Status: Published as a chapter of the book H. K. Baker & R. Anderson, Eds. (2010), Corporate Governance: A Synthesis of Theory, Research, and Practice (pp. 409-425). Robert W. Kolb Series on Finance. New York: John Wiley & Sons.
An institutional view of shareholders and activism
Corporate governance is a field of many institutions, including the institutionalized practices within the group of actors known (somewhat confusingly in this context) as institutional investors. As discussed in Chapter 3, above, some investors occupy positions close to the centre of the field. Pension funds, the investment arms of insurance companies – in particular those which are themselves listed companies – and main traditional asset management firms operate under broadly similar points of references. Their trade associations often work together on lobbying and on occasion intervene together when corporate governance arrangements at specific companies deviate too far from the standards those organizations support.
In recent years, the rise of hedge funds and sovereign wealth funds, as well as the growing prominence of non-UK institutional investors in UK markets, provide indicators that current arrangements were undergoing changes, at some times radical. What happened in the UK was replicated in other national markets around the world. If anything, the trend was stronger in other markets, which lacked the UK's match of large-scale asset management operations and large listed companies.
Another shift has altered the investment landscape, with implications for institutional arrangements in corporate governance. Cross-border listings of some large corporations mean that large companies domiciled in one jurisdiction now have their primary listing on the stock market of another country, as discussed in the chapter above "Waste makes haste". Viewed through the lens of institutional theory, in particular Greenwood and Hinings (1996), such developments represent shifts the institutional and/or the market context, which may run counter to the values or interest of actors in which organizational field we use as our level of analysis, forming
part of the background needed for radical institutional change. They also look different, depending on whether you view the field from the vantage point of a corporate board, a mainstream investor, or an alternative investor; they depend as well on the stance those investors take, as the chapter seeks to describe.
Although written as an attempt to provide a framework for practical analysis of the field, this essay may be seen as describing ways of view competing and conflicting institutional logics at work (Lounsbury, 2007; Reay & Hinings, 2009), where an institutionalized view of shareholder value held by actors in one part of the field conflicts with the presence of multiple and divergent logics arising from the shifting market conditions. This is a theme to which we return in the concluding chapter.
The politics of shareholder activism
(2010)
Abstract: Shareholder activism is an exercise of power that is sometimes benign or threatening to the interests of corporate management, boards, and other shareholders. The complexity of these relationships helps explain the difficulties directors face in pursuing shareholders' interest. What arises, particularly in relation to the growth of hedge-fund activism, is greater dispersion of shareholder interests and growing questions about the legitimacy of how those interests are acted out in the political landscape of corporation governance. This chapter offers a framework to examine the stance that shareholders take when exercising or not exercising their power. Anticipating the expression of shareholder power involves assessing their intentions along three dimensions: (1) their attitude towards an individual stock (buy-hold-sell), (2) their approach to activism (docile, "walkers", or activist), and (3) their investment horizons (long-term, short-term, or "perverse" where shareholders’ economic interests do not coincide with their holdings).
Introduction
By the middle of 2008, big institutional investors had grown uneasy about their investments in the German carmaker Volkswagen AG (VW). Owning the shares had become too political. Porsche Automobil Holding SE held more than 30 percent of the shares. VW's supervisory board chairman, Ferdinand Piëch, was a member of the family that controls Porsche, which had become something of a corporate governance pariah by refusing to accept the unofficial norm of quarterly financial reporting in Germany. Porsche had also irritated the country's Social Democrats by dropping the Aktiengesellschaft legal form in favor of the new European Union Societas Europeas form that allowed Porsche to reduce representation of German workers on the supervisory board. Moreover, Piëch had ousted the VW chief executive in 2006 and then entered a court battle with the company's second largest shareholder; the state of Lower Saxony that held more the 20 percent of VW’s equity. Lower Saxony also benefited from a special law giving it veto power over important managerial and board decisions, a statute recently reinforced by the German parliament after the European Court of Justice ruled parts of the old law illegal. The European Commission had said that the
new version of what German news media called the "VW law" was illegal and Porsche agreed. But attempts at VW's annual meeting by other shareholders – including activist institutional investors – to challenge Porsche's creeping control of its rival carmaker fell on deaf ears (Milne, 2005, 2006; Milne, Williamson, & Tait, 2008).
Within a few months Porsche used a derivative instrument known as a contract for difference to acquire an economic interest equivalent to about 75 percent of the stock. Although Porsche had not directly purchased 75 percent of the shares, under German law, the company was able to keep this fact a secret. Speculators, including hedge funds that had expected a fall in the price of VW and sold short, soon faced a mad scramble to cover their positions. VW shares soared by 400 percent, briefly making it the most valuable company in the world. Newspaper reporters began to liken Porsche itself to a giant hedge fund with a small carmaker attached (Schäfer & Mackintosh, 2009).
Shareholder activism is fundamentally a battle for power acted out in a political landscape that stretches from boardrooms through national legislatures and encompasses supranational organizations. The exercise of power by shareholders shapes and is shaped by the political force-fields of corporate governance. When public policy concerning private-sector companies is set, some shareholders make their voices heard as well. Sometimes, the goal is to ensure that shareholder power over management is strengthened. Sometimes, it is to avoid the erosion of power to employees or outside lobbies. Often, however, the goal is to wrest power away from other shareholders.
An obvious and occasionally overlooked question when considering the forces that shape corporate governance is: What is in the shareholders’ best interests? One interests of one shareholder often do not coincide with those of others. Most of the time, diverging shareholder interests do not matter because shareholders are not often able to vote on matters of corporate policy. But for directors with their fiduciary responsibility to look after shareholder interests, understanding what is in the shareholders’ best interests represents an important question. The competing interests of shareholders arise from different stances that investors take to their investments. Shareholder interests constitute a complex picture of rivalry for the high ground. The rivalry shapes the way shareholders vote at company annual meetings, how they vie for directors’ attention, and how they seek to influence the public policy debate on the enterprise’s future. The discussion of activism focuses mainly on the approaches that
institutional investors take. They dominate the investment landscape, even in the United States, where private persons – retail investors – give a greater sense of "democracy" to shareholder capitalism than in many other countries around the world. These private individuals, unless extremely wealthy and willing to take risks, are rarely able to gain a voice in the political debate that sets the policy of individual companies and the framework of laws and regulations in which boards operate.
The purpose of this chapter is to describe the role that shareholder activism plays in corporate affairs. The first section gives a history of activism, showing how the practice has changed, especially as hedge funds have become activist investors, and discussing the issues that type of activism raises. The next two sections develop a model called the Shareholder Stance. They explore how different shareholders' interests can collide and how coalitions of shareholders can develop over issues, despite the different approaches to their investments. The next section shows how these differing stances can lead to conflict over policy decisions, leading to conclusions that suggest the difficulty in identifying what "shareholder value" means when activism is viewed as a political process.
Issues in shareholder activism
Many people, including policymakers in major countries, believe that shareholders ought to actively engage with the managements and boards of the companies in which they invest. In Britain, for example, the government has encouraged institutional investors, who collectively own more than 80 percent of the equity in U.K. listed companies, to vote their shares. Pension funds have been under pressure to publish their voting records so that beneficiaries can judge their performance. But in the minds of many corporate executives, a difference exists between shareholders being active and being activists. From its origins in the efforts of small shareholders not to be overlooked, the evolution of shareholder activism has resulted in institutional investors ousting management, changing a firm’s strategic direction, or altering a company's direction. With the addition of activist hedge funds to the mix in the past few years, some writers such as Lipton (2008) now see a condition in which shareholder activism is on steroids.
Naming and shaming
The practice of naming and shaming began in the United States during the 1940s when a change in securities regulation gave shareholders the right to offer resolutions for consideration at corporate annual meetings. However, there were restrictions: proposals had to be "proper subject for action by securities holders" (for elaboration, see Gillan & Starks, 2007, p. 56). In the 1970s, many such resolutions were the product of a handful of "gadfly" investors, private investors including Lewis and John Gilbert and Evelyn Davis. These “gadfly” investors demanded higher dividends or other shareholder-friendly changes in company policy through a combination of direct agitation at annual meetings and skillful use of the media to publicize their efforts. Other activists came from religious groups and from those espousing political causes, often adopting the techniques of the gadflies (Marens, 2002).
In the mid-1980s came the addition of research-led programs, backed by pension funds and other institutional investors to seek out underperforming companies and effect changes in direction. Robert Monks used his LENS asset management company and his research firm Institutional Shareholder Services to identify issues with corporate governance practices in companies. He built coalitions of investors including large, public-sector pension funds such as the California Public Employees Retirement System (CalPERS) to demand changes from corporate managements as well as legislative and regulatory actions that would give shareholders a bigger say in setting corporate policy and selecting directors.
Ward, Brown, and Graffin (2009) found that naming and shaming poor performers had an effect on share prices, as institutional investors reacted to a reputable signal, in their case, the Council of Institutional Investors and its focus list. But, they found the investors' reaction was less pronounced in the case of companies with boards that were seen as independent of management. Those boards responded to the signal by changing management incentives to favor a change in direction.
These efforts are often confrontational as these activists frequently use the media to challenge corporate decisions and muster support for their positions from other investors. By contrast, much of this form of shareholder activism in Europe takes place behind closed doors. Asset managers occasionally join together to discuss issues with companies in their portfolios. Asset managers, however, must bear in mind the rules about not acting so closely together that they might be deemed to be "acting in concert" and thus be forced to make a takeover bid. The Association of British Insurers and the
National Association of Pension Funds in the United Kingdom, whose members have investments in financial markets around the world, will sometimes organize meetings with company executives and directors to seek to resolve issues or change the board's thinking. Seldom do these encounters reach the glare of public attention. "If our engagement ever reaches the front page of the Financial Times," one pension fund manager states, "that is because it has failed" (in a private conversation with the author).
A somewhat different approach can be seen in perhaps the most vocal of European investment institutions, Hermes. Similar to CalPERS, the U.K. asset management firm Hermes, owned by the old British Telecommunications pension fund and the largest pension fund manager in the country, set up a special unit to conduct activist campaigns. Because of its size and its actuarial needs, Hermes invests across the entire U.K market. Hermes justifies its activism as the only way to improve the performance of its investments. Again like CalPERS, Hermes has a subsidiary to target underperforming companies, takes very large stakes, and then presses management for changes in policy and personnel − often in private but occasionally in public. A study of Hermes’ performance by (Becht, Franks, Mayer, & Rossi, 2008) shows abnormally high returns on its portfolio through engagement activities. The lesson: activism pays. Its success in the United Kingdom led Hermes to move into continental European and U.S. markets.
Hedge fund activism
Actions such as those undertaken by CalPERS and Hermes became in many ways the model for a new form of shareholder activism. Activist hedge funds use detailed analysis of a company's business to identify weaknesses. They then build large equity stakes to force management to listen. The biggest difference between the older-style activists, such as Monks and his allies, and the newer-style activists, such as hedge funds, is that the hedge funds exploit very high leverage. They also build positions in options and other derivative instruments that traditional asset managers would not be willing or allowed to use. As a result, hedge funds potentially seek policy changes designed to affect shorter-term performance than their more traditional counterparts. This short-term orientation frequently allows the popular press to portray hedge funds as rapacious. In Germany, a politician once likened them to "locusts" (see the section on "Shareholder politics and markets" below). Are hedge funds, especially the activist
ones, the devil described in popular accounts? They may be aggressive, but do they justify the fear that corporate managers often show?
In the United States, Klein and Zur (2006) find that hedge funds took quite a different activist approach than traditional activist investors. Instead of targeting underperforming companies and seeking changes in direction, these funds sought to extract cash from generally well performing companies.
Activist strategies among hedge funds have gained support, albeit based on data during the heady days in investment markets in the mid-2000s. Brav, Jiang, Thomas, and Partnoy (2006) find hedge funds working in ways often prescribed to large blockholders: friendly interaction with management in striving for better financial performance. At other times, hedge funds may confront management that they see as entrenched. Importantly, Brav et al. find that the performance improvements they sought persist after the hedge funds had exited their positions. As Brav et al. (p. 37) note, "Unlike traditional institutional investors, hedge fund managers have very strong personal financial incentives to increase the value of their portfolio firms, and do not face the regulatory or political barriers that limit the effectiveness of these other investors."
Clifford (2008) reports that target companies of hedge funds pursuing activist agendas perform better than a control group of investments that hedge funds passively held. But Clifford's evidence suggests that the funds seek a greater liquidity buffer for activist portfolios. That is, the lock-in periods for activist funds are typically longer than the lock-in periods that the hedge funds manage without engagement. By examining the record of voting, litigation, and change of control contests, Partnoy and Thomas (2006) find that hedge-fund activism is more effective in inducing change in corporations than engagement by traditional institutional investors.
Moreover, Haarmeyer (2007) believes that activism by hedge funds has accelerated the distribution of corporate cash in mature businesses, through dividends and share buy-backs. According to Haarmeyer (p. 38), "Hedge fund activists become catalysts for initiating and helping to execute the painful but critical process that moves resources into more productive uses and thus drives shareholder value creation and economic prosperity."
Issue-based activism
A more limited form of activism comes in agitation over particular issues either in corporate policy or in company law and regulation. A topical case is the growing calls for new ways to address the persistent problem – as seen from the perspective of investors – of giving shareholders a "say on pay" of senior management. Since 2002, shareholders in the United Kingdom have had an advisory vote on compensation policy, an example where "voice" has made some difference. Practitioners argue that such efforts – copied in some other European and Australian jurisdictions and a matter of heated debate in the United States – could undermine the board's discretion in setting pay levels. Keith Johnson, a former Wisconsin state pension fund manager, and Daniel Summerfield from USS, the U.K.'s second largest pension fund, argue that giving shareholders a direct voice on pay should empower the board, rather than undermine it. As Johnson and Summerfield (2008, p. 3) remark, "Say on Pay leaves boards with full control over executive compensation while giving them increased support for a display of backbone when needed! … Muddling through is no longer an option." Johnson and Summerfield see the move at many U.S. companies for majority voting, instead of plurality voting, as a step to create greater shareholder voice on pay. A study of the outcome of the U.K. experience by Ferri and Maber (2008) gives a more qualified view of the success that shareholder votes on pay might have on the level of executive pay. Their analysis suggests that say-on-pay increased the sensitivity to pay levels of executives in poorly performing companies, and especially among those that had high compensation before introduction of the law. Still, giving shareholders a voice had little effect on the overall levels of pay.
Giving shareholders greater rights is only one part of the activist equation. For a