibility of the

business operations. The business activity that creates affluence is of

81 However, this is not to say that their activities have been discontinued. In many cases, the number of shareholders has been reduced to a single shareholder. By way of example, steel is still being produced in IJmuiden, but by Tata Steel rather than the original public company Hoogovens. 82 The fact that it is precisely the less actively traded companies that are more likely to disappear from the stock exchange is diametrically opposed to the assumption that the increase in stock trading is detrimental to the continuity of businesses.

36

primary importance. For this reason, continuity cannot be regarded as a

separate company objective.83

According to Rietkerk, continuity, like independence, is in fact a

management objective, says Rietkerk. He argues that the boards of directors

of publicly traded companies have become the dominant party, one that

postulates its own objectives as the company objective.

Our conclusion has to be that the management strives for eternal life. We

also have tried to demonstrate that a company only has the right to exist as

a public company as long as it is of use to a large number of shareholders.

Apparently, the opinions of shareholders and managers differ when it

comes to defining the optimum long term. This implies that a corporate

governance issue is at stake: corporate governance involves the relationship

between a companys board members and shareholders, which is referred to

as an agency relationship.

83 Rietkerk (1998).

5 The first agency issue

If the number of shareholders in a company increases, this not only results in

stock trading (a capital market), but also creates a more strenuous

relationship between the shareholders and management. As the number of

shareholders and the distribution of share ownership increases, individual

shareholders will be less inclined to monitor the managements performance.

This observation forms the basis for a great portion of the thinking on

corporate governance since Jensen and Meckling84 defined the separation

between ownership and control that was signaled by Berle and Means85 as an

agency issue: the agent (manager) has other interests than the principal

(shareholder). 86 So how can the general shareholders meeting nevertheless

ensure that the management achieves an optimum performance? Or, as

Shleifer and Vishny defined the field of corporate governance as an agency

issue: Corporate governance deals with the ways in which suppliers of

finance to corporations assure themselves of getting a return on their

investment. How do the suppliers of finance get managers to return some of

the profits to them? How do they make sure that managers do not steal the

capital or invest it in bad projects? How do suppliers of finance control

managers? 87

In principle, there are three88 disciplinary mechanisms that principals can

use to control agents:

- To request information

- To exercise supervision

- To switch agent.

84 Jensen and Meckling (1976). 85 Berle and Means (1932). 86 It should be noted that this is not a legal definition. In legal terms, the manager is not an agent and the shareholder is not the owner. Shareholders cannot give managers instructions. In legal terms, there is a fiduciary relationship between the management and shareholders. Consequently, the agency model is not used in a legal sense to determine rights and obligations, but rather in terms of maximising the economic benefit. 87 Shleifer and Vishny (1997). 88 Some people argue that the remuneration structure for managers comprises a fourth disciplinary mechanism, as it can align the interests of managers with those of shareholders.

38

To enable the use of these disciplinary mechanisms, publicly traded

companies have more obligations with regard to information provision than

non-listed organizations. Added to which, higher demands are made on

auditors of public companies.

Moreover, once a corporation has more shareholders, a new kind of

supervision will arise. In the Netherlands, this supervision has taken the

form of a Supervisory Board, which was originally intended to promote the

interests of suppliers of capital, but has taken on a broader responsibility

since the second half of the 20th century.89

To switch agent implies a management change. This is something the

existing principals can do, but in case of a public company this can also take

place through a merger or acquisition (the so-called market for corporate

control), in which case it is often a single party that makes an offer for all

shares. In this way, the distribution of the share ownership is undone again,

so that in agency terms there is a single new principal.

Alternately, better regulation is sought for the three disciplinary

mechanisms. With regard to the corporate governance debate in the

Netherlands, the initial focus was on a better functioning of the acquisitions

market (in the Appendix to the annual report of the Vereniging voor de

Effectenhandel [Association for Stock Trading] for 1986). Subsequently, the

focus shifted to improving the supervision (in the report De Veertig

Aanbevelingen [The Forty Recommendations] report by the Corporate

Governance Commission chaired by Jaap Peters in 1997), and finally to

activating the role of the shareholder in the Dutch Corporate Governance

Code, as formulated by the committee led by Morris Tabaksblat in 2004.90

No-one will dispute that shareholders have a certain role to fulfill at public

companies. The question, however, is what that role is. What is certain is

that they will not want and will not be able to interfere with the operational

policy. They lack the required information and expertise. Investors are also

unwilling to take up a seat on the board. Of all the forms that a company

can take, the publicly traded company may be the one in which the supplier

89 Den Boogert (2005), Hone (1996). 90 Frentrop (2004).

of risk-bearing capital has the least say. They are, as it were, silent partners.

They trust that the management performs its work in the way it should.

And that is usually the case:

The typical management is honest, competent and fair-minded. It does the right thing,

even though it could easily get away with the wrong thing, comments Graham91 in

his guide for investment professionals. However, he adds, there are

exceptions. If at one company out of ten either the management is

incompetent or the shareholders are not treated properly, it is imperative

that the owners take action.

This is not something that can be expected of private shareholders.92 In

fact, since the advent of institutional investors as the largest party in the

stock market, people have been hoping that they will be able to solve the

agency issue at the company level.93 There is not much that a private

shareholder can do at a large corporation with a widely distributed share

capital. Institutional investors conversely do in fact possess the required

expertise and means.94 Perhaps they have a moral or fiduciary duty to do so,

as people tend to think in the United Kingdom.95

For the moment, the results that institutional investors achieve in this field

leave a lot to be desired.96 That said, it is important to bear in mind the fact

that although institutional investors may be large in terms of managed

capital, their scope for action is limited. Market competition is the strong

force that is to keep managers on the right track. Shareholders are typically

unable to exert anything other than a soft force.97

The natural terrain for shareholder voice is where bankruptcy and capital markets

constraints are weak for the not too badly run, fairly mature, public company that can

91 Graham (1949). 92 This even remains difficult when they combine their forces, as in the case of the VEB [The Dutch Association of Shareholders], for example. 93 Alfred Berle foresaw that pension funds would eventually own half the stock market and as a result would turn into naked power vehicles. Adolf A. Berle Jr, Economic Power and Free Society (1957), pp. 10-13, cited in Strine (2010), p 13. 94 Drucker (1991). 95 Walker Review: The role of institutional shareholders: communication and engagement (2009). 96 Though an exhaustive evaluation goes beyond the scope of this paper, Sahet et al. (2010) even report adverse effects of interference by French investors. Mizuno (2010) is of the opinion that in Japan the general state of corporate governance has improved since institutional investors became involved, but does not observe any significant differences in the business performances of companies. 97 Physics distinguishes strong and weak forces. The term soft force, I believe, finds its origin in the Dutch poetess Henritte Roland Holst, who wrote, The soft forces are sure to prevail; I hear this inside me as an intimate whisper . In turbulent times, without fail people refer to these soft forces, hence my use of the term in this connection. (See also footnote 61).

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service its debts and generate internally or borrow much of the cash it needs to fund new

investments, Shareholder monitoring may prevent some companies from wandering too far

off the profit path. It can be a quicker, lower-cost alternative to hostile takeovers or

bankruptcy constraints.98

Incidentally, I would also like to reverse this argument: only a company that

is managed fairly well, that operates in reasonably mature markets, that is

able to amply pay off its liabilities and that generates sufficient cash flow to

finance the required investments is worthy of being a publicly traded

company with a distributed share capital.

This is the only type of company whose shareholders can trust their soft

force to be sufficient. This entails that only companies with a strong market

positioning that enables a relatively stable cash flow are suitable candidates

for a listing. Consequently, there should be high participation thresholds for

new competitors. This is a requirement that wise investors have demanded

since the beginning of stock trading. The Dutch East Indies Company was

attractive to shareholders because of its monopoly in trade via the Cape of

Good Hope.99

Adam Smith had a sharp eye for the agency issue. He wrote the following

about publicly traded companies: The directors of such companies, however, being

the managers rather of other peoples money than of their own, it cannot be well expected,

that they should watch over it with the same anxious vigilance with which the partners in

a private co-partner frequently watch over their own.100

Consequently, he was of the opinion that only companies with a large

capital requirement but with fixed income were suitable candidates for a

listing. In particular, he referred to banks, insurers, canal operators and

water suppliers.

What can investors do in such reasonably stable companies?

Winter (2011) distinguishes between three types of action:

98 Black (1992) p 832. 99 Frentrop (2002). 100 Smith (1776) V.i.e.18.

Compliance. Minimal action, blindly following the rules. No added

value.

Intervention. Incidental. Knowledge of the business required. The

objective is to create specific value or prevent loss.

Stewardship. A continuous, involved and conscious component of the

investment strategy, intended to generate long-term value.

Black (1992) compiled a list of specific topics. He argued that institutional

investors should not engage in micro-management, but rather focus on a

proper arrangement of processes such as voting, share issuances, the

implementation of protective constructions, the remuneration policy,

dividend policy and decisions about acquisitions.

Added to which, in some cases in which managers clearly overstep the

mark, institutional investors should actively intervene, partly pour encourager

les autres (to encourage the others). And they should do their utmost to

ensure an optimal composition of the supervisory board.

In this connection, institutional investors in particular could contribute

towards a healthy community of public companies, even though there are

obstacles, particularly with regard to taking action at individual companies,

especially for institutional investors.101

An example is the free rider issue. Why should a single investor incur costs

for his intervention if all the shareholders benefit from it? Also, conflicts of

interest may be involved. For instance, in its capacity of shareholder, an

insurer will not be keen to kick up a fuss at an existing or potential client,

while the pension fund of a particular company will not take action against

another company. Collaboration with other institutional investors is

required, but difficult to achieve. For starters, there is the risk that if an

active investor makes known his concerns about a company to a fellow

investor, the latter might immediately sell his shares in what is referred to as

a race to the exit. There may also be obstacles in terms of securities law that

complicate joint action.

101 Coffee and Black (1994) pp. 2055 2072.

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The list of objections is not exhaustive and is based on the assumption that

institutional investors act in a spirit of goodwill. That is to say that they will

do what they can to tackle the agency issue that is simply inherent in a

public company. Thus, we assume that institutional investors are prepared

to make an effort to maximize the long-term performance of the companies

in which they invest.

But is this really what institutional investors strive for? This is something we

cannot automatically assume, since a second agency issue is at stake. The

first issue concerns the relationship between companies and their

shareholders and has been outlined above. In this context, the managers of

companies are agents that have to properly manage other peoples money.

The second agency issue concerns the relationship between organizations

that invest other peoples money and their clients. In this context, the

institutional investors are the agents. We will go into the second agency

issue in the next chapter.

6 The second agency issue

In the professional investment business we are all agents, managing

other peoples money.

Jeremy Grantham (2012)

Company law has been set up to ensure that companies are properly

managed. To this end, it focuses in part on the responsibilities of the

management with regard to the general shareholders meeting.

However, company law does not take into account the fact that by now,

this general shareholders meeting for the most part consists of institutional

investors who have an agency issue of their own, namely their

responsibility to their client base.102

It cannot be automatically assumed that institutional investors will fulfill

their role as shareholders in a way that yields optimum results for their

clients103, since these clients do not specifically ask for this and because the

interests of institutional investors differ from the interests of their clients.

Like managers of companies, institutional investors have a continuity

objective. Their actions are mainly geared towards maintaining existing

mandates (and, in the case of open-ended investment funds, towards

avoiding capital flight).

Like managers of companies, institutional investors often have the wrong

remuneration incentives. If they are rewarded on the basis of their managed

capital, they will mainly strive to increase this capital rather than achieving

an optimum return on that capital.

102 Strine (2010) p 4. 103 Used here as an umbrella concept for, among other things, shareholders in investment funds, participants in pension funds and policyholders of insurers.

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And if they are rewarded based on a relative rather than absolute return (e.g.

in relation to a stock index or to other investors), they will not strive for an

optimum return in absolute terms.

Until recently, the academic and public interest in this second agency issue

was isolated from the debate on corporate governance.104 However, as

institutional investors are attributed a greater role in corporate governance,

this second agency issue is coming more into focus. For instance, in 2003

the Dutch Corporate Governance Code still exclusively fo