Change the tax code to favor dividends.

• Author: Lataif, Louis E.
• Position: From Where I Sit

Amid all the recent attention attracted by corporate malfeasance, there is no shortage of valid explanations: unbridled personal greed, a general degradation in business ethics, lax boards of directors and complicit corporate lawyers. Certainly, executives found guilty of unlawful behavior must be brought to justice.

Behind the punishable crimes, however, is one overlooked and relatively new phenomenon--the effect of institutional investors on management priorities. Institutional investors, such as pension funds and mutual funds, now own half of all the publicly traded stock in the United States. That's an increase from just 10 percent 40 years ago, reflecting the wealth of the aging baby boomers.

Although institutions are investing the money of millions of Americans, individual investors have relatively little influence. In virtually all cases, the individual investor's s voice is unheard by corporations, except as represented by the fund managers. And the legitimate motivation of a fund manager is to maximize the value of fund. Because U.S. tax law discourages the payment of dividends, the primary method of improving fund value is through stock price appreciation.

One method of improving a company's stock price is to have the company acquired. Such a sale almost always generates an acquisition premium, usually about 40 percent. So, institutional shareholders typically vote against takeover defenses, like staggered boards or so-called "poison pills." And, if a company is not attractive in total, then institutional investors often promote break-up value, the value of the company's pieces that, if sold separately, may be greater than the whole.

The need to constantly generate smooth earnings and support stock price levels has become all-pervasive. Failure to meet quarterly earnings expectations can be disastrous for stock prices and fatal to CEO tenure (which is growing increasingly shorter).

Institutional shareholders also support the leveraging of balance sheets (the new art of financial engineering) so that available capital can be deployed for the purpose of expanding the business, making acquisitions or buying back company stock to increase the earnings per share of the remaining outstanding shares. It's worth noting that in 1973, 27 percent of corporate bonds in the Lehman Brothers Aggregate Bond Index were rated AAA and only 9 percent were rated BBB. By 2001, a mere 8 percent were rated AAA and 34 percent were rated BBB. Today, there...