Conflict of Interest: When A Money Manager’s Parent is a Bank
I’ve been reading John Bogle’s latest book, “The Clash of Cultures: Investment versus Speculation.” Mr. Bogle is the founder of Vanguard Group, the largest mutually owned mutual fund company and the inventor and chief proponent of the index mutual fund. Now in his 80s, he continues to drive home a clear message about the value of saving money and building wealth in broad-based, low cost, and simple investments. While Mr. Bogle’s investment principles have gained wide acceptance in the past several decades, he laments that speculation and conflict of interest are more prevalent than ever in the investment business.
|Thorn In Our Side (2003)|
His book reminded me of some of my least pleasant experiences in managing money inside large financial institutions, and the inherent conflict between acting in the best interest of investors and generating fees and profits for the company. While some of my stories go back ten or fifteen years, most of these practices live on.
Let’s begin with corporate governance. If a money manager invests in equities on your behalf, he votes on all corporate matters on your behalf as well. Whether it’s a slate of directors, the approval of a merger, or some new stock scheme, he’s supposed to act in your best interest as he votes on these matters. As Mr. Bogle hammers home in his book, this isn’t how money managers behave. Many money managers pay little or no attention to corporate governance. Money managers have a variety of reasons for cozying up to corporate executives rather than confronting them on proxy matters. Many corporations are a potential source of business, and thus money managers don’t want to jeopardize their own business. Sadly, if portfolio managers violate their duties, there’s no one serving as a check to CEOs and corporate directors.
Early in my stint at NationsBank, I served as Director of Research. One of my responsibilities was to chair the proxy committee, the group that reviewed corporate governance matters. Like most institutional investors, we cast our votes with management almost all the time. As I recall, we opposed a few measures that had a strong tendency to entrench management, such as poison pills and staggered boards. On all other matters, we simply followed management’s recommendations.
We held a sizable position in Kmart, which was already struggling in the mid-90s. The company had acquired Waldenbooks, Borders, Builder Square, and the Sports Authority, and management decided that the way to “create” value for investors was to issue something called “tracking stock” in each of its major subsidiaries. Tracking stocks were mere pieces of paper (not actual ownership) that we could trade based on the value we ascribed to each of the Kmart entities. Somehow these pieces of paper were going to be worth more than the price of Kmart’s languishing stock.
Our proxy committee thought that this proposal was a poor substitute for needed changes at Kmart. Management had spent too much time with their investment bankers and not enough time investing in the technology and inventory necessary to compete with Wal-Mart and Target. The proxy committee decided to vote against the Kmart proposal. As a courtesy, I called the CFO of Kmart to let him know that we were going to oppose management’s proposal. We had a polite and straightforward conversation. I was still commuting back to New York from Charlotte at the time, so after phoning the CFO I headed off to the airport.
On Monday morning I returned to my office to find my voicemail overflowing with irate messages. It turned out that NationsBank was a significant lender to Kmart, and Joseph Antonini, Kmart’s CEO, was not pleased. In fact, he was threatening to cut the bank out of future business. All sorts of NationsBank executives, who I’d never heard of, had called to find out why I hadn’t checked with them first. Other executives simply called to tell me I was stupid or worse.
Fortunately my boss, Jim Sommers, understood that I’d acted entirely appropriately, and some how put out the fires among the bankers. NationsBank’s business relationship with Kmart suffered. However, as fiduciaries for our investors (folks in our mutual funds and trust department), our only appropriate consideration was to vote in the best interest of those investors.
Later in 1994, Kmart came up with another plan and conducted an actual initial public offering of shares in Borders and Sports Authority. However, Mr. Antonini failed to turn around the core Kmart business and was terminated in 1995. Fortunately, my tenure at NationsBank coincided with a roaring bull market, and we didn’t face very many controversial proxy matters. However, I always felt the enormous presence of the bank, and I knew that the bank’s interest and our clients’ interests were seldom one and the same.
Money management firms owned by large financial conglomerates are unlikely to take corporate governance seriously. A bank or insurance company has too many reasons to maintain good relations with the very companies their investment subsidiary is investing in. As a result, you should not expect the money manager to act completely independently from its parent. Money managers know where their paychecks come from.
The money management business is rife with conflicts. Tomorrow I’ll related some of those pressures inside the mutual fund business.