On January 7th, Jason Zweig -- the talented author of the Intelligent Investor column at the WSJ -- published a very interesting article on the development of web sites intended to reduce the cost of corporate governance activism by retail investors. As Jason (if I may be so bold) summarized it:
If you think the directors at XYZ Corp. should be fired, you will be able to circulate a throw-the-bums-out proposal on Sharegate with the click of a mouse. Every other XYZ shareholder on the site will see it immediately; you will promptly be able to tell whether they agree with you.
Contrast that with the status quo, in which you can't know what actions other investors are prepared to take until your annual proxy statement arrives—assuming that any grievances haven't already been quashed by the company.
The article prompted me to write a long blog post touching on a couple of points that are standard fodder here at PB.com. First, shareholders don't own the corporation. Second, the system properly is designed to keep shareholders passive rather than active participants in the governance of firms. Third, assuming arguendo that these web sites reduce the cost of shareholder activism, an increase in shareholder activism would be a very bad thing.
Jason has now posted a responsive blog entry, which continues the discussion by making some very interesting points. Here's the gist:
There isn’t any doubt that when you buy stock, under normal circumstances you delegate the making of business decisions to the board of directors and the management they oversee. But circumstances aren’t always normal. When management and the board make operational and strategic blunders, then — at the very least — investors will want to consider hiring different people to make the decisions about how the company should be run.
Must an investor revolt come from big institutions, or can it come from smaller stockholders instead?
In support of an affirmative answer to that question, Jason relies on what debaters would call an argument by appeal to authority. And he picked quite a good authority:
The great financial analyst Benjamin Graham had little faith that investors, large or small, would take intelligent action. He wrote in 1949 that “stockholders are lazy, indifferent, accustomed to obey the management, and suspicious of outside suggestions.” He applied similar criticisms to professional as well as retail investors.
To me, it is telling that Graham devoted barely 17 pages of the 1940 edition of his monumental textbook, “Security Analysis,” to a discussion of how professional investors should confront underperforming corporate management.
By contrast, Graham dedicated 34 pages in the first edition of “The Intelligent Investor,” his 1949 handbook for individual stockholders, to a discussion of the rights and responsibilities of owners. (True, the later book has fewer words per page, but it also has more passion.)
All of which prompts yours truly to take up the basic question left unaddressed in my prior post: Will reducing the costs of shareholder activism encourage more activism by retail investors or simply make life easier for the gadflies who have long used the proxy system as recreation.
I start with a claim that amounts to an article of faith on my part. Rational investors are apathetic.
A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of proxy statements, especially in a proxy contest where the shareholder is receiving multiple communications from the contending parties, the opportunity cost entailed in reading the proxy statements before voting is quite high and very apparent. Shareholders also probably do not expect to discover grounds for opposing management from the proxy statements. Finally, most shareholders’ holdings are too small to have any significant effect on the vote’s outcome. Accordingly, shareholders can be expected to assign a relatively low value to the expected benefits of careful consideration. Shareholders are thus rationally apathetic. For the average shareholder, the necessary investment of time and effort in making informed voting decisions simply is not worthwhile.
The efficient capital markets hypothesis provides yet another reason for shareholders to eschew active participation in the governance process. If the market is a reliable indicator of perfor¬mance, as the efficient capital markets hypothesis claims, investors can easily check the perfor¬mance of companies in which they hold shares and compare their current holdings with alternative investment positions. An occasional glance at the stock market listings in the newspaper is all that is required. Because it is so much easier to switch to an new investment than to fight incumbent managers, a rational shareholder will not even care why a firm’s performance is faltering. With the expenditure of much less energy than is needed to read corporate disclosure statements, he will simply sell his holdings in the struggling firm and move on to other investments.
Finally, many investors rationally prefer liquidity to activism. For fully-diversified investors even the total failure of a particular firm will not have a significant effect on their portfolio, and may indeed benefit them to the extent they also hold stock in competing firms. Such investors might prove less likely to become involved in corporate decision making than to simply use an activist’s call for action as a signal to follow the so-called Wall Street Rule (its easier to switch than fight—a play on an old cigarette advertisement) and switch to a different investment before conditions further deteriorate.
In his original article, jason wrote that:
The great investor Benjamin Graham wrote in 1949 that "the only way to inspire the average American shareholder to take any independently intelligent action would be by exploding a firecracker under him."
Rational apathy perfectly explains why Graham (a) had to devote so much space to haraunging investors to be active and (b) admited that activism required explosive motivation.
All of which tees up the question of whether these new web sites solve the problem of rational apathy. I think the answer is likely to be no.
A rational investor -- and I explicitly exclude the proxy gadflies of the world from this group, since they get utility from (I guess) seeing their name on proxy statements and such -- incurs at least four sets of costs when choosing to pursue corporate governance activism:
- Coordination costs: An agreived shareholder who owns a tiny fraction of a company's shares is individually powerless. He must communicate with and coordinate with other shareholders. The websites prsumably will reduce this cost.
- Regulatory costs: A shareholder who colicits proxies as part of his efforts to engage with management must comply with the SEC's detailed proxy rules. This can include the very expensive process of drafting and disseminating a proxy statement. It also exposes one to litigation under the proxy rules' antifraud provision. Sharegate recognizes this is a potential problem and therefore states on its website that "As a general rule, proxy solicitation is not authorized on Sharegate." Because proxy solicitatons remain the most effective way of really challenging management, the websites don't necessarily eliminate regulatory costs. In particular, the websites don't eliminate the risk that an unsophisticated activist will inadvertently stray over the line into a solicitation and find both the SEC and incumbent management filing proxy lawsuits against him.
- Opportunity costs. What's the use of your time that returns the greatest utility? Would you rather spend time reading dull corporate disclosures drafted by lawyers or watching TV? As noted above, proxy statements and other corporate disclosures tend to be long and complex. Accordingly, the opportunity cost entailed in becoming an informed investor are quite high. Gadflies are willing to incur that cost either because they get utility from annoying management or they're willing to look like idiots because they failed to become informed before starting to jump up and down about something or both. But why should rational investors do so?
- Free riding. Activism is problematic because on those occasions in which gains might arise from activism, only a portion of them would accrue to the activist. Suppose that the troubled company has 110 outstanding shares, currently trading at $10 per share, of which the potential activist owns ten. The activist correctly believes that the firm’s shares would rise in value to $20 if the firm’s problems are solved. If the activist is able to effect a change in corporate policy, its ten shares will produce a $100 paper gain when the stock price rises to reflect the company’s new value. All the other shareholders, however, will also automatically receive a pro rata share of the gains. As a result, the activist confers a gratuitous $1,000 benefit on the other shareholders. All of this makes shareholder activism a classic example of a situation in which free riding is highly likely. In a very real sense, the gains resulting from activism are a species of public goods. They are costly to produce, but because other shareholders cannot be excluded from taking a pro rata share, they are subject to a form of non‑rivalrous consumption. As with any other public good, the temptation arises for shareholders to free ride on the efforts of those who produce the good. Given that activism will only rarely produce gains, and that when such gains occur they will be dispensed upon both the active and the passive, it makes little sense for rational investors to incur the expense entailed in shareholder activism. Instead, they will remain passive in hopes of free riding on someone else’s activism. As in other free riding situations, because everyone is subject to and likely to yield to this temptation, the probability is that the good in question—here shareholder activism—will be under-produced.
In sum, these vaunted "new tools" affect only one part of the cost schedule faced by retail shareholder investors. Hence, I still think retail investor activism will remain the province of gadflies and not rational retail investors.
Lastly, before you try to switch tacks and talk about institutional investors, read my article Shareholder Activism in the Obama Era, which argues that:
The logic behind the shareholder empowerment project is that institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, institutional investors could play a far more active role in corporate governance than dispersed individual investors traditionally have done. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm’s performance and to make changes in the board’s composition when performance lagged.
In fact, however, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.