The Gadfly Shortage

Why didn’t more shareholders make trouble before the corporate scandals?

The real reason American business is melting down may be that this is the first year since the Great Depression without the troublemaking Gilbert brothers: Lewis, who died in 1993, and John, who died just this month. John had been too ill to file any shareholder proposals for this year’s annual meetings. John’s passing, at the bleakest moment in recent Wall Street history, should remind investors who have forgotten about shareholder activism how much it can protect them.

Lewis first attended an annual shareholder meeting in 1932, and when management refused to answer any questions, he was incensed. He and his younger brother spent the rest of the 20th century going to annual meetings, as many as 100 a year, to challenge corporate directors and executives on behalf of the shareholders.

The Gilberts are responsible for most of the rights shareholders now have (and mostly ignore). They persuaded the then-brand-new SEC to allow shareholders to circulate their criticism of management at company expense by submitting shareholder proposals that would be included on the company’s proxy.

The Gilberts fought for shareholder approval of auditors, confidential voting to protect shareholders from coercion, cumulative voting to give minority shareholders the ability to elect one director to the board, and annual meetings held in cities that were conveniently located. The Gilberts were among the first to object to outrageous CEO pay packages. They had a lot of fun—after one corporate lawyer told John Gilbert that he should be in a circus, he started wearing a clown nose to the annual meetings. They made a lot of money, too. Their investment policy was simple: Never sell.

But the Gilberts never made much progress in persuading other shareholders to take advantage of the rights they fought so hard to win. It’s easy to understand why few investors followed them. Individual shareholders face the collective choice problem. Almost any form of activism will cost them more (in time, hassle, money) than the return they will get while giving other shareholders a free ride.

Institutional investors—mostly pension funds, mutual funds, endowments, insurance companies—hold about half of the stock of most publicly traded companies. They do have the time, the resources, the analytic power, and the sheer amount of money at risk to monitor accounting tricks and executive compensation abuses. But they are leery of troublemaking. They are subject to conflicts of interest. Activism requires upsetting people you want to do business with. A Salomon Smith Barney fund manager, for example, might not want to vote against a CEO’s compensation if SSB hopes to manage that company’s 401(k) assets. Nor can you imagine the General Motors pension fund filing a shareholder resolution objecting to the CEO compensation at Computer Associates. Institutional investors are happy to reap the benefits of activism, but with a couple of notable exceptions like the California state pension fund, TIAA-CREF (the pension fund for university professors), and a couple of union pension funds, they don’t want to lead.

This timidity isn’t good enough any more. Studies have documented that shareholder activism by money managers and other institutional investors brings highly competitive returns. In theory, institutional investors, as fiduciaries, are legally obligated to exercise those shareholder rights when it will benefit the people whose money they manage. But they don’t, and the SEC and Department of Labor don’t press them on it.

Great Britain requires that institutional investors actively monitor and communicate with the management of portfolio companies or explain how they have determined that such activism is not cost-effective. (This is laid out in the Myners Report.) In the United States, for all the focus on post-Enron/Global Crossing/WorldCom/Tyco/Adelphia reforms, there is very little in the new corporate-accountability law that would not already be occurring if corporate board members thought that shareholders were paying attention.

Even if institutional investors suddenly become activist, there’s still a need for little guys like the Gilberts. Individual gadflies have certain advantages over institutions. They don’t need to worry about appearances. They don’t need the corporate big shots to steer them business or political contributions. And today’s activists have a superb tool that the Gilberts never got to use. They can find and communicate with each other over the Internet. Unhappy shareholders in Texas cafeteria chain Luby’s used a Yahoo! message board in the summer of 2000 to organize a campaign that toppled the CEO.

Eternal vigilance is not just the price of liberty; it is also the price of entrusting your money to other people. The Gilberts made sure that executives who forgot their obligation to shareholders were in for, at the least, some very uncomfortable moments. If today’s shareholders don’t take advantage of the rights the Gilberts fought for, we will get what we pay for, and we will deserve it. Here’s hoping someone will take up the Gilbert brothers’ fight—and the clown nose, too.