• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

V. Anantha Nageswaran

From being a beacon for the free world, America could end up as an example of the anarchy that results from brute and unchecked financial Darwinism, with disclosures about the American corporate world and financial market shenanigans showing no signs of abating, says V. Anantha Nageswaran.

THE STREAM of disclosure about the American corporate and financial market place shows no signs of ending. From corporate malfeasance, accounting irregularities, audit complicity, compromise of integrity in research, it has now spread to the fund management business with revelations about unfair advantages extended by fund houses to favoured customers at the expense of millions of retail investors.

There are no signs that any of the fundamental issues has been addressed. Stock options are still being granted and not expensed. Companies present pro forma earnings results and analysts dissect operating earnings as opposed to earnings reported to the Securities and Exchange Commission and one that forms the basis for declaration of dividends, etc.

The gap between corporate profits measured by National Income accounting and operating earnings of Standard and Poors 500 corporations remains as wide as ever.

Something at the core of the American capitalism has gone rotten. Its moral fibre has seriously eroded. America used to be regarded the land of opportunities. Perhaps, compared to other countries, it still is one. However, it has also increasingly become the land of the opportunists with the game rigged in favour of the insiders as opposed to every one having a fair chance of realising their legitimate aspirations.

Active mutual funds have not delivered returns to investors any better than the average fund that passively replicates the index. Historically, investors have paid more fees to active fund managers in return for mediocre performance.

Fund managers encouraged investors to invest at any price claiming that, over long periods, investing in stocks was invariably profitable. Seventy-year-long charts conveniently obscured periods of stagnation that have lasted a decade or even more. Nor was it disclosed to investors that investing at any level would not yield returns that they desired.

On the contrary, given that returns to investing in stocks revert to their mean, buying stocks when they were overvalued by conventional measures meant that there was a high probability of achieving only modest returns over any relevant investment horizon. Most investors were spared this important disclosure.

An insightful article by John Kay in Financial Times (November 21) argues that fund managers also helped to fuel egregious corporate greed. In return for an opportunity to manage 401(K) investment plans for the employees of large corporations, fund managers entered into a Faustian bargain with company managements not to question corporate actions that harmed shareholders and workers in favour of top management. These usually were in the areas of executive compensation including the grant of stock options.

In America, "from 1988 to 2001, the annual compensation of the average CEO rose 443 per cent, from $2,025,000 to $11,000,000, while the compensation of the average worker rose 60 per cent from $16,700 to $26,700 — in real terms, virtually no increase at all."{+'}

In John Kay's article, America's legendary shareholder activist Robert Monks describes this as the most pervasive and peaceful transfer of wealth from shareholders to insiders which history would view as a shameful atrocity.

In an open letter that he wrote to the President of the Harvard University, Lawrence Summers, the former Treasury Secretary, Mr Monks describes the 1990s thus: "History will look back on the 1990s as a time when the principal officers of public American corporations transferred from shareholders to themselves approximately $1 trillion — or 10 per cent of the market value of public exchanges.

"This must be the largest peacetime movement of wealth ever recorded, and it was accomplished through stealth that amounted to theft. At the beginning of the decade roughly 2 per cent of the market value of listed companies was represented by options, at the end the figure was up to 12 per cent".

The full letter is worth a read and the reference is provided in the footnote below.

It is interesting that both Mr Monks and the legendary fund manager and founder of Vanguard Mutual Funds, Mr John Bogle, feel that part of the reason is that ownership of corporations has so diffused that no one is the real owner with any particular stake in the company.

Mr Bogle cites journalist William Pfaff: "The market had so diffused corporate ownership that no responsible owner exists" and he calls this a `pathological mutation in capitalism' that has resulted in the failure of corporate governance in America.

When ownership is diffused, it becomes easier for managers to reward themselves at the expense of the faceless millions. However, it did not have to be. Institutional investors are not faceless and have the potential to exercise both ownership and involvement.

According to Mr Bogle, "the 100 largest managers of pension funds and mutual funds alone now represent the ownership of fully 56 per cent of all US equities: Absolute control over corporate America".

However, they compromise themselves for other business opportunities such as managing the company's pension fund because, in turn, they do not hold themselves accountable to millions of faceless fund-holders. It is much easier for fighter pilots to kill by dropping bombs from heights than for combat troops making eye contact with the enemy.{+'} That is what has happened with modern capitalism.

Trust that marked old network based financing arrangements and where word of mouth was as good as, if not better than, a written contract, was replaced by obligations based on the written document.

The written word was meant to be honoured both in spirit and in letter. However, the regulators, who were expected to enforce them, were either caught sleeping at the wheel or were willing partners to the planned and organised loot as Mr John Monks puts it.

Again, we can go back to his letter to the President of the Harvard College for evidence: "In 1994, the Business Roundtable, an organisation consisting entirely of the CEOs of large public companies, successfully pushed through a Senate resolution by 88-9 (on May 3, 1994) to declare that "in the money" options were not a corporate expense, and did not have to be reflected in the company financial statements.

The Financial Accounting Standards Board, which had laboured for years under Chairman Dennis Beresford, to require this expensing, had to capitulate to the lobbying pressures that infamously included the SEC and the Council of Institutional Investors."

It is worth raising the issue that when owners can no longer trust external managers to behave in their interests and when managers can hijack the agenda in their favour through a complicit and ineffectual Board that is also incestuous, then what is wrong with Asian `crony capitalism' where ownership is not separated from management and passes on to succeeding generations of the same family? What better alignment of owners' interests can there be with management except when they are the same?

Of course, the answer is clear and it has been eloquently and forcefully presented by Dr Raghuram Rajan, now Chief Economist of the World Bank in his book, Saving Capitalism from Capitalists. Access to finance was used by previous generations of industrial owners to shut off competition.

The cosy relationship between bankers and owners (sometimes, they were one and the same) meant that outsiders had no chance of tilting at the windmill. They could be easily choked off finance that unlocked the potential of any enterprise to deliver value to the innovator, owner and thence to the society.

Therefore, the response to the current ills that plague modern capitalism is not a return to the old ways from which we thought we had progressed. That is an opportunity that many are waiting for — to bottle back the openness, public accountability and above all, opportunity to all that modern capitalism promised.

Unlike the old robber-baron capitalism, concentration of wealth is now occurring not through ownership of factors of production but through an incestuous and insidious network of alliances among the elites. In earlier days, the government and the judicial system, as they began to evolve, effectively checked the powers of the robber barons.

Today, the greed of the modern elite is combined with sophistication and guile. As they join forces to infiltrate institutions and corrode the mechanisms that are meant to provide checks and balances against abuse of power, outsiders are left with few, if any, options to defend, protect and enhance their legitimate interests. Mr Bogle calls this managerial capitalism. The nomenclature is not so important as understanding the menace it causes to the society.

The outcome is that both shareholders and workers are robbed off their dues. Workers are robbed twice — once of their wages and livelihood as companies finally crumble, and the second time, as owners of their employer's and other companies' shares through pension funds.

America needs an effective alliance of Marx and Adam Smith to counter this. Shareholders and workers must combine forces. Else, from being a beacon for the free world, America would end up as an example for the anarchy that results from brute and unchecked financial Darwinism.

1. Source: His speech to the Directors' Summit of the State of Wisconsin Investment Board, Madison, WI, October 1, 2003. For the full speech, visit http://www.vanguard.com/bogle_site/sp20031001.html

2. See http://www.ragm.com/library/topics/ToHarvardWithLove100203.html

3. As in (1) above

4. Source: John Kay's article in Financial Times (November 21, 2003)

(The author is Director, Global Economics and Asset Allocation, Credit Suisse, Singapore. The views are personal. Please send feedback to anantha@nageswaran.com)

Article E-Mail :: Comment :: Syndication

Stories in this Section
Recruitment travails

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line