Chapter 2

Short-Termism and Corporate Governance

GENERALLY SPEAKING, THE PHRASE “corporate governance” describes the processes corporations use to make decisions—to pay dividends, raise employee salaries, introduce new products, hire or fire the CEO, and almost every other matter. The subject can be mind-numbingly boring and technical. Most people would rather have a root canal than try to understand even its basic elements. Perhaps this is why narrow special interests have been able to quietly capture control over the immense public companies that are the beating heart of our economy and in many circumstances use that control to serve themselves.

If you want to understand what makes corporations tick—if you want to understand what’s gone wrong with our system, how it’s harming our people and our nation, and how we can fix it—you need to take a deep breath and plunge in. We will try to make the lesson as painless as possible. We can promise you that when we are done, you will be disturbed to learn that corporations don’t work the way most people think they do—and the reality of modern corporate governance might be hazardous to America’s health.

It’s important to note that the governance system we are about to describe does not apply to all incorporated entities, many of which are small businesses that consist of nothing more than an email address and single shareholder who is also the business’s only employee. The corporations we are interested in are the big ones, especially the “public” companies whose shares can be purchased by average investors—the GEs, the Microsofts, the Amazons. Public companies are few in number—fewer than four thousand in the United States, compared to the millions of small “private” corporations that file corporate tax returns¹—but they dominate our economy and our lives. And the forces that determine what they do and how they do it merit attention.

We will begin by introducing the different groups that play the most important roles in the decision-making process of big corporations. For our purposes, the most important players in corporate governance are: (1) the corporate entity itself, (2) boards of directors, (3) shareholders, (4) mutual and pension fund portfolio managers, (5) the behind-the-scenes but enormously important organizations known as “proxy advisors,” and, finally (6) hedge funds. Alert readers may have noticed we have not listed corporate executives, not even the CEO. We’ll explain why soon. And we will introduce you to two significant institutions that you’ve likely never heard of: Institutional Shareholder Services (ISS) and Glass Lewis.

Player 1: The Corporation Itself

Let us begin with the corporate entity. Nonexperts often say corporations “belong” to their shareholders. This is a dangerous mistake—just because you own stock in Tesla doesn’t mean you can stroll into the factory and help yourself to a Model S. In the eyes of the law, a corporation is an independent “legal person” with its own rights, including the rights to own property and to enter into contracts. This is why it’s misleading to say shareholders have “limited liability” for corporate debts. As a general rule, no human has liability for a corporation’s debts—only the corporate entity itself does. Also, the fact that corporations are legal persons does not mean they enjoy the same rights natural persons enjoy. For example, no court has given corporations a right to vote in presidential elections.

Shareholders and the corporations in which they own stock are not the same thing. This is a useful and important distinction, because shareholders are mortal and corporations are not. In fact, state corporate codes grant corporations “perpetual” existence as one of their default characteristics. As “perpetual entities,” corporations have the ability to make investments and pursue projects that will take decades, even generations, to complete. That may be why they were invented. In the Middle Ages, corporate entities were used to build cathedrals and universities. In the eighteenth and nineteenth centuries they built canals and railroads. In the twentieth, they developed the electrical grid, air travel, and the internet. Today they’re working on self-driving cars and space travel.

Player 2: The Board of Directors

Corporations are legal persons, but they are not natural persons: they don’t have brains, or arms and legs. So, how do they decide and act? The answer is: through ever-shifting pools of human beings, especially their boards of directors. Corporate law gives the board the ultimate authority to control what the corporation does, provided the board follows prescribed decision-making procedures. For example, meetings must be held in person or by conference call, a quorum must be present, majority vote decides, and so forth.

Boards of directors are peculiar institutions. Often their members have little or no connection with the company beyond their board position. Directors typically spend only part of their time being directors and are paid relatively little compared to what the company’s executives are paid. Yet directors have nearly unfettered discretion to make decisions on the company’s behalf. Their decisions are constrained by their fiduciary duties—the duty of care and the duty of loyalty. It is their “fiduciary duty of loyalty” that severely restricts their ability to take any money out of the company beyond their relatively modest director fees.

If directors’ positions are part-time and not especially well paid (relatively speaking), how can we expect boards to manage the day-to-day operations of large corporations? The answer is: we don’t. Boards are free to, and usually do, delegate much corporate decision-making and responsibility for taking action to the executive team they select, especially the chief executive officer (CEO). But it’s a mistake to think CEOs control big companies. This may be true as a practical matter in companies where the CEO also controls a majority of the company’s voting shares. Outside that context, executives are hired hands who serve at the board’s pleasure. The public may think the CEO rules the company, just as the residents of the City of Oz believed they were ruled by a gigantic floating green head. But the real power lies with the men and women behind the curtain—the board. Even the most charismatic CEO can suddenly find himself or herself out of a job, as shown by Steve Jobs’ 1985 departure from Apple, Martha Stewart’s 2003 indictment-triggered resignation from Martha Stewart Living, and Travis Kalanick’s recent ouster from Uber’s corner office.

So, if directors enjoy enormous control over and responsibility for companies but are not lavishly paid and are barred by the fiduciary duty of loyalty from using their positions for personal profit, why would anyone want to be a director? The answer surely varies from director to director, and there’s little good data available. But status and reputation seem to provide the answers. Corporate directors tend to be older and well established. Many are retired CEOs, politicians, or public figures who are already wealthy. These individuals view a position on the board of a large company as an honor and an attractive parttime capstone to their careers.

Does it make sense to put these people in charge of such enormously powerful institutions? It depends on your vantage point, but the proof is in the pudding. Board governance has stood the test of time—directors have been successfully governing forprofit and nonprofit corporations for centuries, indeed for as long as there have been corporations. Certainly there have been problems with particular boards at particular companies at particular times. But the system has worked well enough that corporate entities have survived, thrived, and done great things for humanity for centuries. And, in cases where things go wrong with the board, there’s another group that can weigh in and discipline dysfunctional or dishonest directors: the company’s shareholders.

Player 3: The Shareholders

As noted above, shareholders don’t own companies, but they do own shares of stock. Stock can be thought of as a kind of contract between the corporate entity and the shareholder that gives the shareholder two important rights. The first is the economic right to receive dividends—if, and only if, the board of directors declares some. The second right is the political right to vote on certain extremely limited matters. These include the right to veto certain mergers if the board proposes them, and the right to make shareholder “proposals.” Although shareholder proposals often draw a lot of media attention, boards have significant leeway in deciding whether to exclude them, and as a practical matter they have not provided much of a check on the corporate system. Real shareholder political power lies in a third matter the law gives shareholders: the right to determine who serves on the company’s board of directors.

This is a powerful political right indeed. But, as we are about to see, many shareholders are not particularly interested in using it. They don’t buy stock to play a role in corporate governance; they buy hoping to sell to someone else at a higher price.

Shareholders themselves are often divided into two broad categories: individual (retail) shareholders and institutional shareholders. Individual shareholders are just that—people who buy and hold shares in their own names, usually for some goal like saving to retire, to buy a house, or to pay a child’s college tuition. Although the number has been declining, today individual shareholders still directly own approximately 30 percent of shares of US public companies.²

The other important category of shareholders is institutional shareholders. Institutional shareholders account for approximately 70 percent of the market.³ This label is commonly applied to mutual funds, pension funds, and other “pooled investment vehicles” (organizations created to allow investors to pool their funds and put them under the control of professional managers who invest and manage them collectively on the investors’ behalf). Mutual funds and pension funds are supposed to be run not for the benefit of their fund managers but for the benefit of the fund’s “beneficiaries”—the mutual fund’s investors, and the employees and retirees with interests in the pension funds. These beneficiaries are said to invest “indirectly,” leaving it up to their fund managers to decide which stocks to buy or sell and whether to reinvest or distribute dividends or trading profits earned by the fund portfolio. They also, critically, leave it up to their fund managers to decide whether and how to vote the portfolio’s shares.

On first inspection, the politics of US shareholding looks reasonably democratic. In theory, directors control corporations, and shareholders elect (or potentially, could elect) directors. Moreover, about half of American adults own stock, either directly or through their interests in pension or mutual funds.⁴ It would be nice to think our corporations were dedicated to serving the interests of at least that half—including their interests as customers, employees, taxpayers, and human beings who care about their fellow citizens and their descendants.

However, when we look below the surface, things become more complicated. Fewer and fewer Americans are investing. In 2008, 62 percent were in the market. Today that figure hovers around 54 percent.⁵ Moreover, stock holdings are concentrated among the old, the white, and the wealthy. Nearly two-thirds of Americans ages 50–64 invest in equities, but less than one-third of those 18–29 do, and the percentage of young adults in the market is declining.⁶ Share ownership also is skewed by race. In 2011, African Americans had a median liquid wealth of $200, including both checking and retirement accounts, while whites had a median liquid wealth of $23,000.⁷ Finally, the top 10 percent of American wealth holders hold more than 90 percent of shares (and the share votes that go with them).⁸

When shareholders are mostly rich, white, and old, we shouldn’t be surprised if they elect directors who look much the same and tend to run companies in ways that serve these groups’ interests. But the problem of unequal shareholder influence due to biased stock ownership pales in comparison to a more extreme distortion in power over corporate boards. The most influential group in the boardroom today isn’t a shareholder group at all. It’s fund managers—and they may have little reason to pay attention to the needs, desires, or welfare of average shareholders, much less average citizens.

The simple truth is that power over the American corporate sector has been concentrated in the hands of few because most shareholders don’t vote.

Shareholders Who Own Stock Directly Don’t Vote (and Those Who Own Indirectly Can’t)

To understand the dysfunctions driving American companies today, it is critical to first understand that most shareholders who own stock directly don’t vote.⁹ As economists put it, shareholders are “rationally apathetic.” They know voting—even “proxy” voting by mail, phone, or online—demands time and attention. And, because the average individual shareholder owns only a small fraction of the shares of a single company, they also understand their vote is unlikely to affect the outcome. So they prefer to free ride on the votes of other investors. Only shareholders who own enough stock to make a difference—for example, “controlling” shareholders, like Walmart’s Walton family—have reason to vote. For the rest of shareholders, voting is a costly and purely symbolic act. No wonder that when the 2016 corporate election season came around, only 28 percent of shares owned directly by individuals were voted¹⁰ (most, presumably, by wealthy shareholders with large-enough stakes that their vote might be controlling). The other 72 percent of individual investors’ ballots ended up in the physical or electronic trash.¹¹

What about investors who hold stocks through their interests in pension and mutual funds? Like shareholders who own directly, these indirect investors don’t have much reason to care about voting. But, instead of throwing their ballots into the trash, they delegate their voting rights to the manager who runs their fund. Indirect investors are often completely disengaged—they let their portfolio managers vote for them.

For much the same reasons as for individual investors, fund managers also don’t have much interest in voting—careful voting takes a lot of time and attention, especially if you are managing a portfolio of fifty, one hundred, or even more stocks. And because even a large mutual or pension fund typically owns only a small fraction of any single company’s shares, again the fund manager’s vote is unlikely to make a difference. If a portfolio manager thinks a company’s board is doing a bad job, the easiest solution is to do the “Wall Street Walk” by selling the shares as quickly and quietly as possible, before other investors see the problem and the price drops.

But federal regulations pressure mutual and pension fund managers to vote the shares of the stocks in their portfolios anyway.¹² By itself, this may be a good thing; without these rules, the typical public company director election might be a collective shareholder “no-show.” (Corporations still have such difficulty getting a quorum of shares to cast votes that there are specialty businesses to help them do this.) However, it has also perversely distorted our corporate governance system. Individual shareholders mostly don’t vote, but fund managers vote more than 90 percent of the shares they control.¹³ Fund managers have become far and away the most powerful force in director elections in companies that don’t have a controlling shareholder. It is fund managers that directors care about and listen to most closely—not the fund investors and pension beneficiaries whom they are supposed to represent, nor the individual shareholders who still own the largest single chunk of the market, and certainly not average Americans.

Player 4: Fund Portfolio Managers

So, if we want to understand who really controls corporations, we need to understand fund managers and what makes them tick. This is important, because the interests of fund managers and the interests of individual investors, and even the interests of fund managers and the fund investors and beneficiaries they supposedly represent, may be different.

Most individuals who invest in the stock market—whether directly or indirectly through a fund—have long-term goals in mind. Again, this might be saving for retirement, buying a home, or paying for a child’s college tuition. Fund managers, however, are usually evaluated and compensated according to how their portfolios have performed in the last few quarters or at most the last few years. They have little room to think about the long term. The manager whose portfolio underperforms the market for four quarters risks being called on the carpet or even canned.¹⁴

And fund managers have even less room to think about how the companies in their portfolios are performing in terms of how they treat their employees, the quality of their products, their environmental responsibility, paying their fair share of taxes, and so forth. Fund managers’ education, training, culture, and especially their compensation plans drive them to define “performance” in terms of how much the value of the portfolios they manage has risen or declined after taking account of cash received from dividends and share repurchases, trading profits from buying and selling, and how much the market prices of the shares in the portfolio have risen or fallen over the past year or so.¹⁵

The result is a deep divide—one might even say a chasm—between the personal interests of fund managers and the interests of average citizens who invest in funds (not to mention future generations and the planet). This divide is the source of many of the economic, social, and ethical problems we see in how corporations operate today.¹⁶ It is reinforced and widened even further by the activities of proxy advisory services and hedge funds.

Player 5: Shareholder Proxy Advisory Services

The fifth important group that plays a critical role in corporate governance today is a type of business most readers have never heard of: shareholder proxy advisory services. Because companies may have hundreds of thousands or even millions of shareholders—far too many to bring together in one place at one time—corporate elections for boards of directors are typically held by “proxy,” i.e., shareholders don’t vote in person but instead send their votes in by mail or electronically. For an institutional investor overseeing a portfolio that includes the stocks of dozens or even hundreds of companies, casting all those votes is a burdensome chore. In the past, fund managers, like individual shareholders, often either didn’t bother to vote or routinely cast their votes to support incumbent boards. However, federal regulations passed in the past few decades have put increasing pressure on fund managers to vote their shares and to explain their voting policies to their investors.¹⁷ Most have responded by outsourcing the whole messy business of proxy voting to for-profit businesses known as proxy advisory services.

Proxy advisory firms play a powerful role in corporate elections today. For a modest fee, proxy advisors issue guidance on how to vote the stocks in the fund manager’s portfolio and will even do the job of actually casting the votes. The largest player in the industry is Institutional Shareholder Services (ISS), followed by Glass Lewis. In 2007, the US Government Accountability Office (GAO) estimated that ISS advised institutional clients holding $25 trillion in assets. Runner-up Glass Lewis is estimated to advise clients holding $15 trillion.¹⁸ Together, it is estimated that ISS and Glass Lewis comprise 97 percent of the total market for proxy services to institutional investors. In other words, these two businesses advise and cast the votes for the vast majority of pension and mutual funds—and those pension and mutual funds control the vast majority of shares cast in director elections in large public companies. In mid-cap and large US companies, ISS alone has been estimated to cast 25 to 50 percent of all shares voted.¹⁹

Many pension and mutual funds assert that they exercise independent oversight on how the shares of the companies in their portfolios are voted and that they don’t routinely vote as ISS or Glass Lewis advise. Yet companies certainly act as if they think the proxy advisory industry’s guidelines have influence. A 2012 survey, for example, found that 70 percent of corporate directors and executives who responded reported that they took proxy advisory firms’ policies into account when making their own decisions regarding executive compensation.²⁰ A recent 2016 report from the GAO found similar results.²¹

Proxy advisors operate in the background, but they are incredibly important players in the modern corporate governance game. Their voting recommendations impact the outcome of many corporate contests, especially in companies that don’t have a controlling shareholder with enough voting power to control the outcome. Boards of directors have become exquisitely sensitive to what the proxy services say about how companies ought to be run. Does ISS recommend the board sell the company to a possible acquirer? Directors know that if they disagree, they may find themselves on the losing side of a proxy battle in the next annual election. Does Glass Lewis recommend the CEO be compensated with stock options? Many boards today are happy to oblige.

This brings us to the sixth group in our corporate governance system—hedge funds.

Player 6: Hedge Funds (the Consummate Short-Term Investors)

Hedge funds are a bit like mutual funds in that they bring together different investors’ assets to be collectively invested by professional managers. Unlike mutual funds, however, hedge funds are very lightly regulated. Only wealthy individuals and institutions like universities and pension funds are allowed to invest in them. (Yes, pension funds can pass the job of managing their beneficiaries’ assets on to hedge funds.)

Hedge fund managers typically are paid only if their investments have positive returns. Moreover, although they don’t allow their investors to demand their money back immediately, the typical investor “lock-up” period is only one or two years. Hedge fund managers accordingly are under tremendous pressure to produce profits quickly. If they don’t, they don’t get paid, and their fund is likely to fail.²²

One kind of hedge fund, the activist fund, has learned how to take advantage of today’s corporate governance system—often at the expense of other investors, corporations, and society. Activist funds typically hold investments for an average of two years or less.²³ One of their strategies is to acquire a block of a company’s shares (typically 5 percent or less), then launch a publicity campaign targeting the company’s directors and executives (often intended to shame and/or embarrass them). The campaign is then typically followed by threatening a proxy contest to replace members of the board who don’t agree with the hedge fund’s proposed strategy. Such strategies tend to be couched in terms that urge the company to pursue corporate policies to “unlock shareholder value” by quickly raising share price, for example, or by repurchasing shares, divesting assets, or cutting payroll and research and development. If the board agrees and the share price rises, the hedge fund sells and gets out.

Boards know that even though an activist may only own a small percentage of the company’s shares, hedge funds often form “wolf packs” that work together. Moreover, once an activist campaign has begun, the activists’ ideas are likely to get the support of the proxy advisors—and with it, the votes of the fund managers who play such an outsized role in corporate elections. Boards accordingly fear and loathe activists, and dread being targeted by them. They often give in to activists’ demands, and companies that haven’t yet been targeted adopt similar strategies to keep share price high and discourage activists from showing up in the first place.

In 2016, activist funds collectively controlled only about $110 billion in assets.²⁴ This is a drop in the corporate bucket compared to the US stock market’s total capitalization of around $30 trillion. Yet they have become enormously influential in corporate director elections, launching campaigns against the directors of nearly 10 percent of public companies each year and targeting ever-larger firms.

Let us see how this all plays out by looking at the case of ValueAct Capital and Valeant Pharmaceuticals, which illustrates the interaction among the six players in the corporate governance system that create a short-termism feedback loop.

Can the System Fix Itself?

Unequal share ownership, even more unequal shareholder voting power, skewed incentives, the capture of entire industries by unaccountable hedge funds, and the replication (again perhaps unwittingly) of these tendencies in proxy service guidelines leaves us with a current system of corporate governance that is lopsided, broken, and dysfunctional. It places control over many of our biggest and most economically important companies in the hands of a small group of individuals and institutions who wield grossly outsized influence and whose incentives oftentimes drive them to single-mindedly seek short-term share price gains while ignoring harmful consequences to other investors, stakeholders, the environment, and even the company’s own future.

Is there any hope the system can fix itself? (Or would free markets fix the system?) Two trends are worth mentioning. The first is the rise of “indexed” mutual funds that buy and hold shares in the stocks that make up a particular index, like the S&P 500 or the Russell 2000. Index funds and a variant on them, the exchange-traded fund or ETF, are of necessity long-term “passive” shareholders; they can’t do the Wall Street Walk that active fund managers are so fond of. As a result, their portfolio managers’ interests may be more closely aligned with those of longer-term investors.

In practice, two factors work against this. First, index funds have little incentive to challenge corporate policies that emphasize profits over concerns like employee welfare or environmental quality. Second, even a large index fund typically holds only a small percentage of the shares in any particular company. This makes index fund managers subject to the same rational apathy that discourages other noncontrolling shareholders from paying attention to corporate governance. Not surprisingly, many index funds also turn to proxy advisors for help in voting guidance and logistics.⁴¹

The second trend may have far greater impact, for good or for ill. Many businesspeople recognize the current governance system makes it difficult or impossible to run a public company in a sustainable, responsible fashion. In response, they are taking steps to avoid being enmeshed in the governance system we’ve described. Where once company founders eagerly looked forward to “going public” and acquiring outside shareholders, many entrepreneurs now dread this. Uber, SpaceX, Pinterest, WeWork, and Airbnb have all chosen to remain private companies. Meanwhile, founders and managers of other public companies have bought out their public shareholders and “gone private,” as Michael Dell did when he took data storage provider EMC private.

And the founders and management teams of companies that do go public are increasingly adopting a clever strategy to ensure control remains in their hands: issuing two or more “classes” of shares. The share class sold to the public has weak voting rights—say, one vote per share (or in the case of Snap-chat, no votes per share)—while the class issued to founders and managers has stronger rights (e.g., ten votes per share). Google, Alphabet, and Facebook—not to mention the early example of Warren Buffett and Charlie Munger’s famed and highly successful investment firm Berkshire Hathaway—are all seemingly public companies that are actually controlled by a handful of individuals.

Corporate America’s collective move away from market pressure may have social benefits. Companies insulated from the demands of short-term hedge fund activists and mutual fund managers have more freedom to pursue long-term, innovative research projects. Alphabet is working on developing self-driving cars; SpaceX on commercial space travel. Founders and managers also have good reason to spend substantial time and energy understanding a company’s business and tend to be longer-term investors who aren’t interested in sacrificing the company’s future just to temporarily boost share price. Having created and nurtured their companies, they are more likely to be concerned about, and even take pride in, the quality of its products, the welfare of its employees, and its public reputation. Of course there is no guarantee that a company’s managers and founders will care how their company impacts society. But if they do care, they have more breathing room to act on their concern.

Yet there is a dark side to the trend. Individuals have amassed great fortunes creating companies that they still control. Prominent examples include Jeff Bezos at Amazon, Mark Zuckerberg at Facebook, the Walton family at Walmart, Elon Musk at Tesla and SpaceX, and Charles and David Koch at Koch Industries. They can use their economic power to seek political or cultural power: consider Bezos’s purchase of the Washington Post, or the Koch-funded political advocacy group Americans for Prosperity. Meanwhile, public participation in the stock market is declining, and the number of public companies in which average Americans can invest has been cut by more than half over the past two decades, from approximately 7,500 to approximately 3,500.⁴² We are seeing the rise of a small, enormously powerful, and unaccountable elite of controlling shareholders who not only enjoy the lion’s share of the financial wealth generated by the businesses that drive our economy—they control these powerful, pervasive entities as well.

From Ancient Rome, to eighteenth-century France, to Russia in 1917, to many modern Arab states, history has shown that societies dominated by small, wealthy elites fare poorly. They may end with a bang (revolution and revolt) or they may end with a whimper (slow stagnation). But the end is rarely pretty. Is the United States destined to become a hereditary plutocracy? Such a future does not mesh with American heritage, values, or aspirations.

Thus, how can we address the flaws in the corporate governance system?

Author Lynn Stout repeatedly pointed out how any attempt to fix the system requires a bit of “corporate jujitsu.” Finding the right leverage points and points of attack are key to redirecting the behavior and outcomes of the system. The Universal Fund offers such an intervention.