Sustainable Wealth Generation Requires Active Shareholders. Kaspar Baenziger IHEID Geneva

Sustainable wealth generation
requires active shareholders
IHEID INP FINAL PAPER
DR. KASPAR BNZIGER
GENEVA, SWITZERLAND AUGUST 2016
All Rights Reserved
Sustainable wealth generation requires active shareholders ( All Rights Reserved) 1

Content
Chapter Page
Abstract 4
Introduction 5
Structure of the paper 8
Three sets of problems 10
Three regulatory dilemmas 24
Policy options 40
Conclusion 56
Annex 58
References 97
Acronyms 112

Acknowledgments
I would like to thank all the following friends and colleagues who helped me finding
the right trails in the quest for the truth and who motivated me to shape logic on the
topic at hand. Also, I am thankful to all individuals, which enabled me to learn the
many aspects of corporate governance, successes and failures alike:
Ahmed Al Sayegh, First Gulf Bank; Ahmed Saeed, JP Morgan; Alfons Simonius;
Andre Guedel, KPMG; Aniko Gaal Schott; A. Gaal & Associates; Anita Grfin von
Schnborn-Wiesentheid; Belinda Fleischmann, UBS; Bezawit Ayfera, USI; Bill
Ackman, Pershing Capital; Carl Icahn, Icahn Enterprise; Christian Wolfensberger;
Daniel Jaeggi, Mercuria; David Beatty, New Generation Power; David Darst, Morgan
Stanley; Douglas Coppola, Client First Advisors; Douglas Lane; Dr. Alex To,
Crosscurrent LLC; Dr. Andreas Kailich, Lyford Global Fund; Dr. Daniel Heller, IMF;
Dr. Dr. Philippe Haas; Dr. Ernie Strapazon, Nestl; Dr. Ernst Thomke; Dr. Fabrizio
Pauletti; Dr. Herbert Tratnik, Quadra Partners; Dr. Joseph Ackerman, Bank of
Cyprus; Dr. Marc Faber, Faber Ltd.; Dr. Markus Diethelm, UBS; Dr. Michael Finney,
Finney Capital; Dr. Nancy Chang; Dr. Pietro Poretti, EFTA; Dr. Rupert Thorne, FSB,
BIS; Dr. Vanja Vuletic, UNIBAS; Dr. Walter Grebler, ETHZ; Eike Batista, EBX;
Elena Heinz; Eric Knight, Knight-Vinke LLC; Eric Ringsby, AREDAY; Erik Hartmann,
Tecnopharma; Flavian Kurth; Florin Baeriswyl, DAI AG; Georg Gyssler; Gregory
Heckman, Gallatin Inc.; H.H. Sheikh Tariq Al Qassimi, Union International; H.S.H.
Prince Michael of Liechtenstein; Hans Apostel, OSF Merchant Banking; Hans
Baumann; Hans Steiger; Hussain Alfardan, Alfardan Group; Idil Mohammed; Igor
Ustinov; Iqbal Meer Sharma, Issar Global LLC.; James Breiding, Naissance Capital;
John Stanley Pottinger; Jorge Paulo Lemann, 3G; Justinian Kateera, Harvard
University; Kassy Kebede, Panthon Capital; Marc Luginbhl, FINMA; Mariam Azarm;
Martin Ammann, Unigamma; Matthew Schwartz, BSF LLP; Michael Flury, Bank
Pictet; Michael Haggar; Michael Httmann, Millenium Global; Michael Pearson,
Valeant; Mohamad Hammour, Capital Guidance; Murat Seitnepesov, Integral
Petroleum; Paola Pedrigniani, Amaranth; Patrick Odier, Lombard Odier; Paul
Volcker; PD Fiorangelo Salvatorelli, London; PD Romeo Cerutti, Credit-Suisse; Peter
Brabeck-Letmathe, Nestl; Philip Falcone, Harbinger Capital; Pipo Salvia,
Geymonat; Prof. Carlos Lenz, SNB; Prof. Cederic Dupont, IHEID; Prof. Davide
Rodogno, IHEID; Prof. Giacomo Luciani, IHEID; Prof. Marc Farha, Georgetown
University; Prof. Peter Lorange, Lorange Institute; Prof. Thomas Bierstecker, IHEID;
Prof. Tobias Straumann, UNIZH; Prof. Wolfgang Klietmann, Harvard University;
Raymond Loretan, Aevis Victoria; Rehan Choudry, Altrinsic Capital; Richard
Davidson, Edinburgh University; Richard Fredericks, Main Management; Robert
Scherer, Private Client Bank; Rudolf Suter, LGT Bank; Sam Zell, Equity Group;
Sergio Marchionne, FIAT; Stefano Roma, Leo Funds; Suresh Abishegam, Azimuth;
T. Boone Pickens, BP Capital Management; Tony Fratto, Hamilton Place Strategies;
Tony Hayward, Glencore; Urs Rohner, Credit Suisse; William Adams; Yun
Takazawa, IHEID.

Abstract
The legal framework of American public capital markets is at a seminal

moment. An emerging dominance of passive investment funds jeopardizes
the quality of corporate oversight to the detriment of shareholder value
creation. Outsourcing the most important governance functions to
independent, market dominating advisors leads to misalignments of fiduciary
duties in the financial value chain. The consequence is a transformation of
shareholder primacy into fiduciary dominance. Well functioning financial
markets are a vital aspect in allocating scarce capital to its most effective use
and are thus decisive to Americas prosperity, including the creation of jobs
and the safeguarding of pension assets. Unless the current evolution is
addressed, the economy will increasingly be exposed to further deterioration
in productivity growth, with fragile markets prone to crisis leading to value
destruction. This paper proposes a set of regulatory adjustments in order to
realign interests and priorities of financial intermediaries.

Introduction
The financial crisis and the great recession demonstrated, in a dramatic and
unmistakable manner, how extraordinarily vulnerable are the large share of
American families with very few assets to fall back on (J. Yellen).1
The American economy is exposed to two main risks, one structural and one cyclical.
While a slow erosion of gross domestic product (GDP) and productivity growth is a
structural concern, financial crisis are of cyclical nature. Over the past two decades
the average annual GDP growth has declined from 3.1% to 2.4% along with a
decrease in productivity growth from 3.6% to 1.3%.2 The cyclical perils are naturally
recurring market adjustments, some of which can damage the entire society. Such
was the case during the great recession of 2007-2009 where the majority of
Americans lost on average 45% of their total wealth and retirement accounts
declined by a third.34 The US Treasury had to bail out several large companies it
deemed too big to fail with a $455 billion emergency financial facility.5 Such drastic
measures by governments should not occur in a free-market economy, where
millions of families depend on sustainable economic growth for building their financial
future.
American wealth is built on three pillars of capital formation: 1. Industrial productivity

increase. 2. Efficient financial markets. 3. Rational management of savings. The
corporation is at the heart of extraordinary wealth generation, allocating capital
actively to the most promising investments and producing residual claims as value to
their owners (Figure 23). In the USA, the private industry is leading, contributing 87%
1
Speech be Federal Reserve Chair Janet L. Yellen at the 2014 Assets learning conference
of the Corporation for Enterprise Development, Washington D.C. Sept 18, 2014.
www.federalreserve.gov
2
Real GDP growth: 3.2% per year average since 1945 (FRED): 1955-1975: 3.6%, 1975-
1995: 3.1%, 1995-2015: 2.4% (Table 9). Labor productivity increase has averaged 3.6% per
year since 1988 but stands at 1.3% today (Figure 47; Leubsdorf 2016; Census bureau;
FRED, 2016)
3
2007/8: 45% of worldwide wealth was destroyed. American wealth destruction was primarily
due to decline in home valuation and investments. 63% of American families lost on average
45% of their wealth (FCIC, 2011. Financial crisis inquiry report; Claus, 2015; Pirson, 2011)
4
Valuation declines: Median Family wealth: -23%. Median household mutual fund: -31%.
S&P 500: -57% (Dec 2007-June 2009). Home values (S&P/Shiller): -32% (Dec 2007-June
2009), (Schlesinger, 2011).
5
TARP (Table 8): https://www.treasury.gov/initiatives/financial-stability/TARP-
Programs/Pages/default.aspx

to the countrys GDP (Figure 20; Figure 21).6 The strength of public companies is
reflected in an increasing public market capitalization, which rose from $2 trillion in
1985 to $26 trillion today at a compounded rate of 9% per year (Figure 19). 7
Industrial surplus leads to increasing payouts and capital gains to shareholders that
accumulate into savings, which are the bedrock for a healthy society. Genuine
savings affect the ability to spend, to make long-term investments, to pay for
education and to increase financial resilience during illness or unemployment.
Pension funds, which represent 60% of the entire public equity market capitalization,
depend on efficient capital allocation for generating risk adjusted return for
safeguarding assets (Figure 30).8 While Federal laws provide the framework for a fair
and largely self-regulated market, corporate governance is regulated by a set of rules
and customs connecting household saving to the real economy (Armourt, 2016;
Bucks, 2015; BLS, 2016; De Haan, 2004; Gillan, 2000; Hanley, 2014; Lipton, 2013;
McCraw, 2014; Markham, 2009; OECD, 2015; Schlesinger, 2011; SEC 2016).
The great recession of 2007-2009 exposed the delicate interdependence among all
market participants. While financial shocks can be described as the result of slow
evolving asset mispricings, the cause for a structural economic decline is more to be
found in the realm of regulatory misalignments. Both weaknesses can be attributed
to increasing market complexity along the financial value chain. Changing legal
boundaries, distorted incentives and misaligned duties of financial intermediaries are
leading to twisted corporate governance arrangements. Of particular concern is the
emergence of large and highly concentrated passive investment funds, which seem
to transform shareholder primacy into stakeholder dominance. The consequence is
an increasing disenfranchisement of the ultimate beneficial owner. A possible
consequence of such a value transformative process is a deterioration in corporate
governance, which jeopardizes the safeguarding of shareholder interests and leads
to increased financial market risk.
6
US GDP 2015: $16.4T. $14T (87%) from private industry (86% service industry, 19%
manufacturing industry). Over the next three decades, the American population is expected to
reach 420m people. US Bureau of Economic Analysis April 2016 http://www.bea.gov/
7
The health of Americas public corporations and financial markets and public trust in both
is critical to economic growth and a better financial future for American workers, retirees
and investors (Armourt, 2016).
8
Pension assets are primarily invested through 401(k) and mutual funds. A 401(k) is a feature
of a qualified profit-sharing plan that allows employees to contribute a portion of their wages
to individual accounts. https://www.irs.gov/retirement-plans/401k-plans.

Active corporate governance is crucial for sustainable growth
The financial crisis highlighted the importance of having market oriented policies and
institutions in place that allow for adaptation and foster sustainable economic growth.
Better corporate governance could have reduced the severity of the downturn and
prevented financial scandals. We should remember that shareholders are not only
the owners of an asset but also responsible for their own actions. Without the
participation of active shareholders that provide for proper corporate oversight and
strategic guidance, the American capitalistic system remains prone to future crisis.9
We now have the chance to re-balance the distribution of power and responsibilities
among the key financial players with the goal to increase productivity and reduce the
risk of capital loss. Regulatory adjustments should intend to correct the current
misalignment of interests and empower shareholder friendly measures. The U.S. has
shown over time the ability to adopt legislation in order to accommodate social and
economic changes while balancing the fundamental values of a free-market
capitalistic system. Whereas previous legislation was enacted after a crisis, we
should evaluate the possibility to realign the legal framework in anticipation of future
difficulties, to render the economy structurally more resilient in the future (Barton,
2011; Cioffi, 2003; Gilson, 2013; Kirkpatrick, 2009).
9
Our future depends on these companies being managed effectively for long-term
prosperity, which is why the governance of American companies is so important to every
American. Corporate governance in recent years has often been an area of intense debate
among investors, corporate leaders and other stakeholders. Yet, too often, that debate has
generated more heat than light (Armourt, 2016).

Structure of the paper
This paper deciphers points of weaknesses in the American economic system with a
focus on public capital markets. Analyses will be given to detail the consequences of
regulatory misalignment of interests and incentives, which may provoke a
deterioration of shareholder value creation. We then develop policy options with the
aim of rendering the American capital markets fit for the coming decades for
sustainable wealth generation and increased resilience for future crisis.
The discussions in this paper revolve around the core pillars of the American
financial system, which are the corporation, its investors and the financial markets
(Figure 1):
1. Corporation: The Corporation, a legal personality with limited liability, is at the

core of capital formation by increasing productivity. The main purpose of the
corporation is to increase shareholder value over time with the Board of Directors
responsible for governance, including the operational strategy and efficient capital
allocation. Most public American corporations are incorporated in the State of
Delaware and therefore fall under its legal constituency (Glaser, 2013; Millstein,
2012; Palia, 1999; Pitelis, 2010; Tian, 2011).101112
2. Investor:13 The ultimate beneficial owners provide their savings as risk capital to
corporations in return for potential capital gain. Most shareholders mandate
intermediaries such as fund managers to handle their investments. Shareholder
rights are limited to residual claims and some influence over corporate affairs such
as voting for the election of directors (Bainbridge, 2013; Black, 1990).
10
Wealth creating ability of market economies: Visible Hand of the firm and the invisible
hand of the, market. Adam Smith, Wealth of Nations, 1776.
11
Productivity isnt everything, but in the long run it is almost everything. Paul Krugman,
1990. Around 90% of the increase in real per capita output is attributable in efficiency growth
(Palia, 1999).
12
Starting with Alexander Hamiltons plan of the central bank to structure credit and currency,
it liberated the entrepreneurial sprit to embrace investments while assuming limited liability for
business decisions. The general promotion of long-term business confidence led to social
capital mobility. It encouraged risk taking; scientific advancement and productivity increase
with the result of generating great wealth (Chapter 11, McCraw, 2014).
13
The definition of investor, owner and shareholder will be used interchangeably throughout
the paper depending on the context.

3. Market: The market provides a fair and orderly exchange and is vital for the
supply of capital to stimulate economic growth. The shareholder is connected to
his asset via a complex financial value chain, which enables a plurality of market
participants to price risk, essential for efficient capital allocation. (Figure 22;
Gilson, 2013; Desai, 2012). Only five main Federal acts have been ratified by the
Congress to govern the securities industry since 1933. The Security and
Exchange Commission (SEC), as the main regulatory agency, is responsible for
rulemaking and law enforcement but outsources most of its tasks to self-regulating
organizations, such as the Financial Industry Regulatory Authority (FINRA). 14
Figure 1: Pillars of the American financial system
Asset pricing
Risk premium
Market
Capital allocation
Liquidity Capital Gain/Loss
Corporation Investor
Corporate Governance Risk diversification

Productivity increase Capital formation
Residual claims
The paper is structured in three parts:
1) Analyzing three sets of problems that remain after the Dodd-Frank Act.
2) Questioning three regulatory dilemmas.
3) Developing several policy options.
14
Securities Act of 1933, Securities Exchange Act 1934, Investment company Act of 1940,
Sarbanes Oxley Act of 2002 and Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010 (www.sec.gov).

Three sets of problems
The recent financial crisis highlighted the fragility of the American capital system. Of
particular concern has been the detrimental effect on retirement savings. Profound
congressional inquiry has deciphered aspects of regulatory deficits. The subsequent
enactment of the Dodd-Frank Act in 2010 reduced some of the structural legal gaps.
However, the prevailing market structure and regulatory framework continues to
produce substantial points of concern. Three particular problem zones require careful
study:
1. Pension funds struggle to generate 7.5% return per year

2. Increasing concentration of power in index funds
3. Investors have no incentive for active corporate governance
1. Pension funds struggle to generate 7.5% return per year
Aging demographics, rising wealth and employee based retirement systems led to an
accumulation of $12 trillion in pension funds representing 70% of all US investment
holdings.15 Pension funds need an average return of 7.5% per year, in order to fulfill
their retirement obligations. This is an enormous challenge. Today, pension funds
run by large companies are underfunded by $562 billion and the public retirement
plans show a staggering deficit of $3.4 trillion. Until the 1990s, required returns could
be generated from relatively stable bond income streams. However, with changing
monetary policies, asset allocation shifted increasingly towards equity investments in
search for higher returns, which currently represents 63% of a pension portfolio
(Figure 2; Figure 25; Authers, 2016; Rauh, 2016; Schfer, 2014; Martin, 2015; ICI,
2015; OECD, 2015).16
15
To put this number into context: The total American equity market capitalization is around
$25T out of which $18T are from institutional investors, which contain $12T of pension fund
assets. Therefore, pension fund monies represent around 50% of the entire US equity market
capitalization.
16
OECD 2015: Pension fund five year nominal average growth: 5.7%.

An equity investment return is generated by the combination of dividend income and
capital gain.17 In order to generate 7.5% return per year with equities entails a risk
that is three times higher than to generate the same amount with bonds (Figure 24;
Martin, 2016). 18 The dividend income which tends to be the safer portion of
monetary gain has become less safe over the past two decades for three reasons: 1)
average dividend yields have declined from 3% to 1.8%; 2) dividend growth has
declined from 1% to 0.5% and 3) the safe portion of gain out of the total return has
declined to 17% from 27%. Therefore, all parts of the safer portion of return have
decreased, leaving pension funds exposed to higher uncertainty (Figure 26; Figure
27).
Investments in equities are more complex than investments in bonds. It requires a

combination of fundamental understanding of industries and active participation in
corporate governance issues to direct capital towards the most promising projects.
The pension fund market as it is structured today is not able to provide such know
how on a rational basis as it is entirely focused on managing diversified portfolios.
Policies should encourage the production of intelligent industry expertise and its
application in portfolio management along with comprehensive engagement in
corporate governance.
Figure 2: Over 60% equity exposure required to meet pension obligations19
Alternatives: 8%
Alternatives: 25%
Equities: 40%
Bonds: 100%
Equities: 63%
Bonds: 52%
Bonds: 12%
1995 2005 2015
Expected return 7.5% 7.5% 7.5%

Standard deviation 6% 8.9% 17.2%
17
Capital gain: difference between the purchase price and sales price of a share of an asset.
18
In order to receive an equivalent return on investment, equities are exposed to a volatility of
17% versus 6% for bonds (Martin, 2016).
19
Martin (2016); Authers (2016).

2. Increasing concentration of power in index funds
The global market capitalization of companies is $60 trillion with 43% of these
located in the USA 20 . Today, most equities are managed by a few investment
companies. American institutional investors have $18 trillion under management,
70% of those are from pension funds. Up to one third of shares in large companies
are held by the top five institutional investors. As a consequence, more than 20% of
the biggest 1500 companies in the U.S. have fewer than 300 official shareholders.
Such a concentration of power in a few hands is prone to a set of negative effects
(Figure 34; Figure 35; Table 17; Gilson, 2013; Schmalz, 2014; Zweig, 2016). 2122
The leading investment companies have emerged with a focus on index funds,
managing assets in a passive way. An Index funds purpose is to replicate a defined
market and offer the product at low cost. This is achieved by reducing the tracking
error of the fund, which can be done by an automated computational approach.23
Today, 20% of the entire equity market, or $1 out of $5, is invested in index funds.24
The top 100 index funds collectively manage $4.7 trillion, with BlackRock, Vanguard
and State Street controlling 70% of total assets. BlackRock alone holds around $2.9
trillion in passive funds. 25 26 During the past seven years, $1.7 trillion of assets
20
World Bank, July 2016.
http://data.worldbank.org/indicator/CM.MKT.LCAP.CD?end=2015&locations=US&start=1975
&view=chart.
21
The twelve largest institutions control up to 40% of the ten biggest public companies
(Schmalz, 2014). 2009: The 12 largest institutional investors owned 25% of Exxon, 32% of
Microsoft, 37% of Apple, 44% of Google (Gilson, 2013). Example 2013/2014: Institutional
investors now own 80% of all stocks in the S&P 500 Index. The top 4 shareholders of JP
Morgan owning 20% of the company were: BlackRock, Vanguard, State Street and Fidelity.
The same top four owned also 17% of Bank of America; 22% of Citigroup; 19% of Apple; 17%
of Microsoft and 25% of CVS (Elhauge, 2016).
22
SEC 1934 regulation requires to list only the institutions that represent the ultimate
beneficial owner. Such as BlackRock, Schwab, Fidelity etc. As an example, Nvidia
Corporation with a market capitalization of $25b and 534 m shares out has only 342
shareholders listed. However, the company estimates that there are at least 200000 different
shareholders. This concentration trend seems to be accelerating. Average number of
shareholders listed for the largest 1500 stocks in the US S&P500 index decreased from 3342
in 1995 to 1969 shareholders today. Among all stocks traded by SP Dow median shareholder
shrunk from 1626 in 1995 to 352 today. Under SEC rules, a company with fewer than 300
shareholders may de-register with federal securities regulations and the company is no longer
required to file its financial statements (Zweig, 2016).
23
Tracking error: The return of a funds net asset value relative to the return of the index
defined (Weinberg, 2012).
24
Index funds share of all stock fund assets: 2000 9.5%, 2013 18.4% (ICI, Wathen, 2015).
25
Largest ETFs: Top 100 ETFs by assets. http://etfdb.com/compare/market-cap/ . 50 largest
equity mutual funds by total net assets. (Lipper, Reuters, July 14, 2016).
26
March 31, 2016, BlackRock's assets under management total US$4.737 trillion across
equity, fixed income, cash management, alternative investment, real estate and advisory
strategies. 70% of $4.7T are in Index funds and ETFs ($2.9T: $1.8% in Index, $1.1T in

changed from active- to passive managed funds with an accelerating trend.27 The
reason of such a shift is a combination of policy changes, a one-sided academic
body of belief, convenience and cost. Active managed funds are challenged to
charge adequate fees, as their performance seems not to justify their cost.28 Only
39% of active managed equity funds beat their benchmark but charge 0.82% in fees
compared to 0.05% for index funds. Constrained by regulations and cost
consciousness, pension funds are increasingly geared towards passive investments
and hold around 30% of their assets in index funds. This trend is reflected by the
private index industry, which controls around 20% of pension fund assets today
(Figure 36; Table 10; ICI, 2015; Gullapalli, 2007; ICI, 2015; Steverman, 2016 Stein,
2016; Wathen, 2015). 2930
the shift to indexing will not only continue but will be massive (L. Fink).31
What might be the ultimate outcome of such a drastic shift towards passive
investment funds? If the trend continues, a strong case can be made that a majority
of equities will soon be held in a few index funds that have the right and fiduciary
duty to vote. A simple calculation: Approximately 20% of all public equities are held in
index funds, a ratio which is expected to grow to 30% by 2020. This would imply that
the three largest fund companies would control around 20% of all stock voting by
2020 (Figure 3):32
ETFs). Fidelity mutual funds; $1.5T (Dec 2015) in 452 funds and over $1T in equity assets.
BlackRock and Vanguard alone manage $7.5T in Index funds (Voth, 2016).
www.blackrock.com/au/individual/about-blackrock.
27
We expect that the growth of passive investing will remain strong, Alex Matturri, CEO of
S&P Dow Jones Indices in New York, Bloomberg July 13, 2016. The reality is that indexing is
taking over. Johnson, Franklin CEO. FT, June 2016.
28
Academic investment and asset management thought has been based on the modern
portfolio theory with the assumption that in an efficient market to is best to minimize risk via
investing into a diversified portfolio of shares (Markowitz, 1952; Gilson, 2013).
29
Calculation: $4.7T index funds, 70% from pension funds = $3.29T. $3.29 out of total $12T
of pension funds = 30%. Top three control 70% of market out of 30% of pension assets =
20%.
30
Average mutual fund expenses: 2000 99bp; 2014 70bp. Index funds 11bp. 70% of equity
funds are in lowest quartile. 85% of the index funds are in the low expense ratio. Over 60% of
the 401(k) assets are in lowest quartile mutual funds.
31
the shift to indexing will not only continue but will be massive. Larry Fink (Stein, 2016).
32
Calculation: Growth of index funds as shares of total equities 2000-2007: 3.1% CAGR.
2007-2013: 7.7%. Own estimates 2013-2020: 8% CAGR. The growth of total US equities is
estimated at around 6% CAGR from $26T in 2014 to $37T in 2020 (est at 30bp below
historical CAGR since 1985). At above estimated index share growth to 30% out of total
implies a total index fund volume of $11T. If top three index fund companies still control 70%,
that makes $7.8T attributed to them, or 20% of the entire equity market.

Figure 3: Total equities held in index funds by 2020
+$2.4T
100% 100%
Voting power in active
Voting power in passive

Managed funds
Managed funds
Share of equities
in index funds
US public equity market:

2014: 20% ($4.8T) of $24T, 2014
Equities in index funds
2020e: 30% ($7.2T) of

Equities in index funds,
representing30% of US equity
voting power from passive funds
Index funds will be permanent owners who can never sell. That will give them
power they are not likely to use well (C. Munger).33
The question is whether such a concentration of power in passive funds is potentially

damaging to the economy? Market dominance can lead to loss of competitiveness
and income inequality which can jeopardize the delicate economic balance to the
detriment of the consumer. A sequence of antitrust acts defines which sort of power
concentration is acceptable within a certain industry until it assumes a monopolistic
character that can influence prices and market share. The emergence of few
dominant index funds suggests such a monopolistic trajectory, with the potential to
influences prices of financial products and the risk of jeopardizing a vibrant market
(Figure 42; Wong, 2013).3435
33
Charlie Munger, Berkshire Hathaway, Annual daily journal meeting, March 2015 (Wathen,
2015).
34
American antitrust acts which restrict the formation of cartels and prohibition other collusive
practices as being regarded to restrict trade. They also restrict monopoly and abuse of their
power.

If we will not endure a king as a political power we should not endure a king
over the . sale of any of the necessaries of life (J. Sherman).36
To understand the policy implications of power concentrations, we have to study the

legal history of American regulations. Laws evolved along a line of deep distrust of
large accumulation of capital for fear of abuse, which goes against the free-market
beliefs. Over the past century, the concentration of power has shifted from
shareholders to managers and now to institutional investors. Each time a critical
concentration matured, new regulations were enacted with the goal to counteract
market-damaging trends and to protect the consumer while stimulating competition.
The American evolution of market regulation can be described in few episodes. In
the 19th century, large market dominating trusts emerged, which led to installments of
antitrust laws to stimulate competition. Subsequently, a vibrant stock market with
new sources of liquidity developed. However, abusive market manipulation resulted
in the crash of 1929 followed by the Great Depression. The consequence was the
enactment of a series of securities laws to regulate markets and the installment of
the Securities and Exchange Commission (SEC) as its core.37 In the late 1990s, the
failure of proper audit supervision ended in massive corporate frauds, which
stimulated the Sarbanes-Oxley Act in 2002. Then, during the past two decades,
opaque and complex securitizing of real estate mortgages caused the financial crisis
of 2008. Accordingly, large financial institutions became better regulated under the
Dodd Frank Act in 2010 (Figure 4; Table 16). Today, the growing size of index funds
1) The Sherman Antitrust Act of 1890: prohibited trusts to accumulate market dominant
shares in order to dictate prices and drive competition out of the market (Woth, 2016). US
Code, Title 15, Chapter 1, 1; https://www.law.cornell.edu/uscode/text/15/1.
2) Clayton Antitrust Act and Federal Trade Commission Act 1914 (www.ftc.gov): clarification
and expansion to the Sherman Act both, substantive and procedural modifications. US Code,
Title 15, Chapter 1, 12; https://www.law.cornell.edu/uscode/text/15/12.
3) Hart-Scott-Rodino Antitrust Improvement Act of 1976.
35
To highlight the possible dimension of index fund market power: Today, around five
companies control 20% of the entire public equity market with the rights to vote. Considering
that these voting rights are outsourced to proxy advisory companies, mostly opting for
automated turnkey voting procedure, leads to a hidden stakeholder value transformation.
Taking into account that two companies control 97% of the proxy markets entails a high
probability that at the end less than ten companies implicitly rule over 20% of the entire
American equity market. This concentration is likely to increase to 30% in the near future. The
last time America encountered such a concentrated financial market power situation was in
th
the late 19 century.
36
If we will not endure a king as a political power we should not endure a king over the
production, transportation, and sale of any of the necessaries of life. Senator John Sherman.
Chapter The political economy of citizenship, page 232. Democracys discontent: America in
search of a public philosophy. Michael Sandel, Harvard University Press, 1996. John
Sherman, was the champion of the antitrust act, named after him in 1890. The Sherman
Antitrust Act (Sherman Act, 26 Stat. 209, 15 U.S.C. 17).
37
Securities Exchange Act of 1933, Securities Act of 1933.

displays a different kind of power control. While index funds are highly cost efficient,
they have metamorphosed the shareholder value chain into something different than
what was intended by law (Banoff, 2003; Elhauge, 2016; Frank, 2011; Picketty,
2003).
Figure 4:Concentration of power in American markets38
Shareholder Managerial Institutional

concentration concentration concentration
Shift from money market Shift to institutional

Shareholders
Power with the funds to mutual equity ownership:

Increase household 1980: 35%, 2005 72%.
banker as directors to funds
equity ownership Stakeholder doctrine
raise capital for Portfolio theory
industrial expansion emergence dominates shareholder
(credit related) primacy
Divergent interest
Corporations
Concentrated Emergence of Concentrated

ownership with managerial power ownership with
shareholders Institutional funds
1930s Time 2000+
1880-1935 1933-34 SEC 2002 Sarbanes Oxley

Laws that large companies are not protect shareholders ERISA 1974
Independence of director
Laws
controlled by big banks and pensions funds from

(financial disclosure; election, audit committee
insurance employer to employee
director voting and and reimbursement
Clayton Act, Fed Trade Commission 401k, 1982 fungibility
proxy access 2009 Dodd-Frank Act
Act, Fed Reserve Act, McFadden of pension funds
Act, Glass Steagal act
Limit shareholder Limit managerial Limit managerial

thought
power
Legal
concentration power
Promote capitalism
Index funds sterilize the shareholders
Critical is the fact that institutional investors hold equities on behalf of the ultimate
beneficial owners with the fiduciary duty to vote. Therefore, the perceived passive
index funds become active owners for the wrong reasons. 39 Greater shareholder
power is presumably expected to be coupled with greater shareholder responsibility.
However, due to the impossibility of handling vast amount of votes themselves, the
funds mostly outsource their obligations to independent advisors. These provide
38
Fligstein, 1995; Ross, 2008; Rock, 1996, Roe, 2003; Fisch, 2012, Cole, 2007; Mitchell,
2006.
39
I wouldnt call them passive owners. They say themselves that they are passive investors,
but active owners. They vote on the board makeup, and they discuss business topics and
strategy with executives. They are the biggest shareholders. (Schmalz, 2014).

automated turnkey voting procedures, which are heavily influenced by the incumbent
management of companies in the portfolio. This stakeholder influence tilts interests
towards management and implicitly disenfranchises active, informed investors. Such
an evolution is highly concerning as it increasingly sterilizes the ultimate beneficial
owner. A further thought merits attention in this regard. If index funds purpose is to
replicate the market, then the very fund becomes de facto a proxy market. However,
there is a big difference between a market as defined to provide an efficient
exchange and a proxy market as provided by a fund. While the real market has no
voting rights, the index fund does. This leads to the question why an index fund, that
provides nothing other than replicating a market return, should maintain the right to
vote?
From one share, one vote to one vote for many shares
The golden standard of corporate governance is the assumption that all shareholders
have one vote per share they own. Current centralization of voting power in few large
index funds leads them to decide over many shares. Thus, the emerging golden
standard should rather read as one vote for many shares. While the funds declare
non-partisanship and work for the clients best interest, a monopoly over how to vote
seems a dangerous proposition in a democratic market system 40. If the top five
institutional investors hold up to 33% of shares in large companies, and additionally
are engaged in cross shareholding entanglement, then a pluralistic democratic voting
process looks questionable.41 A potential misuse of such dominating voting power
and the shift of purpose clearly goes against the bedrock of the American democratic
capitalism and shareholder doctrine. As a consequence, index funds offered at very
low cost implicitly squeeze out different forms of investment management structures,
such as active fund managers. Unless a financial market is able to offer a variety of
40
As an important part of our fiduciary duty to our clients, BlackRock advocates for public
policies that we believe are in our investors long-term best interests.
http://www.blackrock.com/corporate/en-us/insights/public-policy.
41
investment advisers manage $19 trillion on behalf of their clients, in most cases, clients
give these advisers authority to vote proxies relating to equity securities. This enormous
voting power gives advisers significant ability collectively, and in many cases individually, to
affect the outcome of shareholder votes and influence the governance of corporations.
Advisers are thus in a position to significantly affect the future of corporations and, as a result,
the future value of corporate securities held by their clients. Final rule: Proxy voting by
investment advisers. SEC 17 CFR part 275, final 2003 https://www.sec.gov/rules/final/ia-
2106.htm#P76_15555.

investment products that address manifold industrial needs, a market is prone to
failure. Policymaking should focus on a combination of reducing the accumulation of
power in passive funds and give the votes back to informed- and engaged
shareholder oriented fund managers (Azar, 2011; Azar, 2016; Elhauge, 2016;
Gregory, 2013; Illig, 2007; Morck, 2009; Morris, 2015; Ockenfels, 2016; Schmalz,
2014; Wathen, 2015).
One share, one vote
Index funds:
One vote for many shares

3. Investors have no incentive for active corporate governance
Investors are the nexus between the ultimately beneficial owners and the
corporations by holding shares directly or indirectly in a fund. There are four different
types of investors: active- and passive managed funds, pension funds and activists
investors:
1) Active managed funds: Typically mutual funds that are predominantly

occupied managing a portfolio of shares, trying to beat a defined benchmark.
They are incentivized to increase the assets under management but have
little interest in corporate governance. Mutual funds are ruled by the Federal
investment company-, and the investment advisory acts of 1940.42
2) Passive managed funds: Mostly index funds that try to replicate a defined
market. Index fund management companies focus on structuring cost efficient
investment products and have little motive to become active (Markowitz,
1952; Steverman, 2016).
3) Pension funds: Predominately allocate assets to external fund managers

that deliver low cost relative to performance. Pension funds are ruled under
the Employee Retirement Income Security Act (ERISA) and by individual
State law.43 They have little competition as most state employees have no
options to opt-out of their pension plans.
4) Activist investors: They have a mandate to generate absolute returns.

Activists are focused on increasing shareholder value by creating valuable
private information about companies and their industries. These investors
may engage actively in corporate governance issues including proxy
engagements and fights for board control (Figure 37).
42
Investment Company Act 1940: requires managers to invest 75% of assets in a diversified
way, limits of ownership to no more than 10% and no more than 5% of assets under
management can be invested into a single company (Illig, 2007).
43
Employee Retirement Income Security Act (ERISA), 1974. Shift from employer to
employee, privately funded pension system. Shift to defined employer contribution plans.
Congress enacted the legislation to set up special entities to manage pension resources,
which are governed by trustees with the fiduciary duty to act only on behalf of the beneficiary.
The result was a massive pension fund growth from $870b in 1980 to $3T in 1990 (Gilson,
2013; Zelinsky, 2004).

Changing perception of shareholder rights
While investment strategies and tactics have changed over time, all investor types
maintain a fiduciary duty towards the ultimate beneficial owner. However, a fund
managers range of actions to fulfill the shareholders rights and obligations are
limited. They are implicitly rewarded when focusing on marketing to gather assets
under management and are not incentivized to defend shareholder rights or to act as
corporate governors. This conflict of interests leads to a set of problems. Among
others, institutional investors are generally reluctant to engage actively on boards as
it might conflict with the companies whose assets they manage. Also, if a fund
manager incurs a loss, they would rather sell the position instead of trying to correct
corporate strategies (Table 11; Dasgupta, 2015; Davis, 2008; Gillan, 2007; Gilson,
2013; Illig, 2007).4445
The perception of shareholder rights has changed over time. After the Great
Depression, shareholders were elevated, given the right to vote and dissent with
management via the 14a-8 proxy access schedule. However, these rights were later
curtailed due to corporate raids in the 1980s. With the enactment of the Employee
Retirement Income Security Act (ERISA) in 1974, public pension funds began
advocating for stakeholder issues via proxy access, as not voting is considered a
fiduciary failure and breach of duty (Benoit, 2015; Coffee, 2016; Del Guercio, 1999;
Gilson, 2013). 46 Nevertheless, their activism has been more of political and social
nature; distracting management and often leading to a share price decline (Figure
40). Even if the management of a company should settle to adopt social changes,
these are more often of a symbolic character in order to get rid of the nuisance of the
dissident stakeholders (Figure 33; David, 2007; Gershenson, 2015; Jiao, 2013;
Lucchetti, 2004). Today it is recognized that strong shareholder rights along with
alignment of interests are responsible for increased sales growth and profits leading
to higher equity valuation (Gompers, 2003).47
44
Example: A fund manager invests 3% of the funds into a 5% ownership of a company with
the goal of a 10% gain. The gain in the fund assets would then be 0.3% (0.1x0.03). 95% of
the benefit from the funds activism goes to free rider, yet the fund may pay 100% of the cost,
which reduces his 0.3% gain. Therefore, the fund is better spending the money to market the
fund to gather more assets under management (Gilson, 2013).
45
To sell an investment that turned negative is called the Wall-Street Walk.
46
Regulations around proxy access: Board director election, State law. Audit firm approval
and compensation packages, Federal law (SOX). Major changes approval, State law. Vote
shareholder resolution, Federal law (SEC 14a-8).
47
CEOs are paid a remuneration composed of cash and incentive in shares. The equity
share of total compensation increased from 20% in 1990 to 70% today (Desai, 2012). A

Activist investors are corporate governance champions
Corporate governance is key for effective cash flow allocation. Good corporate
governance aligns the interests of stakeholders with those of shareholders and is
related to increased profitability, capital formation, investor confidence and reduced
agency cost. On the other hand, bad corporate governance leads to skewed
incentive schemes, distorted asset valuations, misallocation of capital and capital
loss. If managers of a corporation are left with too much financial flexibility, they may
engage in wasteful spending, driving down productivity and shareholder returns.48
Furthermore, a loose management has a higher likelihood for earnings management,
which leads to financial report restatements, deterioration in performance and direct
damage to the value of the firm (Table 12; Table 13; Figure 29; Figure 31; Drobetz,
2010; Belghitar, 2015; Bhagat, 2002; Bhagat, 2008; Cioffi, 2003; Chih, 2008; Chung,
2005; G20/OECD 2015; Gompers, 2008; Hoffman, 2015; Harris, 2007; Hadani, 2011;
Jensen, 2001; Kahan 2007; OECD 2015; Picou, 2006; Pfarrer, 2008; Rindermann,
2015; Renneboog, 2011; Von Lilienfeld, 2014). 4950
Activist investors are filling an important function as governance entrepreneurs. They

address strategic issues such as capital allocation to enhance productivity,
profitability and increase shareholder value. Activists are agents of change; reduce
agency cost and have a disciplinary market role. Today, they manage around $166
billion. This investor class is able to take concentrated investment approaches by
creating valuable private information, and then getting engaged in a sophisticated
way as shareholder champions.51 To gain corporate influence demands tremendous
effort and board participation is usually required for changing company strategies.
management whose compensation is linked to share price is better for total shareholder
return only if the corporate strategy is properly backed and monitored by vigilant board
members. Well-governed companies see a strong outperformance of 4-10% if the CEO is an
owner (Dalton 2007).
48
Proper corporate governance has profound impact on the valuation of the company and the
value of cash. The market values $1 in a well-governed corporation for up to $1.8 whereas in
a poorly governed corporation for only $0.42 - $0.8, a 50% discount. Companies with better
transparence demand a 9% higher share price than equivalent companies (Cremers, 2005;
Durnev, 2005; Dittmar, 2007; Faulkender, 2006; Drobez, 2010).
49
Earnings management: Manipulation of the firms earnings report in the financial
statements. The effects of earnings management can be: Increased cost of capital, share
price decline, earning quality erosion, misallocation of capital. The Sarbanes Oxley Act, 2002
tried to minimize earnings management (Hadani, 2011). Between 1997-2002, 919
restatements (9.95%) of all companies due to accounting irregularities, lowering the
combined market value by $100b (US General accounting office, 2002).
50
Delaware General Corporate Law, DGCL (Title 8, Chapter 1 of Delaware code).
51
Assets under management by activist investors: 2002: $23b, 2014 $166b (Table 18:
Some activist funds; Coffee, 2016).

When activists single out a company deemed as underperforming, they will start to
buy shares to gain influence. A set of rules limits the corporate actions an investor
can take and how fast. For example, schedule 13D regulates that an investor who
buys more than 5% of a company must file the source of funds and the investment
intent within ten days to the SEC (Figure 43; Birstingl, 2016; Chattopadhayaya, 2011;
Coffee, 2016; Hill, 1989; Thakor, 2010). 525354
Activists render companies more competitive
Overall, activist investors are successful over 50% of the time in achieving their
declared goals. They render companies more innovative and competitive, increase
sales and lower capital expenditures.55 Furthermore, active corporate governance
has a positive effect on stakeholders such as creditors, employees and carries a
positive spillover effect on peer companies. 56 Companies that are exposed to
activists show a substantial share price increase on the short-term as well as over
the long term57. This positive effect is reflected in a statistical significant increase in
wealth for all stakeholders. Nevertheless, there are controversies around the
assumption that some activists are exclusively focused on maximizing short term
profits by either leveraging the company with excessive debt and paying out special
dividends, or selling non-core assets (Lipton, 2013). However, most activists are
sophisticated, have a profound understanding of the company; its business sectors
and act rationally. Their engagement is primarily of a collaborative nature with the
incumbent management and only few active engagements proceed to a proxy
contest58 (Table 14; Aslan, 2016; Asbaugh-Skaife, 2012; Bebchuk, 2013; Bebchuk,
2015; Boyson, 2011; Bouvatier, 2013; Clifford, 2008; Coffee, 2016; De La Merced,
2013; Faleye, 2004; Goranova, 2014; Gilson, 2013; Harris, 2010; Holderness, 1985;
52
SEC 13D beneficial ownership report.https://www.sec.gov/answers/sched13.htm.
53
Delaware law discourages the formation of large stakes. Also, the controlling shareholder
has fiduciary obligation to minorities as ruled by decisions such as Zahn v, Transamerica,
1947; Sinclair Oil Corp. v. Levien, 1971; Weinberger v. UOP, 1983 (Bainbridge, 2005).
54
Objectives of activists: Maximize shareholder value, 60%. Governance issues, 31%.
Business strategy, 18%. Sale of company, 15%. Adjust capital structure, 13%. Data
represents the reason of activism after filing for 13D with SEC. Median size of target company
$1bn. Data range 2001-2006 (Brav, 2015).
55
Total factor productivity (TFP) increase based on activism is around 7-10% higher three
years after intervention (Brav, 2013).
56
Labor efficiency increases 7.3% after activism (Brav, 2013).
57
Share price increase defined as difference after 13D filing in excess of buy and hold only
strategy. Activism effects over long term (Return on equity) do not show a short-term gain
reversal (Brav, 2013).
58
Carl Icahn commented in a recent interview that even he was "surprised by how often he is
being invited to join company boards without having to launch a proxy fight. (Laide, 2014).

Johnson, 2009; Johnson, 2013; Klein, 2009; Kahan 2007; Voussem, 2015; Frick,
2016; Venkiteshwaran, 2010).
A free ride for all at the cost of one
Successful activism is based on developing strategic ideas of substance and

communicating them effectively across a wide audience of investors, media and
stakeholders (Nathan, 2013). To develop such sophisticated strategies is pricey and
time consuming. The resulting privately developed information is highly valuable and
a form of property right (Kobayashi, 2010). A proxy campaign can be very expensive
and costs vary between $300k to $12m.59 In order to have a meaningful impact on a
corporation necessitates a substantial acquisition of shares. However, if more than
5% are acquired the SEC requires filing of schedule 13D which renders the private
good public. While all investors profit from a successful campaign, the cost is born
only by the investor who created the private information. The activist is therefore
challenged in how to recuperate the high costs assumed. There are three ways in
that regard: 1) Management fees; 2) performance fees and 3) reimbursement by the
corporation if an activist gains control over the board (Gilson, 2013; Rubach, 2009).
The performance fee is the biggest incentive but also the riskiest. The problem is, in
order to generate a risk adjusted return, an activist must accumulate enough shares.
However, the silent accumulation of shares leads to an above normal turnover, which
is recognized by the market. Expecting a shareholder friendly move and resulting
increase in share price, other investors start to buy and getting a free ride. The free
rider dilemma is a problem and leads to a neglect of more shareholder activism.
Regulations should be crafted carefully in order to not discourage those that produce
valuable private information and engage in shareholder value accretive corporate
governance (Figure 44; Aslan, 2016; Becht, 2010; Bainbride, 2005;
Chattapadhayaya, 2011; Copland, 2015; Gantchev, 2013; Grossmann, 1980; Hall,
2014; Illig, 2007; Kahan, 2011, Schfer, 2014).6061
59
Average cost of proxy contest depending on market cap of targeted company: MC <$300m,
$270k; MC $300m-$1b, $650k; MC >$1b, $2.7m. Range overall between $30k-$9m. 2009
numbers. Most cost accrues in private information generation, the proxy media campaign and
legal costs (Kahan, 2011, Activist Insight, 2014; Lohr, 2002).
60
Example: Company X has 110 shares out at $10 per share. An activist investor buys 10
shares for $10 with the intention to change corporate governance and expects to unlock value
by his actions. If problem is solved, the share price goes to $20. If share price indeed doubles
to $20, the activist sells his stake and makes $100. The other passive investors which held on
to the stake made $10x100 shares=$1000 benefit without incurring cost to do so. The
difference is ten fold at no cost whatsoever (Bainbridge, 2005).

Three regulatory dilemmas
Dissent is the highest form of patriotism (T. Jefferson).62
Based on recent market failures and the increasing concentration of power,

conventional thinking needs to be questioned. We have to assess perceived
imbalances, which lead to dilemmas and possible regulatory failures. Current market
regulations lead to a structural paradox. While the law tries to protect the ultimate
beneficial owner and its property, the current legal framework turned the essence of
this intent against the shareholder. Such a transformative process is not obvious
when looking from any one single power distributive logic. However, it becomes
clearer as we analyze the underlying mechanics of the American capitalistic system.
Three dilemmas emerge which disenfranchise the shareholders. All three revolve
around the American concept of a free competitive market with the freedom of choice
and protection of property at its core. A strong case can be made that without
addressing the current weaknesses appropriately; the American economy will be
prone to market failures in the future.
1. Principal- Agent dilemma

2. Consumer- Product dilemma
3. Fiduciary Duty dilemma
Disenfranchise shareholder
Principal - Agent Fiduciary duty
+
dilemma dilemma
Stakeholder transformation
Consumer - Product
dilemma
61
If passive shareholders buy shares during a public disclosure of an activist engagement
(13D) then they could earn an additional raw return of 12-14% above normal buy and hold
without incurring the cost to do so (Becht, 2010, Bainbrudge, 2005).
62
Thomas Jefferson quote: https://www.monticello.org/site/jefferson/dissent-highest-form-
patriotism-quotation.

1. Principal agent dilemma
The financial value chain is an interconnected web of intermediaries that act as

agents between the principal who is the ultimate beneficial owner of an asset. There
are at least three different agents that function to facilitate the accessibility, valuation
and management of an asset. Agency problems may arise with increasing distance
and complexity between the main actors leading to asset mispricing, capital
misallocation and self-serfdom (Table 12). 63 Two legal spheres regulate the
interaction between shareowners and their agents, one from the Federal level and
the other from the State level. State law primarily protects the corporation from
shareholder abuse while Federal law protects the shareholders from market andor
corporate abuse. Both legal spheres compete for influence and led to a change in the
perception of ownership (Figure 5):
Figure 5: Legal sphere of influence
State law Federal law

Protection of corporation Protection of shareholders
from abusive shareholders from abusive intermediaries
Agent 3: Agent 2: Agent 1:

Board Market Investor / Fund
Asset: Principal:
Corporation Ultimate beneficial owner
Federal law trumps over corporate State law
The prime purpose of an American corporation is to maximize shareholder value

(Friedman, 1970; Kornhauser, 2010; Millstein, 2012; Sundaram 2004)64. State law
63
The problem today is that the investment chain between principal and agent is often long
and complex with numerous intermediaries that stand between the ultimate beneficiary and
the company OECD 2015, Corporate Governance Principles.
64
Milton Friedman, 1970: The social responsibility of business is to increase its profits. .
There is one and only one social responsibility of business to use its resources and engage

regulates the corporation giving the management maximum amount of discretion
over decisions while leaving only minimal rights to shareholders (Campbell, 2012). 65
Federal law on the other hand tries to protect the owner of an asset and to align
interests of managers with those of the shareholders.
The liberalization of securities markets; the rise of institutional investors and the
increasing complexity of the economy shifted the legal influence over corporations
from State- to Federal legislation for controlling management discretion. Today,
corporate law of public companies can be regarded as 90% federally regulated
(Berle 1932; Rock, 1996; Roe, 2003). Whether this shift of legal dominance is
beneficial to shareholders can be debated as State law suggests providing more
flexibility for private ordering (Bainbridge, 2005; Black, 1990; Cioffi, 2003; Fisch,
2012).
While common understanding describes the principle-agent nexus as a logical power

distribution between shareholders and the corporation, reality in the economic and
legal setting portrays a different situation. Today, the corporation is a contested legal
entity wresting power between shareholders, stakeholders and incumbent managers
(Table 1). Technically, all agents act on behalf of shareholders, as it is their duty to
do so. De facto however, many agents are being disabled by rules, regulations and
wrong incentives to act in the best interest of ultimate beneficial owners. We may
distinguish between three separate principle-agent doctrines (Figure 6):
Figure 6: Who is the principal?
Shareholder Stakeholder Corporate

Doctrine Doctrine Doctrine
Principal Shareholder Stakeholder Corporation
Agent Board Board Board
in activities designed to increase its profits so long as it stays within rules of the game
(Friedman, 1970).
65
The US corporate and securities law is highly unusual in the extent to which it
disenfranchises shareholders from any explicit influence (Geltner, 2009).

First, the classic understanding of a principal is a shareholder whose ownership is
represented by an agent, which is the board of directors. The board is at a complex
nexus between external capital markets and management and is responsible for
strategy, overseeing operations and cash flow allocation (Marks, 1999; Pitelis, 2010)
66
. Second, the stakeholder doctrine explains a primacy of all agents between the
principal and its residual claims, which includes employees, clients, creditors and
others (Figure 28). Third, the corporate doctrine describes the emergence of the
manager having enormous influence over the board (Page, 2009).
Table 1: The corporation: A contested legal person
Who Interests Rights Obligations
Shareholders Natural person Sustainably Residual claims None

increase for life of
Ultimate dividends and organization (net
beneficial owner capital gains cash flows)
Vote for election
and
amendments
Proposals via
Proxy access
Stakeholders Creditors Protect their Contractual / Contractual /

Employees contractual Law based Law based
Clients rights and
employment
position
Corporation Legal person Increase Contractual / Contractual /

shareholder Law based Law based
value
Shareholder doctrine upside down
The nomination and election of directors is the principal way for shareholders to hold
boards accountable and influence corporate policy and strategy. Depending on its
composition, a board can be biased towards promoting shareholder issues or
stakeholder issues. If stakeholder issues reign, shareholder interests can be
jeopardized. The bigger the influence of the incumbent management over the
66
Delaware General Corporation Law (DGCL) Code: Title 8 141 (a)
(http://delcode.delaware.gov/title8/c001/sc04/index.shtml).

selection of board members, the worse the market reaction may be and vice versa. It
is recognized that the election of qualified and independent board members is crucial
to enhance the fidelity of managers and align agent interest with the interest of the
shareholders (Campbell, 2010; Kirkpatrick, 2009; Gordon, 2007; Goh, 2016; Erkens,
2012; Carey, 2016).67 Today however, the managers have tremendous power over
the composition and the election of board members. This turns the very essence of
the shareholder doctrine upside down, transforming the corporation as legal person
into the principle with the board as its agents (Figure 7; Campbell, 2012; Cunat,
2012; Francis, 2012; Lan, 2010; Shivdasani, 1999; Tihanyi, 2003; Ward, 2009). On a
positive note, the implicit demand for independent directors on corporate boards has
largely been met, although mostly under the corporate doctrine logic (Bainbridge,
2005; Campbell, 2012; Cioffi, 2003; Eisenhardt, 1989; Fama, 1983, Gordon, 2006;
Picou, 2006). 68
Figure 7: Shareholder doctrine inverted
Theory Reality
Shareholder Issues Stakeholder Issues

Board
Strategy
Cash flow allocation
CEO Selection
Delegates Influences
Selects
Stakeholder Issues Shareholder Issues

CEO
Labor issues Board selection

Clients Cash flow allocation
Creditors Strategy
etc
Shareholder Doctrine Corporate Doctrine
67
Truly independent corporate boards are vital to effective governance, so no board should
be beholden to the CEO or management. Diverse boards make better decisions, so every
board should have members with complementary and diverse skills, backgrounds and
experiences. Its also important to balance wisdom and judgment that accompany experience
and tenure with the need for fresh thinking and perspectives of new board members
(Armourt, 2016).
68
Independent directors on boards: 1950: 20%, 2007: 75%. Disclosure of SEC 10k
information, 2005: 170 pages on average and 11 pages managements discussions and
analysis versus 2 pages in 1974 (Gordon, 2007).

Policy frameworks should be geared towards encouraging shareholder primacy. The
selection of directors should be handled by the shareholders themselves with a focus
on candidates with deep industry expertise and valuable networks. The only
investment group capable of focusing on fundamental shareholder issues such as
corporate strategy and efficient capital allocation, are the informed activist investors
(Table 2).
Table 2: Principal agent paradox
Passive
Activist
Index Funds institutional
Investors
investors
on behalf OF NO NO YES
Who is Shareholders
acting
AS YES YES YES
Who is on behalf OF NO YES NO/YES

Stakeholders
acting
AS NO NO/YES NO/YES

2. Consumer- product dilemma
Freedom of choice in economic decisions is a central feature of the American

capitalistic belief. Laws and regulations try to protect and elevate the consumer,
while stimulating competition on the product side. In financial markets, the question is
what are the products from which the consumer may derive a compounding value? If
the source of value is a residual claim, then the corporation is the product of choice.
Regulations deprive the consumer from his property rights
If we consider a corporation as the ultimate value-creating source, then all financial

intermediaries such as funds and markets are nothing more than a conduit,
connecting the consumer with a product of choice. Therefore, the intermediarys aim
can only be to provide a service to increase the availability and selection of financial
products; the efficient management of assets and reducing frictional cost.
The Federal regulatory framework has been set up explicitly to protect the consumer
from intermediaries wrongdoing, while State law implicitly requires the fiduciary duty
for engaged, corporate governance. Hence, the nexus between consumer and
product can only be bridged if the intermediaries are able to satisfy both sides; 1) the
obligation to manage the clients money according to Federal regulation and 2) to
fulfill fiduciary duty as active corporate governors. Here the divergence between
explicit- and implicit consumer protection occurs. There is a conflict as the first
obligation is exposed to market dynamics that undermine the possibility to create
intelligent information necessary for fulfilling the second obligation. While the
intermediaries are obliged to install consumer protective measures to adhere to the
explicit Federal regulations, they abandon the implicit obligation bestowed upon them
for active shareholder engagement to maximize value and protect the consumer from
managerial meandering. Even if mandated, the intermediary cannot take care of
increasing the value of the ultimate product, as this would be too expensive and in
direct conflict with serving the customer according to Federal regulations. Therefore,
to satisfy both obligations the intermediary is constrained to disrupt the consumer-
product axis by outsourcing the most important functions of corporate governance to
non-accountable third party advisors. Hence, the legal restrictions erected via some
aspects of the SEC 1940 act and ERISA in 1974 led to a shift of huge collective
voting power into passive funds. By doing so, these passive conduits implicitly

reduced the impact of the active conduit by putting priority of stakeholder issues over
shareholder ones (Figure 8):
Figure 8: Consumer deprivation of products rights
transformation
Shareholder Stakeholder
Passive conduit
Consumer Product
Active conduit
Shareholder Shareholder
Should law protect the consumer?
Consumer protection is a fundamental aspect of American legislation, which evolved

along a line of a deep distrust of large accumulation of power.69 There is an ongoing
debate about whether consumer protection is really performing its task. Some even
argue that such regulations are not beneficial. Current consensus is that in the longer
run, the cost of regulation is passed on to the consumer in one way or the other.
Today, economists seem to understand the possible counterproductive and indeed
counterintuitive effects of consumer protection laws (Azar, 2011; Azar, 2016; Cole,
2007; Elhauge, 2016; Morris, 2015). 70 If so, then the protection of the shareholder
from market abuse seems counterproductive. If the consumer transfers his rights to
an intermediary, then this one should do as the consumer mandates. However, if the
very regulations disable the effective exercise of that mandate and lead to a
transformation away from shareholder primacy, then the consumer is being deprived
effectively from his fundamental rights. Whereas the original intention of protecting
69
Acts to protect the consumer and avoid accumulation of power: 1) Sherman Act, 2) Clayton
Act; 3) SEC acts; 4) Sarbanes Oxley Act; 5) Dodd-Frank Act.
70
Watters v. Wachovia bank.

the consumer from market risk and investor abuse performed well, it failed to extend
the rights for corporate governance along the shareholder value chain. Deprivation of
property, even if implicitly achieved, via a complex transformation process goes
against the fifth amendment of the USA constitution.71 Therefore, with the goal to do
good, the current legal value chain is likely to cause more harm than intended.
Legislative measures should be taken to liberate the consumer from perceived
protection and to reconnect him to its product uninterruptedly without provoking
hidden value transformation mechanism.
71 th
USA Constitution, 5 amendment, Due process: no one shall be "deprived of life, liberty or
property without due process of law." https://www.law.cornell.edu/wex/due_process.

3. Fiduciary duty dilemma
A fiduciary is a person who is entrusted to act in the interest of

another.without gaining any material benefit except with the consent of the
person.72
Who serves whom? In the shareholder doctrine, the owner of an asset is the
principal and the company its asset. The chain of duties flows from the ultimate
source of value to the ultimate beneficial owners, who transfer their rights to agents
that act as their trustees. Each agent is exposed to a different set of fiduciary duties.
Regulations, incentives and investment strategies have led to a biased view of who is
responsible for what and rendered current definition of trusteeship of limited function
at best (Figure 9):
Board: The board members are bound by duty of loyalty to act only in the best
interest of the beneficiary to increases residual value and by the duty of care to not
act negligently as defined by the business judgment rule (Anabtawi, 2008; Ertimur,
2010; Gregory, 2013). 73 Proxy access enables the nexus between the shareholders
and the board but leaves little possibility to interact constructively (G20/OECD, 2015;
Picou, 2006).7475
Market: The duty of securities regulatory bodies is to assure a well functioning

market at all times for all members. Regulations, within the national market systems
were highly successful in fostering competition among actors. Electronic trading
fundamentally altered the way financial markets function as it enabled the narrowing
72
A fiduciary is a person who is entrusted to act in the interest of another.without gaining
any material benefit except with the consent of the person SEC administrative ruling: 17
CFR Part 275, RIN 3235-AI 65. Proxy voting by investment advisors. August 6, 2003.
73
Duty of loyalty: Strong and principal legal constrain against managerial misbehavior, serve
one master. Duty of care: weak based on subjective business judgment rule (Anabtawi,
2008).
74
Corporate Governance Guidelines and codes as defined by several associations: American
Bar Association, American Federation of labor and congress of industrial organization (AFL-
CIO), American Law Institute, American society of corporate secretaries, Business
roundtable, CALPERS, Council of Institutional Investors, National Association of corporate
directors, Teachers Insurance and annuity association, College retirement equities fund
(TIAA-CREF) etc.
75
Effective governance requires constructive engagement between a company and its
shareholders. So the companys institutional investors making decisions on proxy issues
important to long-term value creation should have access to the company, its management
and, in some circumstances, the board; similarly, a company, its management and board
should have access to institutional investors ultimate decision makers on those issues
(Armourt, 2016).

of the bid and ask spread leading to substantially reduced transaction costs. Today
we can say that the market, as an efficient exchange, fulfills its duty towards
shareholders well in providing more service at reduced cost (Angel, 2010).76
Fund managers: Fund managers have two separate duties. One is the duty to
safeguard the investors monies and the second is to act diligently towards their
investments. The duty to vote is the most important function of a shareholder.
However, current regulations and incentives leave little room for intermediaries to
perform their fiduciary duties as agents to correct capital misalignment on behalf of
shareholders. This goes against the spirit of American capitalism, which is clearly
intended to serve the shareholder doctrine model. Other countries such as Germany
or Japan are more stakeholders driven (Schnepper, 2004).
Figure 9: Chain of fiduciary duties
Shareholder Principal
Duty to protect capital and

Fund manager 1st Agent
increase capital gain
Duty to provide liquidity

Market 2nd Agent
and low transaction cost
Duty to increase residual

Board 3rd Agent
claim
Company
76
US daily trading volumes increased from 3 billion shares traded per day in 2002 to 10
billion shares trade per day in 2009 (Angel, 2010). NYSE bid-ask spread decreased from
0.125 in 1993 to 0.025 in 2002 (Chordia, 2008). Regulatory changes 1997: order handling
rules and 2001 decimalization to reduce transaction cost (Angel, 2010).

Management controls on whom to vote and what to vote for
A set of rules tries to balance the rights of shareholders and managers. Article 14 of
the Federal SEC Act 1934, rules the proxy access for shareholders to the board of
directors. Proxy access regulations intend to allow the exercise of fund managers
duties on behalf of the shareholders. However, these seem not to be very effective
and lead to a discretionary handling of shareholder proposals by the directors and to
a fiduciary negligence of fund managers obligations (Figure 41; Black, 1990; Coffee,
2016; Del Guercio, 2008; Illig, 2007; Mitchel, 2006). 7778 Voting is considered to be
the most important fiduciary duty and can be divided into the election of corporate
directors and other issues. Shareholders have limited rights and may put forward
only one proposal under proxy rule 14a-8.79 Issues such as nominating directors or
suggesting proposals that address corporate strategy or capital allocation are not
permitted. The election of directors commands around 80% of the effort during a
normal annual meeting and is the most contested legalistic point. Due to the limited
shareholder access, the proxy system seems asymmetrical biased towards the
management sponsored proposals, as they are free to spend as much time and
money to push their own interests. On average, the incumbent management puts
forward 97% of the proposals with the majority being related to the election of
directors, with the board deciding on which nominees to list on the proxy card.80
From the shareholder-sponsored proposals, only 20% address corporate governance
issues (Figure 32; Figure 38; Figure 39; Gilson, 2013; Economist, 2004).81 Even if a
shareholder proposal gets on the proxy card, they rarely pass by a majority. On top
of that, the management has the discretion to void the decision as it is not legally
bound to obey. For example, the proposals to separate the CEO from the
chairmanship, passed only in 5.8% of the time. This shows the strength of the
77
2006: 99% of the S&P 500 companies were completely unconstrained by institutional
investors. Institutional investors sponsored only 17 proposals and 44% of corporate
governance proposals were withdrawn (Illig, 2007).
78
SEC Art 14 amendments: 1992: 14a-2(b3) distribute proxy advice; 14a-2(b1) allows
shareholders to communicate with each other. 1999: 14a-12 permits almost unlimited
communication with other shareholders before proxy statement. 14e-3 tipping to others of its
intent to launch an activist campaign is legal. Tipping is only illegal if tender offer is planned
(Coffee, 2016).
79
Under article 14a-8, a shareholder can put forward only one proposal per year, not
exceeding 500 words. It must address a proper subject for shareholder action, cannot relate
to ordinary business operation nor to the election of directors and may not conflict with
management proposals (Black, 1990).
80
80% of their proposals are related to the election of directors.
81
https://www.sec.gov/spotlight/proxymatters/voting_mechanics.shtml.

incumbent management in advancing their interest and the almost impossibility to
change such a position by normal proxy shareholder proposal demand. While
Federal law is restrictive, inefficient and costly, Delaware corporate law allows more
flexibility with private ordering for enhancing proxy access for shareholders (Aslan,
2016; Becker, 2013; Copland, 2015; Dharwadkar, 2008; 2012; Erkens, 2012; Kahan,
2010; Laide, 2015; Renneboog, 2011; Sachs, Veasey, 2011). 82
Proxy advisors control on how to vote
Fund managers have the duty to manage a portfolio of stocks and minimize risk via
diversification. However, fiduciary duty of managers includes voting and to
proactively participating in corporate governance issues. Today, regulations, time
and few incentives have led to a passive investment approach and a lax handling of
most corporate governance topics8384. Therefore, fund managers tend to outsource
their fiduciary duties to independent proxy advisory companies such as Institutional
shareholding service (ISS). These advisory companies are very powerful with ISS
and Glass Lewis together controlling 97% of the proxy advisory market.85 While the
proxy advisors enable the efficient voting process, they are highly influential and
advise investors about how to vote in over half of the worlds common companies.86
ISS for example provides an option of automatic turnkey voting to the
87
shareholders. In 2014, 25% of the mutual funds voted exactly as ISS
recommended. Generally, over 90% of the management proposals are not contested
and in 95% of the time, the fund companies vote to support management proposals.
82
Delaware General Corporation Law (DGCL) Code: Title 8 112-113.
http://delcode.delaware.gov/title8/c001/sc01/.
83
The Employee retirement income security act, 1988 (ERISA), rules that pension plan
managers must act for the exclusive benefit of plan participants. A key requirement is to
diversify investment so to minimize the risk of large losses.
(https://www.dol.gov/general/topic/retirement/erisa).
84
The fiduciary duty of an advisor do not include to engage in shareholder activism.
Department of Labor, Interpretive Bulletin Relating to Written Statements of Investment
Policy, Including Proxy Voting Guidelines, 29 CFR 2509.94-2 at 3 (2001), FInal rule: Proxy
voting y investment advisers. SEC 17 CFR Part 275, 2013. https://www.sec.gov/rules/final/ia-
2106.htm.
85
ISS has a 60% share and Glass Lewis a 37% share.
86
1991: SEC reduced cost of proxy proposal. 1997: Elimination of Cracker Barrel Q&A (Illig,
2007; Stanton, 1999).
87
ISS turnkey voting option for automatic voting for clients. ISS advises: 24 of 25 largest- 81
of top 100 mutual funds; 25 of top 25 asset managers; 17 of top 25 public pension funds. For
corporate governance, ISS assesses 50000 companies based on four risk metrics. Glass
Lewis analyses 15000 companies (Clark, 2013). Fidelity has fiduciary duty to 401k
employees and follows ISS guidelines by default even if ISS guidelines may not fit the interest
of employees (Clark, 2013; ISS, 2015).

Even poorly performing directors and firms typically receive over 90% of votes
(Black, 1990; Ertimur, 2010; ICI, 2008; Jensen, 2001).88
By outsourcing the fundamental task of shareholders duties, the fund managers are
implicitly accepting the proposals of managers, the stakeholders. Outsourcing the
voting obligations is convenient and efficient but leads to a shareholder neglect of
building private information about the invested companies. Therefore, shareholder
voting as implicit fiduciary duty and as a regulating mechanism seems not to work
well. This neglect to act in the best interest of the shareholder is reflected by a large
fund companies, which have only few people that deal with governance topics.
BlackRock for example, has only 30 people out of 12000 employees dealing with
corporate governance issues. Such a small number for managing all proxy votes of
their $4.7 trillion assets under management seems very challenging (Figure 10; Choi,
2010; Kahan, 2008; Morgenson, 2016; SZ, 2016). The OECD recognized this deficit
and stated that passive funds have been voting in a mechanical manner relying
on proxy voting advisors and generally failing to challenge boards in sufficient
number to make a difference. (Cai, 2009; Coffee, 2016; Clark, 2013; Gumbs, 2015;
Isaksson, 2013; ICI, 2010; Kahan, 2011; Lipton, 2013, Listokin, 2008; Mitchell, 2006;
Yermack, 2010).
88
Value creation is only objectively measurable with shareholder action. Stakeholder
performance is subjective and can lead to distortions of capital allocation (Jensen, 2001).

Figure 10: Fiduciary duties and conflict of interest
Real fiduciary duty sphere Fiduciary duty of managers:

Maximize shareholder value by efficient external
(market)- and internal (corporate) capital
allocation by representing ultimate beneficial
owner with shareholder rights and obligations
Shareholder
Fiduciary duty:
Maximize shareholder value
Influence voting No fiduciary

Fiduciary duty:
duty
External capital
allocation
Risk management
Market Fund manager Proxy advisor
Outsource fiduciary duty
of implicit internal capital
Sterilize fiduciary allocation by opting for
duty link to board turnkey default voting
Fiduciary duty:
Board to shareholders
Corporate
Managers Influence Proxy advisor
for beneficial rating
Implicit disciplining Implicit disciplining

management via market price management via ratings
Company
Real fiduciary duty links
Theoretical fiduciary duty links
Jeopardized fiduciary duty links
If board access is so strongly embedded in the realm of State law, how is it then
legalistically possible to adjust corporate governance rules? Following exercise
highlights the difficulties to realign governance affairs imposed by Federal law. In
2010, congress inserted article 14a-11, into the Dodd-Frank Act, enabling qualified
investors to nominate directors directly on the proxy card. However, the Business
Roundtable contested the article, which was subsequently vacated within a year by
the courts (Bochner, 2014; Davis, 2015).89 Paradoxically, while the Federal act was
not successfully implemented, on State level, several corporations started to allow
shareholders the nomination of board candidates. This implicit change is
nevertheless heavily biased toward the stakeholders (Marchand, 2015). 90 On a
89
2010: 14a-11. Shareholders have the right to nominate if they have 3% of a company for
three years. July 2010 Dodd-Frank Act signed by Obama, adopted by the SEC in Aug 2010.
Business roundtable objected and the article was vacated in July 2011 by the D.C. circuit
court based on ambiguity (Kahan, 2011, Bochner, 2014).
90
Large corporations amended their bylaws to allow shareholders that own at least 3% of the
shares outstanding for at least three years, to nominate directors directly to the proxy card.
Companies that have recently change such corporate policies include Citigroup, GE, Yum,
Prudential, Bank of America and others (Marchand, 2015).

positive note, in the past years, proxy advisory companies increasingly recommend
voting in favor of proxy access change proposals (Davis, 2015). 91
Policies should attempt to correct the misalignment of fiduciary duties across the
investment value chain. A key point is to reduce the transformation from shareholder
interest to stakeholder interest. A focus should be put on eliminating conflicted
intermediaries and either relieving them from their implicit duties or rendering them
explicit via Federal regulation. This applies to fund managers, proxy advisory
companies as well as corporate directors.
91
2014: The New York City Comptroller ($160b assets of NYC pensions) started the
boardroom accountability project to demand changes to the proxy access rules for long-term
shareholders. Several companies compromised in different forms. For example, Whole Foods
allows now a single shareholder with 9% holding over five years to nominate board members
(Davis, 2015; Bocher, 2015).

Policy options
The role of public sector .is, as the private sector innovates, to come up
with appropriate regulations and the goal is to try to get the best benefit from
these innovations while minimizing the harm (Frank, 2011).
When we address regulatory adjustments we should focus on the underlying logic of

the American economy and craft the legal frame accordingly. If American law
protects property rights, freedom of choice and fosters a free market, then regulation
should accommodate these beliefs. However, if regulations implicitly start to
transform the meaning of rights and choices into something else, an erosion of the
values of the American free market economy will be the consequence.
We should remind ourselves, that money flows according to where it legally can, to
the destination of least resistance and to expected highest return. These monetary
channels are enabled or disabled by policies, which have a substantial influence over
the economic outcomes. Only when capital flows to the highest social use can a
strong economy emerge. A sequence of Federal laws aims to protect the
shareholder and entrepreneurs as the main financial actors. If we create rules we
have to be very careful to not implicitly lead these market participants to construe
ways of actions that result in situations of dominance that work against the essence
of the American financial market strength. Legislation should therefore be structured
with prudence to not disturb the delicate balance of market forces and avoid
unnecessary negative externalities. Instead, it should protect the market dynamics
and champion active corporate governance as intended by laws and customs. In this
regard, the Administrative procedure act (APA) aims to disallow rules and regulations
that are deemed internally contradictory or arbitrary and logically inconsistent
92
(Grundfest, 2010, Bochner, 2014). Legalistic complexity is a tremendous
administrative burden on the industry. It increases agency costs and can lead to a
deterioration of market stability (Pacces, 2010).93 Therefore, regulations should be
understandable and clear to all market participants with Bright line rules to reduce
judicial interpretation. Some American securities acts such as the Glass Steagall Act
have proven to perform better than others (Figure 11; Table 6; Seligman, 1995).
92
US code: Title 5,Part I, Ch. V: https://www.law.cornell.edu/uscode/text/5/part-I/chapter-5.
93
Bright-line rule: An objective rule that resolves a legal issue in a straightforward, predictable
manner. A bright-line rule is easy to administer and produces certain, though, arguably, not
always equitable results. https://www.law.cornell.edu/wex/bright-line_rule.

Figure 11: American economic system
American Economy Jeopardized today
Liberal
Monopolistic character of
Belief Democratic
intermediaries
Capitalistic
Disenfranchisement of principal
Freedom of choice
Abuse of freedom of choice
Protection of property
Law / Policy Distorted consumer protection
Free-market
Shareholder to stakeholder
Consumer protection
transformation
Cheapest fund product prevails

Money fund flow to:
Deterioration of corporate
Where it can flow
Effect governance
To the place of least
Challenged productivity growth
resistance & highest return
Decreased market resilience
Focus on the shareholder

If the key function of a corporation is to maximize shareholder return then the
shareholders must be empowered above the stakeholders for the exercise of their
rights and obligations. Profit maximization necessitates an active engagement of the
shareholders in strategic decision-making and efficient capital allocation. Empowered
by State law, directors have the primordial function as agents to control cash flows.
While directors are free to choose on how to allocate capital, they must be held
accountable for their actions. Regulations should not foster fiduciary duty ignorance
but champion active corporate governance to increase shareholder value. Policies
ought to be crafted to prioritize the shareholder doctrine and accommodate, instead
of obstruct, activist investors explicitly in their pursuit of increasing shareholder value.
There is now an opportunity to adopt legislation to render the financial system fit for
future decades. The overreaching goal should be to make markets more efficient and
resilient so that industrial productivity continues to increase, generating wealth for
American citizens and enabling the efficient management of savings.
The chapter of policy options is structured as follows:

Policy options overview p. 42
Relevant agencies for regulations p. 44
Strategy and Tactics for negotiation p. 45
Policy options detailed p. 46

Policy options
We develop three core policy options, which aim to correct the discussed legal
misalignments. These are:
1. Empowerment of shareholder focused investors.

2. Reduction of the concentration of power of index funds.
3. Correct shareholder to stakeholder transformation.
The policy options are segregated into the three domains along the financial value
chain: The investor, the market and the corporation. Numbers in brackets serve as a
guide for further policy options descriptions (Table 3):
Table 3: Policy options
Investor Market Corporation
Definition of Incentivize Enable activist

structural investor corporate activists: investors to
function: Legally Enable nominate directors
Empower
redefine the remuneration for (1C).
1 shareholder
functions, rights active investors
focused investors
and obligations of that act as
passive and active corporate
investors (1A). governors (1B).
Reduce Reduce voting Reduce cross

concentration of power for passive holdings of large
2
power of index investors (2A). corporate stakes
funds (2B).
Explicit code for Redefine rights

Correct shareholder
corporate proxy advisory
3 to stakeholder
governance (3A). (3B).
transformation
The majority of possible regulatory adjustments will lie within the domain of Federal
legislation, while some may be addressed on State level. The advantage of Federal

regulations is the possibility for crafting bright line rules applied across the entire
public market, while State law tries to protect and advance private ordering (Figure
12):94
Figure 12: Policy option legal domains (Numbers explained in Table 3)
1C
Active
Board Proxy Access
1B 2B 1A 2A
Proxy Advisor Passive
3A 3B
13D
Corporation Market Investors
State Law sphere Federal Law sphere
94
Delaware Corporate laws are based on enhancing flexibility and engage private ordering
and generally avoid legislations which are of prescriptive or proscriptive character
(Hamermesh, 2006).

Relevant agencies for regulations
Multiple Governmental agencies are responsible for regulating the market; provide
legal stability and fairness, while several Non-Government organizations represent
the particular industry interests towards authorities. Together, they form a complex,
but cohesive regulatory network. The agencies are necessary to develop solid policy
options and are responsible for the eventual implementation of laws. The following
institutions and organization are to be addressed and involved for constructive
negotiation for increasing the probability of passing new legislations and regulations
successfully. Abbreviations will be used to explain below policy details (Table 4;
Table 5; McCaffrey, 2006):
Table 4: American financial market regulatory bodies
Federal US Congress Legislature (Table 5; Figure 46; Figure 48)

SEC (Security and Exchange Commission)
IRS (Internal Revenue Service)
FSOC (Financial stability oversight council)
FTC (Federal Trade Commission)
Shareholders & Investors Directors
State State pension systems such as Delaware State

CALPERS and TIAA-CREF95 etc Legislature for
NASRA (National Association of corporate law96
State Retirement Administrators)
Non- Government FINRA (Financial Industry Business
Regulatory Authority) Roundtable
NYSE (New York Stock Exchange) NACD (National
ICI (Investment company institute) Association of
CII (Council of Institutional Corporate Directors)
investors)
CIRCA (Council for Investor Rights
and Corporate Accountability)
ISDA (International Swaps and
Derivatives Association
Proxy advisors and Investment communication services97
95
Teachers Insurance and Annuity Association of America; https://m.tiaa-
cref.org/public/peb/accounts.html .
96
Delaware State legislature: http://legis.delaware.gov/. Delaware corporate law, Article 8:
http://delcode.delaware.gov/title8/c001/ .
97
Proxy service providers: ISS, Glass-Lewis. Investment communication services:
Broadridge, RR Donnelley and others.

Strategies and Tactics for negotiation
The complexity of policy strategies is a function of the numbers of parties involved

and ways and means of passing new laws and regulations. Generally, the more
parties involved and the higher up in the Governmental legislative ranking, the more
complex, costly and time consuming a policy will be. Structural market adjustments
are difficult, will take more time and tend to have a higher chance to pass during
times of economic- and social stress. Technical legal adjustments tend to fall directly
into the realm of Government agencies, which have a clear mandate to craft rules.
The following matrix highlights the strategic frame and tactical opportunity points to
advance new policy options along with its expected complexities (Figure 13; Figure
14):
Figure 13: Negotiation strategies and tactics
Structural Technical
Strategy Multilateral Single to few

Congress based agency driven
Tactics When society Interest groups

demands change alignments
During or after
market crisis
after pervasive
financial
scandals
Figure 14: Policy option complexity (Numbers explained in Table 3)
Complexity
2A 1A
Federal
2B 1B
1C
3B 3A
State Complexity

Policy options detailed
1. Empower shareholder-focused investors.
Both, the passive- and the active fund manager have a stake in the market. If
passive funds are efficient investment vehicles for external capital allocation, then
this is what index funds excel in. If active funds improve internal capital allocation
and render the companies and industry more productive, then this is in what activists
succeed. Active investors can only be successful when they are incentivized to
produce information for the benefit of all shareholders while passive investors may
only enjoy an increase in productivity if active investors are competitive corporate
governors (Strine, 2014). Both should be able to focus entirely on what they are good
at. However, if regulatory structures, as they are today, implicitly hinder the logic and
natural axis of value creation, then we have to develop options to return the markets
towards its original course. To reconcile the ultimate beneficial owner with its
property, we imagine a legal framework that enables both, the passive and active
investor to complement each other in an optimal way for the benefit of all
stakeholders and the economy at large. Rules should be crafted to decrease the cost
of engagement for a long-term sustainable outcome not only by the virtue of the
market forces but also bestowed upon them by appropriate legislation
Following policy options shall empower shareholder-focused investors:
A. Definition of structural investor function: Legally redefine the functions,

rights and obligations of passive and active investors.
B. Incentivize corporate activists: Enable remuneration for active investors
that act as corporate governors.
C. Enable activist investors to nominate directors.

1A. Definition of structural investor function.
Legally redefine the functions, rights and obligations of passive and active
investors.
Problem Passive investors are conflicted between fiduciary duties to

the ultimate beneficial owner and corporate governors.
Outsourcing of the voting rights transforms shareholder
doctrine into stakeholder doctrine.
Policy proposal Rights and obligations need to be redefined (Figure 15:
Investor redefinition). The distinction between active- and
passive investors could be:
Active investors: Absolut return driven.
Passive investors: Replicate markets, relative return
driven.
Agencies Congress, SEC, ICI, CIRCA, FTC, FINRA (Table 4).
Possible Resistance of passive investors which may lose rights.
externalities Increased power of abusive activist investors.
Boiler plating of functions in order to fall into active
category.
Strategy 1 : Federal level, SEC, FTC. 2nd: ICI, CIRCA, FINRA.
st
Figure 15: Investor redefinition:
Focus:
Liquidity
Accessibility
Cheap capital
Market
Focus: Focus:
Corporate governance specialists Portfolio management
Internal capital allocation & strategy Activist Passive External capital allocation
Increase productivity & residual claim investors investors Increase equity return,, reduce risk
Explicit discipline to management Implicit discipline to companies
Focus: Focus:
Increase productivity & residual claim Corporation Savings Compounding
Explicit discipline to management interest

1B. Incentivize corporate activists.
Enable remuneration for active investors that act as corporate governors.
Problem Current regulations disincentivize the active engagement and

enable for passive investors to have a free ride.
Policy proposal A. Externalize cost.

B. Internalize return from passive funds (Swap).98
A. Externalize cost via explicit market based reimbursement;

explicit corporate based tax paid to the activist or implicit
reimbursement via tax deduction for activists (Figure 45: How to
internalize costs):
Market based reimbursement mechanism, Tax the free

riders: The SEC may structure a dedicated department with
a reimbursement mechanism for activist that prove to
enhance shareholder value via objective parameters over a
defined period of time. An example is provided under Figure
16.99
Corporate based tax: As described above, the SEC together
with the activist might define endpoints in order to get a part
of the costs returned. The costs could be borne directly by the
company paid in cash to the activists.
Tax deduction: As described in above SEC mechanism, the
IRS in accordance with the SEC may allow a tax deduction
reflecting the cost and success of a active engagement.
B. Internalize return from passive funds (Swap). Develop an

agency based Swap mechanism so that activists may amplify
their economic engagement. The SEC in collaboration with the
Swaps and derivatives association (ISDA) could enable the
98
Swap: A derivative deal where two counterparties exchange cash flows of one partys
financial instrument for those of the other partys financial instrument.
99
Return measurement: Could be calculated in various ways. 1) Excessive return above the
average industrial sectorial return over time, 2) Improvement of operational metrics such
sales; earnings; cash-flow; balance sheet improvements etc.

reservation of a fraction of the largest passive funds for serving
as economic leverage to the activist investor. The amount of
shares to enter into such a Swap could be a range around the
total amount of shares the activist investor put at risk. An
explanation provided in Figure 16; Figure 17 and Equation 1.
Agencies SEC, IRS, FINRA, ISDA, CIRCA, ICI, States of incorporation

(Table 4). 100
Possible Difficulty on how to register free riders: High share

externalities
turnover makes registering a challenge. However, if SEC is
informed upfront, registering shareholdings should be
possible.
Difficulty in defining objective endpoints: The Food and
Drug Administration (FDA) could serve as a guide because it
deals with many issues of similar complexity on how to define
objective endpoints and be rewarded if met.
SEC arbitrariness: Skepticism of arbitrariness of the SEC on
what kind of metrics to apply. The no action letter impartiality
could serve as an example.
State law might invalidate the rule: However, federal
regulation of public companies might overrule the
discretionary handling of State reimbursement bylaws.
Confidentiality of the Swap department might not enable
discretion over activists investors intentions.
Strategy 1st: SEC, FINRA, CIRCA, IRS. 2nd: ICI, ISDA, States.
100
Section 113 Delaware general corporate law would permit such adaptations on corp.
amendments (Kahan, 2011).

Figure 16: Externalize cost to free rider101
Period A: Period B:
SEC clears, registers, monitors SEC taxes
Share price
180 % 7% Activists meet
SEC cleared
endpoints
5% Average Abnormal
returns
Abnormal Versus buy and
share turnover hold strategy
20 %
6-10 days
1-3 years Time

13D Depending on SEC cleared definition
SEC clearance
filing
SEC tax registered free

1) Activist files confidential intent to engage with SEC
rider for gain during
2) SEC definition of endpoints
engagement period A.
3) SEC clearance for cost reimbursement if endpoints met
Reimburses activist
Figure 17: Internalize cost from passive funds (SWAP)
Economic benefit:
Dividend + capital appreciation
Floating
leg Equity leg
Company Passive funds Market authority Activist investors
Short party Long party

Keep voting rights No voting rights
Give up a share of Economic benefit
economic benefit Settle difference
Reserves a fraction of the

largest passive funds for
SWAP options to activists
filing for 13D
101
When an activist intends to purchase 5%, it may file a confidential disclosure to the SEC,
which will then monitor the share turnover around the 13D filing. Potential Free riders, which
will buy into the rumors before the 13D filing are registered. Should the active engagement
result in meeting the predefined endpoints, the registered free riders will be taxed a percent of
the gain. The ratio of reimbursement depends on the a) filed cost of engagement from the
activists and b) the absolute return of the engagement over time, which needs to be defined,
upfront with the SEC.

1C. Enable activist investors to nominate directors.
Facilitate board access for active investors.
Problem Proxy access today is cumbersome and does not allow the
nomination of directors.
Policy proposal Render proxy access restrictive to passive fund
managers.
Enable active funds to nominate directors.
Definitely vacate 14a-11 for passive investors.
Agencies SEC, States of incorporation (Table 4)
Possible Rigging the process: Clear definition by the SEC of

externalities active managers should lead to exclusion of abusive
shareholders.
Skepticism over the effectiveness for better proxy
access to investors.102
Failure of 14a-11 might serve as precedence.
Strategy 1st: States level, SEC, ICI, CIRCA. 2nd: ICI.
102
we do not believe proxy access is likely to paly a role for activist as: no control seeking
requirement of board, holding period of shares too long (3y), board members restricted to
generally 20-25%. Activists that threaten are unlikely to use proxy access (Cohen, 2015).

2. Reduce concentration of power of index funds.
A. Reduce voting power for passive investors.
B. Reduce cross holdings of large corporate stakes.
2A. Reduce voting power for passive investors
Curtail the passive funds of their voting rights.
Problem Passive funds show signs of oligopoly, which leads to

transformation of shareholder doctrine to stakeholder dominance.
Policy proposal Prohibit passive investors from voting.
Dilute voting rights: Curtail voting rights according to the %
of passive funds out of total funds in public markets. For
example, currently 20% of market capitalization is in passive
funds. Therefore, the passive funds voting rights would be
collectively reduced by 20% etc (Figure 18):
Figure 18: Voting power loss for passive funds (%)
-20%
-40%
-60%
-80%
20% 40% 60% 80%

Share of passive equity funds out of total equity funds
Agencies SEC, FSOC, FTC, probably Congress; ISS, Broadridge etc;

FINRA (Table 4).
Possible The perception of losing the freedom of choice.
externalities Boiler plating of functions in order to fall into active category.
Strategy 1st: SEC, FSOC, FINRA. 2nd: Congress. 3rd: ISS, Broadridge.

2B. Reduce cross holdings of large corporate stakes.
Reduce the accumulation of quasi controlling equity share blocks.
Problem Over 30% of shares in large companies are held by the top
five institutional investors.
Policy proposal Disclosure of ultimate beneficial owner.
Limit index fund assets: In case of possible collusion,
which may restrain competition to the detriment of
shareholder value, a split up of the index fund needs to
be considered.
Agencies FTC, SEC, FINRA, Congress (Table 4).
Possible externalities Complexity to disclose ultimate beneficial owner:

High share turnover may complicate registering process
and increase agency cost.
Increase fund costs: Economic of scale work in fund
management and might be jeopardized if large
structures are prohibited.
Strategy 1st: Congress, FTC, SEC. 2nd: FINRA.

3. Correct shareholder to stakeholder transformation.
A. Explicit code for corporate governance.

B. Redefine rights proxy advisory.
3A. Explicit code for corporate governance
Render corporate governance topics accountable for investors
Problem Corporate governance obligations are implicit in the realm

of State law.
Policy proposal Render corporate governance topics explicit. Redefine
parts of the fiduciary duties for investment advisers under
SEC rule 17 CFR 275.103
Agencies State of incorporation, SEC, CIRCA, FINRA (Table 4).
Possible externalities State law: State legislature might object further
intrusion.
Passive funds objections over loss of rights.
Governance philosophy competition: What is right?
(Table 7: Recent Corporate Governance endeavors).
Strategy 1 : SEC, State. 2nd: FINRA, CIRCA.
st
3B. Redefine rights proxy advisory.
Reduce the reliance on proxy advisors for opinions on how to vote.
Problem Outsourcing of the voting rights transforms shareholder

doctrine into stakeholder doctrine.
Policy proposal 1) Preclude index funds from relying upon
automated turnkey voting (Strine, 2014).
103
SEC 17 CFR Part 275, rules and regulations, investment advisers act of 1940, point 19
https://www.sec.gov/rules/final/ia-2106.htm#P76_15555.

2) Vote consciously or opt-out of rights to vote.
3) Split up proxy advisors if risk of collusion.
Agencies SEC, FINRA, FSOC, FTC (Table 4).
Possible externalities Agency cost: If advisors are stripped from offering
services, proxy cost might increase.
Accountability: If advisors are held accountable for
their advice, they might stop providing service
altogether.
Fund manager ignorance.
Strategy 1 : SEC, FSOC, FTC. 2nd: FINRA, ISS, Glass-Lewis.
st

Conclusion
The American financial regulatory framework enabled the emergence of powerful
market dominating passive asset management companies. They have the right to
vote as every other shareholder. The current trend towards index funds is expected
to continue and grow. There is a high likelihood that within a couple of years a few
investment companies will control the voting power of up to a third of the entire
American public equity market. The consequence is a hidden transformation of
shareholder primacy to stakeholder dominance. The result of such a value
conversion is a possible deterioration of corporate governance. This will lead to
declining productivity, jeopardizing the sustainable returns of pension funds and
increase market risk. Current regulatory evolution goes against the fundamental
American capitalistic belief of freedom of choice, protection of property and free
markets, which has brought prosperity and social advance.
Market oriented policies should enable shareholder primacy. Such an approach

ought to realign the interests of the agents with those of the ultimate beneficial
owners and render intermediaries accountable for their actions. To reach this aim,
three policy options are proposed:
1) Empower shareholder-focused investors.

2) Reduce the concentration of power of index funds.
3) Correct shareholder to stakeholder transformation.
These structural regulatory adjustments require multilateral negotiations between the

relevant Federal legislative bodies and the various industry interest groups. As an
initial step I advise the American Congress to develop special committees,
composed of market authorities and antitrust agencies to analyze the value
transformative paradox, which goes against the ultimate beneficial owners and risks
to destabilize the economy and pension assets.104 Furthermore, as money fund flows
are global and interconnected, similar market distortions are likely to be found
outside the USA. Therefore, I further suggest developing a critical dialogue among
the global financial governance bodies to address the transformation paradox and its
104
Federal: Senate, SEC, FTC, FINRA, FSOC, State Delaware. Interest Groups: NYSE, ICI,
CII, CIRCA, NACD, ISS.

impact in the international context.105 Based on the study outcomes, policy options
and strategies should be developed with the goal of enhancing the accountability of
shareholders and empower active investors explicitly. In this regard, the US should
take the lead and champion its free market capitalistic belief.
While we may not eliminate a future financial crisis, we may be able to improve the
current market system making it more resilient. The global economy should not be
exposed to another financial melt down as was experienced in 2007-2009.
Sustainable wealth generation requires engaged shareholders!
105
BIS, G20, OECD, ECB, FSB.

ANNEX
Tables
Figures
Table 5: American market regulatory bodies and interest groups:
US Senate The United States Constitution (Article I, Section I) grants all legislative powers to
the Congress, which consists of a Senate and a House of Representatives. The
Senate also has "advise and consent" privileges in matters of treaties and
nominations. The sources listed below include descriptions of the legislative
process, a compendium of Senate rules and procedures, and a more detailed
analysis of specific aspects of the process
http://www.senate.gov/legislative/process.htm
(Figure 48: How a Senate Bill becomes a law (USA)
How long does it take to pass a law?

Average: 263.57 days; Median: 215 days, Minimum: 1 day; Maximum: 712
https://www.quora.com/How-long-does-it-take-to-pass-a-bill-in-the-US
SEC The mission of the U.S. Securities and Exchange Commission is to protect
investors, maintain fair, orderly, and efficient markets, and facilitate capital
formation.
an agency may engage in rulemaking to update rules under existing laws, or to
create new rules within existing authority that the agency believes are needed. For
the most part, the SECs authority to issue rules derives from what are generally
referred to as the Federal Securities Laws: the Securities Act of 1933, the
Securities Exchange Act of 1934, the Investment Company Act of 1940, and the
Investment Advisers Act of 1940. Newer laws, such as the Dodd-Frank Wall Street
Reform and Consumer Protection Act of 2010, also give rulemaking authority and
require some specific rulemaking by the SEC. Rulemaking generally involves
several steps that are designed to give members of the public an opportunity to
provide their opinions on whether the agency should reject, approve, or approve
with modifications a rule proposal. Here is a brief description of some of these
steps: Concept Release; Rule Proposal; Rule Adoption.
https://www.sec.gov/answers/rulemaking.htm
www.sec.gov
CALPERS The CalPERS Board of Administration works with the California Legislature and

Congress to enact laws that are in the best interest of CalPERS members,
contracting employers, and the System. CalPERS administers benefits that are
defined in current law and regulations, and proposes changes in these areas to
ensure equity for our members and employers, and the security of our programs
and services. https://www.calpers.ca.gov/page/about/laws-regulations
FINRA Dedicated to investor protection and market integrity through effective and
efficient regulation of the securities industry. FINRA is not part of the government.
Were an independent, not-for-profit organization authorized by Congress to
protect Americas investors by making sure the securities industry operates fairly
and honestly. We do this by: writing and enforcing rules governing the activities of
3,917 securities firms with 639,680 brokers; examining firms for compliance with
those rules; fostering market transparency; and educating investors.
www.finra.org
ICI three core missions: encouraging adherence to high ethical standards by all
industry participants; advancing the interests of funds, their shareholders,
directors, and investment advisers; and promoting public understanding of mutual
funds and other investment companies. (ICI, 2014, 2015)
www.ici.org
Business Business Roundtable is an association of chief executive officers of leading U.S.

Roundtable companies that promotes policies to improve U.S. competitiveness, strengthen the
economy, and spur job creation. Promotion of sound public policy and a thriving
U.S. economy. Business Roundtable CEO members lead U.S. companies with $7
trillion in annual revenues and nearly 16 million employees. Member companies
comprise nearly one-fifth of the total market capitalization of U.S. stock markets
and invest $129 billion annually in research and development equal to 70
percent of U.S. private R&D spending. Our companies pay more than $222 billion
in dividends to shareholders and generate more than $495 billion in sales for small
and medium-sized businesses annually http://businessroundtable.org/about
http://businessroundtable.org
NACD NACD aspires to a world where businesses are sustainable, profitable, and
respected, and where stakeholders trust directors to develop strategies that create
long-term value and provide effective oversight.
www.nacdonline.org/AboutUs/?navItemNumber=556
CII leading voice for good corporate governance, CII engages directly with public
companies on certain core governance practices (CII, 2015)
www.cii.org
CIRCA We are a consortium of investors who believe that a well-functioning system of

checks and balances between boards of directors and shareholders is
fundamental to long term economic growth and U.S. prosperity. As stewards for
the savings of the American public including retirees, pension funds, endowments
and households, actively engaged shareholders play a vital role in this system
http://www.investorrights.org/about/
NASRA Guiding principles to retirement security and public plan sustainability:

Participation of all relevant stakeholders; Policy-driven decision making based on
objective and pertinent information; Tailored solutions, achieved by affected
stakeholders working through the state and local legislative and regulatory
processes; Removal of federal policy barriers to the preservation of these central
retirement plan design features in the public sector and adoption of federal policies
that encourage their inclusion in the private sector..
http://www.nasra.org/principles
ISDA ISDAs pioneering work in developing the ISDA Master Agreement and a wide
range of related documentation materials, and in ensuring the enforceability of
their netting and collateral provisions, has helped to significantly reduce credit and

legal risk. The Association has been a leader in promoting sound risk management
practices and processes, and engages constructively with policymakers and
legislators around the world to advance the understanding and treatment of
derivatives as a risk management tool.
http://www2.isda.org/about-isda/
IRS The IRS Mission: Provide America's taxpayers top quality service by helping
them understand and meet their tax responsibilities and enforce the law with
integrity and fairness to all. This mission statement describes our role and the
publics expectation about how we should perform that role. 1) In the United
States, the Congress passes tax laws and requires taxpayers to comply. 2) The
taxpayers role is to understand and meet his or her tax obligations. 3) The IRS
role is to help the large majority of compliant taxpayers with the tax law, while
ensuring that the minority who are unwilling to comply pay their fair share.
https://www.irs.gov/uac/the-agency-its-mission-and-statutory-authority
OCC Office of the Comptroller of the Currency

The OCC charters, regulates, and supervises all national banks and federal
savings associations as well as federal branches and agencies of foreign banks.
The OCC is an independent bureau of the U.S. Department of the Treasury.
Supervises more than 1,500 national banks and federal savings associations and
about 50 federal branches and agencies of foreign banks in the United States.
These institutions comprise nearly two-thirds of the assets of the commercial
banking system. The Comptroller also is a director of the Federal Deposit
Insurance Corporation (FDIC) http://www.occ.gov/
FSOC FSOC Financial Stability Oversight Council
The Council has important new authorities to constrain excessive risk in the
financial system. For instance, the Council has the authority to designate a non
bank financial firm fro tough new supervision to help minimize the risk of such a
firm from threatening the stability of the financial system
Established with the Dodd Frank 2010. It is a collaborative body chaired by the
Secretary of the Treasury that brings together the expertise of the federal financial
regulators, an independent insurance expert appointed by the President, and state
regulators Dodd Frank Section 112:
https://www.treasury.gov/initiatives/fsoc/about/Pages/default.aspx
FTC Federal Trade Commission
The FTC is a bipartisan federal agency with a unique dual mission to protect
consumers and promote competition
The FTC protects consumers by stopping unfair, deceptive or fraudulent practices
in the marketplace. Competition in America is about price, selection, and service. It
benefits consumers by keeping prices low and the quality and choice of goods and
services high. By enforcing antitrust laws, the FTC helps ensure that our markets
are open and free. The FTC will challenge anticompetitive mergers and business
practices that could harm consumers by resulting in higher prices, lower quality,
fewer choices, or reduced rates of innovation.
(https://www.ftc.gov/about-ftc/what-we-do
NYSE NYSE rules: Regulation of the Exchange and its Member Organizations: The
Exchange and the Financial Industry Regulatory Authority, Inc. ("FINRA") are
parties to a Regulatory Services Agreement ("RSA") pursuant to which FINRA has
agreed to perform certain regulatory functions of the Exchange on behalf of the
Exchange. Notwithstanding the fact that the Exchange has entered into an RSA
with FINRA to perform certain of the Exchange's functions, the Exchange shall
retain ultimate legal respossibility for, and control of, such functions.
http://nyserules.nyse.com/nysetools/PlatformViewer.asp?SelectedNode=chp_1_2
&manual=/nyse/rules/nyse-rules/

Table 6: Performance of installed legal acts and regulations
Act Goal Consequence Failure
Gramm- Remove Industry Failed to give any supervisory authority to

Leach- barriers consolidation. any agency.
Bliley Act between Cross
1999 banks, leverage and lack of explicit statutory authority for the
securities 2007-9 Commission to require these investment
companies financial crisis bank holding companies to report their
and fall out capital, maintain liquidity, or submit to
insurances leverage requirements, the Commission in
2004 created a voluntary program, the
Option for Consolidated Supervised Entities program,
voluntary in an effort to fill this regulatory gap
supervision
Opt in or out. fundamentally flawed from the beginning,
No because investment banks could opt in or
requirement out of supervision voluntarily. The fact that
investment bank holding companies could
withdraw from this voluntary supervision at
their discretion diminished the perceived
mandate of the CSE program, and
weakened its effectiveness
Securities and Exchange Commission

Chairman Christopher Cox
Washington, D.C., Sept. 26, 2008
https://www.sec.gov/news/press/2008/2008-
230.htm
Glass limited Designed to provide for the safer and more

Steagall, securities, effective use of the assets of banks, to
legislation activities, and regulate interbank control, top prevent the
(1933) affiliations undue diversion of funds into speculative
within operations, and for other purposes. It was
commercial legally clear, superviseable and effective
banks and until its repeal by the Gramm-Leach-Bliley
securities firms Act (Financial Modernization Act ) in1999
(Maues, 2013). The elimination of these
important parts of the Glass Steagall Act led
to a substantial industry consolidation of
financial companies and the establishment
of large financial cross service providers.
The Act failed to give to any Federal agency
authority to supervise the new
conglomerates, leaving the sector to
voluntary regulation
(https://www.sec.gov/news/press/2008/2008
-
230.htm).http://www.federalreservehistory.or
g/Events/DetailView/25;
https://www.gpo.gov/fdsys/pkg/PLAW-
106publ102/html/PLAW-106publ102.htm
No. 2: Tearing Down the Walls The

deregulation philosophy would pay
unwelcome dividends for years to come. In

November 1999, Congress repealed the
Glass-Steagall Act - the culmination of a
$300 million lobbying effort by the banking
and financial-services industries, and
spearheaded in Congress by Senator Phil
Gramm. Bank culture came out on top.
There was a demand for the kind of high
returns that could be obtained only through
high leverage and big risk-taking
(Stiglitz,2009)
Dodd- To prevent the Taxpayers will Inefficient, inadequate for addressing global
Frank excessive risk- not have to financial crisis. Has not stimulated growth
(Reform taking that led bear the costs has increased transaction cost and
and to the financial of Wall compliance cost for both the government
Consumer crisis. The law Streets and industry. Does not address the
Protection also provides irresponsibility; weakness in shareholder rights.
Act; 2010) common- Shareholder rights are unclear and can be
sense Separates eliminated by discretion (contractual and
protections for proprietary judicially). The Dodd Frank appears to shift
American trading from the power from the board to shareholder,
families, the business the reality is that shareholders do not have
creating new of banking; real power to direct or influence matters that
consumer were traditionally decided by the board
watchdog to Ending under state laws (Nwogugu , 2015; Dimitrov,
106
prevent bailouts 2015).
mortgage
companies The Dodd-Frank Act, seems to be
and pay-day dysfunctional as it lacks explicit rules and
lenders from bright lines and is based on an extremely
exploiting lengthy and complex layout. It contains
consumers. 2300 pages with 400 new rules and
mandates and requiring 2600 new full time
employees . This in contrast with eth SEC
which could show an improvement in
compliance as reflected by a reduction of
enforcement cases (LOhse, 2014; Prasch,
2012; Balasubramnian, 2014; Dodd-Frank,
2010; Oversight of Dodd-Frank Act
Implementation. Financial Services
Committee:
http://financialservices.house.gov/dodd-
frank/).
106
https://www.whitehouse.gov/economy/middle-class/dodd-frank-wall-street-reform.

Table 7: Recent Corporate Governance endeavors107
Commonsense Principles of Corporate A powerful coalition of corporate officers

Governance and leading fund managers endorsed a
draft to increase the performance of how
American companies are managed in
term of corporate-governance practices
such as avoiding dual-class shares and
replacing ineffective directors (Lublin,
108 109
2016) . (Armourt, 2016)
CIRCA: In order to bolster their political voice,
leading activists have formed a council
for investor rights and corporate
accountability (CIRCA) in Washington
DC for the purpose of lobbying for their
positive actions of shareholder activists
and their impact on corporate
governance and business policies in
110111
public companies (Flaherty, 2016) .
Principles of corporate Governance (Table 13; G20/OECD, 2015)
112
Stewardship code UK
113
Principles for responsible investment UN-PRI
114
Comply of Explain ECIIA
107
Current US lawmakers seem to move towards more shareholder engagement to restore
market trust while. Other countries adopted a set of regulatory changes, which may have an
impact on institutional investors (Hupp, 2011; Bratton, 2010). The UK commissioned a
Walker review, which lead to the sub sequential adaptation of the Stewardship code based
on seven principles. The UN issues a UN-PRI paper on principles for responsible investments
(Hupp, 2011; Gilson, 2013; Arsalidou, 2012). Holland adapted a comply or explain soft law
approach, which has been supported by the European commission (Hooghiemstra, 2011).
The European Securities and market authority (ESMA) put forward four proposals on comply
or explain (Olson, 2012; ECFR, 2014). The EU commission produced a green paper on
corporate governance, 2011 which defines shareholders engagement as actively monitoring
companies, engaging in a dialogue with management and using shareholder rights including
voting and cooperation with other shareholders to improve governance (Isaksson, 2013).
The Basel committee issued guidance on corporate governance for banks (Kirkpatrick, 2009).
108
Companies include: Berkshire Hathaway; J.P. Morgan; General Electric;
General Motors; Verizon Communications Inc; BlackRock Inc.; Vanguard Group Inc.; State
Street Global Advisors; ValueAct Capital Management Ltd., The goal is to drive best
governance practices through companies of all sizes, not just the biggestwhere they are
more common today There should be a continuing board-refreshment process that includes
robust, regular evaluations of board members to ensure their skill sets remain sufficiently
current and broad in dealing with fast-changing business dynamics, the group said (Lublin,
2016).
109
http://www.governanceprinciples.org/.
110
Lead backers include investors such as: Carl Icahn, William Ackmann of Pershing Square,
Daniel Loeb of Third Point, Paul Singer of Elliott Associate, Barry Rosenstein of Jana
Partners (Flaherty, 2016).
111
Icahn is considering funding a Super PAC focused on regulatory reform. Previously
Icahn has commitment of $150 million which was targeted at "tax inversions"(Alban, 2016;
Wapner, 2015).
112
Hupp, 2011; Gilson, 2013; https://www.frc.org.uk/Our-Work/Publications/Corporate-
Governance/UK-Stewardship-Code-September-2012.pdf.
113
The Principles were developed by investors, for investors. They have nearly 1,500
signatories, from over 50 countries, representing US$60 trillion. www.unpri.org.
114
ECIIA: European Confederation of Institutes of International Auditing; Olson, 2012.
http://www.eciia.eu/exploring-comply-explain-principle/.

115
The EU corporate governance EU Commission
framework
116
Guidelines for corporate governance BIS
principles for banks
117
Shareholder rights project Harvard law
Table 8: Some large corporate Governance failures and the TARP118
Cause Federal bail out
American car Improper corporate governance rule; TARP for cars committed in
industry corporate culture; company managed 2009, $80b, total cash back
like an institution, chronically slow to as of July 2016, $70.5b
change and adapt, very bureaucratic (TARP, 2016).
and highly risk averse.
Old GM has $30b of fund retiree
obligations, or $1500 added cost for
every car sold in the US and was
more than the cost of steel per car.
GM Healthcare costs for retired US
union workers were transferred to
UAW (United Auto Workers), thus
removing $30b in obligations (Canis,
2013).
General Motors Uncompetitive, high healthcare Bankruptcy 2009 for 40 days
liabilities, unionized with a $51b bail out from the
US treasury under the TARP
program. IPO 2010, made
$2.1b. 2013 exited all shares
recouped $39b
Chrysler Uncompetitive, high healthcare TARP $12.5b, Bankrpuct in

liabilities, unionized 2009 for 2 months. Until
today $11.2b has been
repaid.
Ally Financial (Ex GMAC was primary source of finance TARP $17.2b. 2014 Treasury
GMAC) for GM dealers and consumer for exited with $2.4b more than it
119
over 90 years. Significant overhead. put in $19.6b
115
Isaksson, 2013; http://ec.europa.eu/internal_market/company/docs/modern/com2011-
164_en.pdf.
116
Kirkpatrick, 2009; http://www.bis.org/bcbs/publ/d328.pdf.
117
McRitchie, 2013 http://www.srp.law.harvard.edu/index.shtml.
118
Generally, the Troubled Asset Relief Program (TARP) has been a huge success and
allowed to restructure some of largest financial- and manufacturing companies. As of July
2016, the US treasury recuperated 97% of the $455 billion distributed for the bail-out of failed
corporations. TARP for cars committed in 2009: $80b, total cash back as of July 2016,
$70.5b. TARP for banks committed in 2009: $250.5b, paid back in cash $275b (July 2016),
with a +10% return (TARP, 2016; Congress USA, 2012)
https://www.treasury.gov/initiatives/financial-stability/TARP-Programs/automotive-
programs/Pages/overview.aspx.
119
https://www.treasury.gov/initiatives/financial-stability/TARP-Programs/automotive-
programs/Pages/overview.aspx.

Banks Corporate governance of banks is different than of other
industries. Besides shareholders, the stakeholders in banks are
both numerous (depositors, debt holders, government) and
large (over 90% of balance sheet is debt). Yet shareholders
control the firm, and evidence shows that both the boards and
the compensation package for CEOs represent the
shareholders preference for increasing risks. That preference,
however, is in conflict with the preference of other stakeholders.
Shareholders respond to their incentives; Laeven and Levine
(2009) and Ellul and Yerramilli (2010) show that the presence
of institutional investors increases the riskiness of the bank.
The goal of increasing risk was largely successful, even though
the outcome of that increased risk during the crisis was not
(Mehran, 2011)
Table 9: American Statistics:
1985 2015 2045e

120
Population 240m 320m (+80m) 420m (+100m)
121
GDP $4.4T $18T $30T
122
Market cap $2.3T $25T $50T
123
Pension funds $3T $15T (~60% of market) $30T
Public pension 6.8% of GDP

spending
Population over 65 23% of working age

of age population (OECD)
Return needed to 7.5% 7.5%

meet obligations 60% from equities assume 50% from
124
equities based on
slow increasing rates
(ME)
=$15T in equity
market allocation
(50% of exp GDP)
Pension fund 5 year average: 5.7%
120
World Bank forecast.
121
OECD GDP long term forecast, July 2016.
122
Market cap est. to double rather conservative. Past 30 year x10. If we applied for next 30
years, then it would be $250T.
123
Pension fund assets: Implied estimates based on 2015 where around 60% of the US
market capitalization were pension funds. Applied to 2045, implies 60% of $50T = $30T.
124
Pension fund will need to derive their returns of expected 7.5% per year from an
increasing equity share. We estimate that bond yields will gradually increase over next
decades as analysts assume that a 35-year bond run comes to an end (Mackintosh, 2016).
That would imply that the equity portion might gradually decrease. We estimate that in 30
years, the equity portion will still be around 50% of pension fund exposure, therefore around
$15T which is equivalent of 50% of expected GDP.

nominal average 10 year average: 2.6%
return
Growth rates Real GDP: 3.2% per year average since 1945 (FRED): 1955-
1975: 3.6%, 1975-1995: 3.1%, 1995-2015: 2.4%
Labor productivity, manufacturing sector: 3.6% per year
average since 1988
Business Sector: Real Output Per Hour of All Persons: 0.58%
change average per year since 1947
Nonfinancial Corporations Sector: Real Output: 1% change
average per year since 1947
Wilshire 5000 Total Market Full Cap Index: 10% per year on
average since 1971. 1975-1995: 15% pa, 1995-2015: 11%
Gross Private Saving: 7% per year change average since
1947 ($3.5T in 2015)
Personal Saving: 8% per year change average since 1947
($680b in 2015)

Source: OECD; World Bank; Census bureau; FRED (2016); own estimates.
Table 10: 25 largest mutual funds (Lipper, Reuters, July 2016):

Table 11: Differences between an active and passive investor:
Passive Investor Activist Investor
Business goal Increase shareholder value by Increase shareholder value by

investing in diversified portfolio of engaging actively in corporate
stocks to minimize risk and governance in companies they
maintain liquidity for drawdowns invest
Investment style Portfolio theory application, linked Absolut return driven with different
to defined benchmark. Regulated strategies (balance sheet
in part by securities regulations restructuring, return excess cash,
sell assets)
Incentives to Fixed fee for assets under Asset management fee and
perform management performance fee (carried interest)
No benefit to engage on corporate
governance issues
Possible conflict Focus on increasing assets under Self interest to maximize return
of interest management and not maximize above the long term focus of the
shareholder value for ultimate companies they invest
beneficial owners
Fiduciary duties Towards their ultimate beneficial Towards ultimate beneficial

owners owners directly and indirectly by
being active on boards of
companies
Voting rights Mostly not applied effectively and Important and taken seriously
outsourced to independent
investment advisors such as ISS.
Will not vote against the
companys proposal whose
pension fund they manage
Corporate No incentives to be active in Influence board directly by gaining

Governance corporate governance board seats or indirectly by strong
advocacy
Performance Rarely measurable on corporate Increase productivity,

level competitiveness and profitability
Outperform over passive
investments of short and long
term. Increase take over premium
Controversies Dont take fiduciary duty for Short term oriented
creating shareholder value Asset stripping
serious.
(Lipton, 2013; Nathan, 2013; De La Merced, 2013; Frick, 2016; Listokin, 2008; Klein 2009;
Kumar, 2008; Cioffi, 2003, SEC 2003, Morgenson, 2016, Aslan, 2016; Becht, 2010;
Goranova, 2014; Bouvatier, 2013, Campbell, 2013).

Table 12: Agency cost drivers:
1 Free cash flow misallocation by management

125126
2 Capital structure choice misalignment
127
3 Entrenched boards leading to reduced firm value
4 Anti take over charter, poison pills
5 Dual class shareholder structure
6 Stakeholder over shareholder doctrine
7 Empire building, investing into low to negative yielding projects or companies
8 Pension fund voting power
(Beghitar, 2015; Boot, 2011; Baker, 2002; Bebchuk, 2005; Bethel,1998; Bates, 2007;
Halman, 2013; Chung, 2005; Chava, 2010; Arnott, 2003; Von Lilienfeld, 2014;
Kumar, 2008; Renneboog, 2013; Bebchuk, 2014)
Table 13: G20/OECD principles of corporate governance (G20/ OECD 2015):

Articles What Details
1 Ensuring the basis for The corporate governance framework would A desirable mix between legislation, regulation, self regulation, voluntary
an effective corporate promote transparent and fair markets, and standards etc
governance framework the efficient allocation of resources. It should
be consistent with the rule of law and support Should be developed with a view to its impact on overall economic performance,
effective supervision and enforcement. market integrity and the incentives it creates for market p[participants and the
promotion of transparent and well functioning markets
Stock market regulation should support effective corporate governance
II The rights and The corporate governance framework should Shareholders should have the opportunity to participate effectively and vote in
equitable treatment of protect and facilitate the exercise of general shareholder meetings and should be informed of the rules.
shareholders and key shareholders rights and ensure the equitable
ownership functions treatment of all shareholders, including Effective shareholder participation in key governance decisions such as
minority and foreign shareholders. All nomination and election of board members, should be facilitated.
shareholders should have the opportunity to
obtain effective redress for violation of their
rights.
III Institutional investors, The corporate governance framework should The presence of intermediaries acting as independent decision markers influence
stock markets, and provide sound incentives throughout the the incentives and the ability to engage in corporate governance.
other intermediaries investment chain and provide for stock
markets to function in a way that contributes If shareholder engagement is not part of the institutions business model and
to good corporate governance. investment strategy, mandatory requirements to engage, for example through
voting, may be ineffective and lead to a box ticking approach.
Failure to exercise the ownership rights could result in a loss to the investor who
should therefore be made aware of the policy to be followed by the institutional
investors.
The corporate governance framework should require that proxy advisors,

analysts, brokers, rating agencies and other intermediaries disclose their possible
conflict of interest. Proxy advisors are among the most relevant from a direct
corporate governance perspective.
IV The role of
stakeholders in
corporate governance
V Disclosure and
transparency
VI The responsibility of the The corporate governance framework should The board should be able to exercise objective independent judgment on
board ensure the strategic guidance of the corporate affairs
company, the effective monitoring of
management by the board, and the boards
accountability to the company and the
shareholders.
125
Depending on the price of the stock price and asset value, managers tend to issue debt
rather than equity to not loose managerial control (Boot, 2011).
126
Market timing has a large, persistent effect on capital structure. When Price/Book (P/B)
ratio is high, raising capital will lead to lower leverage in future, than when P/B ratio is low
(Baker, 2002).
127
Entrenched boards are likelier to block company charter changes as they need board
majority support. Company bylaws can be changed with shareholder majority and do not
need to have board approval (Delaware State Corporate Law; Bebchuk, 2005).

Table 14: Activist investment performance variables:
Strategies of activists Address cash flow

Pay out excessive cash
Address Investment strategies
Change operations
Sell corporate parts
Increase share price during take over battles
Share price change after 5.1%-12% (USA: 3.4-8.1%; UK: ~4%; Europe: 6-12%; Japan: 6%)
filing 13D
(above buy and hold)
Share price increase one 11.4%-17.8%

year after filing 13D
(above buy and hold)
Share price return overall 39% average raw return, over 19 month campaign (Gantchev)
42% average return over campaign period. 21% annualized
average return (Brav)
22% market adjusted return (Klein, Zur)
13% annual return for activist hedge funds v. 5.8% normal hedge
funds (Coffee, 2016)
Success in achieving set >65% overall (2013: 19 out of 24; 2014: 73%; 2013: 52%)
goals after one year 44% of companies changed CEO over 18 month activism
>70% gain board seat
>90% in stock buybacks
50-75% in changes in corporate strategies
(Klein, 2009; Klein, 2011; Kumar, 2008. Kahan, 2009; Brav, 2008; Brav, 2015,
Gantchev, 2013; Clifford, 2008; Coffee, 2016; Ertimur, 2011; Krishnan, 2015; Laide,
2015; Lee, 2009).

Table 15: 200 Highest paid CEO's 2016 (Equilar, NYT 2016):
Company CEO Total Compensation Revenue Total

compensation change (%) change (%) shareholder
($m) return (%)
Expedia Dara 95 81 16 47
Khosrowshahi
CBS Leslie 56 4 1 -14

Moonves
Viscom Philippe P. 54 22 -4 -42

Dauman
Oracle Mark V. 53 na 0 5
Hurd
Oracle Safra A. 53 na 0 5
Catz
First Data Frank J. 51 454 3 na

Bisignano
Regeneron Leonard S. 47 13 46 32
Pharma Schleifer
Walt Disney Robert A. 43 0 7 17

Iger
General Sandeep 39 702 -5 -1

Growth Mathrani
property
Vector group Howard M. 36 29 4 24

Lorber
Average 19 4 2 1
Table 16: SEC's evolving priorities (Gershenson, 2015):
Period SEC Focus
1934-1953 Champion of shareholder rights. Proxy access
1945 Shield management from policy oriented shareholder
1953-1972 SEC chairman dismissive of shareholder proposals, blocks 1000 proposals via no-action
letters
Wall between society and markets
1972-1976 Watergate: Loss of confidence
SEC invited ethical claims
1976-1991 SEC as gatekeeper. Proxy proposals to differentiate between excludable ordinary business
decisions and includable business decisions with substantial policy implications
1983-1988 SEC more business friendly. Discourage abuse of proxy statements from stakeholders. Rules
that allow to exclude proposals that concern operations which account less than 5% of gross
assets
1988-1992 Instability of SEC as gatekeeper as large new pension funds sponsor policy oriented
proposals. Conflict with ERISA, 1974 which mandates private pension fund managers to
focus on fund performance.
1992-now SEC reasserts market autonomy.

Table 17: Concentrated shareholding (Schmalz, 2014)

Table 18: Some activist funds128
Barington Capital Group James A. Mitarotonda

Basswood Capital Management LLC Matthew Lindenbaum
Baupost Group Seth Klarman
Blue Clay Capital Management Gary Kohler
Blue Harbour Group Clifton Robbins
BlueMountain Capital Andrew Feldstein
Bollor Group Vincent Bollor
Breeden Capital Management Richard Breeden
Bulldog Investors Phil Goldstein
Cartica Management Teresa Barger
Casablanca Capital Douglas Taylor
Cevian Capital Christer Gardell
CIAM Catherine Berjal
Clover Partners LP
Corvex Management LP Keith Meister
Elliott Management; Paul E. Singer
Engaged Capital Glenn Welling
Engine Capital Arnaud Ajdler
ESL Investments Eddie Lampert
FrontFour Capital Zachary George
Greenlight Capital David Einhorn
H Partners Management Rehan Jaffer
Highbridge Capital Management Glenn Dubin
Icahn Enterprise Carl Icahn
Jana Partners Barry Rosenstein
JCP Investment Management LLC James Christopher Pappas
Knight Vinke Eric Knight
Land and Buildings Jonathan Litt
Legion Partners Chris Kiper
Lion Point Capital Didric Cederholm
Lone Star Value Management Jeffrey Eberwein
Lucus Advisors LLC Schuster Tanger and Joshua Packwood
Luma Asset Management Gregory P. Taxin
Marcato Capital Management Mick McGuire
MFP Investors Michael Price
MHR Fund Management Mark Rachesky
Nanes Balkany Partners Julien Balkany
Oasis Management Seth Fischer
Osmium Partners LLC John Lewis
Paulson & Company John A. Paulson
Perry Capital Richard Perry
Richard Perry
Pershing Square Capital Management William A. Ackman
Polygon Investment Partners Reade Griffith
Quantum Pacific Capital Greg Mazur
QVT Financial Dan Gold
Rambleside Holdings Gregory Cohen
Red Mountain Capital Partners Willem Mesdag
Relational Investors Ralph V. Whitworth
(Closed 2016)
Sachem Head Capital Management Scott Ferguson
Sandell Asset Management Thomas Sandell
Sarissa Capital Management Alex Denner
Sherborne Investors Management Edward Bramson
128
Alden, 2014, Stevenson, 2015, Benoit 2016, Enginalev, 2014.

SkyBridge Capital Anthony Scaramucci
Sorin Capital Management
Soroban Capital Partners, Eric Mandelblatt
SpringOwl Asset Management Jason Ader
Standard General Soo Kim,
Starboard Value Jeffrey C. Smith
TCI Christopher Hohn
The Yucaipa Companies Ron Burkle
Third Point Daniel S. Loeb
TPG-Axon Capital Management Dinakar Singh
TRB Advisors Timothy Barakett
Trian Fund Management Nelson Peltz
ValueAct Capital Management Jeff Ubben
VIEX Capital Advisors, LLC Eric Singer
Voce Capital Management Dan Plants
West Face Capital Greg Boland
WSD Capital Management Ertan Enginale

Equation 1: SEC 13D Swap access schedule example
An option to internalize the benefit for the activist: Develop a securitized market for
SWAPs dedicated for activist investors that file for 13D. Example:
Situation Action
1 Activist (A) wants to get engaged in Private information generation, costing

company X with a market capitalization of $m. Developing ideas and options in how
$100m as it deems it is an undervalued to unlock shareholder value. Expected
stock and A believes by active cost of engagement $2m.
engagement on the board they are able to
unlock shareholder value of 50%.
2 A intends to start buying 5% of the Declares confidentially to SEC 13D-SWAP

company shares . Deems return on access schedule. Defines the share
investment is not justified to spend $2m. desired to block in the SWAP pool (5%
additional, $5m)
3 A build up first stake of 5% with voting Buys $5m of shares (5% of company),
rights Files 13D schedule after 10 days.
4 SEC earmarks 5% of company X for A Cost of finance SWAP option start to
declared SWAP share. SWAP share carry accrue to A. Cost of finance 10% of SWAP
no voting rights ($0.5m)
5 A has now 10% of economic exposure to Net equity exposure: $10m, 10% of
X with 5% voting rights. company X.
Cost of engagement: $2m campaign and
$0.5m for SWAP
Total exposure: $12.5m
6 A gets active on company X Restructure company, increase
shareholder value
7 Company X share price starts to increase A finishes restructuring and sells the stake
by 50% for 50% return
8 A generates return of A receives $2.5m net profit ($0.5m from
1) 25% to A voting shares and $2m from SWAP
2) 50% to Passive investors shares)
This is $2m more than if A would engage
solely on buying 5% share.
SEC/FINRA/NYSE
or other authority as
Target company X Market Activist (A)
settlement
intermediary
Bank
SWAP fund
Investors
Without swap Market cap ($M) 100 150 Gain cost net gain
Activist investor (A) 5% 5 7.5 Active 2.5 2 0.5 10%
Passive investor (P) 95% 95 142.5 passive 47.5 0 47.5 50%
With swap Market cap ($m) 100 150 Gain cost net gain
Activist investor (A) 5% 5 7.5 Active 2.5 2 0.5 10%
Swap 5% 5 7.5 Swap 2.5 0.5 2 40%
Total gain to A 10 Total gain A 2.5 25%
Passive investor (P) 90% 90 135 passive 45 0 45 50%

Figure 19: US market capitalization:
Federal regulation
Market: Equity, Currency, Commodity,

Bonds, Derivatives, Real Estate
Public
Public
Corporations
$24T*
State law
Private
Corporations
*Market capitalization of:

1) Listed US companies: $24T (1985, $2T), (World Bank , 2014)
2) Global markets $70T, ~90% of global GDP (Deutsche Bank est. 2015)

Figure 20: US GDP per sector (%, Bureau of Economic Analyses, 2016):
$16.4T $2T
$14T $3T
13%
19% $11T
100%
87%
68%
US GDP Government Private Industries Private Goods Private Goods

Producing Services
Private Goods: Agriculture, forestry, fishing, and hunting; mining; construction; and manufacturing
Private Services: Utilities; wholesale trade; retail trade; transportation and warehousing; information; finance,
insurance, real estate, rental, and leasing; professional and business services; educational services, health care,
social assistance; arts, entertainment, recreation, accommodation, and food services; and other services, except government.
Figure 21: US GDP per private sector (%, Bureau of Economic Analyses, 2016):
13 4.4
4
12.1
11.8 2.9
4.8
100 7.1
87
13.2
12.1
8.3
3.9 2.4
P
or
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ce
es
es
rs
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ai
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le
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ne
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an
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at
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at
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le
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al
ts
tu
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Figure 22: Capital market system:
Activist investors
Active
Board Proxy Access
Input
Strategy Proxy Advisor Passive
13D
Corporation Market Investors
Credit rating
agencies
Productivity
Output
Residual claims Capital formation Capital Gain
Wealth creation for

Savings
Ultimate beneficial owner
Figure 23: Wealth creation:
Wealth = Capital formation

via
increase in productivity and savings
Where Corporation Market
Internal capital External capital

Input
allocation allocation
Productivity Savings
Output
increase increase
Residual claim Capital gain
Active
Who Board
shareholders

Figure 24: Public pensions falling returns (Martin, 2016):
Figure 25: Equity market statistics ($T):
26 18 26 4.7
21.3
18 12
12 3.6
8 8.4
6
T)
rs
gs
rs
gs
gs
rs
T)
ds
rs
ng
ng
e
he
e
,$
,$
in
in
in
n
th
th
th
di
di
fu
ld
ld
ld
ot
SA
SA
O
O
ol
ol
ho
ho
ho
ex
lh
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(U
(U
d
d
ex
na
na
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n
n
n
n
d
fu
fu
io
io
tio
tio
In
at
at
n
n
u
io
io
lis
lis
tit
tit
ns
ns
s
s
ita
ita
In
In
Pe
Pe
ap
ap
tc
tc
ke
ke
ar
ar
m
m
ty
ty
ui
ui
ICI 2015; OECD 2015; World Bank 2016

Eq
Eq
l
l
ta
ta
To
To

Figure 26: Portion of dividend income in total return129
Dividend yield
share in total 27% 25% 42% 17%
return
5.7
8 11.8
9.1
4.1
3 4
1.8
1965-2015 1975-1995 1965-1985 1995-2015
Dividend yield (% per year) Capital Gain (% per year)
Figure 27: Dividend yield over time130
Total equity 11% 10% 15.8% 11%

return
Dividend yield 1% 2.7% -3% 0.5%

growth
12%
8% 6%
9%
4% 4%
3%
2%
1965-2015 1965-1985 1975-1985 1995-2015
Capital gain average (SP500, % per year)

Dividend yield average (SP500, % per year)
129
St. Louis Federal Reserve Bank, FRED and NYU Stern, Damodaran:
http://people.stern.nyu.edu/adamodar/New_Home_Page/data.html.
130
St. Louis Federal Reserve Bank, FRED and NYU Stern, Damodaran:
http://people.stern.nyu.edu/adamodar/New_Home_Page/data.html.

Figure 28: Shareholder versus stakeholder focus
Shareholder value
Goal is to Increase:
Net present value, internal rate of return, return on assets and investments
Cash Flow Profit & Loss Balance
Operations Revenues Liabilities
Investing Operations
Financing Earnings Equity
Shareholders Strategic investments Increase revenues Increase equity

Reduce Operation cost Mange costs Manage balance sheet
Access cheap capital Focus on earnings Reduce risk
Stakeholders Focus on
Employees, creditors,
Clients, environment
etc
Figure 29: Agency costs and possible remedies
Agency costs Remedies
Principal Shareholder Passivity Activists
Cost reduction via

1st Agent Fund manager Management cost indexing &ETFs:
Well working
Transaction cost Cost reduced via

2nd Agent Market Insider trading, front running electronic markets:
Bid, ask spread Well working
Wrong strategy Proxy access,

3rd Agent Board Capital misuse engagement:
Managerial doctrine Too complex & expensive
Shareholder
Entitlements
Agent Stakeholders engagements,
Capital misallocation
countermeasure
Company

Figure 30: Global pension funds ($T):
$22T
24.5
$11T 50% of global

pension funds Institutional investors
are from the USA
Insurance funds
30 Investment funds
Pension funds
$11T
21.8
OECD 2012 Global pension Non USA USA pension

funds funds

Figure 31: Misallocation of capital and market reaction:
Manager invests into a project

against interest to increase
shareholder value (empire building)
Disagreements with shareholders
Active shareholders Passiveshareholders
Activists get engaged in Fund managers sell

capital allocation shares
Explicit discipline to Implicit discipline from

cancel project market reaction
Company value
High chance for better
decrease with risk of
shareholder return with
value destruction. Risk
smarter capital
of increase of cost of
allocation and increased
capital to company,
productivity. Risk of
decreased productivity
value destruction
and loss of
preempted
competitiveness
(Thakor, 2010; Venkiteshwaran, 2010; Jensen, 1986; Dittmar, 2007; Durnev, 2005;
Glaser, 2013)

Figure 32: Proxy proposals over three years (Gilson, 2013):
20434 19788 84 proposals

proposals Proposals* from mutual funds
17
80%
100% 97%
646
proposals
3%
2009 proxy Proposals from Shareholder Proposals from Social and Corporate
season management proposals shareholders environmental governance and
issues performance
issues
In 3 years only 17 proposals regarding corporate governance

*2009 management proposals:
73% election of directors, 11% audit firm, 11% other management proposals (mostly compensation)
The % distribution is pretty steady over a 10 year period.
Figure 33: Shareholder sponsored proposals (ICI 2010):
Sponsor Number of % of all proposals Cumulative Cumulative % of

proposals number of proposals
sponsored proposals
John Chevedden and affiliates 267 14.2 267 14.2
NY City pension funds 147 7.8 414 22
United brotherhood of carpenters 94 5 508 27

pension fund
Evelyn Davis 91 4.8 599 31.8
Gerald Armstrong 89 4.7 688 36.6
AFSCME Employees pension fund 67 3.6 755 40.1
AFL-CIO Reserve Fund 64 3.4 819 43.5
LongView Funds 42 2.2 861 45.8
People for the ethical treatment of 36 1.9 897 47.7

animals
International brotherhood of 29 1.5 926 49.2
teamstes general fund
Trillium asset management 26 1.4 952 50.6
Action fund management 24 1.3 976 51.9
246 other sponsore 3.7 48.1 1882 100

Figure 34: Global financial assets 2014e (Deutsche Bank 2015):
$294T
69 69
58 90%
Stock market capitalisation
Public debt
60 75% Bank Bonds
Corporate bonds
31 40% Loans
76 ~70%
Global finacial assets ($T) As % of World GDP
Figure 35: Global assets under management $33.4T in 2014 (ICI, 2015):
15.6
17.8 17.8
10.8
Global assets US Mutual funds US Short term mutual US Long term equity
funds (<1 year) funds (>1year)

Figure 36: Shift from active- to passive managed index funds (ICI, 2015):
+$1 T
Domestic Index
equity funds
Domestic active
equity funds
-$0.8T
7 years
Figure 37: Active and passive investors:
Ultimate beneficial owner
Investor type Activist fund manager Passive fund manager
Performance goal Return on in investment Beat benchmark
Asset under
Incentives Performance fee (carry)
management
Increase residual claim Portfolio management

Investment focus
Capital gain Risk diversification
Shareholder via Shareholder via risk

Fiduciary duty
Corporate governance mitigation

Figure 38: Shareholder proposals 2006-2014 on largest American companies
(Fortune 200, Copland, 2015; Westcott, 2016):
40% 39%
100% 100%
27%
39%
32%
1% 22%
er
ts
es
n
e
r
ie
te
nc
io
is
to
ld
th
ni
lic
at
lia
tiv
na
ho
es
pa
ns
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ffi
ac
nv
er
re
m
ra
pe
ov
al
a
li
co
al
Sh
bo
m
ci
ua
ci
G
0
So
co
so
La
id
20
es
te
iv
e
ra
d
ni
iv
nd
an
po
pa
ut
tu
ri
or
us
ec
m
r
he
Fo
C
co
io
Ex
ot
ig
0
el
d
20
an
R
e
s
n
fly
tu
ad
r
Fo
Figure 39: Sample proxy card (SEC):131
131
https://www.sec.gov/spotlight/proxymatters/proxy_sample.htm#.

Figure 40: Average % share price change relative to S&P500, a year after
shareholder proposal introduced. 2006-2014, Fortune 200 companies (Copland,
2015):
3.6%
2.3%
CalSTERS NYC Pension Florida State NY State CalPERS

Funds Board of Common
Administrators retirement fund
-2.0%
-7.3%
-8.1%

Figure 41: Schedule 14A Proxy access:
Vote for proposal if inserted

into proxy card
Corporation Shareholder
1. Insert proposal on proxy card Can propose if holding $2000 worth

2. No action letter of stock or 1% of company over 1
3. Ignore year
1 proposal, 500 words, 120

days in advance
Figure 42: Income inequality in the United States, 1917-2014:132
55%
Share of top decile in national income
50%
45%
40%
35%
30%
Low antitrust High antitrust Increased horizontal
enforcement enforcement shareholding
25%
1917
1925
1933
1941
1945
1953
1957
1965
1973
1981
1989
1997
2005
2013
132
Elhaug, 2016; Picketty, 2003.

Figure 43: Proxy campaign (Gantchev, 2013):
13D filing Success rate Cost
2/3 withdraw Collaboration
Demands 7% $2.9m
20% proceed
Board seat 40% $1.8m
10% proceed
Proxy threat Confrontation
7% proceed
Proxy fight 57% $6m+

Figure 44: SEC 13D Schedule (Brav, 2015):
180 % 7%
5% Abnormal returns versus

buy and hold strategy
Abnormal
share turnover
20 %
6-10 days
20 days 10 days 13D 20 days

before before filing after
Figure 45: How to internalize costs:
Positive
Return on
investment:
Freerider
Public Return on
investment: Activist
with externalize cost
Return on
investment: Activist
bearing full cost
Benefit
30 days 2-3 years

Externalize cost
over time
Before 13D filing stock 2-3 years

Private
starts to move
Compensate for capital gain
1) Taxing freerider Negative
Cost only
13D 2) Freeze % of passive
investors at 13D, release
Cost to if positive return to
1) Produce private activist
information for proxy fight 3) Tax deduction to activists
2) Stage proxy campaign if positive outcome

Figure 46: State Delaware legislative process:133
133
http://legis.delaware.gov/legislature.nsf/FSMain?OpenFrameset&Frame=right&src=/legislatur
e.nsf/lookup/bill_process.

Figure 47: St Louis Federal Reserve charts (FRED, July 2016)

Figure 48: How a Senate Bill becomes a law (USA)134
134
http://www.senate.gov/legislative/process.htm.

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Governance Advisor, March, April 2016
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Acronyms
BIS Bank of International Settlement.

CALPERS California Public Employees' Retirement System.
CFR Code of Federal Regulations (USA).
CII Council of Institutional Investors.
CIRCA Council for Investor Rights and Corporate Accountability.
DGCL Delaware General Corporate Law.
EFTA European Free Trade Association.
ETF Exchange Traded Funds.
ETHZ Eidgenssische Technische Hochschule Zrich.
FCIC Financial Crisis Inquiry Commission.
FINRA Financial Industry Regulatory Authority.
FRED Federal Reserve Economic Data.
FSB Financial Stability Board.
FSOC Financial Stability Oversight Council.
FTC Federal Trade Commission.
GDP Gross Domestic Product.
ICI Investment Company Institute.
IHEID Institute de Hautes tudes Internationales et du Dveloppement.
IMF International Monetary Fund.
IRS Internal Revenue Service.
ISDA International Swaps and Derivative Association.
MC Market Capitalization.
NACD National Association of Corporate Directors.
NASRA National Association of State Retirement Administrators.
NYSE New York Stock Exchange.
OECD Organization for Economic Co-operation and Development.
S&P Standard and Poor.
SEC Security and Exchange Commission.
SNB Swiss National Bank.
UNIZH University of Zrich.
END PAGE

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requires active shareholders

IHEID INP FINAL PAPER

DR. KASPAR BNZIGER

GENEVA, SWITZERLAND AUGUST 2016

All Rights Reserved

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 1

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 2

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 3

The legal framework of American public capital markets is at a seminal

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 4

American wealth is built on three pillars of capital formation: 1. Industrial productivity

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 5

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 6

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 7

1. Corporation: The Corporation, a legal personality with limited liability, is at the

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 8

Figure 1: Pillars of the American financial system

Corporate Governance Risk diversification

The paper is structured in three parts:

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 9

1. Pension funds struggle to generate 7.5% return per year

1. Pension funds struggle to generate 7.5% return per year

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 10

Investments in equities are more complex than investments in bonds. It requires a

Figure 2: Over 60% equity exposure required to meet pension obligations19

1995 2005 2015

Expected return 7.5% 7.5% 7.5%

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 11

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 12

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 13

Voting power in passive

US public equity market:

2020e: 30% ($7.2T) of

The question is whether such a concentration of power in passive funds is potentially

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 14

To understand the policy implications of power concentrations, we have to study the

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 15

Figure 4:Concentration of power in American markets38

Shareholder Managerial Institutional

Shift from money market Shift to institutional

Power with the funds to mutual equity ownership:

Concentrated Emergence of Concentrated

1930s Time 2000+

1880-1935 1933-34 SEC 2002 Sarbanes Oxley

controlled by big banks and pensions funds from

Limit shareholder Limit managerial Limit managerial

Index funds sterilize the shareholders

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 16

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 17

One share, one vote

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 18

1) Active managed funds: Typically mutual funds that are predominantly

3) Pension funds: Predominately allocate assets to external fund managers

4) Activist investors: They have a mandate to generate absolute returns.

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 19

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 20

Activist investors are filling an important function as governance entrepreneurs. They

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 21

Activists render companies more competitive

Sustainable wealth generation requires active shareholders ( All Rights Reserved) 22

A free ride for all at the cost of one

Successful activism is based on developing strategic ideas of substance and