We’ve argued that the notion that companies are obligated to maximize shareholder value is a theory made up by economists and eagerly adopted by corporate executives, with little to no foundation in law. We received confirmation of our thesis in the form of a Columbia Law Review article by the chief justice in Delaware, Leo Strine, arguing that shareholder activism needs to be curbed.
As we will discuss, some of his recommendations are contrary to SEC rulemaking under Dodd Frank. This means we have a prominent judge arguing that companies shouldn’t be required to obey the law because it takes time and managers have better things to do. Gee, did Strine manage to miss that the executive class pays itself ginormous amounts of money?* If they can’t figure out how to deal a fundamental job requirement, that would seem to argue that they need to be replaced.
Here are key extracts of a Financial Times story on Strine’s Columbia Law Review article:
Activist hedge funds and institutional investors have never wielded so much influence on company boards but the trend is in danger of getting out of control, according to one of the most powerful legal arbiters of US corporate governance disputes.
Yves here. Notice that this is an argument often made in defense of poorly-functioning but long-established institutions: they need to be left alone because making them accountable (or otherwise fixing them) is too messy a process.
Moreover, the argument that investors “have never wielded so much influence” is irrelevant. The fact is that public companies are a classic example of a principal/agent problem, where the principals (shareholders) lack adequate mechanisms for disciplining agents (CEOs and boards). As we wrote in 2013:
Disenfranchised shareholders are an inherent feature of liquid stock markets. In 1994, Amar Bhide argued in a Harvard Business Review article that efficient equity markets inevitably led inevitably to deficient corporate governance. Bhide explained that an ambiguous promise like equity is not suitable to be traded on an arm’s length basis. Historically, equity investors typically acted like venture capitalists: they knew the owners personally and were involved in the company’s affairs. The securities laws of 1933 and 1934 tried to make it safe for distant, transient shareholders to invest by providing for timely, audited financial statements, disclosure of information about top executives and board members, and prohibiting insider trading and other forms of market manipulation.
But that turns out to be inadequate. No outsider can be told enough to make an informed judement about a company’s prospects; critical information, like acquisition and plans for new products, must be kept secret until well advanced because they are competitively sensitive. Boards are protected from liability by directors’ and officers’ insurance (plus hardly anyone even bothers pursuing board members. For instance, have any Lehman board members been sued?). Moreover, only a comparatively small cohort of people are deemed public-company-board worthy. Their incentives are to make nice in their community and not rock the boat, which means not making life difficult for the CEOs, since a nominating committee (of the current board) is responsible for nominating directors, which means the entire process is incestuous.
This system has been fairly impervious to outside challenge. Once in a while, a company is so abysmally run that an activist investor will take up a proxy fight. But that dog seldom catches the car; instead, they might get a bad CEO to exit or force a restructuring. The stock trades up and the rabble-rousers take their winnings and depart.
In other words, Strine is annoyed that it’s gone from impossible to merely very difficult to get the attention of CEOs and boards, and the rabble is cluttering up his court.
The proof of how effective these measure have been is in the pudding, as in whether CEO pay has responded to investor pressure. The evidence says no. From the Los Angeles Times in late 2013:
The great management guru Peter Drucker advised companies to stick to a ratio of about 20 to 1 between the pay of the CEO and that of the average worker. That’s “the limit beyond which they cannot go if they don’t want resentment and falling morale to hit their companies,” Drucker wrote…
Drucker’s standard was in line with the ratios of the 1970s and early ’80s, when he wrote those words. Today they seem positively quaint. The average CEO-to-worker pay ratio in 2012 was about 350 to 1…
It’s plain that this ratio typically has little to do with an executive’s performance. The CEO-to-average-worker pay ratio of the 250 largest companies in the Standard & Poor’s 500 index ranges from 1,795 to 1 (J.C. Penney’s Ron Johnson) to 173 to 1 (Agilent Technologies’ William Sullivan), according to Bloomberg, which ran the data for 2012.
Do those figures reflect the two CEOs’ relative value to their companies? Well, no. Agilent shares have risen 49% over the last year, while J.C. Penney’s have fallen 73%.
Yves here. Studies have repeatedly found that CEO pay tends to be negatively correlated with performance. So Strine airbrushes out of the picture that corporate governance is fundamentally broken, and things have gotten so bad that normally complacent institutional investors have finally roused themselves.
Back to the Financial Times:
The chief justice’s proposals, in an article in the latest issue of the Columbia Law Review, include limiting the frequency of say-on-pay votes and charging investors to submit proposals to a company’s annual shareholder meeting.
Without such curbs, Mr Strine says, investors could “turn the corporate governance process into a constant ‘Model United Nations’ where managers are repeatedly distracted by referenda on a variety of topics proposed by investors with trifling stakes”….
In the article, he expresses scepticism that the shifting balance of power between corporate boards and shareholders has been of benefit to the economy, and that the resulting rise in hedge funds’ activist campaigns will be in the long term interests of investors.
Strine might rouse himself to consult data rather than defend our CEO oligarchs reflexively. As an earlier Financial Times story noted, citing a study by Alon Brav, Wei Jiang, Frank Partnoy and Randall Thomas, that:
…hedge fund agitators do not live up to their caricature as short-term speculators, with a median holding period of about a year. More important, their crusading seems to be linked to excess relative returns – ranging on average between 5 and 9 per cent – that do not dissipate in the months following regulatory filings. That should certainly count as wealth creation, though how much individual investors get after fees would make for good reading as well.
Similarly, another study looked at the UK’s most active activist investor, Hermes**, which often operates through private channels (note that this is not unheard of in the US. For instance, institutional investors met in 2009 with Lloyd Blankfein to urge him to rein in Goldman’s pay levels). Its conclusion:
This article reports a unique analysis of private engagements by an activist fund. It is based on data made available to us by Hermes, the fund manager owned by the British Telecom Pension Scheme, on engagements with management in companies targeted by its UK Focus Fund. In contrast with most previous studies of activism, we report that the fund executes shareholder activism predominantly through private interventions that would be unobservable in studies purely relying on public information. The fund substantially outperforms benchmarks and we estimate that abnormal returns are largely associated with engagements rather than stock picking.
Back to the Financial Times:
In particular, he criticises the convention of having annual votes for directors and on a company’s compensation policies, both of which should be judged over longer periods, he argues.
Institutional investors are being overwhelmed by the number of votes they are required to cast, he says, and are failing to give them proper attention…
Say-on-pay votes could be held every three or four years, says Mr Strine. Shareholders should also be charged a fee for submitting other proposals, just as politicians must pay a fee to stand for election, and banned from resubmitting losing proposals year after year.
This “proposal” is remarkable in that it contradicts Dodd Frank rulemaking. From the SEC’s website:
The SEC’s new rules specify that say-on-pay votes required under the Dodd-Frank Act must occur at least once every three years beginning with the first annual shareholders’ meeting taking place on or after Jan. 21, 2011. Companies also are required to hold a “frequency” vote at least once every six years in order to allow shareholders to decide how often they would like to be presented with the say-on-pay vote. Following the frequency vote, a company must disclose on an SEC Form 8-K how often it will hold the say-on-pay vote
So effectively, a powerful jurist has said he is opposed to a statute. Normally, judges who say clearly that they aren’t inclined to enforce the law are required to recuse themselves, or risk having their opinion overturned on appeal for having shown that they are biased. But Strine can abuse his position by virtue of being on the Delaware Supreme Court. There’s no ready venue for appeal (in theory one might go to the US Supreme Court, but I doubt the Supremes would be willing to hear an appeal based on questioning the propriety of a state Supreme Court chief justice).
And as to the “shareholders get to vote on boards too often as it is,” Strine knows full well that it is incredibly difficult to replace a board now, by design. Public companies almost universally went to staggered boards (1/3 of the directors up for a vote every year) as an anti-takeover measure in the 1980s, when raiders stalked the earth. Please tell me the last time we’ve had a hostile takeover in the US. Hint: it’s not something CEOs lose sleep over these days (in fact, they secretly lust for them, since it would trigger another defense, the golden parachute).
So while I suppose it should not be surprising, it’s still vile to see such a shameless defense for imperial CEOs and boards, which in turn amounts to defending their right to loot. When I expressed my consternation to a law professor, he wrote back, “Delaware is, well, different.” And as we can see, not in a positive manner.
*”Pays itself” is not inaccurate when you understand how cronyistic the CEO pay system is. Boards hire pay consultants who are typically recommended and paid for by the HR department, making the independence of this process optical rather than actual. And CEOs often sit on boards, given them an incentive to elevate pay levels generally. And board members benefit, since higher CEO pay levels lead over time to higher board fees.
We explained in 2008 how the system is set up to assure ever-rising executive compensation:
Based on their belief of what constitutes good modern practice (influenced in no small degree by the pay consultants) most boards set general target ranges for how they would like the CEO to be paid relative to peers. The comp consultant then helps define and survey the peer group’s pay ranges, setting a benchmark for how the CEO in question is to be paid.
That all sounds fine, right? Well, except just as all the children at Lake Woebegone are above average, no board likes setting a target below peer group norms. I have heard of numerous examples of targets being set somewhere in the top half (66th percentile, top quarter, top 20%), hardly any at the mean, and none I know of below average…
So with this mechanism in place, any CEO who has fallen below median pay who is targeted to be in a higher group will have his pay ratcheted up, independent of performance, merely to keep up with his peers. This increase raises the average and creates new laggards. The comp consultants have institutionalized a leapfrogging process that keeps them busy surveying competitor reward levels and keeps top-level pay rising relentlessly.
**Some Hermes funds made a donation to the site years ago for our crisis-related reporting and analysis, which apparently proved helpful in formulating their investment strategies.