"Shareholder Activism: The Good, the Bad, and the Ugly"
New York, NY
April 21, 2006
** As Prepared for Delivery**
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I'm delighted to be here today at an Equities magazine conference. Editor Robert Flaherty has been referred to as the Mark Twain of the American capital markets-funny, blunt about the risks of investing in emerging companies, and basically optimistic about the range of possibilities offered by our entrepreneurial country.
Today, I'm going to talk about shareholder activism, and you might say that the Chamber's attitude toward the subject would fit right in on the pages of Equities magazine. Here is why:
- We're discriminating: We know that not all forms of shareholder activism are alike.
- We don't take things at face value: We see some stupid things masquerading as reform, and we'll talk about the dangers of that in a minute.
- Yet, we are basically optimistic: We think that engaged, vocal investors are good for American business.
Let's start with a little history. As we all know, shareholder activism was given a big push forward by the watershed event that was Enron. But its root cause was something that's been brewing for at least two decades: a spectacular broadening of the investor class, as more Americans have become investors. Today, about half of all households-57 million in all-own stock directly or through mutual funds. That's nearly double what it was just 16 years ago.
Increasingly, what was once a country of wage earners is now a country of citizen investors. Corporations are no longer viewed merely as sources of jobs. They are seen as sources of value.
Think of the implications. We don't just plan for retirement with 401(k)s and IRAs. We plan for medical expenses with Health Savings Accounts and for our children's education with 529 College Savings Plans and Coverdell accounts—all of which can be invested in the markets.
So-to put it mildly-a lot more people are a lot more interested in market performance than ever before. And we've got the Internet, 24-hour TV news, and the whole explosion of the financial media to feed this interest.
At the U.S. Chamber of Commerce, we recognize what this revolution means. Our role is not just to advocate for business. We have to advocate for value.
And when we see changes that businesses need to make, we point them out. We recognize the need for greater transparency and smart corporate governance. We support intelligent regulation that gives investors confidence in the quality of information they are given. For example, in November, we launched a commission on the capital markets to find ways to update a regulatory structure that dates from the 1930s.
Greater public involvement in markets has put pressure-I view it as positive pressure-on all companies to maximize performance for their owners. And by performance, I mean the real common denominator. The one that unites every single owner, whether he or she is the heir to a great fortune or the hardworking wage earner who's socked away a few dollars in an IRA: Return on investment.
In its best form, shareholder activism aims squarely at improving returns on investment. In its worst form, it actually reduces those returns-but let's start with the good.
As I see it, shareholders are doing businesses a big service by demanding three types of reform.
One: Information should be made available to all investors so that they can make the best possible decisions. At the Chamber, we support the goal of electronic delivery of proxy and other investor relations documents. We are also behind the adoption of XBRL, which stands for extensible business reporting language, as an open standard for financial reporting, because it will make cross-market analysis so much easier for investors.
Two: Managers should focus on the long-term value creation that benefits Main Street over the short-term earnings management that pleases Wall Street. As I have said many times, quarterly earnings guidance is a bad idea. Why? Let me tick off a few obvious reasons.
- Quarterly profit predictions narrowed down to a penny or two per share don't say much about a company's long-term prospects.
- It's against the law to manage earnings-if you still do it and it ends up costing the stockholders money, you can get socked by class action lawsuits. These suits are a net loss for everybody-except the lawyers.
- It's bad for the long term. If managers starve R&D or marketing to keep short-term profitability up, they imperil the long-term future of their companies. Today's investors should expect long-term value creation and that requires long-term strategy.
Which brings me to the third area of smart shareholder activism: The demand for greater transparency about strategy. Regulation FD was set up to keep companies from giving crucial information to just a handful of investors. But because of the way the rule was written, every public utterance by a corporate official can become grounds for some future SEC lawsuit or criminal prosecution. The effect of Regulation FD was not more disclosure-but less of it. We need sensible disclosure rules that allow managers to talk candidly with investors without fear of being sued.
Greater shareholder involvement may make some managers uncomfortable in the short term, but on balance, companies are more responsive as a result, and that helps America's economy grow even faster. So I'd like to define this kind of shareholder activism as "pro-value."
But there is another kind of shareholder activism that reduces returns. I call it "anti-value." While it uses the language of investor capitalism and waves the banner of shareholder democracy, this kind of activism is, in fact, an anti-democratic, anti-markets approach to investment.
If pro-value activism promotes public involvement in markets, anti-value activism reduces it.
If pro-value activism raises returns, anti-value activism lowers them.
Anti-value activism is the act of saying "I'm shaping this company up," while you're actually shaking it down.
How can you recognize this kind of activism? It tends to take a few distinct forms.
First, it often involves trial lawyers. Everyone here is familiar with these product liability cases that have little merit but end up costing companies millions to settle. We have the same thing in securities litigation, where frivolous class action lawsuits are filed alleging that a stock fell because company management made false statements about its prospects. But here's the crazy thing: When the lawsuit is filed, the stock price usually falls again-costing the company's shareholders even more. No wonder most companies settle rather than fight. The bad publicity from a messy courtroom drama is often worse than the cost of settling. Either way, less is left over in the company treasury for dividends, buybacks, or earnings, all of which would help shareholders. So who benefits from all the legal work? The trial lawyers, not the investors.
Let's talk about the second value killer: Government overinvolvement in financial markets. Government agencies in Washington and in all 50 state attorneys general offices are able to mobilize armies of career attorneys to investigate and indict businesses. I want to be clear about the role of these government lawyers: If there's clear evidence of real unethical or truly illegal conduct, the government should pursue the perpetrators with vigor. But as with lawsuits, a criminal or civil indictment damages a company's valuation so much that many executives settle as quickly as possible, whether they have done anything wrong or not. State attorneys general sometimes publicly threaten criminal prosecution if the company doesn't pay a fine or fire its management-a form of extortion that has no place in our legal system.
Do investors gain anything from this? The state of New York has collected tens of millions of dollars in fines, but we can't be sure where those dollars have gone. One thing is for certain: They did not go into the pockets of shareholders who suffered losses.
What's worse, in a way, is what all this litigation does to long-term value creation. Because of the 20-20 hindsight that these litigators practice, CEOs and corporate boards are more reluctant to take the kinds of risks that produce long-term growth in companies and our economy. It's become so risky just to sit on a corporate board that many outstanding individuals are simply declining to serve. A number of companies have decided that being a publicly held corporation-with all the regulatory and litigation headaches-is not worth it. They would rather go private. Is this good for our growing investor class?
Let's talk about the third area of value destruction: Investors who will do anything-including breaking the rules-to make a buck. Hedge fund and private equity investors are a valuable and growing industry-they are creating pools of capital that help many companies grow. But a small minority of these investors spend a lot of time pressuring management to do things that are antithetical to long-term value. Some push to take on lots of debt so that companies can pay special, one-time dividends. Some press for spin-offs or sales of assets that should stay in the company's fold. Sometimes rumor campaigns are started that drive down stock prices.
Bottom line: Such investors have their own objectives, their own agenda, and they're not necessarily out there to help you.
Then there are short sellers who use fraud and rumor to drive down the value of companies. They do this while claiming to be shareholder activists. I want to be clear that I am not challenging the legitimate use of the short sale. If you think a company is overvalued and are willing to bet its shares will fall, fine-that's a time-honored and legitimate investment strategy.
But if you feed bad information to regulators or the financial media or Internet chat rooms-that is not activism. It is fraud. And it's more common than you think.
Today, I want you to focus on one more type of anti-value activist-and I want to tell you how to fight back. Right now, investors are getting shrink-wrapped packages from companies containing proxy ballots. Many investors simply toss these materials away, figuring that the stock price is the thing that matters most in evaluating a company. But proxy battles are serious business-and increasingly, they are the weapons being used by labor unions or other special interest groups to advance their own objectives.
Not all proxy battles are created equal. Some are about value. Take the proxy fight over Hewlett-Packard's acquisition of Compaq-that probably passes this test.
But many times, proxy battles represent a power grab that hurts every other investor in the company.
Let me tell you about a particularly glaring incident. In 2004, CalPERS, the nation's largest public pension fund took a lead role in an attempt to oust from Safeway the supermarket chain's chairman and two of its board members. At the time, CalPERS said its sole concern was to eliminate conflicts of interest and improve corporate governance.
But CalPERS had its own conflicts of interest. CalPERS' president was a union official who had personally organized and hosted rallies against Safeway during a labor dispute. In fact, 11 of CalPERS 13 board members were union members, union officials, or government officials who received or solicited contributions from unions.
So, who was CalPERS working for in its proxy battles? For the retirees and California taxpayers for whom it had a fiduciary duty to generate the best possible returns? Or for organized labor? Ultimately, the truth came out. But it does not always.
More recently, union and public pension funds have taken to peppering companies with a whole host of shareholder resolutions designed to further their own political and economic agendas. Sometimes they have even worked with the trial bar to propose resolutions that push companies to settle lawsuits.
They have also taken up the banner of "majority voting." Do you know what that is about? I can tell you that it is not about democracy. It is about a few groups who hold chunks of stock on behalf of retirees who want more leverage to push social and political objectives. I wonder how many of these groups actually ask the retirees how they want their shares to be voted.
Increasingly, powerful public pension funds are using proxy battles to achieve what they could not win at the bargaining table: pro-union policies. These policies may be good for unionized workers, but they do not produce one cent of added value for the other shareholders. If they did, they would have been adopted long ago.
I should note that some union pension funds do pursue their objectives in a reasoned and responsible way. We may disagree frequently with union leaders on several issues, especially when it comes to their proposals that are anti-value, but on some matters, we can have a fruitful dialogue.
For example, we have had very positive discussions with the Carpenter's Union on issues relating to executive compensation. We don't always agree-but that isn't the point. The point is whether activism is really intended to make companies better and add value-or whether it is just designed to score points in the media and advance one agenda over everyone else's.
Anti-value activists would be less successful if it were not for a unique quirk in the proxy process. As it turns out, the gatekeeper, bookkeeper, and goalkeeper for virtually the entire proxy process in America is controlled by one entity that has wrapped itself completely in the mantle of shareholder rights. I am speaking of Institutional Shareholder Services, a self-appointed expert on proxy battles and matters of corporate governance.
Although there are other proxy research services, such as Glass Lewis, ISS is so dominant that its opinion on any given proxy vote is, in effect, the default position for the entire securities industry. If you are a mutual fund manager, you're not obligated to vote with ISS-but you'd better be prepared with a thought-out explanation for why you didn't, because those are the rules.
ISS has even cemented its virtual monopoly with an electronic proxy voting platform that is used by an increasing number of mutual and pension funds-and votes their shares with its own views.
If you are going to set yourself up in this way as prosecutor, judge, jury, court clerk, and stenographer for all matters of corporate governance, you had better be above reproach yourself. But ISS works all sides of the fence here to make a buck. ISS is a private business that does more than just advise shareholders on which companies need to be shaken up by a proxy challenge. It also advises companies on how to raise their governance ratings-so they avoid proxy battles in the first place.
Imagine if the Stanley Kaplan test prep agency not only ran a course training high schoolers how to take the SATs, but also designed the tests, scored them, and then decided who gets into which college. You think college seniors would feel a bit more obligated to enroll in Stanley Kaplan courses?
In effect, ISS does the same thing. We have a term for this in America: It's called a shakedown.
At the U.S. Chamber, we don't often find ourselves in the position of pushing for more regulation. However, when a monopoly has asserted near-total control over a wide range of our economy, with huge implications on our financial markets, economic growth, and household wealth, shouldn't someone be asking questions?
Some people will say it's disingenuous to complain about some forms of shareholder activism while welcoming others. But I disagree. The anti-value crusaders are not real shareholder activists. They have simply borrowed the vocabulary and mechanics of shareholder activism to suit their needs.
What the pseudo-activists are giving us is not more shareholder democracy, but less.
If U.S. financial markets become known throughout the world as the playground of union-run pension funds, trial lawyers and government litigators, and not as a place for value creation and returns on investment, capital will stop coming here. It is already happening: In 2005, 9 of the largest 10 IPOs globally were launched outside the U.S. Out of the top 25, 23 went overseas.
Here is what I see happening if we do not act: The cost of capital will rise. Businesses won't grow as quickly. Neither will jobs or wages. And neither will the 401(k)s, IRAs, HSAs, and 529 College Savings Plans of 84 million Americans.
Shareholder activism that works toward the same goals these 84 million people share-a better return on investment-will always be good for America's economy. But shareholder activism that elevates one group's agenda over the goals of other investors doesn't just ruin companies-it ruins a country.
How do we end this madness? Remember what shareholder activism is all about-the demand for value and the right of all shareholders to be treated equally. There is an expression in journalism-when your mother tells you that she loves you, check it out. So when someone tells you that a CEO is no good, check it out. Maybe he or she is a bum-but maybe the person whispering in your ear has another motive for spreading bad advice. If some hedge fund says a company's board needs to be shaken up, check it out: Are they still long in the stock? When someone says your company needs a new labor policy, check it out: Who says?
In other words, use the same analytical skills on proxy battles and corporate governance disputes that you use when you look at a company's balance sheet or earnings statement. Don't just assume ISS or someone else is looking out for your interests. They have their own agenda - and it isn't yours. Scrutinize proxy proposals just like you would scrutinize a proposed merger or a new product launch.
Do you, as an owner, want to be part of something that kills long-term value? Of course not-yet that is what many investors are doing every day when they let ISS and others vote their shares. They are standing by as a company's value-their company's value-is getting bludgeoned.
We all get those shrink-wrapped proxy ballots in the mail. We all know it's a pain to look at them, one-by-one. But check them out and pay attention. Make sure that someone isn't trying to force a company you own to adopt one of their pet policies. Make sure your company's managers are always focused, first and foremost, on the creation of value. After all, that's the definition of shareholder activism.