As regular readers of my blog and/or my scholarship know, I am a skeptic of shareholder activism. I doubt both whether it's very important and whether it is a good idea. See, e.g., my article Shareholder Activism and Institutional Investors.
In today's W$J there are two articles that might appear, on first glance, to suggest that shareholder activism is both important and effective. The first deals with Washington Redskins owner Dan Snyder's successful proxy contest at Six Flags:
Stockholders representing in excess of 57% of Six Flags' shares outstanding support the Snyder-led plan to remove three of the company's seven board members, including its chief executive and chairman. Barring dissent from the remaining board members, Mr. Snyder is expected to assume the chairman's role, with former ESPN executive Mark Shapiro taking the chief-executive mantle and builder Dwight C. Schar the last board seat.
... With just under 12% of shares under their own control, they were able to sway enough other holders to endorse their vision.
Let's hope for the sake of Six Flags shareholders that Snyder replicates the financial success he's had with the Redskins as opposed to the 'Skins on-the-field mediocrity.
In any case, Journal reporter Berman observes:
Mr. Snyder's four-month mission underscores the influence that activist shareholders lately have been able to wield over corporate managements.
The point would seem to be further supported by a second Journal article on activism by hedge funds:
... activism, often by hedge funds, is pushing share prices higher and forcing management to unlock value. ... The list of companies in the sights of activists includes large firms, such as Time Warner Inc., McDonald's Corp., German stock-market operator Deutsche Börse AG, Morgan Stanley, Six Flags Inc. and OfficeMax Inc. Sometimes they gently push the companies, with ideas and promises of support; other times they push hard for a sale or other steps.
Sorry, but I don't buy it.
Snyder's success at Six Flags illustrates a couple of truths we have long known: First, proxy contests are the most effective form of shareholder activism. Second, proxy contests are most likely to succeed where there is a central organizing figure who owns a large block of stock around which to rally other shareholders and who has some private motivation for incurring the costs associated with investor activism.
We have seen this phenomenon before, including one of the best known case studies of shareholder activism; namely, the effort to get investors to withhold authority for their shares to be voted to elect directors at Disney’s 2004 annual shareholder meeting. In that case, however, the campaign had a central organizing figure—Roy Disney—with plenty of private motivation for waging battle. Even then, a plurality of the shares was voted to re-elect the incumbent board.
It is also instructive that Disney management later persuaded Roy Disney to drop his various lawsuits against the board and sign a five year standstill agreement pursuant to which he would not run an insurgent slate of directors in return for being named a Director Emeritus and consultant to the company, which nicely illustrates how a company can buy off the requisite central coordinator when that party has a private agenda.
In contrast, when CalPERS, the biggest institutional investor of them all, struck out on its own in 2004, withholding its shares from being voted to elect directors at no less than 2700 companies, including Coke director and legendary investor Warren Buffet, the project went no where.
We don't know what private benefits Snyder and his cohorts might reap from running Six Flags, WSJ reporter Berman, however, does tell us that:
... Mr. Snyder and Mr. Shapiro are eager to take the reins of the company, which has a market capitalization of $695 million and an additional $2.2 billion in debt.
Why, one might reasonably ask? After all, since they only own 12% of the stock, 88 cents out of every dollar of increased shareholder value they generate will go to other investors. Might they have some plan for reaping non-pro rata private benefits (stock options? executive compensation? related party transactions?).
As for hedge fund activism, they have had relatively little success in the absence of a central coordinating figure like Snyder or Disney. They did not, for example, manage to derail the MCI-Verizon merger even those most hedge funds favored Qwest's bid for MCI.
Even when they have a central figure around whom to rally, moreover, hedge funds have not always enjoyed financial rewards. The Journal reports:
... lately, some activists have done a better job creating headlines than value. Activist investors, including Steel Partners and Cannell Capital, waged a bitter proxy fight to gain seats on the board of BKF Capital Group Inc., an asset-management company. But shares of BKF have tumbled to $21 from $43 since March, though they are up from $15 since the end of October. Mr. Icahn purchased about 10% of shares of Blockbuster Inc. and took a board seat earlier this year, after criticizing management's spending plans. But shares of the video-rental chain have tumbled to around $3.60 from a high of more than $10 in April.
Let us suppose, however, that activism by hedge funds managed to do more than just pick off a few low-hanging fruits here and there. Let us suppose that they began to wield substantial influence over many firms. Would that be a good thing?
According to Journal reporter Gregory Zuckerman, "today activists push for higher share prices for all investors in a company, not just for their own stakes." I'm not so sure about that.
As blawgger and corporate law expert Gordon Smith observes:
The motivation for activism is that "it is getting tougher to show top-notch returns as more hedge funds pursue similar investment ideas and overall market volatility drops." This is the best argument against shareholder activism that I have seen in a long time. Does anyone (other than a hedge fund manager) believe that hedge fund managers know more about the companies in which they invest than the officers and directors of those companies?
The basic problem is that hedge funds are under constant pressure to maximize short-term returns. The relationship between hedge funds and other shareholders of a company thus is an example of what my UCLA law school colleague Iman Anabtawi calls the problem of divergent shareholder interests. She explains that while shareholders are usually assumed to have a common interest in maximizing shareholder wealth:
Some of the most significant modern shareholders ... have private interests that conflict with (1) the goal of maximizing shareholder value generally or (2) the interests of other shareholders who would choose to maximize shareholder value differently, given their peculiar characteristics. Such private interests may induce influential shareholders to engage in rent-seeking behavior at the expense of overall shareholder welfare.
She then offers an apt example:
Pitted against shareholders’ common interest in enhancing share value are significant private interests. Take, for example, a hedge fund shareholder that is about to raise capital for a new fund. As part of its marketing effort, it wants to show impressive returns on its prior fund. To generate such returns, the hedge fund is likely to favor policies by the firms in which it invests that produce short-term gains, even if a more patient investment orientation would generate higher long-term returns. In contrast, a pension fund or life insurance company shareholder is more likely to be concerned about the long-term value of its investments, which will allow it to meet its future obligations.
We therefore would do well to be skeptical of Zuckerman's claim that "activists push for higher share prices for all investors in a company, not just for their own stakes." We therefore also do well to be skeptical of proposals to further empower activist investors. The SEC's effort to expand the rights of shareholders to nominate directors, for example, likely would not have improved corporate governance so much as it would have increased the extent of private rent-seeking by select investors.
Update: Reader Pithlord asks:
If I understand your position, it is that executives should focus solely on shareholder interests, but shareholders should not have any power to make them do so. What, then, will be their incentive? The law won't work except in cases of outright fraud. Compensation will create its own conflicts between how executives get paid and long-term shareholder value. What's left? Conscience?
A fair question, deserving a fair answer.
In the first instance, corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents.
In the second, agency costs are the inescapable result of placing ultimate decision-making authority in the hands of someone other than the residual claimant. Neither the power to wield discretionary authority nor the necessity to ensure that power is used responsibly can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, however, they also are antithetical. Because the power to hold to account differs only in degree and not in kind from the power to decide, one cannot have more of one without also having less of the other.
As Nobel laureate economist Kenneth Arrow explained:
[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem.
Hence, directors cannot be held accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.
The central argument against shareholder activism thus becomes apparent. Active investor involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decision-making authority in the board of directors.
The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decision-making structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge. Again, I quote Arrow: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”
While some argue that shareholder activism “differs, at least in form, from completely shifting authority from managers to” investors, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel.
As noted, giving investors this power of review differs little from giving them the power to make management decisions in the first place. Even though investors probably would not micromanage portfolio corporations, vesting them with the power to review board decisions inevitably shifts some portion of the board’s authority to them. This remains true even if only major decisions of A are reviewed by B. The board directors of General Motors, after all, no more micromanages GM than would a coalition of activist institutional investors, but it is still in charge.
If the foregoing analysis has explanatory power, it might fairly be asked, why do we observe any restrictions on the powers of the board of directors or any prospect for them to be ousted by shareholders via a takeover or proxy contest? Put another way, why do we observe any right for shareholders to vote?
In the purest form of an authority-based decision-making structure, all decisions would be made by a single, central body—here, the board of directors. If authority were corporate law’s sole value, shareholders thus in fact likely would have no voice in corporate decision making.
Authority is not corporate law’s only value, because we need some mechanism for ensuring director accountability with respect to those rights for which shareholders and other constituencies have contracted. My director primacy theory views the corporation as a vehicle by which directors bargain with factors of production. All corporate constituencies thus end up with certain bargained-for contractual rights, including the shareholders.
Chief among the shareholders’ contractual rights is one requiring the directors to use shareholder wealth maximization as their principal decision-making norm. Like many intra-corporate contracts, however, the shareholder wealth maximization norm does not lend itself to judicial enforcement except in especially provocative situations. Instead, it is enforced indirectly through a complex and varied set of extrajudicial accountability mechanisms, of which shareholder voting is just one.
Importantly, however, like all accountability mechanisms, shareholder voting must be constrained in order to preserve the value of authority. As Arrow observes:
To maintain the value of authority, it would appear that [accountability] must be intermittent. This could be periodic; it could take the form of what is termed “management by exception,” in which authority and its decisions are reviewed only when performance is sufficiently degraded from expectations. . . .
Accordingly, shareholder voting is properly understood not as an integral aspect of the corporate decision-making structure, but rather as an accountability device of last resort to be used sparingly, at best.
Indeed, as Robert Clark observes, the proper way in which shareholder voting rights are used to hold corporate directors and officers accountable is not through the exercise of individual voting decisions but rather collectively in the context of a takeover. Because shares are freely transferable, a bidder who believes the firm is being run poorly can profit by offering to buy a controlling block of stock at a premium over market and subsequently displacing the incumbent managers, which presumably will result in an increase in firm value exceeding the premium the bidder paid for control.
Hence, just as one might predict based on Arrow’s analysis, shareholder voting properly comes into play as an accountability only “when [management] performance is sufficiently degraded from expectations” to make a takeover fight worth waging.
In sum, given the significant virtues of discretion, one ought not lightly interfere with management or the board’s decision-making authority in the name of accountability. Indeed, the claim should be put even more strongly: Preservation of managerial discretion should always be default presumption. Because the separation of ownership and control mandated by U.S. corporate law has precisely that effect, by constraining shareholders both from reviewing most board decisions and from substituting their judgment for that of the board, that separation has a strong efficiency justification.
