Last week the Millstein Center for Corporate Governance and Performance at the Yale School of Management held its annual Governance Forum, drawing to the Yale campus in New Haven over one hundred of the leading figures in the corporate governance field. My invite was due to my previous position as Director of the OECD team that developed the OECD Principles of Corporate Governance, which are recognized by the World Bank, the IMF, and the Financial Stability Board as the global standard in this field. The objectives of this year’s Forum were to explore what is required to restore trust in the financial system and what changes are needed going forward to avoid future crises. As has been underlined by the global financial crisis, trust is essential for the easy flow of capital.

A central issue relating to restoring trust in the market system is the marked increase in the role of government in the United States as lender to and shareholder in public corporations, together with its expected strengthened role as market regulator. Will investors be willing to invest in situations where government is a major shareholder of the firm or of competitors, where government is seen as forcing mergers not in the interest of shareholders, where government may cap profits, where government may alter the priority among creditors, etc.?  Participants appeared generally to accept the reasons why the government decided to take exceptional actions in confronting the crisis. Also, it is evident that the US Treasury really does want to get out of its ownership role as rapidly as possible, and the Fed and the economic advisors in the White House share this view.  However, the part of government that is a concern is on Capitol Hill, where there appears to be less interest in getting out soon. Legislators, rather, are concerned about their constituents and the effects on them due to such developments as the closing of plants or dealerships.

Many difficult questions are raised by the government becoming an engaged shareholder in a public company, particularly where it also has a strong regulatory role. Should government directors have special obligations or limitations? Can you sue the government for insider trading? The advice from the Forum is that the government should seek to put the best people it can on the boards and give them the objectives of looking after the interests of all shareholders and moving the firms forward rapidly to a situation in which the government can exit.

Turning to regulatory reform, the Millstein Center issued a June 11 press release containing a proposal entitled “Roadmap to Restoring Capital Market Integrity,” which was sent to President Obama and others in Washington. The proposal was featured in an editorial in the Saturday, June 13 edition of the New York Times.  Among the signatories were Roger Altman, James Wolfensohn, William Donaldson, Harvey Goldschmid, Arthur Levitt, and Ira Millstein. The proposal advocates a “phased roadmap to reform the capital markets,” moving first on “shovel-ready” improvements that can be implemented immediately (such as improved oversight of key derivative products and merging the Commodities Futures Trading Commission into the SEC) and then developing a “blueprint for built-to-last regulation reform.” One speaker referred to the approach as moving fast to plug visible holes in the dike but taking the time necessary to carefully study the dike before making major changes in its fundamental structure. The full text of the proposal can be found at http://millstein.som.yale.edu.

The “Roadmap” supports several long sought-after steps to strengthen the role of shareholders in the governance of firms, mandating that all public companies offer annual advisory shareholder votes on compensation policies (“say-on-pay”) and ensuring that SEC “access” rules are protected under federal law so that investors can more easily nominate candidates to boards. It appears increasingly likely that such changes will be forthcoming. Indeed, Treasury Secretary Geithner announced last week an administration that would require companies to give shareholders a nonbinding vote on pay, without setting limits. Directors who determine the pay and consultants that advise companies would have to be more independent from management. This increased focus on empowering shareholders rather than adding new rules that eventually would be gamed, should be welcomed.

There are limits, however, to this approach. After being in effect for six years, say-on-pay in the UK is experiencing problems of micromanagement.  Shareholder groups seeking a role in nominating directors will have to develop the means to identify qualified candidates. They risk being in the position of a dog chasing a car and finally catching it. What does he do with it?

And if engaged shareholders are to be expected to play an increased governance role in order to restore trust and avoid excessive regulation, institutional investors will be pressed to carry out their shareholder responsibilities.  While some large public-sector and trade-union pension funds and some hedge funds have been very active, most of the large mutual funds have remained on the sidelines, calculating that the costs of engagement exceed likely benefits. This is particularly clear for index funds that have no interest in the behavior of the management of the companies they own. There is also the problem of hedge funds that are short-term owners. Their interests can diverge sharply from those of the long-term investor.  It was noted that one form of institutional investor is now being looked upon much more favorably these days: the sovereign wealth funds.

The final session of the Forum looked at global trends in corporate governance. This will be subject of a separate Commentary. It is worth noting here that there is considerable evidence that corporate governance is improving in many markets. At Cumberland, the prevailing quality of governance is an important consideration in our international investment strategies.