Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

1 Introduction

C h a p t e r 1 Introduction James P. Hawley, Shyam J. Kamath, and Andrew T. Williams Background In late 2008 and early 2009, the subject of financial risk was widely debated and discussed among academics and practitioners, in the business press and on blogs, and among the general public, as well as in the U.S. Congress and parliaments abroad. Yet some of us were struck by how little serious attention (indeed, how little attention of any sort) was being paid to the relation of corporate governance to financial risk, especially the role (or lack thereof) of large institutional investors who have dominated corporate governance activities globally over the past two decades or so. Institutional investors (public and private pension funds, mutual funds, and, in some countries, banks) have long since become the majority holders of not only public equity but other asset classes as well (e.g., bonds, hedge fund and private equity investments, real estate).1 In prior work two of us (Hawley and Williams) have characterized these large investors as ‘‘universal owners’’ (UOs) because they have come to own a representative cross section of the investable universe, having broadly diversified investments across equities and increasingly all other asset classes.2 One consequence of UOs dominating the global investment universe is that their financial and long-term economic interests come to depend on the state of the entire 2 Hawley, Kamath, and Williams global economy. This contrasts with earlier periods of financial history (especially in common law countries where institutional investors were the rare exception rather than the rule prior to the 1970s) that were dominated by less diversified individual and family owners. Additionally, UOs have come to be the conduits for the majority of the working and retired populations ’ savings and investments in many countries, also a historically unprecedented development. Since UOs have broadly diversified financial and economic interests (and indeed, the majority of them are fiduciaries to individual pension fund beneficiaries and retirement investors), it would be logical and, in our view, a fiduciary obligation to closely monitor the behavior of the firms they own. During the past few decades such monitoring became more common of individual firms but of individual firms only. Such monitoring was especially directed at firms with poor corporate governance and poor (relative to their benchmarked peers) economic and financial performance. In fact, growing corporate governance activism since the late 1980s and early 1990s by some UOs (mostly public pension funds, trade union funds, and some freestanding large investors, e.g., TIAA-CREF in the United States, USS and Hermes in the United Kingdom) has indeed led them to monitor and attempt to change the way in which firms operate (through focus on proxy voting processes, staggered boards of directors, division of CEO from board chair, top executive pay linked to clear performance standards). Varying by country, corporate governance activist UOs have achieved some significant reforms—putting a reform agenda both before the investing public and on the table of the political process while having some impact on how firms’ governance structures operate. In spite of this sea change in both ownership and firm-specific monitoring and corporate governance actions, missing was a program among almost all UOs prior to the financial crisis, and often in its early days as well, which would have monitored the various warning signs of financial danger and then developed actions to mitigate damage, both to their own portfolios and systemically. Additionally, the three editors of this volume came to ask ourselves whether, and if so to what extent, the various ways large UOs operated might have, unwittingly, contributed to the financial crisis itself, not necessarily as a primary cause, but as a potentially important factor. In our discussion with various UOs, with academics, policy analysts, and others, we concluded that the time was ripe for a candid discussion of these questions. Introduction 3 Thus, we organized a by-invitation-only meeting of academics, policy analysts, and UOs for a candid, off-the-record two-day conference entitled ‘‘Institutional Investors, Risk/Return, and Corporate Governance Failures: Practical Lessons from the Global Financial Crisis.’’3 All but one of the chapters in this book are revisions of presentations at that conference. An additional chapter was solicited from a participant in the conference who has written widely on risk and who has had a long career as a...