Financial overhaul meets corporate governance …

July 15, 2010

The long-anticipated Wall Street reform bill just passed the U.S. Senate and is heading for President Obama’s desk. It still has a number of the investor-protection and corporate-governance provisions we mentioned before, but we were recently reminded that even some of the headline issues — bank capital standards, systemic-risk oversight, derivatives regulation — have a strong corporate-governance twist to them.

At any rate, that’s the provocative argument we got this afternoon while we were talking with Daniel Alpert, founding managing director of investment bank Westwood Capital.

Here’s the part that caught our attention the most: Much of American stock holdings is tied up in huge mutual funds. That just intensifies the diffusion of ownership that leaves shareholders with pretty indirect influence over the managers that run their companies.

You’d think the big funds would have clout, but they’re hamstrung, too. They have to keep billions of dollars invested in a given industry, making it difficult to boycott bad companies — especially when doing so could jeopardize the fund’s all-important performance, leaving it to lag its benchmark index. This is particularly true in the financial sector, where increasing consolidation means the biggest names are becoming an ever-bigger proportion of the industry — making them even harder for investment managers to avoid should they behave badly.

“In that environment, the ability of large shareholders, including mutual funds and others, to vote with their feet is limited,” Alpert said. “There’s a complete collapse of shareholders policing the investments that they make. … It’s endemic in our system right now that corporate governance doesn’t work any more.”

Case example: The financial crisis and our hard slog back from the brink. Banks misbehaved by loading up on risk, and far from losing support and suffering the discipline of the capital markets, shareholders didn’t peep.

And that, he argues, is why the government has to step in and tighten regulation. If Apple’s shareholders let Steve Jobs run roughshod over them, “the world has a few fewer iPhones,” as Alpert puts it. If the same thing happens in the financial sector, we’re all in serious trouble.

“You don’t get to operate independently and operate on the theory that the market is somehow going to discipline you, because the market has shown no discipline,” Alpert said. “The state has to come in and do what the shareholders are unwilling to do.”

That’s harsh medicine. Is he right?

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