The “meh” economy that accounts for some of the sourness in the American electorate is partly due to a design flaw in the US corporate governance system. One proffered diagnosis is that companies invest for the short term and are too quick to return cash to shareholders through stock repurchases. Why? It’s the attack of hedge funds, shareholder activists looking for short term gain even at the expense of investments that would produce higher returns over the long run, and, along the way, would lead to employment gains and then wage gains. What follows, then, is a prescription for changes in tax policy and legal rules that would hamper the activists, all to promote the “long run.”
But this is a misdiagnosis, which fails to realize that the shareholders activists’ success reveals a major shortfall in corporate governance for large public corporations. Let’s start with this fact: When we examine the behavior of institutional investors who are the majoritarian stockholders of the largest public firms, we learn that the same investors who purportedly follow the activists’ siren song for the “short term” also turn over large sums to venture capital firms and private equity for investment in promising companies over a ten year commitment period. This is the very definition of long term investing.
What accounts for this anomaly? It is that the board of a large public company, as presently constituted, cannot credibly evaluate management’s strategy or respond to activist criticisms of that strategy. The current model of corporate governance is a product of academic thinking of the 1970s, which produced the “monitoring board” staffed by “independent directors” whose main source of monitoring capacity is the stock price performance of the company over time and compared to peers. These directors are decidedly part-time; relying on information supplied by management and stock market prices, they are “thinly informed.” In its time, this model of board governance was an advance and suited the needs and capacities of dispersed shareholders.
Ratchet forward 40 years. Ownership of large public companies is now re-concentrated in institutional investors – pension funds, mutual funds, insurance companies — which have the capacity to evaluate competing strategic alternatives for portfolio companies. Now turn to an activist’s campaign, which starts with a claim that the current management is making serious operational or strategic mistakes, reflected in the company’s underperformance. Institutional investors have the voting power to determine the outcome; how should they respond? To start, institutions increasingly have come to understand the activist is sincere in its belief about problems at the “target,” since it has made a significant upfront investment and has a business model that depends upon repeated successful engagements.
The counter-pitch comes from incumbent management, which almost certainly will want to defend its strategy and its continued tenure. How is the institutional investor to resolve this dispute? Even if institutions are disposed to favor management, an information-rich counterplan by a credible activist – a thick power-point slide deck – may well open up serious questions.
Here is where the current board model runs into its limitations: The thinly informed independent director has no answer to the activist’s counterplan and thus is not a credible adjudicator for the institutional investor. That is, given the present board model, the institutional investor cannot say, “we know management is biased, but the directors, who have deep knowledge of the firm and the industry, have looked closely at the activist’s counterplan and have rejected it, and therefore so should we.”
Reform should move not in the direction of closing down the activists who are bringing the news about this design flaw. Rather we should develop a new role for the board: credibly evaluating and then verifying that management’s strategy is best for the company (or making changes if it is not). Boards need directors who will have that credibility, which is won through deep knowledge about the company and its industry and an appropriate time commitment. Venture capital and private equity firms attract funds for long term investing because they provide a different style of corporate governance that includes directors who are engaged and knowledgeable. Such “thickly informed” directors provide “high powered” monitoring of managerial performance. They enable investors to trust that the firm is pursuing a planning horizon that is suited to its genuine opportunities, “right termism.” Public corporations will be better run if their boards are staffed by directors with such capacities.
In short, the present wave of shareholder activism shows us that the current corporate governance infrastructure is creaky, a swaying bridge that needs renewal. To cast this as a debate over “short term” vs. “long term” misunderstands a genuine problem.
The preceding post comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia Law School and Co-Director of the Millstein Center for Global Markets and Corporate Ownership.