Two articles (among several) in a comprehensive proposal to revise EU corporate governance would have a significant beneficial impact if they were to be adopted in the United States. In large measure they mirror recommendations by Chief Justice Leo E. Strine, Jr., in two essays: Can We do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law, 114 Columbia Law Review 449 (Mar. 2014) and One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term? 66 Business Lawyer 1 (Nov. 2010).
Posts Tagged ‘Short-termism’
We published this post last August. Since then there have been several developments that prompt us to revisit it; adding the first three paragraphs below.
First, Delaware Supreme Court Chief Justice Leo E. Strine, Jr. published a brilliant article in the Columbia Law Review, Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law in which he points out the serious defects in allowing short-term investors to override carefully considered judgments of the boards of directors of public corporations. Chief Justice Strine rejects the argument of the academic activists and activist hedge funds that shareholders should have the unfettered right to force corporations to maximize shareholder value in the short run. We embrace Chief Justice Strine’s reasoning and conclusions.
Excessive risk-taking by financial institutions and overly generous executive pay are widely regarded as key factors in the 2007-09 crisis. In particular, it has become commonplace to blame banks and securities companies for compensation packages that reward managers (and more generally, other risk-takers such as traders and salesmen) generously for making investments with high returns in the short run but large risks that emerge only in the long run. As governments have been forced to rescue failing financial institutions, politicians and the media have stressed the need to cut executive pay packages and rein in incentives based on options and bonuses, making them more dependent on long-term performance and in extreme cases eliminating them outright. It is natural to ask whether this is the right policy response to the problem. It is crucial to ask what is the root of the problem—that is, precisely which market failure produced excessive risk-taking.
The recent announcement of the formation of the Shareholder-Director Exchange, a new group that aims to facilitate direct communication between institutional shareholders (namely, mutual funds and pension programs) and non-management directors of the U.S. public companies they own, has been accompanied by a flurry of articles regarding the purposes and possibilities of this new group. From my perspective, the Shareholder-Director Exchange has tremendous potential to help improve corporate governance and performance in this country.
In our paper, The Real Costs of Disclosure, which was recently made publicly available on SSRN, we analyze the effect of a firm’s disclosure policy on real investment. An extensive literature highlights numerous benefits of disclosure. Diamond (1985) shows that disclosing information reduces the need for each individual shareholder to bear the cost of gathering it. In Diamond and Verrecchia (1991), disclosure reduces the cost of capital by lowering the information asymmetry that shareholders suffer if they subsequently need to sell due to a liquidity shock. Kanodia (1980) and Fishman and Hagerty (1989) show that disclosure increases price efficiency and thus the manager’s investment incentives.
However, the costs of disclosure have been more difficult to pin down. Standard models (e.g. Verrecchia (1983)) typically assume an exogenous cost of disclosure, justified by several motivations. First, the actual act of communicating information may be costly. While such costs were likely significant at the time of writing, when information had to be mailed to shareholders, nowadays these costs are likely much smaller due to electronic communication. Second, there may be costs of producing information. However, firms already produce copious information for internal or tax purposes. Third, the information may be proprietary (i.e., business sensitive) and disclosing it will benefit competitors (e.g., Verrecchia (1983) and Dye (1986)). However, while likely important for some types of disclosure (e.g., the stage of a patent application), proprietary considerations are unlikely to be for others (e.g., earnings). Perhaps motivated by the view that, nowadays, the costs of disclosure are small relative to the benefits, recent government policies have increased disclosure requirements, such as Sarbanes-Oxley, Regulation FD, and Dodd-Frank.
Harvard Law School Professor Lucian Bebchuk believes that shareholders should be able to control the material decisions of the companies they invest in. Over the years, he has written numerous articles expressing this view, including a 2005 article urging that shareholders should have the power to initiate a shareholder referendum on material corporate business decisions. In addition to his writings and speeches, Prof. Bebchuk has established and directs the Shareholder Rights Project at Harvard Law School for the purpose of managing efforts to dismantle classified boards and do away with other charter or bylaw provisions that restrain or moderate shareholder control of corporations (see “Harvard’s Shareholder Rights Project is Wrong” and “Harvard’s Shareholder Rights Project is Still Wrong”). In addition, Prof. Bebchuk has been at the forefront in arguing to the SEC that, despite the specific action of Congress in 2010 to empower the SEC to adopt a rule to require fair and prompt public disclosure of accumulations of shares by activist hedge funds and other blockholders, the SEC should not do so because it would limit the ability of activist hedge funds to attack corporations. In short, Prof. Bebchuk believes that shareholders should have the power to control the fundamental decisions of corporations—even those shareholders who bought their shares only a few days or weeks before they sought to assert their power, and regardless of whether their investment objective is short-term trading gains instead of long-term value creation.
In our paper, Equity Vesting and Managerial Myopia, which was recently made publicly available on SSRN, we study the link between real investment decisions and the vesting horizon of a CEO’s equity incentives. We find that research and development (“R&D”) is negatively associated with the stock price sensitivity of stock and options that vest over the course of the same year. This association continues to hold when including advertising and capital expenditure in the investment measure. Moreover, CEOs with significant newly-vesting equity are more likely to meet or beat analyst consensus forecasts by a narrow margin. However, the market recognizes such CEOs’ incentives to inflate earnings—the lower announcement returns to meet or beating earnings forecasts are decreasing in the sensitivity of vesting equity. These results provide empirical support for managerial myopia theories.
Many academics and practitioners believe that managerial myopia is a first-order problem faced by the modern firm. While the 20th century firm emphasized cost efficiency, Porter (1992) argues that “the nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms,” such as innovation, employee training, and organizational development. However, the myopia theories of Stein (1988, 1989) show that managers may fail to invest due to concerns with the firm’s short-term stock price. Since the benefits of intangible investment are only visible in the long run, the immediate effect of such investment is to depress earnings and thus the current stock price. Therefore, a manager aligned with the short-term stock price may turn down valuable investment opportunities.
The results of the 2013 proxy season and other recent corporate governance developments have demonstrated that boards and management teams should thoughtfully assess their approach to dealing with hedge funds and other “long” investors that are considered “activist.” Responding effectively to these activist shareholders in today’s environment requires more continuous engagement with shareholders, a recognition of the broad support given to many activist campaigns by traditional investors and advance preparation.
The universe of “activist” shareholders has expanded and their supporters more so. There is a broad spectrum of activist behavior that many traditional institutional investors—mutual funds, pension funds, sovereign wealth funds and others—increasingly see as essential to enhancing their returns. This trend is reflected both in the increasing investor inflow into funds managed by hedge fund activists, which has permitted them to initiate action at larger companies, and in the increased voting support traditional institutional investors give to activist campaigns. To a greater or lesser extent, today many institutional investors are activist investors. These developments have highlighted the importance of management preparedness, board awareness and active, regular investor engagement on issues of importance to investors.
A long-term oriented, well-functioning and responsible private sector is the country’s core engine for economic growth, national competitiveness, real innovation and sustained employment. Prudent reinvestment of corporate profits into research and development, capital projects and value-creating initiatives furthers these goals. Yet U.S. companies, including well-run, high-performing companies, increasingly face:
- pressure to deliver short-term results at the expense of long-term value, whether through excessive risk-taking, avoiding investments that require long-term horizons or taking on substantial leverage to fund special payouts to shareholders;
- challenges in trying to balance competing interests due to excessively empowered special interest and activist shareholders; and
- significant strain from the misallocation of corporate resources and energy into mandated activist or governance initiatives that provide no meaningful benefit to investors or other critical stakeholders.
Shareholder activism in the U.S. has increased significantly over the past several years, with activist campaigns increasingly targeting well-known, larger market capitalization companies, such as Apple, Hess, Procter & Gamble and Sony. In 2013, the number, nature and degree of success of these campaigns has garnered the attention of boards of directors, shareholders and the media. While the continued level of success of activists is uncertain, and the longer-term impact of activism is unknown, at the moment shareholder activism is exerting considerable influence in the M&A and corporate governance arenas. In this evolving landscape, public company boards and their managements need to be aware that virtually any company is a potential target for shareholder activism.
Key Factors Influencing the Current Paradigm
Activism has become a viable and increasingly applied (arguably mainstream) tool for shareholders to seek to influence corporate policy. Several changes have occurred over the past few years that have contributed to the heightened — although not universal — success now being enjoyed by activism, including factors related to the activists, institutional investors and corporate defenses.