Friday, June 12, 2009

Securities Reform

A few days ago I saw a Wall Street Journal article about reforming corporate elections. I have some thoughts about that below...

Yesterday, I saw a short video of Rep. Barney Frank (D-MA) making a fool of himself. When he walked off the set I thought for a minute that he might have a point, but then I watched the full interview. He clearly did not understand the question. Yeah, he's one of our betters in Washington providing Congressional oversight of the financial sector.

The question was vitally important and my suggestion below for reform plays right to it. CNBC's Mark Haines asked Barney Frank (I'm massively paraphrasing): "The current investment model doesn't work very well because most shares are not owned by individuals but rather by mutual funds and ETFs, so the funds (mutual funds or ETFs) that an investor owns have voting rights, but the individual with the equity stake does not. How do you pass voting rights through mutual funds and ETFs to the actual investors?"

If you've only ever bought mutual funds through your company's 401k, you might not be aware of how the underlying asset works. You probably know that your S&P500 tracking fund buys shares in all the companies on the S&P500. You may not realize that the people that manage that fund at Fidelity, Vanguard, or a host of other investment houses vote your shares their way at the annual board meetings. You should get to vote your own shares: that is the inequity that CNBC's Mark Haines was getting at and the knuckle dragging Barney Frank was too dimwitted to grasp.

When you buy a fund, you are buying a small fractions of shares in many different companies. I would like to see funds reformed to account for the voting preferences of the shareholders. If someone buys shares in a mutual fund, their representation at board meetings should be proportional to their equity stake in the fund. In other words, if the fund effectively owns 13 shares of AAPL on behalf of John Doe, then John Doe's desire to kick Al Gore off the board of Apple Computer (AAPL) should be represented at the board meeting by the fund voting those 13 shares to oust Gore. Obviously, there's a substantial amount of calculation that has to happen to figure out who gets to vote on what. Furthermore, presenting all of that to someone that just wants to setup their 401k and be done with it is potentially problematic—no one wants to read the proxy statements of all the companies on the Wilshire 5000.

The way to bring representation to fund investors is two fold. First, fund investors should be granted the right to attend and participate in the annual meetings of companies whose shares are owned through the investor's fund. This does not compel companies to distribute their proxies to every fund investor that owns a fraction of a share through a fund. Rather, investors will have to determine when the annual meeting is for themselves (or perhaps be notified by their brokerage).

The second step is to require funds to track investor preferences. This can be accomplished by allowing investors to select rules that represent their preferences. Here are some rules of thumb for boards of directors:
  • Against all board members if company lost more than $1/share last year
  • Against chairman if company lost more than $0.50/share last year
  • Against the following specified board members: Al Gore
  • For the following specified board members: Steve Jobs, Anne Mulcahy
  • Against board members that donated to ANY political campaigns
The bolded parts should be user definable; they're variables. If you only want to support board members that donate to the Libertarian party, you should have that right. If you're wondering why I don't specify more rules for voting "for" board members, it has to do with how corporate elections are done. Every share in a company is voted in a corporate election. The board of directors signs off on a proxy statement (effectively, a ballot) that share holders are mailed. If a shareholder does not respond to the proxy, their shares are voted per the preference of the board. Needless to say, the board's preference is always for reelection.

I do not think the above list is complete or that you should only pick one of those rules. I would want all of those rules, but I might switch the last two. Steve Jobs and Anne Mulcahy are amazing corporate leaders. I suspect Steve donates to liberal politicians, but I'd like to keep him around anyway. In other words, each rule is considered in order so they narrow the field. If the "for" was last it would save Steve even though he may have made some iffy (in my opinion) donations.

The other question that is voted on annually is the choice of accounting firm. I have a simple rule for that one:
  • Against, if accounting firm has been selected in either of the previous two years
I don't want the companies I own to get to cozy with their auditors.

Corporate proxies often have a lot of other questions. Many of those will be hard to capture in the system of rules that I'm talking about, but some are not. Here are some obvious one:
  • Against all poison pills
  • For tender offers worth 10% over the share price
  • Against issuing more shares
Please leave your thoughts and suggestions in the comments!

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