The revolution of corporate governance has been one of the central business issues over the last decade. Nearly anyone who follows this issue in the United States acknowledges shareholder activism has been a prominent theme in Corporate America. Curbing excessive salaries for executives, seeking increased board oversight and independence, and calling for better performance have become prevalent. The primary impetus for these changes has come from institutional investors. Leading the way has been the California Public Employees' Retirement System (CalPERS).

CalPERS has long been at the forefront of shareholder activism in the United States. With assets of more than $110 billion, we routinely put pressure on companies in an effort to achieve better corporate performance and better corporate governance.

As a large institutional investor with stock in over 1,500 American companies and over 750 companies outside the United States, we have become long-term shareholders of major corporations. High transaction costs associated with selling equities, large portfolios, and more money to invest have all created incentives for us to buy and hold.

At CalPERS, we have no greater responsibility than the prudent management of our portfolio. We are under considerable and constant pressure to increase returns by pursuing every possible strategy to increase the value of companies in which we invest. As a result of these factors, we have used corporate governance activism to improve performance in the United States.

However, our crusade for better performance has not always been easy. Corporate governance was largely dormant in modern times. Until the mid-1980s there was little evidence of shareholder activism restricting the behavior of boards and management at most American corporations. Boards and management were, in effect, responsible to no one but themselves.

The Birth of a Movement

Corporate governance was born in 1984. It began simply as objections by a few shareholders to certain company actions that were considered to be self-serving. Companies created anti-takeover devices and procedural obstacles that were viewed more as protecting the corporate status quo than serving the long-term interests of shareholders.

A debate quickly ensued over whether shareholders -- particularly institutional investors who were accused of being transitory and only interested in short-term profits -- had a right to participate in decisions concerning the long-term viability of a corporation.

In late 1989, CalPERS began working closely with the U.S. Securities and Exchange Commission. This relationship led to the 1992 reform of executive compensation disclosure and proxy solicitation reforms. These reforms paved the way to elicit support from other shareholders through communication and to work together to bring about change.

As our corporate governance program evolved, we moved away from a specific-issues approach to focus on company performance. This approach proved effective.

The success achieved by our corporate governance program was documented in a study performed for CalPERS by Wilshire Associates of Santa Monica, California. Their analysis, known as "the CalPERS Effect", suggests that our corporate governance activism targeted at underperformers had a tremendous impact on corporate performance. Despite underperforming the Standard & Poor's (S&P) 500 index by an average of 85 percent for the five years prior to CalPERS shareholders activism, the 62 companies that were targeted by the System from 1987 to 1995 have outperformed the S&P 500 index by 33 percent over the subsequent five years. We estimate that the companies' improved performance has correlated with approximately US $150 million annually in added returns -- a clearly justifiable solution for our efforts.

In fact, many changes have occurred in structure, strategy, and leadership over the last decade at such American corporations as General Motors, IBM, American Express, Kodak, Sears, Westinghouse, and Kmart.

What the past has shown us is that we have increasingly succeeded in delivering our message to Corporate America. And it is clear that the emphasis placed on corporate governance practices is not loosing momentum as the 21st century approaches. Instead, the principles of good corporate governance are gathering global support. The natural result of this phenomenon for CalPERS is to begin turning our attention to the state of corporate governance in the international markets.

Crossing Borders

Over the last decade, we have witnessed a change in capital markets worldwide. Continually, we see a move away from traditional forms of financing and a collapse of barriers to globalization of the capital markets.

The end result is that corporations from around the world are beginning to compete with each other in every market. This competition is forcing corporations to reduce labor and capital costs, improve productivity and change the way they do business in order to sustain viability. In doing so, corporations are tapping international markets.

There has also been a dramatic increase in the level of institutional investment in the international markets as well. By one estimate, ownership of foreign shares by the largest U.S. pension funds grew roughly 34 percent to more than $225 billion dollars over the last two years.

Overall, domestic and overseas institutional investors now account for more than three quarters of the value of shares on the stock market. The 10 largest investors alone make up a quarter of total market capitalization. Many corporations now have one or more shareholders with stakes in excess of 5 percent, and about a third of the largest companies have at least one institutional investor with a stake in excess of 10 percent.

CalPERS entered into the international security markets in the late 1980s to seek better returns and achieve diversification of the Fund's investment portfolios. In December 1994, the CalPERS Board of Administration decided to increase the System's asset allocation to international equities from 12 to 20 percent of the Fund's total portfolio. Today, CalPERS exposure to the international markets is among the largest of any major pension fund. Current assets exceed $24 billion invested outside the United State in equity and fixed income.

The increase in international ownership combined with the rapid globalization of markets has had a number of important consequences for CalPERS.

As the size of CalPERS international holding began to grow, we asked ourselves -- if we are going to exercise our ownership rights to increase returns to our trust fund in the Unites States, should we not extend these efforts to our investments in the international markets? Given our fiduciary responsibilities, are we free to ignore international corporate governance?

At the same time, we recognized that globalization was largely causing countries to reassess and adapt their corporate governance systems to a more competitive environment. The realization that economic and capital markets were quickly breaking down barriers to globalization presented a significant opportunity for us to share our domestic corporate governance experiences. We believed that we could ultimately influence the discussion as to what form corporate governance should take in a global market.

As a first step in understanding the unique differences of the global markets, we conducted a study on the role of international corporate governance and increased performance monitoring of our international stock holdings. Based on this study, we adopted a formal International Corporate Governance Program in March 1996 focusing on the four countries with the System's highest equity exposure: Japan, France, Germany and the United Kingdom.

We followed the study with the adoption of a set of global governance principles. The principles focus on the six basic concepts that are fundamental to free and fair markets throughout the world, without impinging upon the legal, economic and cultural traditions of each country. Moreover, the principles reflect the core of the corporate/shareholder relationship. The principles address the following:

• director accountability to shareholders
• transparent markets
• equitable treatment for all shareholders
• easy and efficient voting methods
• codes of best practices that define the director shareholder-relationship; and
• long-term corporate vision which at its core emphasizes sustained shareholder value.

Recently, we adopted market-specific principles for the United Kingdom and France. These principles are designed to complement the governance work already performed by investors within these countries -- the Cadbury Code and Greenbury Report in Britain, and the Vienot Report in France.

The principles embody the growth and changes inherent in the corporate governance systems in the United Kingdom and France. Ultimately, they will serve as a tool to assist us in monitoring our investments in these countries while pursuing better corporate governance for the companies in which the Fund invests.

Later this year CalPERS will be rolling out similar corporate governance practice guidelines for Germany and Japan.

The next generation of corporate governance

Clearly, the practice of corporate governance has become a dominant and focused theme in the U.S., and increasingly abroad.

The popular expectation is that institutional investors and CalPERS will continue their crusade for a more robust corporate governance framework that instills improved corporate performance, long-term vision, and shareholder value. In both the domestic and international marketplace, we will see a greater focus on quality directors who are independent of management and have the skills vital to long-term success of corporations.

We hope that our program will stimulate further debate and discussion about appropriate corporate governance practices. We recognize that there are differences, but we embrace them. By working with investors abroad to achieve consensus, CalPERS hopes that its voice, experience, and support can help corporate governance systems grow in a way that focuses on shareholder value in changing global markets.

Charles P. Valdes is Vice President of the CalPERS Board of Administration and serves as the Chair of the System's Investment Committee.