Proposed Investor Behavior

The proposed New Paradigm calls for investors to consider going on the public record to speak out against the short-term demands of activist investors, to help reduce the disruption their demands can have when unchallenged by other shareholders whose interests are inconsistent with their purportedly short-term investment horizon. It also calls for institutional investors to be mindful of the message their support will send to other corporations that may be considering whether to tailor their business strategies to meet short-term objectives and avoid attack by an activist.

Proposed Integration of Citizenship Matters into Investment Strategy

The New Paradigm asserts that institutional investors may wish to consider the following, some of which are already underway by leading institutional investors: (i) creation of portfolio ESG risk profiles to stimulate discussion among portfolio managers on ESG factors; (ii) incorporation of ESG metrics into firm-wide risk management and investment platforms; (iii) training of portfolio managers on identifying material ESG factors for corporations; (iv) research of individual ESG factors and their materiality to corporations in specific sectors to help inform investment analysis and risk measurement; and (v) engagement in robust dialogue with corporations with respect to the thinking of management and boards on the importance of ESG factors.

Proposed Disclosure of Investor Policies and Preference

As part of their engagement efforts, the New Paradigm asks that investors clearly communicate their policies and consider disclosing:

Many if not most of these recommendations for institutional investor behavior would be valuable to corporations as well as to the underlying investors in their investment strategies.

There are significant challenges, however, regarding achieving adoption beyond the largest investors. Institutional investors operate in a highly competitive marketplace. Many may not have the ability to fund some of the above concepts without penalizing performance. Those that do have the funding are comprised of many portfolio managers charged with executing various strategies, measured by their underlying investors on a short-term basis, and bringing them all together to adopt a single set of policies may not be feasible. The effort, however, will be interesting to watch.

Activist Playbook

As a first step, the activist acquires shares in the targeted company—typically somewhere between 5% and 10%, but sometimes less than 1%. He then asserts himself by issuing directives, often publicly released. To add to his leverage, he will often alert other hedge funds to his actions, and separately they may also invest, firming what has come to be called a “wolf pack.” The directives make liberal use of the language of ownership.

In 2014, for example, to advance a takeover of Allergan by Valeant Pharmaceuticals, Ackman attacked Allergan’s board for failing to do what the directors were paid to do “on behalf of the Company’s owners.” In one letter to the Allergan board, Ackman challenged the board’s professionalism: “Your actions have wasted corporate resources, delayed enormous potential value creation for shareholders, and are professionally and personally embarrassing for you.”

Whether true or not, there is nothing to stop him from making and publicizing whatever assertions he likes and depending on the size of his position and the length of time he has held it, he may not need to disclose his holdings. To add further to the damage such behavior can cause, his firm is free to invest throughout the capital structure and even to short the target’s stock, which reminds us of Isaac de la Maire.

As Ian Gow and Suraj Srinivasan (with others) have documented in their study of nearly 800 campaigns at U.S. companies from 2004 to 2012, activists tend to focus on capital structure, strategy, and governance. They typically call for some combination of cutting costs, adding debt, buying back shares, issuing special dividends, spinning off businesses, reconstituting the board, replacing the CEO, changing the strategy, and selling the company or its main asset. Tax reduction is another element of many activist programs.

Unheeded, an activist may initiate a proxy fight in an attempt to replace incumbent board members with directors more willing to do the activist’s bidding. In a few instances, activists have even offered their chosen nominees special bonuses to stand for election or additional incentives for increasing shareholder value in their role as directors, which certainly betrays their lack of respect for the role.

More companies may be being targeted—473 worldwide in the first half of 2016 (including 306 in the United States), up from 136 worldwide in all of 2010—and activists’ demands seem to be being met in a number of cases. In the United States in 2015, 69% of demands were at least partially satisfied, the highest proportion since 2010. Activists are also gaining clout in the boardroom, where they won 397 seats at U.S. companies in 2014 and 2015. Although activist hedge funds saw outflows of some $7.4 billion in the first three quarters of 2016, assets under management were estimated at more than $116 billion in late 2016, up from $2.7 billion in 2000.

Proxy Fights and Shareholder Candidates

While we look at activist strategies, let us also look at the shareholder’s right to present director nominees at annual meetings. The most important barrier facing the presentation of such candidates continues to be the expense of compliance with the SEC’s proxy rules as well as cost of the printing, mailing and publicity involved in engaging in an election contest in a diffusely-owned firm. The rules that emerged in the 1950s strongly favored the incumbents, finding that the dissidents must fund their campaign from their own pockets.

As a practical matter, the dissidents are reimbursed only if they successfully gain control of the board. Proposals for proportional reimbursement based on the dissident’s fraction of the vote have not gained traction. In January 2007, however, the SEC adopted a rule that would allow an insurgent to provide internet availability of proxy materials rather than to have to print and mail the materials, though it must provide a paper copy to any requesting shareholder. Given increasingly concentrated shareholdings, it may be that shareholder candidates will emerge.

The Bower and Paine Analysis of Maximizing Shareholder Value as Corporate Goal

In the fall of 2014, Allergan shareholder Pershing Square Capital Management leader Bill Ackman became increasingly frustrated with Allergan’s board of directors. The reason: their apparent failure: refusing to negotiate with Valeant Pharmaceuticals about its unsolicited bid to take over Allergan—a bid that Ackman himself had helped engineer in a novel alliance between a hedge fund and a would-be acquirer.

Ackman cited Valeant’s plan to cut Allergan’s research budget by 90% as “really the opportunity.” Valeant CEO Mike Pearson assured analysts that “all we care about is shareholder value.” These comments encapsulate a way of thinking about the governance and management of companies that seems to have become pervasive in the financial community and much of the business world, perhaps because all parties in the financial system are evaluated and compensated based on short term results, as in “what have you done for me lately?”

It again showcases the idea that management’s objective should be maximizing value for shareholders, but it addresses a wide range of topics—from performance measurement and executive compensation to shareholder rights, the role of directors, and corporate responsibility. This thought system has been embraced not only by hedge fund activists like Ackman but also by institutional investors more generally, along with many boards, managers, lawyers, academics, and even some regulators and lawmakers. If this book achieves nothing else, I hope it will help thoughtful people consider these concepts and the dangerous folly they represent.

In the contest between Allergan and Valeant, the playing field was famously not level. A member of Allergan’s board who held shares in Valeant would have been expected to refrain from voting on the deal or promoting Valeant’s bid. But Allergan shareholders with a stake in both companies were free to buy, sell, and vote as they saw fit, with no obligation to act in the best interests of either company. Institutional investors holding shares in thousands of companies regularly act on deals in which they have significant interests on both sides, while preaching publicly about the need for companies to manage for the long term.

Consider this: should managers and boards follow the edicts of letters like Mr. Fink’s and focus on long-term value to the detriment of short term results, organizations such as Blackrock might take advantage of lower values to increase their positions and possibly engineer corporate combinations to improve their own results. Taken to an extreme degree, Mr. Fink’s letters, written as they are, by the head of an organization that is assessed on its own short- term results, could be seen as a way of jawboning market behavior in his own firm’s interest.

My point is that in a well-ordered economy, rights and responsibilities go together. Giving shareholders the rights of ownership while exempting them from responsibility creates a malicious hazard by fomenting opportunism and misuse of corporate assets. When shareholders use their positions, visible and invisible, to influence specific corporate decisions, they present a serious risk.

The issue is at its most stark when temporary holders of large blocks of shares determine that they should and will reconstitute a company’s board, change its management, or restructure its finances. Their goal is to win and unfettered by securities regulation or the rules of discretion and decorum that inhibit corporate response, they will stop at nothing in their effort to drive up its share price. Victorious, they can then sell and move on to another target without ever having to answer for their intervention’s impact on the company or other parties.

Reliance on what can be said to be a spurious doctrine of alignment between company and shareholder gain spreads moral hazard throughout a company and narrows management’s field of vision. Among other issues, this agency theory depends on an impossibility: that all shareholders want the company to be run in a way that maximizes their own economic return in the same investment horizon.

Shareholders have varying investment objectives, tolerance for risk, and time horizons. Pension funds may seek current income and preservation of capital. Endowments may seek long-term growth. Proxy voting records indicate that shareholders are divided on many of the resolutions put before them. They may also view strategic opportunities differently.

In the months after Valeant announced its bid, Allergan officials met with a broad swath of institutional investors. As cited by Bower and Paine’s article, according to Allergan’s lead independent director, Michael Gallagher, “The diversity of opinion was as wide as could possibly be.”

The notion that all shareholders have the same interests and that those interests are the same as the corporation’s masks provides intellectual cover for powerful shareholders who seek to divert the corporation to their own purposes while claiming to act on behalf of all shareholders. To combat this, we need to govern in a way that takes the corporation seriously as an institution in society and centers on the sustained performance of the enterprise.

The Dangers of Agency Theory

Since Meckling and Jensen laid it out in their 1976 paper mentioned above, agency theory has attracted a wide following and provided the intellectual rationale for changes in practice that have enhanced the power of shareholders and shifted governance toward a shareholder centered model. This is a dangerous trend that needs correction, as taken to its logical extreme, it may ultimately drive value out of public markets.

In 1997 the Business Roundtable issued a statement declaring that “the paramount duty of management and of boards of directors is to the corporation’s stockholders” and that “the principal objective of a business enterprise is to generate economic returns to its owners.” A response to pressure from institutional investors, it revised the Roundtable’s earlier position that “the shareholder must receive a good return, but the legitimate concerns of other constituencies also must have the appropriate attention.” According to surveys by the Aspen Institute, many business school graduates regard maximizing shareholder value as their top responsibility.

The sources of alleged value creation by activists need to be analyzed carefully. Though research on this question is limited, one study suggests that the positive abnormal returns associated with the announcement of a hedge fund intervention can be, for example, a transfer of wealth from workers to shareholders. The study found that workers’ hours decreased, and their wages stagnated for the three years after an intervention.

Other studies have found that some of the gains for shareholders come at the expense of bondholders. Still other academic work links aggressive pay-for-stock- performance arrangements to various misdeeds involving harm to consumers, damage to the environment, and irregularities in accounting and financial reporting. Shareholders’ gains are sometimes simply transfers from the public purse, such as when management improves earnings by shifting a company’s tax domicile to a lower- tax jurisdiction—a move often favored by activists, Similarly, budget cuts that eliminate exploratory research aimed at addressing some of society’s most vexing challenges may enhance current earnings but at a cost to society as well as to the company’s prospects for the future.

It may be that measures to enhance shareholders’ accountability can be useful. Suggestions include the notion that activist shareholders seeking significant influence or control could, for example, be treated as fiduciaries for the corporation or restricted by securities laws in their ability to sell or hedge the value of their shares. Regulators might be inclined to call for greater transparency regarding their beneficial ownership of shares and their own governance. Regulators might close the ten-day window currently afforded between the time a hedge fund acquires a disclosable stake and the time the holding must actually be disclosed.

The time has come to challenge the agency-based model of corporate governance. Its mantra of maximizing shareholder value is distracting companies and their leaders from the innovation, strategic renewal, and investment in the future that require their attention. History has shown that with enlightened management and sensible regulation, companies can play a useful role in helping society adapt to constant change.