The dark side of shareholder activism
Shareholder activism sounds so respectable, even noble. The phrase conjures images of good-corporate-governance folk fighting greedy or dysfunctional management in the company’s best interest. While shareholders can be disciplinarians who right the wrongs of abusive directors, many boardroom activists advance some of the most destructive short-term thinking in business today.
Sparring with management is popular sport for short-termists seeking to maximize the value of their assets. The game ranges from venal to honorable. “Don’t let the Elliott Hedge Fund pursue its self-serving short-term agenda and destroy the long term [sic] value of your investment,” Hess Chief Executive Officer John Hess wrote in a letter to shareholders last week. T-Mobile CEO John Legere blamed “greedy hedge funds” after proxy advisors to MetroPCS investors advised shareholders to block a merger with the wireless giant. In February 2012, Apple’s board agreed to majority voting, a once-fringe officer election process that can have unintended consequences and has become more common at large-cap firms. Coincidentally or not, since the resolution was adopted, Apple announced that it will distribute $45 billion in dividends from its $137-plus billion in cash reserves.
In a way, it makes sense that shareholders have become so active in corporate gamesmanship. Tussles between directors and equity holders have traditionally favored internal stakeholders; legal protections for shareholders are relatively weak. Aside from voting out management, alleging a breach in duty of care is virtually the only legal standard for holding officers accountable for wrongdoing. An alternative is litigation, and the number of securities class actions has fallen, though settlements reached $2.9 billion in 2012, around double the $1.45 billion awarded in 2011, according to a report by Cornerstone Research and Stanford Law School professor Robert Daines.
Still, short-termers have many reasons to be ebullient, as shareholders with relatively weak protections can end-run corporate governance law. These days, companies are at the mercy of a small group of highly engaged investors who want quick results. Blocked mergers and ousters are common. Moreover, spring is proxy season. Corporate lawyers are armed and ready for the “ambush,” a way for a small subset of activists to force a particular action by asking shareholders to vote on proposals that merely require written consent by the board to facilitate shareholders to act.
Proxy season this year is no different. Shareholder resolutions are as plentiful as new buds. According to the Harvard Law School Forum on Corporate Governance and Financial Regulation, about 600 already have been filed this season. They range from proposals for mandated disclosures of political spending to proxy access, majority voting, independent board chairmen, gender diversity, even compensation protocols. It’s not that these proposals aren’t worthy. It’s just that many are designed to boost shareholder value and few address the problem of short-termism.
Shareholder activism stems from a seismic shift that took place in the U.S. economy not so long ago, though long enough ago that its effects have become entrenched in our markets. The privatization of the financial system began in the 1970s. A U.S. trade deficit and rising inflation led to shorter periods for holding investments. When banks emerged as competitors in securities and universal banking became widely available for even the smallest of companies, more companies went public and sold shares to investors who didn’t have the stomach for asset price volatility, as Pavlos Masouros explains in “Corporate Law and Economic Stagnation: How Shareholder Value and Short-termism Contribute to the Decline of the Western Economies.” Amid a 1980s climate of relaxed antitrust law, less stringent merger control and banking deregulation, the way to stave off a hostile takeover was to push up share prices. Pension funds privatized savings for public workers who received massive stock options that overcompensated for lower wages. All this has led to a management culture that discourages long-term investment.
Institutional investors who flooded the markets are the big culprits for the onset of short-termism in recent decades. According to a paper published by University of Massachusetts economics professor James Crotty, in the 1950s, households owned 90 percent of corporate stock and held it for long periods. By 2000, households held 42 percent of public shares, while institutions owned 46 percent and were responsible for three-quarters of all trades. In 1960, turnover in the New York Stock Exchange was about 20 percent; now it is more than 100 percent.
When shareholders bully management, economic growth can suffer. Pushing for dividends and buyback shares means the company can’t use the funds to invest in growth. Technology firms require three or four years to move a product. Equity funds can’t be turned into capital that can be reinvested. In other words, the cycles of low interest rates and stagnant economic growth of Keynes’s liquidity trap endure, as Masouros noted.
For all the talk of short-termism, there has been little in the way of remedies. In Europe, reform has been floated. Brussels is considering loyalty dividends, which reward long-term shareholders. A gradual incremental tax rate on stocks has also been discussed. So have time-phased voting rights.
These ideas are unlikely to sell in an economy that deifies the freedom of markets. But in corporate governance, shareholders supposedly are the taskmasters. Since there are more committed investors than shorties, it’s the long-termers’ battle to lose, if they are informed enough to care.