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Wednesday, 4 April 2012

Shareholders Are Revolting

Command and Control

Ever since the joint stock company, the predecessor of the modern corporation, was invented shareholders have engaged in a love-hate relationship with the managers of their firms. At the heart of the battle is a matter of great importance for all investors – who owns and controls the companies they place their capital in?

The balance between shareholders and managers has see-sawed back and forth, but in recent years has swung down firmly in favour of the latter. Now, though, shareholders are fighting back. Shareholders are revolting, and not before time. Unfortunately, they need to be very careful what they wish for.

Dutch Courage

We can date the first recorded dispute between shareholders and managers to January 24th 1609, when Isaac La Maire sued the directors of the Dutch East India company in order to get his investment back. Up until this point maritime corporations had been organised for a limited period or one voyage at a time, and wound up when the trip(s) concluded. The directors of the Vereenigde Oost-Indische Compagnie (VOC) decided not to do this, and instead chose to finance the next voyage from the proceeds of the last, while rewarding investors with a dividend: paid in spices.

When Le Maire lost his case the VOC’s directors were left in charge of a company with many attributes we’d recognise today: an immortal corporation whose shares were publicly traded (see: Frankenstein's Corporations). It was the beginning of modern shareholder capitalism, and arose indirectly out of the first recorded instance of modern shareholder activism.

Le Maire’s other claim to fame is as the first ever short-seller, of Dutch East India stock (of course), which eventually forced the directors to start paying dividends in cash. The response of the Dutch government was also a harbinger of reactions yet to come; they banned short selling, without any obvious success (see: Save Our Short-Sellers). At the heart of Le Maire's dispute were the rapid fortunes made by the directors of the VOC for doing little other than sitting on their spreading backsides. As J. Matthijs de Jongh records in Shareholder Activism at the Dutch East India Company in 1622:
“Their wealth had appeared so suddenly, that it looked ‘like mushrooms that have grown overnight.’ Amongst others, they accused the directors of self-dealing, insider trading, abuse of the remuneration rules and stealing from the company”
Governance and Abnormal Returns

This should all sound wearily familiar from modern scandals. Corporate governance is often one of the main issues at the heart of these problems and although sometimes this is sorted out in the simplest way possible, by shareholders voting with their feet, in modern markets there’s a constant stream of gullible investors, professional as well as amateur, willing to give managements their money.  Although this is often for ridiculously short periods of time, which is destabilising in its own right.

This all leads on to the question as to whether shareholders should actually want better corporate governance.  Opinion is divided.  For starters, back in 2003, Paul Gompers, Joy Ishii and Andrew Metrick showed in Corporate Governance and Equity Returns:
“Firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions”
According to this research investing in firms with the best corporate governance and divesting those with the worst would have led to an abnormal return – i.e. a return in excess of the market average – of over 8% during the 1990’s. Unfortunately this effect seems to have disappeared subsequently, as market participants seem to have learned and taken on board the research (see: Pricing Anomalies: Now You See Me, Now You Don't). In fact, according to Lucian Bebchuk, Alma Cohen, and Charles Wang this effect seems to have reversed in the crisis hit markets of the early part of this century:
“Performance differences exist in crisis and non-crisis markets between a portfolio of well-governed firms and a portfolio of poorly governed firms. During the sample period the portfolio of poorly governed firms outperforms the portfolio of well-governed firms. This performance difference (spread) is substantial and significant”.
Delinking Incentives and Performance

So what on Earth is going on? Well we can get a clue by looking at the work of RĂ¼diger Fahlenbrach and RenĂ© Stulz who examined corporate governance in banks during the credit crisis. In Bank CEO Incentives and the Credit Crisis they showed that there is no relationship between how well, or badly, chief executive remuneration was aligned with their corporations and their subsequent performance. In fact the worst performing chief executives were more likely to be buying stock ahead of the crisis, which suggests the problems were more about ability than incentives.

One other area of note is the research by David Erkens and colleagues, which suggests:
“That while governance is positively associated with the disciplining of executives for losses incurred during the crisis period, it did not prevent these losses, but instead exacerbated them by encouraging executives to focus on short-term performance.”
So, less independent CEO’s, under more pressure from their boards to extract shareholder value, were more likely to take short-term risks in order to maintain performance, often against a basket of their peers. If you were a bank CEO whose competitors were gearing themselves to the gills you were going to need to be a strong character with a blatant disregard for corporate governance to avoid doing the same.  In the end, only those leaders able to ignore short-termist demands to maximise returns were able to do just that.

Box Ticking

The lesson to revolting shareholders seems to be careful what you wish for. Corporate governance is a set of rules about how managements should behave, but relying too heavily on box-ticking bureaucracy to ensure that a company is well run is akin to the problems associated with the Titanic Effect: if you assume you've already protected yourself against everything that can go wrong you’re already one step closer to hitting an iceberg.

Of course, shareholders still have much to complain about and shareholder activism is on the rise across the world. Potentially with good reason: a study of the effect of the UK’s Hermes Pension Fund’s activist role showed that it significantly outperforms benchmarks largely because of its interventionist stance. Meanwhile US firms targeted by campaigns against excessive pay have seen an average $7.9 million reduction in CEO pay.

As Brian Cheffins and John Armour have shown general hedge fund activism has been increasing for the past couple of decades, but actually suffered a setback during the recent financial crisis. The reason for this is revealing of the underlying problem with shareholder activism in general:
“Activism campaigns therefore had to focus much more on improving target company strategy and operations than implementing financially oriented initiatives, a potentially unappealing prospect for many hedge fund activists.”
What an horrific situation. Can you imagine it: shareholders being forced to take a longer term interest in improving the actual businesses they were investing in, rather than engaging in short-term financial manipulation with no regard to a future that they have no intention of being a part of?  What on Earth is shareholder capitalism coming to?  

Trust Not Governance

So, here’s the rub. Not much has changed since the heady days of the VOC and its directors extracting unearned rewards at the expense of shareholders. Corporate governance rules may have got better but, when push comes to shove, it turns out these have a limited benefit. Companies that implement governance measures in full are more exposed to the fallacy of the maximisation of shareholder value than those with a more measured approach.  Corporations with the worst governance tended to do the best during the recent market turmoil presumably because their executives were able to ignore the pressure to engage in short-term earnings manipulation.

On the other hand, allowing executive directors to do as they want unchecked isn’t correct either. Shareholders may be revolting, but they need to focus on what they really should be revolting against. A chief executive and a board whose rewards don’t match the returns made by a company are a legitimate target for activists, but anyone who simply wants boards to focus totally on share price increases is missing the point.

Of course, this comes down to trust.  A trustworthy and prudent board won't take excessive rewards anyway. Good corporate governance is a rule-based smokescreen and shareholders need executives they can trust, not ones they can dominate. Shareholder activism should focus on achieving this, rather than boosting short-term earnings at the expense of long-term viability.

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