and reporting treatment of restricted stock and contributions to stock options should be more favorable than that of unrestricted shares and options. These policies would strengthen links between the company’s long-term share price performance and managerial compensation. A number of corporations are well along in adopting these and similar measures.

Developing a Cadre of Long-Term Investors

A third class of reforms would create a distinctly American version of one of the most successful features of foreign competitors’ capital allocation systems—the presence of a class of long-term investors who are not highly sensitive to short-term fluctuations in share prices. The policy challenge is to preserve the openness and liquidity of U.S. capital markets overall while simultaneously providing substantial investors willing to be treated as insiders, with incentives to hold shares and with access and motivation to acquire and analyze specialized information on corporate investment decisions.

There are several ways that capital market policies could encourage investors to seek and receive more information needed to develop confidence to support long investment horizons and to hold substantial equity stakes longer term.24 More flexible capital market policies could encourage the growth of investment institutions oriented to long-term, committed, active ownership of substantial equity stakes. Currently, several laws and regulations are quite rigid in limiting institutional investors to diversified small takes in companies. Mutual funds, for example, are strongly pushed toward diversification by tax incentives and are limited by the Investment Company Act of 1940 to owning no more than 10 percent of the stock of any firm. Pension fund managers are required by the Employee Retirement Income Security Act of 1974 to demonstrate prudent diversification, which in practice means holding small stakes in scores of companies. State regulations of insurance companies also generally require substantial diversification. Securities and Exchange Commission regulations raise the cost of holding significant stakes in companies by requiring extensive filings above a 5 percent threshold.

24

These proposals are discussed in more detail in Michael Porter’s paper in the forthcoming companion volume.



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