by Cydney Posner
Much has been written about the problems associated with the prevalence of short-term thinking in corporate America. As noted in a post from The Harvard Law School Forum on Corporate Governance and Financial Regulation, a recent academic study revealed that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.” (See this PubCo post and this article in The Atlantic.) Apparently, they weren’t kidding. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks (which can drive increases in EPS), leaving little for alternative uses of capital, such as long-term strategic investment in productive assets, including investment in R&D. (See this PubCo post.) As observed by Professor John Coffee in this post, “[p]resumably, it is self-evident that if an economy cuts back drastically on its investment in ‘R&D,’ it will experience less innovation and technological advances in the future…. That should be a cause for concern.” (See this PubCo post.)
The question is: is there a fix for this scourge? The American Prosperity Project, sponsored by the Aspen Institute, has some ideas.
The American Prosperity Project maintains that our “economic health depends on sustained, long-term investment to support our families and communities and to reinvigorate the economic engine that creates jobs and prosperity,” but right now, our “incentive system for long-term investment is broken.” To support its contention, the Project cites the following data:
- The US now ranks 25th in infrastructure quality, per the National Association of Manufacturers, as a result of decades of inadequate investment.
- The US has fallen to 10th in R&D investment relative to GDP, according to the OECD, and China will soon surpass the US in total investment in basic science research.
- Pressure for short-term financial performance has increased recently according to McKinsey, and has also influenced business investment — “fixed capital investment by American corporations is the lowest since 1952 and employer-paid skills training declined 28% between 2001 and 2009.”
- Our tax system and rules and caselaw reinforce short-termism, directly or indirectly through perverse incentives and requirements.
Why has short-termism taken hold? There are many points of view on the reasons, with blame attributed to, among other things, executive compensation (see this PubCo post and this PubCo post), pressure from Wall Street to increase quarterly EPS (see this PubCo post), traders’ compensation (see The Atlantic article), the “legal underpinnings” of capital markets regulation and the business model and prevailing culture of the investment management industry (see this PubCo post), caselaw regarding directors’ fiduciary duties (see this PubCo post), and, perhaps most significant, hedge fund activism. As suggested in this NYT DealBook column, the activist playbook is certainly not limited to buybacks and dividends: “[a]s activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.”
SideBar: It wasn’t always this way, argues Professor William Lazonick in “Profits without Prosperity,” published in the September 2014 Harvard Business Review: “From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what [he calls] ‘sustainable prosperity.’ This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.” [emphasis added] What led to this change? In Lazonick’s view, the surge in hostile takeovers in the 1980s proved to be a turning point. These takeovers were justified by corporate raiders on the basis that “the complacent leaders of the targeted companies were failing to maximize returns to shareholders. That criticism prompted boards of directors to try to align the interests of management and shareholders by making stock-based pay a much bigger component of executive compensation. Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them ‘manage’ stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.” (See this PubCo post.)
Professor Lynn Stout attributes the transformation to the development of the “shareholder preeminence theory” by the Chicago school of economists, including statements by economist Milton Friedman famously arguing that the only “social responsibility of business is to increase its profits.” Subsequently, two other economists published a paper characterizing shareholders as “‘principals’ who hired executives and board members as ‘agents.’ In other words, when you are an executive or corporate director, you work for the shareholders. Stout said these legal theories appealed to the media — the idea that shareholders were king simplified the confusing debate over the purpose of a corporation. (See this Cooley News Brief.)
To address these failings, the Project offers “a nonpartisan framework for long-term investment,” aimed to achieve three basic goals:
- Focus government investment on infrastructure, basic science research, private R&D and skills training — all “recognized drivers of long-term productivity growth and global competitiveness.”
- Modernize the tax system to promote business investment by reducing the corporate tax rate, eliminating loopholes and rewarding long-term investment, including adoption of a Financial Transactions Tax and a carbon tax and changes to the time horizon for long-term capital gains treatment.
- Align private incentives and regulations with the public good through changes to regulation and corporate governance standards.
It’s this last goal that is of most interest for purposes of this post: what should be done to “facilitate companies’ and investors’ focus on long-term investment”? The Project suggests that we need to make changes to regulations, market expectations and business norms that now encourage short-term thinking. With regard to public companies, the Project suggests that “dampening the drumbeat of quarterly expectations and amplifying the voice of the long-term holders of capital” will lead to “better long-term corporate decisions.” To that end, the Project makes the following recommendations:
- Short-term earnings guidance should be discouraged. In addition, to encourage transparency regarding the drivers of long-term corporate value, companies that do offer guidance should “do so within the context of the company’s long-term strategy.”
SideBar: Note, however, that, while this approach may not adversely affect analyst coverage for larger companies, smaller companies that have difficulty attracting analyst coverage may find this approach difficult to implement without impairing coverage.
- While the vast majority of companies submit non-binding say-on-pay proposals to shareholders annually — in many cases because that’s the interval that shareholders have indicated they prefer — the Project suggests that companies should consider whether a three-year cycle (the longest interval permitted under current SEC rules) may offer the benefit of allowing shareholders “to evaluate executive performance over a longer timeframe.”
SideBar: As noted in this PubCo post, the Financial CHOICE Act, which was sponsored by the Chair of the House Financial Services Committee and is expected to be re-introduced in the new Congress, would require say-on-pay votes only in those years “in which there has been a material change to the compensation of executives of an issuer from the previous year,” and would eliminate the say-on-frequency vote entirely.
- “Incentivize patient capital through enhanced shareholder voting rights and/or dividends that vest over time.” Presumably, the recommendation here is for some form of “tenure voting,” a concept that would give investors additional votes if they hold their shares for at least a specified period of time, thus rewarding long-term holders by giving them more say in the future of the company than, say, short-term hedge fund activists that may favor short-term profits over long-term business strategies.
SideBar: The concept of tenure voting was reportedly invented during the 1980s as a stockholder protection measure in response to a wave of hostile takeover attempts. Under tenure voting, investors would receive additional votes if they hold their shares for at least a specified period of time, thus rewarding long-term holders by giving them more of a voice in the future of the company than, say, short-term hedge fund activists that may favor short-term profits over long-term business strategies. In 1996, in Williams v. Geier, the Delaware Supreme Court upheld adoption by a board of a similar plan as a proper exercise of the business judgment rule to promote long-term planning (even though the effect of the plan was to concentrate voting rights in hands of a controlling bloc); the plan was then approved by a fully informed stockholder vote, which was considered dispositive. Some commentators have observed that tenure voting is hardly a panacea: it may scare off some regular investors and, in the event that the short-term holders were able to persuade long-term holders, might not even be effective to thwart all raiders and activists. In addition, it could be difficult to keep track of the duration of ownership of stock, especially beneficial ownership. Moreover, tenure voting could be difficult for a public company to adopt, with the result that the voting structure might have to be adopted prior to or in connection with an IPO. And, needless to say, proxy advisory firms ISS and Glass Lewis may look askance at this type of uneven voting structure, even though, in contrast to some other approaches, nothing prevents any stockholder from obtaining super-voting rights. (See this PubCo post.)
SideBar: Interestingly, there’s no specific recommendation that addresses the current legal landscape surrounding the “shareholder preeminence theory” (noted above) and the impact some contend that theory has had in shifting corporate focus to maximizing shareholder value — along with the consequent pressure to respond to short-term market forces — and away from a broader spectrum of interests that includes employees, community and society at large. (See this Cooley News Brief.) Some academics and other commentators have advanced the notion that, in making decisions regarding the corporation, corporate directors are also entitled to take into consideration the interests of these other constituencies. For example, Professor Stout has written that “boards exist not to protect shareholders per se, but to protect the enterprise-specific investments of all the members of the corporate ‘team,’ including shareholders, managers, rank and file employees, and possibly other groups, such as creditors.” Arguing for the other side is Chief Justice Strine of the Delaware Supreme Court, who, in an interesting article In the Harvard Business Law Review, makes clear his disdain for the concept that corporate directors are entitled to take into consideration the interests of constituencies other than shareholders. He is, however, a proponent of the concept of “public benefit corporations.” (See this PubCo post.)
In addition, the Project contends that “the long-term orientation of average investors gets lost in the layers of intermediation between these investors and the companies that seek their capital.” To address this issue, the Project recommends that fiduciary duties and disclosures for financial intermediaries and investing institutions be updated, specifically by:
- Applying the standards of the 1940 Act and ERISA to all intermediaries “who substantially advise or influence ERISA fiduciaries or invest retirement savings that are under the care of ERISA fiduciaries.”
- Creating “institutional investor disclosure standards… on relevant compensation, incentives, trading practices and policies on proxy voting and other indicators of compatibility with the goals of long term savers.”
- Ensuring “that the shareholder litigation brought by ERISA fiduciaries is in the interest of plan beneficiaries.”
- Accelerating the Schedule 13D disclosure requirement to allow all investors to “make informed investment decisions based on this material information.”
SideBar: The Brokaw Act, which was introduced in the last Congress but not passed, would have required the SEC to amend Rule 13d-1 to shorten the time to file a Schedule 13D from 10 days to two business days and to expand the definition of beneficial ownership in Rule 13d-3 to include, in addition to voting or investment power, a direct or indirect pecuniary interest in the security. (See this PubCo post.)
One problem the proposed deadline acceleration was designed to address was the conduct of “wolf packs.” As discussed in this post from Columbia Law Professor John Coffee, a “wolf pack,” is “a loose association of hedge funds (and possibly some other activists) that carefully avoids acting as ‘group’ so that their collective ownership need not be disclosed on Schedule 13D when they collectively cross the 5% threshold.” Coffee observes that, for the past decade or so, wolf packs have often relied on “offensive” tactics (i.e., where the hedge fund purchases shares “specifically to challenge management”) that, in effect, seek to engineer stock price increases, such as through stock buybacks. One of the wolf pack tactics that Coffee identifies is the practice of “conscious parallelism.” As discussed in this PubCo post, citing a WSJ article, members of the pack often use the 10-day window prior to disclosure to tip their plans, profiting from the use of material nonpublic information. An analysis by the WSJ demonstrated that, in the “10 trading days before bullish activists revealed in regulatory filings that they had bought particular stocks, the stocks rose an average of 3.2% more than the overall market…. Similarly, an analysis of 43 announcements by bearish activists… found that in the preceding 10 trading days, shares of targeted companies fell by an average of 3.8% more than the market as a whole.” The hedge fund activist can then exploit these changes in share price. The practice of tipping other investors, the article charges, “is part of the playbook. Activists, who push for broad changes at companies or try to move prices with their arguments, sometimes provide word of their campaigns to a favored few fellow investors days or weeks before they announce a big trade, which typically jolts the stock higher or lower. In doing so, they build alliances for their planned campaigns at the target companies. Those tipped—now able to position their portfolios for price moves that often follow activist investors’ disclosures—benefit in a way that ordinary stockholders who are still in the dark don’t.”
