The impact of short-term pressures on long-term decision-making

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And speaking of “the quarterly game,” you remember, of course, that in August, the president, on his way out of town for the weekend, threw out as chum to reporters the idea of eliminating quarterly reporting and moving instead to semiannual reporting.  (See this PubCo post and this PubCo post.) The argument was that the change would not only save time and money, but would also help to deter “short-termism,” as companies would not need to manage their businesses to meet quarterly analyst expectations at the expense of longer term thinking. A lot of folks chimed in—both pro and con. Business groups contended that the pressure of quarterly reporting was one of the deterrents to going public and maintaining public company status and, as a result, advocated for a change in the periodic reporting system. On the other hand, some contended that a change to semiannual reporting would not really have much effect on short-termism.  That is, why wouldn’t the same CFOs who would sacrifice long-term value to make their quarterly earnings targets also make the same sacrifice to achieve their semiannual earnings targets? As one investment strategist quoted in this Reuters article characterized the concept, it’s a “cockamamie idea. For starters, what’s the difference between six and three months? … Either way we’re talking about a very short-term period.” But no one disagreed that a change from quarterly to semiannual reporting would entail a significant overhaul of the current system, which has been in place for over fifty years.

However, at an event on October 11, SEC Chair Jay Clayton put the kibosh on speculation about the topic (except, perhaps, for a remote chance for smaller companies): “‘I don’t think quarterly reporting is going to change for our top names anytime soon….” Then, about a week later, out comes the Fall 2018 Unified Agenda of Regulatory and Deregulatory Actions, which identified “Earnings Releases/Quarterly Reports” as a pre-rule stage, substantive, non-significant agenda item for the SEC.  The abstract indicated that Corp Fin “is considering recommending that the Commission seek public comment on ways to ease companies’ compliance burdens while maintaining appropriate levels of disclosure and investor protection.”

Even more surprising was that the SEC had noticed an open meeting on December 5 at which the Commissioners would consider “whether to issue a Request for Comment on the nature and content of quarterly reports and earnings releases issued by reporting companies.” However, as a result of the observance of the national day of mourning for President George H.W. Bush, that meeting has now been cancelled and has not yet been rescheduled.

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At  a meeting of the SEC’s Investor Advisory Committee in 2017 to discuss the decline in the number of IPOs, some panelists confirmed that potential loss of control was a key factor. One panelist reported that, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from hedge-fund opportunists. Hence, the recent prevalence of dual-class capital structures, which one panelist characterized as merging some private company benefits into a public company structure. Perhaps dual-class structures are a blunt instrument, the panelist indicated, but it’s one tool that is available. (Dual-class structures were discussed by the Committee in March.  See this PubCo post and this PubCo post.) (Interestingly, at the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance.)  (See this PubCo post.)

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Also discussed in the New Yorker piece is a terrific  article by two Harvard Business School professors, Joseph L. Bower and Lynn S. Paine, in the Harvard Business Review.  The article questions the current fastidious devotion to the shareholder preeminence theory—the idea that corporations should be managed for the sole purpose of maximizing shareholder value—and contends that the “health of the economic system depends on getting the role of shareholders right.”  As discussed at length in this PubCo post, the authors contend that the shareholder preeminence theory is of relatively recent vintage, dating to the Milton Friedman school of economics in the 1970s. The theory is rooted in the idea that shareholders own the corporation and, as owners, they “have ultimate authority over its business and may legitimately demand that its activities be conducted in accordance with their wishes.” To the authors, however, because of the attenuated relationship with, and lack of responsibility for, the corporation that characterizes share ownership, the theory leaves an “accountability vacuum.” The consequences of this governance model, they maintain, are damage to companies and harm to the broader economy:

“In particular we are concerned about the effects on corporate strategy and resource allocation. Over the past few decades the agency model has provided the rationale for a variety of changes in governance and management practices that, taken together, have increased the power and influence of certain types of shareholders over other types and further elevated the claims of shareholders over those of other important constituencies—without establishing any corresponding responsibility or accountability on the part of shareholders who exercise that power. As a result, managers are under increasing pressure to deliver ever faster and more predictable returns and to curtail riskier investments aimed at meeting future needs and finding creative solutions to the problems facing people around the world.”

In addition, the tenet that shareholders are “owners,” the authors contend, has also led to the increased adoption of measures that give them more power in the nomination and election of directors and in taking other corporate actions, as well as the elimination of measures once considered “shareholder protection measures,” but now viewed as obstacles to the ability of shareholders to vote on takeover offers.

In the authors’ view, the “model’s extreme version of shareholder centricity is flawed in its assumptions, confused as a matter of law, and damaging in practice. A better model would recognize the critical role of shareholders but also take seriously the idea that corporations are independent entities serving multiple purposes and endowed by law with the potential to endure over time. And it would acknowledge accepted legal principles holding that directors and managers have duties to the corporation as well as to shareholders. In other words, a better model would be more company centered.”

What does the authors’ alternative—a company-centered model—mean? The authors’ model “would have at its core the health of the enterprise rather than near-term returns to its shareholders” and would acknowledge that managers are “obliged to act in the best interests of the corporation and its shareholders (which is not the same as carrying out the wishes of even a majority of shareholders). This model recognizes the diversity of shareholders’ goals and the varied roles played by corporations in society.” The model would appreciate that, in addition to generating wealth, “corporations also produce goods and services, provide employment, develop technologies, pay taxes, and make other contributions to the communities in which they operate” and “must create value for multiple constituencies.”  Rejecting the preeminence theory’s ambivalence toward corporate ethics, the authors maintain that corporations must also fulfill social responsibilities and observe “ethical standards to guide interactions with all their constituencies, including shareholders and society at large.”