Professor Lynn Stout of the Cornell Law School has fired another salvo in the current war to push back against shareholder rights. In a widely-discussed article for the Brookings Institution, “The Problem of Corporate Purpose,” (Issues in Governance Studies no. 48, June 2012), which reiterates her thesis in her recently published book* she identifies a focus upon ‘the maximization of shareholder value’ with the entire movement for shareholder rights. She then goes on to argue that this is identical with a thrust by some investors for short-term profits, and therefore that the corporate governance movement is a concerted attempt to agitate for short-term results at the expense of longer-term strategies, research, development, and reinvestment. In short: maximization of shareholder value = short-term share price outperformance; shareholder rights = short-termism; ergo, corporate governance activism = destruction of long-term interests. In syllogistic terms: Most shareholders are obsessed with short-term returns, corporate governance is concerned with empowering shareholders, therefore corporate governance promotes short-termism.
For starters, this is a false syllogism. It begins with a dubious premise, and proceeds with dubious logic. First, the maximization of shareholder value can take place over different time horizons, some of them very long. The problem comes if the shareholder return (which can also be in the form of dividends, other forms of distribution, or the fulfillment of special shareholder objectives in the case of a charitable or an artistic shareholding) is never adequate, over any reasonable time frame. This happens. All the time. Managers and directors may exploit the company to extract rents, for the purposes of amassing power, in order to aid the evolution of some other cause or enterprise with which they are also involved, or most often, because they are pursuing a poor strategy, marketing an inferior product or service, or have an uncompetitive cost base. To make the point more baldly, long-termism can be as much of an enemy of economic and social utility as short-termism, if the company is being managed contrary to the interests of its shareholders. This is at the core of the concept of sustainability, which should not be a euphemism for a purely social and environmentalist orientation, but rather a serious effort by management to pursue strategies which are most likely to ensure that shareholder returns are real and lasting.
Second, although she denies it at length and with some heat, shareholders are and must be the owners of the corporation. It cannot, as she asserts, own itself. If it could, shareholders would have no standing in a derivative lawsuit, directors would never have to seek election or shareholder assent to make important transactions or change the company bylaws, a bidder would not have to acquire the shares, and so forth. She raises the disingenuous argument that a shareowner in e.g., Ford, is not an owner because he or she cannot walk off with a new car from any Ford agency. Aside from the obvious fact that it is the agency which owns the car, and no longer the Ford Motor Company which manufactured it, this completely misrepresents the notion of collective ownership. If Ford were a partnership, rather than a corporation, one of the partners could not simply expropriate some of its assets, either. Shareholders are the collective owners of the company (and only indirectly of its assets): all or a majority of them can sell the company to a hostile buyer, vote out a poorly-performing board, or elect to liquidate the company. These are the rights of owners. The problem here does not come when the shareholders assert their rights as owners, but when the management of the company (directors and executives) behave as if they were the sole or even majority owners of the company when they are not, and in fact have only a limited economic interest in it. This is the issue that Berle and Means first delineated in their classic article on the agency problem back in 1932. It is not that the relationship between shareholders and managers is not legally one of principal and agent as Prof. Stout argues, but that because the owners are widely dispersed, management can behave as if they were not agents but principals if they so choose, and it will be difficult to bring them to heel if they do. And unfortunately, history is replete with examples where exactly this has happened, to the detriment of shareholders (and often almost everyone else as well.)
Third, short-term price performance is not the only or even the primary motivation of those who strive to assert their rights as shareholders. As a former portfolio manager for many years at one of the largest funds in the world, I must take issue with Prof. Stout’s view of governance activism as an attempt to intimidate management into focusing upon short-term results. We concentrated upon ‘shareholder value’ and in fact were pioneers in the corporate governance movement. We were always very long-term in our orientation, had a low turnover rate in our active portfolios, and a large indexed portfolio which nonetheless received as much governance attention as our active holdings. I think that Prof. Stout is trying to tar all governance activity with the same brush, and that this is completely false as a generalization.
There are short-termist, high-turnover shareholders who intensely dislike any notion of shareholder involvement with governance. There are governance activists who take very large positions and try to foster change from inside the company, sometimes remaining involved for five years or even longer. There are governance-oriented investors who engage actively with their holdings not because they are planning to flip them, but on the contrary, because they expect to be involved for the long haul. There are short-term investors who are essentially arbitrageurs, and who try to hide behind a mask of concern for governance, when all they really want is to stimulate an event or transaction which will enable them to exit at a profit. And there are all sorts of shades in between. In my experience, those who cry most loudly for constant progression of short-term results are analysts who have nothing to do with the corporate governance movement at all, even if somewhere else in their organization there may be a specialized governance staff.
But the most fundamental problem I have with Prof. Stout’s view is that she assumes the infinite benevolence and unselfishness of directors and senior managers. Experience has shown time and again that left to their own devices (i.e., without market pressures) they can drift further and further away from any attention to creating wealth in any form, except perhaps for their CEO. The emphasis upon options incentives may have had many unintended consequences, but it was not the shareholders who insisted upon the unprecedented scale of options awards, their detachment from reasonable performance criteria, or the various ways managers learned to game the release of favorable results and the pricing of their options. It was complacent boards who refused to rein in one of their colleagues, because he was one of them, had chosen them for board seats in the first place, and often because they expected him to approve the same sort of outlandish compensation when he sat on their board. Directors constitute a sort of club united not only by social ties but also by mutual economic interests. They sit on each others’ boards, and do not make waves. They attend lunch with their fellow directors, they listen passively to whatever carefully scripted presentations management decides to give them, in too many cases they rubber-stamp whatever new ideas management presents them with without a serious debate on the alternatives, and they try to avoid the glare of publicity for good or ill. In other words, they become followers rather than leaders. That should not be their function. “Leave us alone,” they say to shareholders, “and we will do what is best for you.” This was the mantra at such disasters as GM, Kodak, Hewlett-Packard, BP, Barclays, and so forth. Enron became a criminal concern, not because of strong governance but because of weak governance. As a European fund manager, I saw companies which had been drifting and underperforming for twenty years and more, always with the argument that they were managing the company for the long-term, and for the benefit of all stakeholders. Not a few of them ended up in bankruptcy.
I agree that too much of a focus on short-term performance is detrimental to both strategic planning and product innovation. But the solution to this problem is not to return outside shareholders to the essentially powerless position in which they were in the 1970s (and where they still are in many countries.) Changing the terms of executive incentives to vest over longer periods, with clawback provisions for illusory results which must subsequently be re-stated goes a long way toward ameliorating this problem. There are other simple choices companies could make to combat excessive short-termism, without disenfranchising their shareholders. One is to STOP GIVING ANALYSTS EARNINGS GUIDANCE. Another is to ABOLISH QUARTERLY EARNINGS STATEMENTS. If you provide the market with a short-term event, of course they will focus upon it. Earnings are the result, rather than the cause of good management. Over the short haul, the number that falls out the bottom of the p&l is incredibly noisy and subject to all sorts of unexpected variations. Companies have to spend a great deal of time massaging it to produce a coherent sequence of numbers, which are largely mythical. Make the market cool its heels and wait for longer term results, and it will have to take a longer-term perspective.
Managements and boards must also understand that SELL-SIDE ANALYSTS (and even buy-side ones) ARE NOT INVESTORS. It is too easy to confuse the eager beavers who are in management’s face every day with the longer-term owners of the company: this is not good corporate governance, nor is it “shareholder democracy,” a misunderstood concept if there ever was one. The sell-side is looking for news, because news creates turnover. They are akin to reporters: a useful aid perhaps, but not to be confused with the electorate itself. In a democracy, the electorate gets to vote on the overall performance of its leaders once every two, four, or five years. Focus groups regarding particular issues are not and should not be determinative, and politicians who try to govern by them usually end up chasing a will-o’ the wisp and failing miserably at leadership. The analogy is a useful one.
Professor Stout has created a straw man in order to impugn all shareholder rights. If “corporate democracy” means anything (and this term is not itself widely accepted among most corporate governance activists), it means that shareholders should have the right, at medium to long-term intervals, to throw management out if they are performing badly. It should never mean they can micro-manage the company of which they are shareholders, any more than the voters should determine a specific appropriations bill or vote upon a foreign treaty. Most investors do not want to involve themselves in the particular decisions of a company, and they will not support anyone who does. The danger is not that hordes of shareholders will follow a few hyper-activists who wish to micro-manage a company, but that they won’t pay enough attention to bother to vote out a board which has been an unmitigated disaster. The system is not perfect, and often short-term interests (particularly in the form of an opportunistic bidder) will overwhelm longer-term considerations. But incumbent boards and managers who have large positions in the equity themselves (including the magical leverage of options) are guilty of this at least as often as dispersed shareholders.
And incidentally, as any experienced manager can tell you, absolute performance is a function of the starting and ending points from which it is measured. The modern governance movement really began in 1985, in reaction to Delaware’s approval of the poison pill. From that date to the market peaks of 2000, 2007, or 2011, shareholders had made an enormous amount of money. By beginning at a peak and ending at a trough, one can prove anything. The assertion of shareholder rights has not been the disaster which Prof. Stout claims. And in fact, the corporate sectors of most of the countries with weak shareholder rights have done far worse.