Tuesday, March 22, 2011
The Appearance of Reality: Shareholders & Ownership
This is the second post in my effort to clarify corporate governance terms that now seem misleading to me. We all know what these words mean in a literal sense but in the context of governance, of business and of our post-crash world do they still mean the same thing?
I look forward to your comments.
What does it mean to be a shareholder or owner in 2011?
Adolph Berle wrote 80 years ago about “...the dissolution of the old atom of ownership into its component parts, control and benefit ownership.” Very crudely this means there are owners who only want a return on their investment and there are owners who want to have a say in how their investment is used.
These two very broad umbrella categories cover a myriad of interests held by owners. Ira Millstein’s telling metaphor describes shareholders as a zoo comprised of animals with very different dispositions and appetites (Charkham Memorial Lecture, 2008). Like any other cross section of society, owners are a diverse group with diverging (and conflicting) interests. And, since modern ownership sometimes amounts to short term holdings managed by computer algorithms, people do not always see themselves as owners (indeed, even if they ever know of this “ownership”).
The Delaware Chancery Court has recently identified two different categories of shareholder – arbitrageurs and the rest – in holding that the board acts correctly in serving the interest of the rest (Air Products v. Airgas). In my opinion, if a court is at liberty to decide which category of shareholder a director is obligated to serve, the disciplining impact of “hostile takeovers” is diluted significantly.
Under the present conditions where shareholders do not share a common interest - indeed, their interests may be diametrically opposed - the traditional pillar of corporate law and governance that accountability to ownership is the duty of management must be crumbling. And without the involvement of active and engaged shareholders, the entire corporate system lacks its basic foundation.
Where there is no identifiable group on whom to focus the fiduciary responsibilities of management, a new basis for corporate legitimacy is needed.
Here are my questions:
1. What do owner and shareholder mean in regards to corporations and governance?
2. Can we lump all stock owners together or do we need multiple classes of stock to accommodate owners with different levels of interest and participation?
3. To whom does management owe fiduciary duty when considering the interest of owners? Does having one class of ownership work in management’s favor because it keeps shareholders from ever truly working together to enact change?
4. How can you have “shareholder responsibility” when there is no possibility of shareholders having a common interest and working together. Because there are today so many different classes and categories of shareholders – arbs, derivatives, borrowed stock, etc – that common purpose is impossible.
March 22, 2011 in Disinformation
, shareholder activism
, ownership
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Right before the crisis the big discussion in corporate law at least in Europe was the one-share/one-vote principle. The Commission took steps to introduce a 1S/1V rule on pan-European basis, but in the end the idea was abandoned. We kind of thought that the 1S/1V would make European firms converge to the more efficient Angloamerican model of corporate governance, as they would have to abandon control enhancing mechanisms, among which dual class structures (particularly in Scandinavian countries) had a prominent position.
It seems that the crisis has revealed eventually that shareholders were actually part of the problem rather than victims. And I am not talking only about those shareholders that are empty voters, but also about the vast majority of shareholders who go long on the share they hold, but are short-termists and all they want is to sell, make a quick buck and leave. These shareholders cannot be deemed "owners"; they don't actually provide risk capital to the firm, since they buy the stock on the secondary market, they push for stock buybacks and thus from them the firm might actually have a net loss, rather than a net contribution of funds to finance its operations.
These shareholders of course might have all the right in the world to buy stock on the stock markets and even treat their shares as betting slips; capitalism has provided them with this right and is difficult to take it back. But, I do not see any reason why under some 1S/1V rule they should be placed in parity with other shareholders, who are invested in the firm for quite some time and have shown they care by being activists. Why should the former's voice have the same weight as the latter's? A corporation is no democracy like the real society, no matter what those, who just want to gain more power in the internal corporate affairs to make the quick buck, say. If it were democracy, then the dividend you'd get wouldn't depend on the number of shares you're holding. The vote attached to the share of the long-termist shareholder cannot count just as much as the vote attached to the share of the arbitrageur. Thus, they must be placed in separate classes. Long-termists can gain more influence in the firm's affairs, while short-termists won't be deprived of the right to treat the shares as betting slips, but at least they won't have their voice heard anymore. You can't have your pie and eat it too.
My concern though is that introducing a dual class structure, although a good policy, might have problems with fundamental principles of corporate law -at least in Europe- such as the principle of equal treatment of shareholders.
A dual class structure may also have problems to be applied in takeover situations in Europe due to the complexities of the Takeover Directive. Some years ago in the EU we introduced the Takeover Directive, which aspired to neutralize takeover defenses of listed corporations. "Multiple-vote securities", defined as securities of distinct and separate class carrying more than one vote each, were deemed to be a defensive measure. According to the Directive rules after the launch of a takeover bid the board has to seek prior authorization of the general meeting of shareholders for any defensive measure it intends to adopt in response to the bid. But, in this specific general meeting multiple-vote securities would only carry one vote each. Now if the bidder manages to acquire 75% of the stock with her bid, then in the first post-acquisition general meeting, which would decide for the removal or appointment of the new directors, multiple-vote securities would again carry only one vote. Member States were for the first time in history given the ability to opt-in or out of these rules. The first rule, the "board neutrality rule", which neutralizes multiple voting stock in the GM that decides on the adoption of a poison pill, is now adopted by most Member States, even by Sweden, the fortress of dual class structures. (Denmark however opted out). The second rule, the "breakthrough" rule, which neutralizes multiple voting stock in the post-bid general meeting, is only adopted by the Baltic states.
There is, therefore, a type of legal impediment in the introduction of dual class structures in Europe, as in essence they do not function within a takeover situation. Of course the non-adoption of the breakthrough rule by most States is still allowing some of the benefits of having a dual class structure, but if you want to create one class of let's say "ownership stock" for the loyal flesh-and-bone shareholders and the one class for the fungible or computer-selected shareholders, then the owners might end up being deprived of their enhanced voting privileges in a crucial moment of the corporate life, which is the takeover situation.
In addition to this, there is always the threat that the European Court of Justice might one day decide that these structures are impeding the free movement of capital within the EU, which is a constitutional fundamental freedom.
Dual class structures are a good idea, but on the one hand in the US they NYSE must be convinced to accept it as a structure and on the other hand the EU must correct a lot of things in its legal framework to be able to accommodate them. It's just not something that can be done right away.
It seems that the crisis has revealed eventually that shareholders were actually part of the problem rather than victims. And I am not talking only about those shareholders that are empty voters, but also about the vast majority of shareholders who go long on the share they hold, but are short-termists and all they want is to sell, make a quick buck and leave. These shareholders cannot be deemed "owners"; they don't actually provide risk capital to the firm, since they buy the stock on the secondary market, they push for stock buybacks and thus from them the firm might actually have a net loss, rather than a net contribution of funds to finance its operations.
These shareholders of course might have all the right in the world to buy stock on the stock markets and even treat their shares as betting slips; capitalism has provided them with this right and is difficult to take it back. But, I do not see any reason why under some 1S/1V rule they should be placed in parity with other shareholders, who are invested in the firm for quite some time and have shown they care by being activists. Why should the former's voice have the same weight as the latter's? A corporation is no democracy like the real society, no matter what those, who just want to gain more power in the internal corporate affairs to make the quick buck, say. If it were democracy, then the dividend you'd get wouldn't depend on the number of shares you're holding. The vote attached to the share of the long-termist shareholder cannot count just as much as the vote attached to the share of the arbitrageur. Thus, they must be placed in separate classes. Long-termists can gain more influence in the firm's affairs, while short-termists won't be deprived of the right to treat the shares as betting slips, but at least they won't have their voice heard anymore. You can't have your pie and eat it too.
My concern though is that introducing a dual class structure, although a good policy, might have problems with fundamental principles of corporate law -at least in Europe- such as the principle of equal treatment of shareholders.
A dual class structure may also have problems to be applied in takeover situations in Europe due to the complexities of the Takeover Directive. Some years ago in the EU we introduced the Takeover Directive, which aspired to neutralize takeover defenses of listed corporations. "Multiple-vote securities", defined as securities of distinct and separate class carrying more than one vote each, were deemed to be a defensive measure. According to the Directive rules after the launch of a takeover bid the board has to seek prior authorization of the general meeting of shareholders for any defensive measure it intends to adopt in response to the bid. But, in this specific general meeting multiple-vote securities would only carry one vote each. Now if the bidder manages to acquire 75% of the stock with her bid, then in the first post-acquisition general meeting, which would decide for the removal or appointment of the new directors, multiple-vote securities would again carry only one vote. Member States were for the first time in history given the ability to opt-in or out of these rules. The first rule, the "board neutrality rule", which neutralizes multiple voting stock in the GM that decides on the adoption of a poison pill, is now adopted by most Member States, even by Sweden, the fortress of dual class structures. (Denmark however opted out). The second rule, the "breakthrough" rule, which neutralizes multiple voting stock in the post-bid general meeting, is only adopted by the Baltic states.
There is, therefore, a type of legal impediment in the introduction of dual class structures in Europe, as in essence they do not function within a takeover situation. Of course the non-adoption of the breakthrough rule by most States is still allowing some of the benefits of having a dual class structure, but if you want to create one class of let's say "ownership stock" for the loyal flesh-and-bone shareholders and the one class for the fungible or computer-selected shareholders, then the owners might end up being deprived of their enhanced voting privileges in a crucial moment of the corporate life, which is the takeover situation.
In addition to this, there is always the threat that the European Court of Justice might one day decide that these structures are impeding the free movement of capital within the EU, which is a constitutional fundamental freedom.
Dual class structures are a good idea, but on the one hand in the US they NYSE must be convinced to accept it as a structure and on the other hand the EU must correct a lot of things in its legal framework to be able to accommodate them. It's just not something that can be done right away.
The scope of “fiduciary duty” has become complicated in recent times. In several states, borrowing from Delaware, there is no duty of care, so the question as to whether duty is owed to the corporation or to shareholders is in that context moot.
In all situations, fiduciary duty requires the trustee to resolve conflicts of interest in favor of the beneficiary, whether that is considered to be a shareholder, a class of shareholders or the corporation, itself. This is the area where we should expect development in the years to come.
Notwithstanding the unmistakable language in ERISA speaking of fiduciaries’ whose “sole” duty is to steward for “the exclusive benefit” of plan participants, the modern conglomerate financial institution is riddled with conflicts of interest due to the many business functions it discharges with companies, whose shares are held in fiduciary portfolios.
In many cases, the conflict of interest is not only theoretical, it is real. Simply consider the circumstances of Deutsche in the notorious Hewlett Packard Compaq merger situation. There have been virtually no enforcement actions by government and very few derivative litigations on the private side.
In all situations, fiduciary duty requires the trustee to resolve conflicts of interest in favor of the beneficiary, whether that is considered to be a shareholder, a class of shareholders or the corporation, itself. This is the area where we should expect development in the years to come.
Notwithstanding the unmistakable language in ERISA speaking of fiduciaries’ whose “sole” duty is to steward for “the exclusive benefit” of plan participants, the modern conglomerate financial institution is riddled with conflicts of interest due to the many business functions it discharges with companies, whose shares are held in fiduciary portfolios.
In many cases, the conflict of interest is not only theoretical, it is real. Simply consider the circumstances of Deutsche in the notorious Hewlett Packard Compaq merger situation. There have been virtually no enforcement actions by government and very few derivative litigations on the private side.
The Model Business Corporations Act of the United States clearly states (as in the UK and Canada), "Each member of the board of directors, when discharging the duties of directors, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation." (see http://is.gd/R5vWYC)
The courts, on the other hand, have interpreted this provision of the law in a variety of ways, which has led to so much confusion about to whom directors owe their fiduciary duties.
However, the question of directors' fiduciary duties is distinct from the question of distinguishing between shareholders and owners. I think Roger Martin puts it best when he says "The only shareholder to whom the CEO owes anything is the shareholder who provided capital to the company." in his HBR Blog posting "Why CEOs Don't Owe Shareholders a Return on Market Value" (see http://is.gd/RPyX5K).
The courts, on the other hand, have interpreted this provision of the law in a variety of ways, which has led to so much confusion about to whom directors owe their fiduciary duties.
However, the question of directors' fiduciary duties is distinct from the question of distinguishing between shareholders and owners. I think Roger Martin puts it best when he says "The only shareholder to whom the CEO owes anything is the shareholder who provided capital to the company." in his HBR Blog posting "Why CEOs Don't Owe Shareholders a Return on Market Value" (see http://is.gd/RPyX5K).
Ah, but is that the thing to which managers owe a fiduciary duty? In UK company law, the directors of a company have a duty to the company, the corporate entity, not to individual shareholders. Arguably, that should give a longer term focus to directors. For managers, they have contractual duty to their employer, again, the corporate entity. Still, very interesting questions raised here.
I need to reflect further on the phenomena of “ownership by index or algorithm” which accounts for some 30% of the total. These shareholders are preponderantly financial conglomerates acting in a fiduciary capacity. Arguably, they are permanent shareholders. The elements of solution are to hand: an identifiable discrete large enough group with enforceable fiduciary responsibilities. A starting point would be serious enforcement of fiduciary law requiring the primacy (or, under ERISA, the uniqueness) of the obligation owed to beneficiaries.