Time for a shareholder revolt

By J Saft
October 27, 2009

jamessaft1(James Saft is a Reuters columnist. The opinions expressed are his own)

There are encouraging signs that shareholders are becoming more assertive in defending their interests.

The Financial Times reported on Monday that some of Britain’s largest institutional shareholders – including Standard Life, Legal & General and M&G – are working on a plan to bypass investment banks by creating a club to underwrite new issues of equity by small and medium-sized British companies, a move that could save hugely on fees.

What, you may wonder, took them so long?

Second only to taxpayers, investors have been the great patsies of the financial crisis, paying massive costs to a financial services industry which has, to put it mildly, not served them well.

Activist shareholders and investors could be a key force in fixing what is wrong with the financial system. Unleashing their power to act in their own best interests should be a main thrust of new regulation.

The British investor group, reportedly being assisted by mergers and acquisition advisors Lazards, would effectively cut out the middle men by agreeing to take up any unwanted new shares in an offering. This is an idea which if successful could save companies and their owners huge amounts in fees and at the same time deal a blow to investment banking profitability.

Fees charged by banks for equity underwriting in Britain have more or less doubled in the aftermath of the crisis to 3.5-4.0 percent of the amount being raised, with the lions share going to banks rather than to the institutional investors who sub-underwrite.

While banks may argue, and in part be correct, that this is because the past two years have demonstrated the risks of capital market underwriting, it is also patently because there are now fewer banks competing for this business.

To be sure, a club approach is better suited for small and medium sized underwritings and would face huge difficulties for a major share issue involving global investors. But if a test run proves successful it would place pressure on fees for transactions of all sizes.

Even before the crisis hit, fees for investment banking services seemed not to follow with the same fidelity the laws of economics which hold such sway in microchips, steel or even tax preparation.

And it’s not just investors, who consume investment banking products, who have been ill-served. Shareholders in companies, particularly in banks, have provided the capital but have not had their fair share of the fruits.

FOR WHOSE BENEFIT IS THIS ZOO BEING RUN?

That has led to bad decisions, decisions often designed to maximize the benefit to employees at the expense of the shareholders who run disproportionate risk.

Paul Myners, a British Treasury official with special responsibility for financial services, gave an absolutely scathing address last week to the Worshipful Company of International Bankers, assembled for dinner in the Mansion House in the City of London.

Myners, who is reported to be considering holding a competition inquiry into banking fees, took aim at the bonus and compensation culture in the industry.

“It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right,” Myners said.

“In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders.”

I imagine that the bankers were a little less worshipful on their way out then they were on the way in.

I would also argue that what Myners said about banking also holds true – to a lesser extent – in other publicly traded companies, where management is able to extract compensation out of proportion to their likely contribution.

Shareholders, and we are really talking about institutional shareholders, have allowed management to get away with it for years because they thought what they were supposed to be doing was outperforming the market by picking winners.

Much of what passed for skilled investment over the last 20 years has been little more than riding the waves of a debt-fueled economy which seemed capable of providing six to ten percent returns on an unleveraged basis.

Adding value too often meant little more than adding leverage to increase returns. When the current rally ends, as it surely will, investors should take a long look at their long term returns. What they will usually see is that they are poor.

A better strategy for the next 10 years may be to spend as much effort protecting your economic interest in what you own as you do in choosing what to own.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

13 comments

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A little late for this no? Institutional shareholders are wealthy, compared to the small time shareholders who invest their 401K and IRA funds in stocks. Most of these folks are friends with the CEOs that have run these companies so badly. Whatever happened to paying for performance. I haven’t seen much of a revolt from institutional shareholders yet. I won’t hold my breadth for them to make things right.

Posted by BB | Report as abusive

Not one of your most insightful or entertaining articles, but I think you have spent 10 paragraphs stating that the investment banking industry is corrupt and evil. I agree.

Posted by J | Report as abusive

More to the point, shareholders let it get to this point because they were happy with their returns… these very same conditions have been in place for years now. I don’t think there is much will in shareholders right now – the groupthink now is ‘we’ll use them since they use us’ and they’re trying to ride the windfall snapback happening now. Trouble is, the guys writing the rules always come out on top, and bottom-line, investing is a zero-sum game and someone has to lose.

Posted by the Shah | Report as abusive

I believe that when you have pooling of capital, as we do today, that the investment managers will not critique their own decissions through shareholder activism. When returns are harder to come by in the long term, then activist shareholders will have better returns as money managers and subsequently their will be more activist shareholder money managers.

If we have a market of these type of money managers, we will certainly see an effort (and potentially through a majority lead stakeholder) moving for divestiture of various business lines (breakup) of several of our major banks. As regulations will tighten firstly on the most sizeable institutions, which should notably sell higher risk, higher profit ventures, pay down government held debt positions and increase efficiencies in their core businesses.

Now if I managed 5 billion dollars and said that, it would mean something.

In today’s market of the BIG, shareholder activists are not the ones in possession of the money, therefore their is no shareholder activism. Our system has been more active stripping down any potential shareholder activist to protect the benefits and rewards that are enjoyed by self-indulgent managments.

Who just so happen to have a very large lobby to assure a shareholder activist will never have a piece of the economic pie.

Any shareholder activist has been stripped like an abandon Porsche under a bridge in the bronx.

That’s what I call real, constructive financial innovation!

Posted by yr | Report as abusive

Although there has been a lot of focus on management rewards lately, it interesting that little has been said about punishment. Under Corporate law, Boards are responsible for ensuring adequate risk management processes within their organisations. They are also required to report material risks to their shareholders. It is self-evident that many Boards of financial companies have proved incompetent in this regard. Why are there no prosecutions? Is the corporate legal framework, intended to protect sharehoders, really so toothless?

Posted by R Gilyead | Report as abusive

I came to the conclusion a while back that investing in the stock market is a foolish thing to do with my retirement funds. After reading the lies in annual reports, seeing unpunished fraud and watching share price falloff a month before the bad news was public I decided that anyone without inside knowledge had no business in stocks. There are better local investments that do have more transparency.

Posted by Peter Swinson | Report as abusive

I would have liked this article to be more focused. I got the message and agree. The financial industry must revise the “free-for-all” compensation for management. Pay for performance is a good start but not the total solution. Shareholders should and must have a hand in approving compensation packages. Investors should be paid first with everyone else in-line behind them. I’ve heard over and over “we must pay to keep talent”. The culture has clearly crossed many lines with this mantra. Managers expect to be (handsomely) paid – success or failure. Paying for talent has only managed to keep large companies large which translates into less competition in the market. Instead of a market player you have a market maker.

Posted by dave | Report as abusive

The key point that lawmakers neeed to understand is that 1) Shareholders need to have a say in the pay of e.g. the 10 or 20 best paid people in the group, i.e. including wholly-owned subs.After all it is the shareholders’ money which ranks before and not after top management’s discretionary and excessive income.

2) Board compensation committees comprised of members effectively selected by the CEO will be inherently conflicted – often owing their board-seats to the CEO and, or chairman (often one and the same person) since, particularly in the USA, proxy-rules makes it nearly impossible for an open vote by shareholders for alternative board members.

3) The rules for nominating and electing board members must become fully transparent, conflicts of interest must be eliminated and the above mentioned proxy rules must be changed.

4) It is time that shareholders took back real control over their companies.
When this happens, we won’t need government functionaries to tell bankers what they should earn. Keep in mind, it isn’t generally the “normal bankers” i.e. the lenders we are talking about, but the traders and M&A deal-makers. Some, but not all, of these sometimes earn their bonuses by taking inordinate risks for their employers, but without any financial risk to themselves, and often with little down-side or reduction in bonuses if the bank looses money.

However, in the mean-time, it may be necessary.
That is unless / until bank boards “start to listen”, and stop adhering blindly to the “pay for talent” theory. After all, there are just so many hedge funds and “foreign” banks” that could pilfer talent (not all of which are attractive places to work otherwise, i.e. except for the money), and not even all top performers are only interested in money. You can after all only eat one dinner par day as they say and life e.g. on the Cayman Islands can get pretty boring quickly. This mess will sort itself out if bank management, boards and shareholders come to their senses.

Posted by Dagfinn | Report as abusive

Great article, good finance/legal theory. Now we must just cut out attorneys too, the more wicked half of the Middleman. One question begs, what is the distribution of owners of shares in banks on a histogram or bell curve ? Most probably highly leptokurtotic towards the super wealthy individuals.

Posted by Casper | Report as abusive

Damn straight.

Posted by borisjimbo | Report as abusive

Hey – I’ve got an idea. Why don’t we find the brightest investment bankers in India and outsource the jobs for pennies on the typical Wall Street compensation package. Could they do worse?

Posted by LA_Crystal | Report as abusive

The problem of course is that institutional investors use and abuse other people’s money in the same manner as teh ceos and directors. The victims are mostly small investors, including the mom- and-pop’s saving for their retirement. This money is play money for the top level executive and money manager. They get to leverage your money for their gain.For an example look at AMR American Airlines with a market cap of $100 million. Although they are in bankruptcy they are able to order $5 billion worth of planes. Compare it with CPA Copa airlines a tiny but profitable airline with a market cap of $2.6 billion. AMR’s assets are $25 billion, yet there is almost nothing for shareholders from one of the world’s largest and once esteemed airlines. Its a disgrace a two year old could run the company better.

Posted by thoma | Report as abusive