Dept. of Labor to Figure Prominently in Coming Year

Now that the election is over, get ready for a deluge of predictions on the coming wave of corporate governance legislation and regulation.

Fair enough; with governance tagged as one of the market guardrails that broke, allowing the economy to go over a cliff, politicians and pundits can’t help but draw up blueprints for substantial intervention. But we’ve been warning in this column for months about the likelihood of legislated ‘say on pay’ and such. So this time we want to spotlight how the new Congress and President might rock your boardroom from a direction few expect: a dusty corner of the U.S. Department of Labor.

Here’s why. Reams of newsprint have been devoted to the power of institutional shareowners to oust CEOs and bend corporations to their will. The truth is that while a handful of public, labor, and relational or hedge funds honestly earn the title of “activist,” the vast majority of asset managers remain inert when it comes to engaged ownership. The vast majority of corporate pension funds give little more than lip service to stewardship of the companies in which they invest. We bet, for instance, you’ve never once seen a shareowner resolution sponsored by a traditional corporate fund. More to the point, few such plans do much more than oversee perfunctory (usually outsourced) proxy voting.

From the corporate investor relations point of view, this big chunk of ownership has been easy to manage. Funds are either prone to back management even when a company is floundering; or if they vote ‘no’ it is simply a robotic impulse tripped by a proxy service and has little bearing on the same fund’s portfolio managers. So too with 401(k)-style defined contribution plans; too many mutual funds selected for employee choice treat voting as a rote compliance exercise with no relation to value.

Few in Washington have paid much attention to this unedifying feature of the capital market. But the economic crisis has drawn attention to two salient facts. First, several of the financial institutions that got hit hardest—think AIG and Washington Mutual, for instance—had long been identified by activist investors as problematic. Indeed, some analytical services—most heroically, The Corporate Library—had defied conventional wisdom in pegging these firms early as high risk. With support of passive owners, though, targeted boards had been able to brush off activist shareowner complaints—until it was too late.

The second fact is that when an employee pension plan is transparent and accountable, it generates at least 1 to 2 percent of additional return per year, according to latest research. By contrast, when pension arrangements are poorly governed, they tend to churn stock, pay for underperformance, harbor conflicts of interest, balk at engagement, and flirt with higher risks of destroying long-term value.

With trillions in value now vanished from American savings, expect politicians, not surprisingly, to work mightily to overhaul the governance of American pension funds to make them more activist as a way of safeguarding investment interests. U.S. corporate directors should be aware of the ways this could alter fund arrangements for employees—and the turbo charge it could deliver to shareowner engagement in the United States.

Just how could this happen? That answer brings us back to the Labor Department. Here are four key steps to watch for.

The incoming administration appoints an advocate of investor interests to the obscure post of Assistant Secretary of Labor for the Employee Benefits Security Administration in the Department of Labor (DoL). The unit oversees plans with some $5.6 trillion in assets, covering 150 million Americans. The fraying Employee Retirement Income Security Act of 1974 (ERISA) created the pension czar. But for years the regulator has tinkered rather than policed.

The new pension cop could mandate that each ERISA retirement plan have a governing body of trustees that includes representation of both the issuer and beneficiaries—and maybe even an independent chair. It would break the mold where corporate management controls employee savings arrangements. But it is hardly revolutionary; at least in a global context. Britain and Australia, among many others, require that a portion of retirement fund trustee seats be held by representatives of plan members. And the International Corporate Governance Network recommends that “it is not desirable that the plan sponsor or employer dominate the governing body. Where this is the case, consideration should be given to the representation of individuals accountable to beneficiaries.” By the lights of overseas experience, a retirement system oversight board independent of an issuer can be a far more vigorous defender of member rights in all sorts of ways, from supporting shareowner engagement to scuttling a merger unless fund needs are satisfied.

An invigorated DoL could require fund trustees to meet professional standards of skills and independence, and to reach tough new disclosure targets that re-channel investment habits. For instance: the pension czar could compel trustees to explain how they ensure that pay for portfolio managers is linked to long-term performance rather than stock churning. Or how investment agents evaluate governance risk as part of portfolio management. Or how trustees manage and protect rights as asset owners—by revealing not only voting records but also reports of how funds dialogue with companies (a requirement of asset managers in Britain, for example).

The new DoL could reverse the lame-duck Bush administration’s interpretive bulletin, issued in the midst of the crisis so no one would notice, that makes it tougher for funds investing for the long term to consider environmental, social, and governance issues such as climate change, human capital and reputation. Ironically, the measure requires more recordkeeping than rules mandate for short-term trading, which considers only daily or even momentary stock price movements.

Finally, simultaneously professionalizing pension fund governance while empowering those pension funds would provide a new approach to some of the most intractable corporate governance issues and make moot the decades-old “regulation vs. laissez faire” argument. In effect, the administration could argue that it was restoring accountability to capitalism, an ardent desire of people with such different political philosophies as Alan Greenspan and Warren Buffet.

The DoL proposal is the type of under-the-radar agenda that may be in store next year. But heck, let’s now add some over-the-radar wisdom, too, based on the same accountability philosophy. ‘Say on pay’ is a virtual certainty in Congress, as we’ve written. But we also predict that through legislation, regulation, or listing rules some form of access to the proxy allowing investors easier routes to nominating corporate directors. There could be a majority rule requirement for director elections, although that seems to have been achieved by marketplace pressure for America’s largest companies at least: clawbacks to recoup payments made to corporate executives based on fraudulent performance numbers; and a swift end to phantom ‘broker voting’ that amounts to ballot stuffing.

Combine the prospect of re-shaped retirement funds with a basket of potent, new shareowner rights, and the result is an agenda bound to radically alter the culture of retirement investment—with big implications for corporations.

If you see the new president naming a shareowner advocate to DoL czarhood, don’t stop to hear us say we told you so. Just join with other firms to help shape the reform, start crunching facts on how your retirement arrangements can adapt, and brace for a new era of accountable capitalism.