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The Establishment and How It Rules By Stephen J. Butler

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In spite of all the talk about improving corporate governance, I doubt if many Americans know much about the practical side of how their major corporations are controlled. On paper, a share of common stock generally constitutes one vote. An election conducted by shareholders will theoretically determine the directors who will represent the shareholders' ownership of the company.

Thanks to something we call "the Establishment," it's not that simple. A major company that has been in the news quite a bit recently may be replacing its entire board of directors. A few of the directors don't want to leave, and for the moment, they are standing in the way of what would probably be a healthy move for this company. Meanwhile the stockholders, who ultimately control the situation, are effectively out of the loop. The decisions are being made by a small collection of middle-aged white men who, fortunately, are experienced and successful business people with very successful track records.

A few years ago, a book called "The Chairman" chronicled the amazing life of John McCoy, a war hero and Harvard-educated lawyer who shuttled between New York law firms, the Defense Department, and some major international banks until his death about fifteen years ago. It's a story about a man who was the archetype of the person we have come to refer to collectively as "The Establishment" --- a vague definition of the group of people who effectively control corporate America and much of the government.

This "shadow government," for lack of a better term, is responsible for much of what we have come to enjoy as a society. As a self-elected body of leaders, we can argue that they have done a great job. Their recent highly-publicized failures, after all, were caused by managers who are alleged (at this point) to have committed fraud. The failures, as a percent of the total, are statistically immaterial.

So how does The Establishment manage to perpetuate itself and remain so entrenched without our say so? What if we stockholders decided that we preferred a coalition of Native American chiefs to represent us since they are doing such a great job with casinos? Any selection of new directors is determined, for the most part, by existing directors who nominate their replacements. This is true even in the case mentioned above where an entire board may be replaced. However, over the last twenty years, the ruling class of Wall Street has been bludgeoned by the meritocracy. The old days of just going to the right schools, joining the right clubs, and marrying the right spouse has been superceded by a collection of extremely smart, hard-working people who sleep in their wastebaskets and cancel their weddings to put the finishing touches on merger and financing deals.

These are the people who figured out how to take over a company by using junk bond money to purchase at least a five percent interest and then waging a proxy battle to oust the existing board and replace it with their own candidates. These Barbarians at the Gate have successfully shaken the complacency of post-war corporate America and have contributed perhaps as much as technology to the increased productivity of the past twenty years.

A second component controlling our "shadow government" is the proliferation of mutual funds and the investments that they control in our behalf. Our funds, as institutional investors, can vote the shares we effectively own, and this gives them the power to control a slate of directors. It is possible today for a board of directors to be thrown out of office by a group of investment institutions that band together to vote the shares they control. The Hewlett Packard/Compaq deal is the most recent example, but a more colorful one was the battle over Kaiser Steel in 1986. In this case, Fidelity Investments played the role of "heavy" as they determined the fate of Monte Rio, the CEO and Chairman who had looted the company.

Since that time, Fidelity and other major fund families have learned to control their corporate investments from behind the scenes. Why? Because in this country we tend to be paranoid about concentrations of power, and we vote for steps to control it. The latest Sarbanes-Oxley bill is a good example of a step in the right direction. Replacing Harvey Pitt, our SEC Chairman would be another, according to Fortune Magazine. With assets approaching half a trillion dollars, a company like Fidelity wields enormous potential power over corporate America. We would like to think that they would operate as a benevolent dictatorship but, as I like to say, "even paranoids have real enemies."

What bothers me about mutual funds controlling corporate America is the fact that so many of their managers are relatively inexperienced. A friend of mine runs a billion dollar company. Once a quarter he has to fly to a mid-western city to meet with the 26-year-old manager of the fund that owns over 10% of his company's stock. He has to continually make the case for not dumping the stock, and fortunately he has been successful at it for years. Frankly, if I had to choose who was ultimately running my life, I'd go with the Establishment over any collection of mutual fund managers. But I must confess, the Establishment probably performs better under the threat of young guns. In other words, our "Shadow Government" has its own checks and balances system just like our elected officials and the courts.

The purpose of this short practical lesson in corporate governance is to help us become more rational investors. We tend to fear what we don't understand. Therefore, it is easy to get upset and even frightened when we experience recent dismal results while reading about corporate crime in the newspaper. Understanding how the system works can make us feel more confident in a tool that has proven to be one of the best for building long term wealth.