There has been a critique lately by retained advisors to management and academics about activist investors and the focus on shareholder value. See for example, here, here and here. This is a counterpoint on why shareholder activism occurs, what “shareholder value” is and is not, and what “shareholder engagement” really means.
Why do activists emerge?
There have been several recent examples of shareholder activism, at Yahoo, J.C. Penney, P&G, Chesapeake Energy, and in Canada, Research in Motion and CP Rail. As experienced non-executive chairman and activist investor Henry D. Wolfe has written, “the best activist investors play a vital role in shaking up complacent boards/managements and positioning companies to for maximum performance and value creation.”
Wolfe goes on to write, “the recent Canadian Pacific Railway situation is a classic case in point. Both the incumbent board and management had presided over multiple years of the “plan of the moment” all of which resulted in a dismal operating ratio for the railroad. Bill Ackman and his team at Pershing Square were made aware of the CP situation, took a deep dive into the industry and the company resulting in a detailed analysis of the company’s underperformance and a high level plan to maximize its performance and value which included a new CEO and a partial board slate with director candidates that all had a greater awareness of the need for the board to have performance and shareholder value maximization as the top priority.” (See also the culture shift brought to Canada because of CP, here and here.)
Wolfe concludes by saying, “What does not seem to dawn, at least not completely, on people such as the authors of this article (see “What Good Are Shareholders, Harvard Business Review”), is that if public company boards really understood and did their jobs, there would be no need for raiders, activists or “shareholder empowerment.”
What is the board’s responsibility when an activist emerges?
The board’s primary responsibility is to ensure that the company’s performance and value is maximized. Directors have a legal obligation to act in the company’s best interest, not management’s, and not their own. The question – the only question – in responding to a “concerned” shareholder (otherwise known as an activist) is what is in the best interests of the company and its shareholders? In many cases, doing so is not further entrenchment such as shareholder rights plans, staggered boards, dual class shares, restrictions on calling meetings or voting, or other restrictions on corporate control. Directors are there to control management in the interests of shareholders, not be beholden to management or hostile to shareholders.
Self interest by boards when an activist emerges?
And – this is very important – directors cannot act out of self-interest. An activist has emerged because the board was not doing its job. If the company assets and performance were being managed efficiently and effectively, there would be no need for shareholder activism. Activism occurs when voices are not heard. When the board responds, it must take a look in the mirror. Activists may have ideas that are in the best interests of the company that include addressing poor management and board performance. The board needs to address this independently and dispassionately.
This is tough to do because the right thing to do may be to step down and let other directors take over, who can do a better job. Surprisingly, sophisticated investors often know more about the business than existing directors. This is further evidence of complacent directors and the current corporate governance model being broken.
Even more surprising, apart from self interest, are views of shareholders: “Other academics, such as Roger Martin, the highly regarded dean of the Rotman School of Management at the University of Toronto, are critical of the emphasis on shareholder value.” As Henry Wolfe comments, “And if one does not believe that Roger Martin supports this, just look at the material decline in performance and total destruction of shareholder value at RIM during Martin's tenure as an RIM board member and his non-sensical comments regarding criticism by investors of RIM’s board.” John C. Caravella added, “Jay Lorsch, also quoted in Joe Nocera’s New York Times column [see here], served on the board of Computer Associates in 2004, when CA paid $200-plus million to the U.S. Department of Justice in restitution to shareholders to settle charges of accounting fraud and obstruction of justice. Caveat emptor.”
Does a board have a “duty” to stakeholders other than shareholders?
Accountability to everyone is accountability to no one. It is simply folly to suggest – as some have – that shareholders should be treated the same as other stakeholders or even subservient to them (see my blog here as an example). Or by extension of the directors’ duty to the company that this duty extends to all stakeholders. Directors, legally, do not have duties to multiple stakeholders, any more than an agent or fiduciary can act for multiple principals. Shareholders are not the same as non-shareholders, such as customers, employees, suppliers, creditors, etc., who contract with the company for their protection. Shareholders do not have contracts with the company, contrary to what Professor Stout stated. They are residual claimants and boards must consider their interests in light of this. Shareholders are principals and they elect directors to preserve and enhance their investment. Public companies are not social institutions and investors do not risk their capital for this purpose, but by the same token, boards cannot unfairly treat its stakeholders and has to be a good corporate citizen.
Shareholder value defined
Next, the obsession with quarterly earnings has been used to mis-characterize shareholder value. This is not what shareholder value is all about. When companies do not maximize their assets or performance, from unsound diversification, complacency regarding costs, or cash in excess of capital needs, these inefficiencies – which should be addressed by boards – are addressed by activists irrespective of quarterly earnings. More often than not, activist investor activity has nothing to do with quarterly earnings.
In addition, shareholder value also does not come at the expense of stakeholder management, but rather results from it and ensures a highly disciplined approach to stakeholders. Stakeholder metrics such as customer service, employee engagement and culture are leading metrics that drive financial performance. These non-financial metrics are underutilized by boards and in executive compensation. This fault squarely rests with boards. Witness GE and Four Seasons when stakeholder management is done right. Witness BP when it is not. Accountability to shareholders cannot be fulfilled without proper stakeholder management and taking into account all the vital components of the business, including reputation and ethical conduct. The anti-shareholder rhetoric suggests that performance and value can be maximized without stakeholder management and ethical conduct. It cannot.
Shareholder engagement and shareholder democracy defined
Next we come to what it means to communicate with shareholders. Shareholder “engagement” as a concept has been co-opted by technocrats to mean voting or procedural rights (when these folk’s business model is predicated on these services). Shareholder engagement is not, in and of itself, say on pay, majority voting, broker non-votes, or technical process that lawyers and compensation consultants advise on. Shareholder engagement is about meeting, face-to-face, between directors and key shareholders, without management present. Shareholder engagement is, most importantly, listening. Board chairs should not be dissuaded by legal concerns over “Reg FD.” Regulation fair disclosure does not in any prohibit directors from meeting directly with shareholders. The SEC Chair has confirmed this. Boards should not allow management and retained advisors to dominate this process. And shareholders need to commit the time and resources to meet directly with boards of the companies they have significant ownership positions in.
Next, shareholder democracy means exactly what you think it means: the ability of shareholders to elect directors. Corporate management has fought vigorously to control the proxy statement and prevent shareholder from suggesting directors, but shareholders should have the right to compel management to put onto the proxy statement directors of their choosing. I have not seen any evidence that experienced investors will not put on top-flight directors. Indeed there has been evidence to the contrary – shareholder-nominated directors are better than many current directors.
What about advisors to boards?
Lastly, something needs to be said about professional advisors to boards and board committees, and specifically in the context of a change in control, a conflict of interest, or responding to an activist. Professionals who advise management should be prohibited from advising the board on responding to an activist, or any other matter involving independent review or oversight. (Independence of auditors and compensation consultants – serving just the board and not management, happened under S-Ox and Dodd Frank, but this needs to be extended to all advisors, including financial and legal advisors.) You cannot serve two masters, especially when their interests are adverse.
An independent advisor needs to be free to recommend to a board action adverse to management and supportive of shareholders and the company. Existing service providers have a commercial interest in supporting management. They are also assessing their own work when they advise a special committee or the board. This is evidenced by lawyers drafting entrenchment devices that protect management. We even see a negative regard to shareholders in their commentary. Observe words such as “attack,” “secretly,” “dissident,” and “activist” – even the title itself is pejorative: “Dealing with activist hedge funds” – and see here, the “risks of direct engagement.” As activist investor Henry Wolfe has said, “When lawyers provide defensive strategies and tactics to clients there is rarely a shareholder focused context; the context is largely to build a moat around the directors.”
Conclusion
The overall commentary of shareholder value has as an undercurrent that shareholders have too much influence and power. In my view, the opposite is true. Shareholders do not have enough impact and influence and directors are not accountable to them. The deck is far more tilted towards incumbent management, directors beholden to them, retained advisors to management, and an overall lack of accountability to shareholders. The existing model of corporate governance should address this.