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UNDER THE HOOD OF THE CAPITAL MARKET

By Ira M. Millstein
Senior Partner, Weil Gotshal & Manges; Senior Associate Dean for Corporate Governance, Yale SOM

  There is a growing awareness that today’s capital markets are very different than they were 50, 20, or even 10 years ago. Beginning in the second half of the 20th century, we’ve seen considerable changes in the pattern of share ownership, complemented by technological market advances, globalization, and the rapid and continuous proliferation of complex financial instruments.

These changes cannot be ignored as they may well have an impact on corporate performance in the broadest sense. The capital markets are not an end in themselves, their end game is providing the “energy,” the fuel, for corporate performance; corporate performance, in turn, is the bedrock of our economy. It would be reckless not to try to understand what’s “going on”.

In the era when share ownership was dispersed and diffused among individuals, the capital markets could be likened to the Ford model “T” or even “A”. You could pop the hood and see for yourself what was going on, the engine and transmission system were relatively simple; what needed tinkering, adjusting or replacing to make the car run. Today’s capital markets are complex and less and less transparent. Modest, let alone major, corrections are difficult to pinpoint even with current technology. Seeming “blips” are capable of sending ripples, even waves, throughout the capital market given its size, interdependency, globalization, and the free flow of capital across ever-shrinking borders. And the impact on corporate performance can be dramatic.

If we were to look under the hood today, our capital markets may look more like the inside of an Aston Martin. Instead of an infinite number of smaller, often home-based direct shareholders, atomized and dispersed, individual capital has become concentrated in large institutions which exercise considerable financial muscle: government pension funds ranging from local to state governmental entities; sovereign wealth funds (of great variety, the largest of which have hundreds of billions of dollars in assets); corporate pension funds; investments by state-controlled corporations; states; mutual funds; banks; and insurance companies. Institutions which owe fiduciary duties to the individual beneficiaries whose capital they have accumulated, or to taxpayers, but too often whose interests may not be aligned with those who knowingly, or unknowingly, have contributed capital. There may be conflicting motivations, ranging from the political to self-interest.

Further, these institutions themselves invest in publicly and privately held corporations, real estate, and increasingly, in private pools of capital such as private equity or hedge funds – each with its own strategy, set of objectives, and appetite for risk. In turn, private pools of capital, acting alone or through club deals, invest in, or buy outright some of the very corporations the institutions themselves have invested in. It becomes even more interesting as some private equity firms have decided to go public themselves. Then there is “exit.” Private equity firms “exit” an acquisition by returning it to the very public market from which it was purchased, or in some cases to another private equity investor. This is hardly an exhaustive list of the possible combinations and permutations that currently exist in the market.

Many applaud all of this as the inevitable consequence of a free market system and its dynamic ability to innovate and grow in accordance with the demands of capital consumers. Many, too, applaud the globalization of the free market system where capital moves swiftly to and from both developed and developing markets. Not unreasonable views.

Yet, even desirable markets have unintended consequences. Look no further than the recent sub-prime mortgage mess to see how a capital market failure impacts corporate performance in so many sectors. The public and private sectors need to take a serious look at what’s changed. When they pop the hood, they will find it too opaque and complex for simple descriptions of what’s “going on.” There is some solid foundational work that’s been done in identifying the changes and creating a taxonomy of the market. But that’s simply geography.

Going forward, the focus should be on neutrally and patiently uncovering the actual impact of these changes on sound corporate performance. The corporation’s affairs are, in one formulation or another, almost universally managed under the authority of a Board of Directors. The Board is quickly becoming the mediator of competing forces on the corporation.

The inquiry, then, should focus on the Board. Some questions to be explored: Should boards modify their corporate governance arrangements in light of significant activism in the capital markets? Most legal commentators agree that the goal of corporate governance, and the goal of the board of directors, is to maximize shareholder value. But which shareholder of the many that now comprise the capital market? Is it possible to accommodate shareholders with differing motives and objectives? How should boards respond to generally, and interact with, activists, analysts and rating agencies? Do strategies need to be altered? Does the profile of the Board need to explicitly assure a level playing field of expertise with members of the new capital market? More specifically, and perhaps more importantly, what is the impact on long and short term performance? These questions won’t yet yield to abstractions, exploration requires interaction with market participants.

Further, in his remarks at a symposium on the twentieth anniversary of his corporate law treatise, Robert Clark, the former Dean of Harvard Law School, predicted that “trends on the investor side ... [which] are presenting boards and managers with challenges that are often perceived as creating a need to choose one kind of shareholder or investor over another.” He suggested that “... law scholars had an historic opportunity to shape the path of the law…” by elaborating on directors’ duties and other aspects of corporate law to find the path through “this new and bewildering forest.” Law is, thus, another area that needs re-examination. Lawmakers, together with legal scholars, need to understand the reality of conflicts among shareholder groups and how potential conflicts may impact traditional notions about the legal role and duties of directors, and the role and responsibilities of the variety of investors.

Exploring all the questions is a predicate to working the way through “…this new and bewildering forest.” Everyone should be striving for responses that encourage capital market innovation, inhibit unintended consequences, and promise desirable corporate performance.

The Millstein Center, in connection with the Organisation for Economic Cooperation Development, is one effort to better understand the challenges and opportunities posed by these profound changes. Many more practitioners, scholars, and politicians need to join.

   To comment on this article, please visit the Center’s Discussion board at: http://millstein.som.yale.edu/forum/