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"The Battle for the Soul of American Capitalism":
Ownership, Entrepreneurship and the Evolution of American Capitalism
By John Bogle
Review by David Binns, Beyster Institute Staff
Ever since the 1932 publication of Berle and Means' classic book “The Modern Corporation and Private Property,” in which they analyzed the impact of the growth of outside shareholders and the separation of ownership and control in large corporations, the issue of the best form of ownership and control of corporations has been a recurrent debate. The growing prominence of private equity firms in the contemporary economic landscape has again raised questions of John Bogle, the founder of the Vanguard Group, one of the world’s largest investment management companies, who believes that the ownership formula is seriously out of whack. In “The Battle for the Soul of American Capitalism,” he castigates what he calls a “pathological mutation” from traditional owners’ capitalism to a new form of managers’ capitalism which has resulted in an enormous transfer of wealth from public shareholders to corporate insiders and financial intermediaries. Much of the responsibility for the subversion of capitalism, Bogle argues, lies in the diffusion of ownership of corporate America and the resulting vacuum of corporate power. Directors, auditors, regulators and legislators failed to protect investors from overreaching by managers.
Bogle’s perspective is based, of course, on his role as a leader of the mutual fund industry and as a shareholder advocate. When he founded Vanguard in 1975 it had $1.8 billion in assets under management, including the long-established Wellington Fund which was the core of the company’s initial portfolio. Today Vanguard has more than $1 trillion in U.S. mutual funds comprised of more than 140 domestic funds and 40 additional funds in international markets. The company’s 12,000 U.S.-based employees serve more than 9 million institutional and individual shareholders.
Noting that “the evolution of capitalism has been in the direction of more trust and transparency,” which creates “a virtuous cycle in which an everyday level of trustworthiness breeds an everyday level of trust,” Bogle argues that "capitalism requires a structure and a value system that people believe in and can depend on.” Today's capitalism, Bogle argues, has departed, not just in degree but in kind, from its proud traditional roots of a free enterprise system based on open markets and private ownership, and on trusting and being trusted. “The classic system — owners' capitalism — based on a dedication to serving the interests of the corporation's owners in maximizing the return on their capital investment, was replaced by a new system — managers' capitalism — in which the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations. This happened because the markets had so diffused corporate ownership that no responsible owner exists.”
“Once an 'ownership society' in which direct owners of stock held voting control over corporate America, we have become an 'agency society,' and the agents — largely mutual fund managers and pension fund trustees — have failed to represent, first and foremost, their principals — pension beneficiaries and owners of mutual fund shares. These intermediaries consume far too large a portion of whatever returns our corporations and our financial markets are generous enough to provide, with far too small a portion of these returns delivered to the last-line investors who have put up all of the capital and assumed all of the risks.”
For Bogle, the most serious distortions of such an agency society are the unchecked rise in senior management compensation — from 42 times the average worker’s compensation in 1980 to 340 times currently — as well as the rise of financial engineering in which managers and financial advisors manage corporate earnings to meet quarterly Wall Street expectations, at the expense of making investments to ensure long-term growth. He is particularly critical of “the failure of our traditional gatekeepers,” such as auditors and even boards of directors, who have relaxed their professional and fiduciary standards. “When we have strong managers, weak directors, and passive owners, don't be surprised when the looting begins,” he cautions, adding “that’s, of course, what we've seen at Enron, WorldCom, and too many others.”
Investors come in for their share of criticism as well. Direct holdings of stock by individual investors, for example, “have plummeted from 92 percent of all stocks in 1950 to only 32 percent today, as corporate control fell into the hands of giant financial institutions — largely pension funds and mutual funds — whose share soared commensurately, from 8 percent to 68 percent, a virtual revolution in ownership.” Bogle notes that “these agents, beset by conflicts of interest, have failed to place front and center the interests of their principals, passively ignoring the need for good governance and allowing corporate managers to look primarily to their own interests. As the economists would say, investment America has an ‘agency problem.’” In addition, “institutional money management, once an own-a-stock industry (holding an average stock for 6 years during my first 15 years in this field) has become a rent-a-stock industry, now holding a typical stock for but a single year, or even less.”
As investment companies themselves moved from private ownership to public ownership by financial institutions, the financial incentives have changed. “It shouldn't surprise you,” Bogle writes, “to learn that these conglomerates are in the fund business to earn a return on their capital, not a return on your (the fund investor’s) capital. They cannot do justice to both, for the record is clear that the more the managers take, the less the investors make. Alas, in the fund industry in the aggregate, you not only don't get what you pay for, you get precisely what you don't pay for.” Bogle adds that the typical mutual fund falls short of overall market returns “by almost exactly the amount of the costs they incurred.”
To remedy the situation, Bogle advocates “a return to the original values of capitalism, to that virtuous circle of integrity — “trusting and being trusted'. When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society's abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises.”
Critics of Bogle’s shareholder-centric perspective note that, for decades, American capitalism has been dominated by chief executive officers who took big risks and transformed entire industries. Arguably, the risks these CEOs took helped create the most robust form of capitalism the world has ever seen. Today, however, the question is whether CEOs and their boards will pull back from taking game-changing risks. Publicly traded companies face blistering new attacks from shareholder activists, who act in tandem with labor unions, hedge funds, pension funds or some combination thereof.
One thread of the emerging shareholder ideology is that American companies should be governed more like their European counterparts, with separate chairman and CEO roles and annual shareholder votes on executive compensation, for example. In fact, a “Big Four” of European pension funds including Britain’s Hermes Pensions Management, with combined assets of $800 billion, has emerged as a powerful force in trying to import European governance concepts into the U.S. “There’s been a movement toward the democratization of certain governance functions or the withdrawal of authority from the board of directors back to the shareholders,” notes Fred Smith, the founder of Federal Express. “That movement, if left unchecked, will lead to a confused state of affairs.”
In addition, five years after the enactment of the Sarbanes-Oxley Act and new rules from the stock exchanges, major power has clearly shifted from CEOs to their boards. For better or worse, some of the tools that motivated CEOs and their management teams, such as rich compensation packages and stock option grants, have fallen into bad odor. CEOs of publicly traded companies have less flexibility to manage the way they see fit because of the pressure to separate the functions of CEO and chairman of the board, or lead director. Independent directors also are required by law to meet in executive session without the CEO present, altering the dynamic of CEO-board interaction.
As power tilts toward boards, boards are becoming more risk-averse than managers. Boards, many of which meet just six or eight times a year, typically want to mitigate risks, not find new ways of taking them. Moreover, despite some limited protections for business at the state level, the climate of litigation is pervasive.
Just who’s in charge here? Could it be that American capitalism is changing its structure and is moving toward a more European, more highly regulated model at the very moment that it needs to become more innovative in the face of emerging giants such as China and India? Does Sarbanes-Oxley compel boards to shift from guiding strategy and advising management to ensuring compliance? Are activist shareholders pressuring boards for more short-term performance rather than long-term value creation? It’s exquisitely difficult to determine whether investors are really long-term players. “Everybody wants to cloak their motives in the armor of righteousness,” says Smith. “The LBO guys will tell you that ‘We keep managements honest because if they don’t maximize shareholder returns, we come in and buy the company.’ The pension funds also say they are on the side of the angels.”
Debates such as these typically ignore the fact that an efficient means of narrowing the gap between managers and shareholders is to increase the numbers of shareholders with a direct stake in the business, i.e., the employees. Employee ownership still tends to be a phenomenon of the private company market, but there are sufficient numbers of publicly-traded firms with substantial levels of employee owners to suggest that broad-based employee ownership can be an effective strategy for promoting both long-term growth and a more equitable sharing of the value that is created.
©2007 The Beyster Institute and its authors and their entities. All rights reserved.
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