“Mutualism: Reimagining the Role of Shareholders in Modern Corporate Governance” Remarks at Stanford University

Thank you, Professor [Joe] Grundfest, for that kind introduction. It is a pleasure to be with you this evening, and I would like to thank the Corporations and Society Program and the Rock Center for Corporate Governance for inviting me to visit with you. In particular, I would like to thank Professors [Anat] Admati and [Joe] Grundfest for extending to me such a warm welcome.

Before I go further, I must state that the views I express today are my own, and do not necessarily reflect those of my fellow Commissioners or the SEC staff.

Tonight, I want to talk to you about something that has been vigorously debated in recent years: What is, and what should be, the role of the corporate shareholder? In the spirit of being in California, this debate could be summarized as follows: Are shareholders merely extras in the corporate movie? Or are they lead actors that need to be empowered so that they can successfully play their roles? However, as most people in this room know, it is actually much more complicated than that. It is not, and should not be conceptualized as, a binary choice. Rather, I would posit that the entire corporate ecosystem’s success actually rests on effective communication and collaboration between corporations and their shareholders. When a company, its management, its shareholders, and its employees work together, companies tend to be more resilient and prosperous. In turn, this benefits companies, their corporate stakeholders, and the economy as a whole.

Today’s corporations influence and impact our society in a multitude of ways. Corporations help grow our economy, provide well-paying jobs, and provide earnings to investors saving for retirement, college, or a new home. Many companies, whether small or large, are helping to drive our society forward, developing new technologies that are raising our living standards, improving our environment, and lengthening our life span. Corporations hold some of our most precious assets, such as medical histories, consumer bank account information, addresses, and other sensitive information. They also are central players in some of our most immediate problems, such as global warming.

Corporations have shaped, and will continue to shape, our society, our identities, and our relationships with one other. This week’s series seeks to promote a discussion of the interrelationship and interdependency between corporations and our society. Pretty heady stuff, to be sure, but extremely important. Not only from an academic point of view, but from a practical and policy point of view, as well.

So, I thought I would start off our discussion tonight by talking a bit about the science of “mutualism.” For those of you not familiar with the concept, mutualism is a symbiotic relationship between individuals of different species in which both benefit from the association. One example of mutualism is the relationship between bees and flowers. Bees fly from flower to flower gathering nectar to make food. By flying from flower to flower, bees pollinate the plants on which they land. Bees get to eat, and the flowering plants get to reproduce. Bees help plants grow, thus supporting other animals, including us humans. The bee-flower relationship is integral to our entire food chain, and our larger ecosystem.

The relationship between a company and its shareholders is rooted in a similar form of mutualism. Shareholders invest their savings or capital in a company. The company then deploys the capital to fund its operations. This allows the corporation and its shareholders’ investments to grow. This corporation-shareholder relationship is likewise part of a larger ecosystem. When all goes well, more employees and managers get hired, and the company produces more products or provides more services, all of which benefits the entire economy.

Unfortunately, the relationship between corporations and their shareholders may be moving away from its origins and becoming less mutualistic. This, I believe, may harm companies and their shareholders, as well as those who depend on the health of the corporation-shareholder relationship.

So, how do we restore mutualism in the relationship upon which our corporate ecosystem is based?

MUTUALISM AND THE CORPORATION-SHAREHOLDER RELATIONSHIP

Brief History

I recently remarked upon the history of the American corporate form, and I would like to start my talk tonight there, as well.[1] Don’t worry, I won’t go as far back as the Dutch East India Company and its participanten, or the tulip bulb market.[2] Rather, I will quickly touch upon the history of the corporation-shareholder relationship in the United States to inform the rest of our discussion.

From the late-1700s to the mid-1800s, corporations started to flourish in the United States.[3] American companies typically operated within a single state or community.[4] The shareholders of a corporation were often members of the same community in which the corporation was located. As a result, they were able to engage and monitor the company’s business affairs in a more direct manner than we currently see today. A corporation also met with its shareholders more frequently, whether in the form of shareholders’ meeting or otherwise.[5]

Beginning in the mid-1800s, however, companies started growing larger and the corporate form changed.[6] Companies began hiring managers—who often had no ownership interest in the companies—to run their affairs. While this transition created certain efficiencies,[7] it also in many cases separated the ownership of the company from the management of the company. This had the effect of reducing shareholders’ ability to directly influence the company’s business.[8]

Mutualism and the Corporation-Shareholder Relationship in Recent Years

A lot has happened since the mid-1800s, and we are now at a tipping point. Instead of being in the midst of an industrial revolution, we are in the midst of a digital revolution. This new revolution comes with many benefits—speed, efficiency, and innovation, to name only a few. Coupled with these benefits, however, are also some risks. I think if we focus on the strengths of the American corporate form, we can successfully reimagine the corporation-shareholder relationship for the Digital Age.

I would like to discuss a few examples of how, in modern corporate governance, the concept of mutualism can help us think through the path forward for corporations, their shareholders, and the larger corporate ecosystem.

Cyberthreats

As we all know, the digital transformation is providing both companies and shareholders with tremendous opportunities. However, one of the biggest challenges facing corporations and their shareholders, their employees and consumers, and our economy as a whole, is cybersecurity.[9] As we have learned, cyberattacks can affect millions of people at once and potentially compromise our most sensitive personal information.[10]

Shareholders have been out front advocating for more information on company practices relating to cybersecurity.[11] The number of shareholder proposals regarding cybersecurity has increased in recent years.[12] But good information remains scarce. Unfortunately, corporate disclosures are far from robust and largely consist of boilerplate language that fails to provide meaningful information for investors.[13]

While companies and shareholders agree that cybersecurity is one of the most prominent corporate issues of our time, it is unclear why companies are not doing more to implement robust cybersecurity frameworks and to provide meaningful disclosures regarding the risks of data loss.

Companies and their intermediaries tend to view cyberthreats as a technology problem instead of, more appropriately, a business risk. As we have seen time and time again, cybersecurity, and the related threats of unintentional loss of data, is a governance challenge for all of us, and it requires a change in culture and approach. Many shareholders seem to understand this and have been urging, and continue to urge, companies to engage.

Regulators are certainly not immune from facing these challenges. In August 2017, I learned for the first time that the Commission’s official record system was breached in 2016, and that this breach may have provided the basis for illicit gains through trading.[14] Clearly, the Commission’s enterprise risk management processes failed to adequately address appropriate escalation protocols. Once he was informed, Chairman Clayton immediately launched an investigation into the breach and has focused the Commission and the staff on improving our risk management framework.

Companies, their managers, their boards, as well as their regulators, all need to do a better job in recognizing and addressing the significant risks that can result from the loss of data. Breaches of security measures can result in theft, reputational harm, or the loss of intellectual property. Simply put, the unintentional loss of data may have material effects on companies. Slowly, regulators around the globe are stepping up to the challenge of issuing data protection laws and regulations. The approach to these issues continues to evolve with the changing landscape. For example, the European Union’s General Data Protection Regulation is set to go into effect in May 2018.[15] China has begun enforcing regulations concerning “critical information infrastructure.”[16] Last March, the New York Department of Financial Services required that regulated firms name a chief information security officer (or CISO). These CISOs must provide an annual report on cybersecurity to the firm’s board.[17] Last year, a bipartisan bill was introduced in the Senate to require publicly traded companies to disclose whether any members of their board have cybersecurity expertise.[18]

We at the Commission have not yet adequately pressed forward. While the Commission’s staff has released disclosure guidance for public companies to consider when dealing with cyberrisks and breaches,[19] the Commission can and should do more. I believe the Commission should consider rules to require disclosure of a firm’s enterprise-wide consideration of cyberrisks. I also believe that we should develop rules to ensure that market intermediaries, including broker-dealers and investment advisers, develop and implement policies and procedures to protect investors’ personal information.

The security and integrity of a corporation’s assets, like the SEC’s, is a great responsibility. As I said earlier, cybersecurity has been viewed by many as simply an “IT” problem, hoisted on the shoulders of a company’s chief information officer. Too often, this has led to a failure to integrate cybersecurity into a firm’s enterprise risk management framework. To be sure, some companies are focused on cyberthreats and recognize their potential economic threat. But companies need to do more than simply recognize the problem. They need to heed the calls of their shareholders and treat cyberthreats as a business risk. Corporations and shareholders will both benefit from greater transparency and focus on the risks related to unintended data loss and the collateral consequences.

Board Composition

The composition of corporate boards provides another example of how the concept of mutualism is informative. Boards can and should be a bridge to investors, but too often they are a wall. Board composition is vitally important as directors play a meaningful role in helping companies make productive investments and good decisions going forward. However, boards remain far from diverse or reflective of shareholders’ views despite evidence pointing to the value of such diversity in their composition.

Gender diversity on boards provides a notable example. This is not about making people feel good—it is about dollars and cents. Studies suggest that women may be better monitors of executives, a central function of boards of directors.[20] Research has also shown that companies with strong female leadership generated higher returns on equity compared to those without.[21] This may be because having a diverse board helps the company better understand purchasing and usage decisions by its clients or customers. Studies have found, after all, that women drive 70% to 80% of purchasing in the United States.[22] As I have remarked in the past, diverse boards also appear to deter “groupthink” and help reduce instances of fraud, forms of corruption, and shareholder contests.[23] The Commission and regulators across the globe have also echoed the importance of gender diversity on boards.[24]

Despite all of this, gender diversity on boards remains elusive.[25] The percentage of women on boards is currently at approximately 20%, an increase of only 5% since 2011.[26] This is striking when you consider that women make up 50.5% of the U.S. population[27] and approximately 47% of the U.S. labor force.[28] Indeed, the United States lags behind many advanced economies in terms of women’s representation on corporate boards.[29]

More striking still, it is not just academics and think tanks that support gender diversity on boards. Shareholders, too, expect the companies they own to have diverse board membership. For example, State Street Global Advisors[30] and BlackRock[31] have adopted policies or guidance with respect to increasing gender diversity on boards, and indicated their willingness to use their voting power to effect change, if necessary.

Yet, despite the documented benefit of diverse boards, many board members do not believe that board diversity enhances company performance.[32] Further, more than half of directors believe that their boards are already sufficiently diverse.[33]

It is one thing for boards to ignore scholarly research, but it is quite another for boards to ignore their companies’ shareholders or owners. Especially when it can affect everyone’s bottom line. Although we have come a long way since the 18^th Century, we still have a long way to go. How can technology help this process? Can it be used to better connect a company and its board with its shareholders? How can a corporation capitalize on mutualism and benefit from the best ideas of its shareholders for the benefit of all?

Shareholder Activism

Changes in the corporation-shareholder relationship are perhaps most apparent when looking at efforts to curtail shareholders’ information and rights. As owners of a company, shareholders actually care about corporate practices of all types and how they affect the bottom line—from strategic plans to employee relations to executive compensation, and much more. So-called shareholder activism can provide a necessary check on a company’s leaders.[34] Or it can be a needless expense for a company ultimately producing no benefit. Whatever your opinion, shareholder activism seems to be here to stay, with 39% of directors believing that there will be an increase in shareholder activism in 2018.[35]

In recent years, shareholder activism has prompted myriad responses from corporate boards and management.[36] Many simply try to fend off shareholders. Many engage with shareholders, but because about 70% of the share ownership of U.S. companies is from huge investors,[37] that is where they focus.[38] Thus, the entire battle is fought for the opinions of a handful of executives at large asset managers.

Though the decision to engage institutional shareholders may simply be a matter of numbers, what are the long-term effects on the company of this sort of narrow shareholder engagement?[39] Does engaging the view of only one group of shareholders result in a form of short-termism? Could it result in a company putting on blinders that can affect its long-term bottom line? Ultimately, how does this sort of one-sided engagement affect the company’s position in the larger ecosystem?[40]

In effect, is shareholder activism a symptom of an underlying problem or part of the cure? I believe that we need to get back to a more mutualistic relationship in order to properly answer that question.

Dual-Class Capital Structures

Another place where the concept of mutualism needs to be considered is in regard to dual-class capital structures, where certain shareholders are starting to be disenfranchised by design.

As you know, in typical dual-class capital structures, corporate insiders receive common stock with multiple votes per share while public shareholders receive shares with one vote per share.[41] This structure allows these corporate insiders to control a majority of the votes of the corporation even though they own a minority of its stock.[42] While dual-class capital structures have existed for many years,[43] much has been written about them recently. This may be in part because of an upsurge in dual-class IPOs—from Google in 2004 to Manchester United in 2012. And we all have heard about Snap and its IPO of non-voting shares in 2017.[44]

Many, including myself, see dual-class capital structures as inherently undemocratic, disconnecting the interests of a company’s controlling shareholders from its other shareholders.[45] The disassociation of interests can grow over time when certain shareholders, but not others, have the right to vote over fundamental corporate matters—like board members.[46] It is not surprising, then, that critics include shareholder groups, asset managers, and stock indices.[47] Or that they are prohibited by some countries.[48] Yet, we are still inexplicably letting dual-class share structures persist.[49]

Why does the appetite for dual-class capital structures exist despite wide investor disapproval of such structures? Where is the symbiosis? Can investors afford not to invest in another Google, even if they do not agree with the share structure? What leverage do they have? What happens when the interests of a company’s controlling shareholders continue to diverge from its other shareholders? Is there a risk that a company’s controlling shareholders will acquire conflicts of interest so large that the company cannot act in the best interests of all of its shareholders?

While some say dual-class capital structures are designed to prevent a takeover or shareholder activism, they also may provide a means to evade management and board accountability. Structures where a minority of insiders lock out the interests and rights of the majority may also have collateral effects on our capital markets. They may be harmful not just for those companies, their shareholders, and their employees, but for the economy as a whole. Dual-class capital structures, in effect, turn the mutualism underlying the corporation-shareholder relationship on its head.

A WAY FORWARD

While it is clear that the relationship between a company and its shareholders is currently in flux, it is less clear how we should move forward. How can we restore the mutualism that serves as the foundation for the corporation-shareholder relationship, and that has benefited companies, their shareholders, and the economy as whole since the 1700s?

Shareholder empowerment is key. As I have discussed tonight, the benefits of shareholder involvement are not abstract. Shareholders often fight for corporate values—such as diverse boards—that empirically have positive, direct effects on the corporate bottom line. They often do this well before managers or boards are willing to consider or implement such changes. Despite this, corporations appear to be searching for ways to ignore shareholders, even on a structural level.

Shareholder engagement is, I believe, a good first step in enhancing the corporation-shareholder relationship for the benefit of both. Despite the trends toward a less mutualistic relationship, there are some positive signs. For example, companies and their shareholders are increasingly sitting down at the same table these days.[50] Companies are also hiring advisors to help them engage directly and consistently with their shareholders.[51] This has allowed companies to have a continuing dialogue with their shareholders.

Many companies are also utilizing technology to better facilitate engagement with their shareholders. From hosting virtual or live webcasts of their shareholder meetings, to using social media and mobile technology, companies are searching for new and better ways to actively engage their shareholders.[52]

Unfortunately, this shareholder engagement has largely been geared toward those with the most voting power. Companies can also benefit from the engagement of retail investors. And, as I have said before, technology can also serve this purpose. After all, more Americans are technology-literate than ever before.[53] Indeed, approximately 80% of Americans had a social media profile in 2016. Perhaps, shareholders should be allowed to vote through social media or a mobile phone application, like in Estonia.[54]

New and cutting-edge technologies may help in other ways. Companies might be able to use distributed ledger or blockchain technology to identify and reach their shareholder bases more effectively.[55] Currently, companies mainly communicate with shareholders through broker or bank intermediaries, because the shares are held in the names of these intermediaries rather than in the names of the beneficial owners. This means that, in some cases, companies do not actually know who their shareholders are. While this complex construct may have been necessary in the 1970s, current technology could enable companies to directly communicate with shareholders without the need for intermediaries.

The Commission can do more, too. While we have issued rules that shape the means by which a company communicates with its shareholders,[56] we should continue to be ready to help fortify the corporation-shareholder relationship as we move forward. For example, we should adopt final rules regarding the use of universal proxy cards.[57] These rules should recognize that few shareholders can dedicate the time and resources necessary to attend a company’s meeting in person and that, in the modern marketplace, most voting is done by proxy. The Commission’s rules need to change to reflect our current reality, empowering companies and shareholders alike.

In a time when ownership is global and disparate, the use of technology and the Commission’s rules are simply tools to further the empowerment of a corporation’s owners. We have seen throughout history that a company’s growth and its owners’ prosperity are often enhanced by direct engagement. In other words, both engaging with one another for the good of all, or mutualism. The result is a corporation that is more nimble and grows in an ecosystem that thrives on transparency. This was true in the 1700s and it is still true today.

* * * * *

As we move forward, we have to ask ourselves how we can strengthen the corporation-shareholder relationship. For it has been foundational to the success of the American corporate form.

As I have discussed tonight, the corporation-shareholder relationship must be reimagined in the context of modern corporate governance to recapture its benefits. Shareholders, like management, share the desire to grow a company’s bottom line. But they can only help if they are heard.

We need to go back to first principles: A corporation’s growth and its shareholders’ prosperity are intertwined. To succeed, they must work together.

Thank you for your time, and for inviting me to speak with you this evening.