The Subversion of Shareholder Democracy and the Rise of Hedge-Fund Activism

Hedge fund activists are technically just minority shareholders, yet they exert enormous influence, often forcing companies to undertake fundamental restructuring and substantially increase stock buybacks and dividends. For instance, Third Point Management and Trian Fund Management, holding only 2 percent of the outstanding stock of Dow Chemical and DuPont, respectively, engineered a merger-and-split of America’s top two chemical giants at the end of 2015 that resulted in massive layoffs and the closure of DuPont’s central research lab, one of the first industrial science labs in the United States. How did hedge-fund activists gain such power?

In the 1980s, predatory value extraction was the province of corporate raiders who flexed their muscles by becoming major shareholders of target companies and staging hostile takeovers. This mode of value extraction was highly risky in two respects. First, the raiders needed to raise substantial amounts of money to purchase enough shares to plausibly threaten to take control of their targets. Second, they frequently faced legal battles with management or incumbent shareholders, because nothing less than control of the company was at stake. Being able to influence corporations without taking those risks would be a corporate raider’s dream.

In the late 1980s and 1990s, this dream became a reality. Driven by a clamor for “shareholder democracy” amid a rapid increase in institutional shareholding of public corporations and broadening acceptance of the maximizing shareholder value (MSV) view, the U.S. government implemented regulatory changes that set the stage for hedge-fund activism

The first  changes were prompted by Robert Monks, who in 1985 set up Institutional Shareholder Services (ISS), the first proxy-advisory firm after  resigning as chief pension administrator of the U.S. Department of Labor (DOL). During his one year at the DOL, Monks tried to make proxy voting compulsory for pension funds, advocating for the notion that the funds should be responsible corporate citizens and exercise their power over management.[1] In 1988, his former DOL colleagues issued the so-called Avon Letter to establish proxy voting as a fiduciary duty of pension funds. Compulsory voting of proxies was later extended to all other institutional investors, including mutual funds, under an SEC regulation in 2003.

Monks and his disciples justified the changes under the pretext of “shareholder democracy,” which, however, was all but irrelevant to proxy voting. A political project that began in the early 20th century, shareholder democracy was intended to increase public trust of corporations and create social cohesion by distributing shares to retail investors who were U.S. citizens. Institutional investors were simply considered money-managing fiduciaries that, not being citizens, had no role  in shareholder democracy.[2] Moreover, voting in most countries is not compulsory, but Monks and his followers cited shareholder democracy to justify making  the voting of proxies a fiduciary duty for institutional investors.

The consequence was a huge vacuum in corporate voting.  Institutional investors were mostly uninterested in doing it, and shares were, in any event, increasingly held by index funds. Institutional investors began to rely heavily on proxy-advisory firms, which were no more competent than the institutional investors at voting and, as for-profit entities, were prone to conflicts of interest. Some large mutual funds and pension funds, responding to criticism of simply outsourcing voting decisions, have set up internal “corporate-governance teams” or “stewardship teams.” However, these teams are understaffed and have been accused of paying little attention to the issues up for vote at individual companies.[3] Hedge-fund activists have been able to exploit this situation by influencing the proxy-advisory firms ISS and Glass Lewis, which claim about two-thirds and one-third of the market, respectively, as well as the corporate-governance teams of mutual funds and pension funds.

The second set of regulatory changes came in 1992 and 1999 to proxy rules and allowed “free communication and engagement” among public shareholders, between public shareholders and management, and between public shareholders and the general public. The changes ostensibly aimed at correcting an imbalance between public shareholders and management by making it easier for minority shareholders to aggregate their votes. By that time, however, the balance of power was already skewed sharply toward public shareholders. Institutional shareholding of U.S. stock approached 50 percent by the early 1990s and, by 2017, reached nearly 70 percent. The proxy-rule changes further strengthened the power of public shareholders by allowing them to form de facto investor cartels and freely criticize management. Hedge-fund activists formed “wolf packs” to bank together in campaigns against target companies.

A third set of regulatory changes allowed hedge-fund activists to gain even more power and stemmed from the 1996 National Securities Markets Improvement Act (NSMIA). Part of the financial deregulation that followed the Clinton administration, NSMIA allowed hedge funds to pool unlimited financial resources from institutional investors without having to disclose their structure or avoid overly speculative investments.[4] This resulted in  co-investments between activist hedge funds and institutional investors. The California Teachers Retirement System (CaLSTRS), for example, cooperated in Trian Fund’s campaign against DuPont and, as it turned out, was both, a long-term investor in DuPont and a major investor in Trian.

In combination, these regulatory changes increased predatory value extraction in the U.S. economy. For more than a decade, major public corporations have routinely disbursed to shareholders nearly all their profits, and often more than their profits, in the form of stock buybacks, dividends, and deferred taxes while investing less and restructuring simply to reduce costs. It is now increasingly rare for management to reject hedge-fund activists’ proposals and risk a showdown at a shareholder meeting. As Steven Davidoff Solomon points out, “companies, frankly, are scared” and “[their] mantra … is to settle with hedge funds before it gets to a fight over the control of a company.”[5]

Misguided regulation should be reversed or recalibrated. Following are some  suggestions for reform in U.S proxy voting and shareholder engagement to encourage sustainable value creation and value extraction.

First, the SEC should require  shareholders to show how any proposals they submit would create value and promote capital formation for the corporation. Second, voting should not be be a fiduciary duty of institutional investors. Compulsory voting merely grants power to proxy-advisory firms and hedge-fund activists.

Third,  regulatory authorities should allow differentiated voting rights that favor long-term shareholders. Fourth, the SEC should require shareholders and management to publicly disclose what they have discussed in engagement sessions. Free engagement has been reserved to a restricted number of influential investors who communicate in private.

Fifth, hedge funds should be subject to the same regulations imposed on institutional investors, because they are already big enough to pose systemic risks to the economy. Since the passage of the NSMIA in 1996, hedge funds have managed a large portion of institutional investors’ funds for the benefit of their ultimate customers, who include ordinary workers and pensioners. There is no plausible reason why hedge funds should be treated as private entities and freed from due financial regulations when they are functioning as surrogate institutional investors.

ENDNOTES

[1] Rosenberg, Hilary (1999), A Traitor to His Class: Robert A.G. Monks and the Battle to Change Corporate America, John Wiley & Sons.

[2] Ott, Julia (2011), When Wall Street Met Main Street: The Quest for Investors’ Democracy, Harvard University Press.

[3] Craig, Sussane (2013), ‘The Giant of Shareholders, Quietly Stirring’, The New York Times, at http://www.nytimes.com/2013/05/19/business/blackrock-a-shareholding-giant-is-quietly-stirring.html.

[4] Dayen, David (2016), ‘What Good are Hedge Funds?’, The American Prospect, at http://prospect.org/article/what-good-are-hedge-funds.

[5] Solomon, Steven Davidoff (2015), ‘Remaking Dow and DuPont for the Activist Shareholders’, The New York Times, at https://www.nytimes.com/2015/12/16/business/dealbook/remaking-dow-and-dupont-for-the-activist-shareholders.html?_r=0.

This post comes from Jang-Sup Shin, economics professor at the National University of Singapore and a senior research associate at the Academic-Industry Research Network. It is based on his working paper for the Institute for New Economic Thinking, which is in turn part of his forthcoming book with William Lazonick on predatory value extraction, available here.

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