Roots of ProxyDemocracy, part 2

In a previous post I explained how my time at Harvard Business School got me interested in mechanisms shareholders use to hold corporate management accountable. In this post I’ll talk about how Mark Latham’s ideas provided the direct impetus for starting work on ProxyDemocracy.

I encountered Mark Latham quite by chance at a May 2003 conference of Transparency International in Seoul, which I was attending in connection with my work on transparency at Brookings. I was mostly busy with my own meetings at the conference but somewhat on a lark decided to attend a session on corporate governance that Mark was holding. I was impressed by Mark’s talk, in which he focused on free-rider problems shareholders face in monitoring management, and spoke with him briefly afterwards; after returning home I read some of the work on his website. The following spring, as I was wrapping up my work at Brookings and getting ready to move on to graduate school, I got in touch with Mark asking if he knew of resources that could help me vote the stock I held in Ford. Mark and I struck up a correspondence (I actually presented his corporate monitoring proposal at a USEC shareholder meeting held in DC that spring) and I continued to think about the ideas he had written about.

In work he had started publishing in the late 1990’s (particularly his paper “The Internet Will Drive Corporate Monitoring”; see all of his papers here), Mark was exploring mechanisms by which shareholders could overcome the collective action problems they face in monitoring corporate management. His vision was that shareholders should elect a “corporate monitor” that would look out for shareholder interests by investigating the performance of the board and senior management. Mark’s key insight was that this shareholder-elected monitor should be paid with corporate funds, which means that shareholders would all collectively pay for the service and the free-rider problem would be solved. With a single, investor-elected monitor doing research on behalf of shareholders (rather than a few proxy advisors doing fee-based research on behalf of a minority of the shareholders and most shareholders investing nothing in oversight), more resources could be devoted to ensuring that shareholder interests are represented. (Mark has since expanded this idea to civic politics and is now advocating the more general concept of “voter-funded media.”)

I thought Mark’s corporate monitoring idea was elegant and interesting, but it seemed to me that there were much more modest steps that should be taken first. In particular, Mark had pointed out in “The Internet will drive corporate monitoring” that a handful of institutional investors had started publishing their intended proxy votes on their websites in advance of shareholder meetings. He predicted that software would emerge to allow investors to automatically mimic the voting decisions of these institutional investors, as well as other trusted sources including security analysts, environmental groups, and journalists. It seemed to me that creating these linkages between specialists and otherwise-passive individuals was a manageable medium-term goal, and perhaps a necessary first step toward further innovations that he and others were proposing. Even if it wasn’t possible to actually implement the automated voting, we could at least help shareholders find out how CalPERS and others planned to vote.

This was the idea that led me to start working seriously on the project that became ProxyDemocracy, in early July of 2004. Being inexperienced and stupid, I thought I could finish the website before entering graduate school in September of that year. Next time I’ll tell you whether that worked (hint: no).

Reasons for votes

Short attention span version: We’re now displaying the reasons institutions provide for their votes. For example, see the June 11, 2008, meeting of Caterpillar Inc here; CalPERS provides reasons for its votes on each of the shareholder proposals. At this point only CalPERS is providing reasons for its votes, but we think more institutions will (and should) follow their lead.

Longer version: ProxyDemocracy offers advance notice of how respected institutional investors plan to vote at upcoming shareholder meetings. The idea behind providing this service is that investors can use this information to vote their own shares more intelligently. 

In some cases, it’s enough to know what the institution’s vote was. If you know something about the institution and its voting record, you might be able to assume that you would agree with the reasons for its position on a particular proposal.

But just as we might we might want to know why the Sierra Club endorsed a particular candidate before following its recommendation, often we’d like to know why an institution plans to vote a certain way on a proposal we face before we cast our vote the same way.

A select few institutions are now making publicly available the reasons for their votes, along with the votes themselves, in advance of meetings. We currently provide votes for one such institution — CalPERS, the California public employee pension fund. As of today we’ve started making available the reasons for their votes. I find these reasons to be very useful, particularly when the content of the proposal is not clear from the brief proposal title we are given, or for director nominations where CalPERS will back up its withhold vote with an explanation that the director serves on too many other boards or has attended too few meetings.

Some interesting ones I found:

• CalPERS explains that it voted against Steve Jobs on the Disney board because he missed too many meetings.
• CalPERS explains why it opposed a proposal asking Google’s board to create a committee on human rights issues.
• CalPERS explains that it opposed a director at the Lowe’s meeting today because he sits on too many other boards.

Let me know if you find anything interesting (or wrong) in the new data.

How much equity is owned by retail investors?

ProxyDemocracy’s main target audience is retail investors — individuals who own stocks or mutual funds. As I’ve worked on this project over the last couple of years, I’ve done research at various points to determine how much equity is owned by different types of investors. It’s surprisingly hard to find numbers on this. I think I have good numbers now but please let me know if you know of better figures.

The main source I use is the Flow of Funds data released quarterly by the Federal Reserve. Table L 213 records the equity holdings of different types of investors — households, mutual funds, private and public pension funds, etc.

As of the fourth quarter of 2007, US households own about a quarter of US equity, and mutual funds own almost exactly the same amount. Household equity holdings have shrunk somewhat since 2003, but mutual fund holdings have grown; together they owned about half of US equity in both years.

Now, some individual investors are foreign, so the total rate of retail investors in US equities is somewhat higher than 25%, although I’m not sure how much. I would guess that foreign holders of US equity are somewhat more institutional than are domestic holders; that would add another 3% to the 25% of holders who are US retail investors.

The bottom line is that a little over a quarter of US equity is owned by domestic and foreign retail investors. Another quarter is owned by mutual funds, which means that ProxyDemocracy’s audience owns over half of US equity, directly or indirectly. As we add pension fund voting data (currently we only have CalPERS), we add another 10% or so to that figure.

I created a treemap of the Federal Reserve data on Many Eyes; WordPress apparently won’t let me embed the visualization in the blog (grrr), but you can click on the miniature version of it below to see and interact with the full visualization (and download the data). The blue block in the tree map represents the equity holdings of US households.

[UPDATE — November 12, 2008] I learned recently that the “households” category in the Federal Reserve data I used includes not only individual investors but nonprofit organizations as well, which would encompass university endowments, private foundations, labor unions, and churches. (The Fed actually calculates holdings in the “household sector” as a residual — it collects data for all the other, more concentrated sectors, and then assigns to the household sector the difference between total equity holdings and the amount counted for the other sectors.) So it was not correct to use “household sector” and “individual/retail investor” synonymously, as I did above. I estimate that nonprofits hold around 8-9% of the equity in the household sector, which means that individual investors probably hold a little under a quarter of all equity rather than a little over a quarter, as I stated below.

Let me explain a bit how I ended up with that figure. In 1996, the last year in which the Fed broke out the equity holdings of nonprofits, 7% of the household sector’s equity was held by nonprofits. The period since 1996 has been marked by the steady advance of mutual fund holdings (at the expense of equity holdings) by the household sector, and I would guess that this shift has happened faster among individual investors than among nonprofits, so let’s assume that about 8.5% of household sector equity is held by nonprofits now. That would mean that the numbers I used above are a bit high — I would put the proportion of equity held by individuals (US and foreign) at about 23% rather than a little over 25%.

The idea that about 8.5% of household sector equity is held by nonprofits roughly comports with my numbers about the asset holdings of foundations, university endowments, and churches. (Prepare for very back-of-the-envelope calculations.) According to the Foundation Center, family and community foundations had about $260 and $50 billion in assets (respectively) in 2006; NACUBO says that the biggest 800 university endowments add up to about $400 billion; and ICCR says its members (religious institutions) have about $100 billion in assets. So that adds up to about 800 billion in assets; let’s guess that there’s another 400 billion floating around in other universities, other churches, labor unions, etc. My impression is that institutions in this category would hold 20-40% of their assets in public equities, and perhaps a little more in mutual funds, with the rest in fixed income assets, real estate, and other assets. So that puts about 400 billion of equities in the nonprofit category, which is 8% of the 5 trillion held by the household sector.

Roots of ProxyDemocracy, part 1

Jim McRitchie, the editor of Corpgov.net, asked me to tell him a little about the intellectual roots of ProxyDemocracy for a piece he is working on. Since others might be interested, I figured I would blog here about the origins and history of the project. Writing history at this point seems a little presumptuous, given that we just publicly launched, but the project has been a long time coming (somewhat embarrassingly long) and many debts have been incurred along the way.    

The short story is that the intellectual ground was laid for ProxyDemocracy during the year I spent as a research assistant for Professor Malcolm Salter of the Harvard Business School, and the seed was planted by the writings of Mark Latham, whose ideas on technological solutions to shareholders’ collective action problems were the direct inspiration for the project. The early part of cultivation (forgive the extended botanical metaphor) relied on some volunteer help by a few programmer friends, and the project ultimately bore fruit because I learned to program, raised some money, and hired a great developer to help me. In this post I’ll relate the first part of the story, and I’ll get to the rest later.

When I graduated from Harvard in 1999 I took a job as a research assistant for Malcolm Salter, a corporate governance professor at the Harvard Business School. Mal needed someone to help write cases about ongoing changes in Japanese corporate governance practices, and while I knew nothing about corporate governance I was good at Japanese and knew how to write and do research, so the match worked. As I began to immerse myself in this new area by working through books and papers on corporate governance and attending Mal’s class “Governance and Corporate Control,” I was surprised by how much I became genuinely interested in the issues at stake. 

What interested me was essentially the same set of puzzles that Berle and Means had written about in 1932: the fundamental conflict between what owners and managers want, and the difficulty shareholders face in creating mechanisms to resolve that conflict. For me, the signal issue was executive pay, which Mal’s class handled in a number of excellent cases. The potential conflict between shareholder interests and manager interests here is obvious, and it seemed to me that much of the talk about the “war for talent” that justified eye-popping payouts was bogus. An array of mechanisms theoretically constrained the worst self-dealing, but it was unclear how well they actually worked.

In Mal’s class I came to appreciate the primary importance of the securities market as a constraint on management: if shareholders are unhappy with managers’ behavior, they can sell their stock; directors and managers don’t want this (primarily because it hurts their own wealth, but also because it makes the company a better takeover target), so they will try to keep shareholders happy. But it was also clear that major information problems made this channel of accountability weak. Not only was it difficult for shareholders to know the extent of the compensation CEOs were receiving, it was also hard for directors to know why shareholders were selling stock, and inside management was unlikely to tell them that it was because of CEO compensation.

In my work at HBS I also encountered the idea that activist investors could successfully fight for shareholder interests. Mal’s class spent a lot of time discussing the slash-and-burn tactics of LBO artists like KKR, but it also devoted attention to the lower-profile efforts of institutional investors like CalPERS to create shareholder value by pushing for governance reform. I came away thinking that the efforts of shareholder activists could be an important way of making sure that corporate executives were putting their investors’ priorities first, which was later an inspiration for ProxyDemocracy.

Next time: Mark Latham and the launch of the project. 

ProxyDemocracy in BusinessWeek

Heather Green of BusinessWeek wrote a nice little piece about ProxyDemocracy last week. Nell Minow of the Corporate Library is quoted as saying, “I just about stood up and cheered when I saw the site.” Given her experience in this area, I myself was moved to stand up and cheer when I read that.

Error fixed

In the past week or so, many users encountered an error message when trying to view a meeting page. It took a while for Roop and me to track down the cause (ultimately Roop figured it out) but as of this morning it appears that the error is fixed. (Our search indexing was getting corrupted.) I apologize for the problem and how long it took to fix. I just hope that error message didn’t turn away too many people.

What do we mean by “activism”?

A few people have expressed concern about the “activism scores” I am planning to introduce with next week’s launch. It wasn’t the concern that I raised in my last post — that people would interpret higher scores as being better, but at the same time wouldn’t understand that 60 is high. Rather, the concern was that “activism” connotes a political agenda separate from the business case for engagement on proxy issues, and that funds with high activism scores would therefore be singled out as irresponsible.

This is certainly not my intent. It’s worth discussing, though, so let me explain my own understanding of this.

In general, “activism” is a propensity to seek change, to work towards some program. In the political sphere there are activists working for all sorts of causes — pro-choice activists and pro-life activists, pro- and anti-death penalty activists, Democratic activists and Republican activists. In general I think there tends to be a slight liberal association with activism, but I think that’s because conservatives by definition don’t usually feel the need to change things; when they do, they’re activists. (As admittedly weak support for this, Google finds a lot more “Democratic activists” than “Republican activists”, but also more “pro-life activists” than “pro-choice activists.”)

In the investment world, the “activist” label is often applied to hedge funds and other investors that try to increase the value of a company in its portfolio by changing the way the company is run. Rather than simply picking stocks and hoping for a rise in the share price, activist hedge funds try to create shareholder value by using their position to replace the management team or change its dividend strategy.

The activism I’m measuring — the propensity to vote against the recommendations of management — is not quite the same thing as hedge fund activism, but it’s similar in the sense that both activist hedge funds and activist proxy voters are working to influence the decisions of corporate managers. When it comes to proxy voting, the passive (ie non-activist) approach would be to vote with management all the time – to approve all of management’s director nominees and compensation plans and reject all shareholder proposals. Passive proxy voters defer to management, advocating no modification to corporate strategy through their votes. The activist approach tries to push and prod management through the proxy, letting the board know when they prefer a different course.

This is not of course to say that more activism is necessarily better. Different investors will have a different sense of what goals are worth pursuing through the proxy and ultimately what the proper role of shareholders should be in corporate governance. Given the right information, I trust people to decide what the right degree of proxy voting activism is for them, just as people usually arrive at a comfortable place on the liberal/conservative spectrum in civic politics. I don’t think investors really have the right information yet, which is why we have to keep working on this. But I think our activism scores are at least a start, in that they help to place mutual funds along a spectrum.

I expect this to be an ongoing conversation, and I look forward to comments.

Developing an activism rating

Yesterday I blogged about FocusLists, which we’ll be releasing on ProxyDemocracy with our (re-)launch slated for next week. As I explained in that post, FocusLists are an attempt to let users select the proposals they think are important and rank mutual funds on those proposals, much as political advocacy groups have done for a long time with the voting records members of Congress. It’s an old approach, but I believe we’re the first to create a public tool so that anyone can make her own list and share the results.

In conjunction with that, I’ve worked on developing a ProxyDemocracy activism rating of our own, to provide a different approach to the same problem. The goal was to come up with a broad-based measure of activism that reflects experts’ sense of what the most important issues on proxy ballots are. As with FocusLists, I hoped that our activism rating would quickly convey information that would be useful to an investor comparing funds’ voting records. Unlike FocusLists, which can reflect the particular interests of individual users (for example, resolutions on climate change disclosure), our ratings would try to capture a general consensus view of what it means to have an activist voting record. My hope is that FocusLists will be particularly useful because they can be created about any topic and are associated with a particular viewpoint, while our ratings will be useful as a broad, impartial, easily understandable measure of activism.

Roughly speaking, the rating system I’ve come up with measures how often a fund votes against the voting recommendation of management. The simplest way to produce this would be to calculate the percentage of all votes cast by a fund that went against management’s recommendation. (In fact we used this in the beta version of the site we released in December 2007.) The problem with this approach is that it weights the different types of proposals according to how frequently they arise at shareholder meetings, whereas most observers of proxy voting would not assess things in that way. For example, the vast majority of votes are on director nominations — about 10 times as many as any other proposal type — so the score calculated based on all votes would be dominated by how the fund voted on director nominations. Since it’s clear that director nominations are far more common than they are “important” (to both proxy voting experts and, I believe, the investors PD is trying to reach), we need a different approach.

I decided to think about what the important issues really are, and devised four categories that seem to be of roughly equal importance to people who care about proxy voting:

• director nominations: who represents shareholders
• executive compensation: how and how much the execs get paid
• corporate governance: the internal rules that structure decision-making
• corporate impact: relationships between the firm and its employees, customers, the world.

So our overall activism score is the average of the activism scores from these four issue areas. One way of putting it is that our activism score measures the percentage of votes a fund casts against management, where the votes are weighted to reflect the equal importance of the four categories above. Another way of putting it is that our activism score is an estimate of how many proposals the fund would vote against, on average, if it were faced with 100 proposals, 25 of which were chosen from each of the above four categories.

Ultimately our ratings are only good if they summarize the information our users want to know about these voting records. I’m not sure if we’re there yet, and (especially once we’ve launched the new site and you can see the ratings) I look forward to getting your feedback.

What I’m particularly worried about with this score is whether we can communicate useful information without editorializing about how much activism is the “right” amount. If ProxyDemocracy took the position that a mutual fund should always vote against management, then this would be easier: I could give our most activist fund, which has a score of 76, a C (or an A, if I want to highlight its leadership) and give most of the other funds an F (the median score in our database is around 20). Since we were all constantly receiving grades for about 15 years of our lives, we would easily understand a rating system like that. But I don’t believe that the most activist fund is the best, and I don’t think ProxyDemocracy should take that position either. So instead I’m using a rating system that is difficult to interpret as a grade and therefore requires the user to come up with her own idea of what the right level of activism is. I don’t know if that’s asking too much. I’m trying to help by showing the funds’ ratings in relation to each other (by reporting percentiles and displaying little histograms) but I guess we’ll just have to see whether this makes sense to people or not once we release the new vote profiles.