While the topic of last week’s fourth SEC-NYU Dialogue on Securities Markets was shareholder engagement—focusing on the roles of institutional and activist investors— the real hot topic was the recent letter to CEOs from BlackRock’s Laurence Fink, which was at least mentioned on every panel.
In his annual letter, Fink articulates the view that governments have not been up to the task, with the result that “society increasingly is turning to the private sector and asking that companies respond to broader societal challenges…. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.” [Emphasis added.]
What does that mean in practice? According to Fink, among other things, a company should consider its role in the community, its management of its environmental impact, its efforts to create a diverse workforce, its ability to adapt to technological change and take advantage of new opportunities, its retraining programs for employees in an increasingly automated world and its efforts to help prepare workers for retirement. But these goals are not just goals in and of themselves; they have a larger purpose. In the absence of this larger sense of purpose, Fink contends, companies will simply “succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to the investors who depend on it to finance their retirement, home purchases, or higher education.”
Fink advocates that, to sustain a company’s financial performance, the company “must also understand the societal impact of your business as well as the ways that broad, structural trends—from slow wage growth to rising automation to climate change—affect your potential for growth.” In effect, Fink is arguing that attention to corporate social responsibility is inherently linked to and inseparable from sustainable financial performance. (See this PubCo post.)
(Based largely on notes, so standard caveats apply.) SEC Chair Jay Clayton opened the program by posing the question of how to address problems requiring collective action when company ownership is diffuse and ever-changing, with one or more layers of intermediaries between beneficial owners and corporate management. What’s more, shareholders themselves are not monolithic and can have divergent views on objectives—e.g., whether capital should be reinvested or returned to shareholders—as well as different perspectives on the ways and time horizons to achieve those objectives. Similarly, how should index funds, which are compelled by definition to hold shares of companies in the index, address a poorly managed or performing company in its portfolio? Support an activist intervention, intervene directly or do nothing? What if the portfolio company does not follow best environmental, social or governance practices? Should the fund intervene? The problem of collective action is compounded, Clayton suggested, by the cost of engagement, which, for smaller holders, may be prohibitive. Likewise, educated voting comes with a cost of time and expense, driving some funds to look to proxy advisory firms, thus adding another intermediate layer. Hedge-fund activists can introduce another element, one with often tectonic effects on companies and shareholder value. But is it positive or negative? Does it contribute to long-term value creation for all shareholders or just the activist? And how do passive institutional owners and proxy advisors factor into activist campaigns? Activists are also diverse, employing different tactics and time horizons and setting different goals. And how does this activity (or passivity) benefit the main street retail investor?
The first panel comprised prominent attorney Martin Lipton and hedge-fund activist Nelson Peltz. You might have expected some fireworks from this pairing, but it was almost all hugs, with the duo expressing agreement on many major points: they agreed—in theory at least—on the importance of investing for long-term value creation and the importance of ESG in attaining that goal; they believed that boards need to take multiple constituencies into account and to be transparent about their long-term strategies; they disapproved of financial engineering to juice the stock price in the short-term; and they both admired the Fink letter.
At the outset, Peltz rejected the label “activist” in favor of “highly engaged shareholder,” and seemed to position himself as a representative or advocate for the small shareholder. In his view, 2017 showed that small shareholders have a say in the way companies operate (presumably reflecting his victory at year end in a highly publicized proxy fight). The practice of his firm is to act as a “free consultant” to the target company and to help inject an “ownership mentality.” The firm provides target companies with white paper analyses offering insights into ways to improve their businesses; according to Peltz, it’s only when he cannot meet with the board to share and discuss the white paper that proxy fights ensue and the white paper is publicly released. Peltz emphasized, perhaps to distinguish himself from other hedge-fund activists, that his fund understands time frames and does not expect change “over the weekend”; rather, he recognized that short-term financial engineering (such as share buybacks designed to lift the stock price) is not where the value is. In the end, he predicted that the “wise guys” would be “weeded out,” and he expected to see many fewer “Saturday night specials” forcing companies to “perform unnatural acts.” He also made a plug for universal proxy cards. (See this PubCo post and this PubCo post.)
Lipton observed that the actions of hedge-fund activists have a larger impact beyond just the target company, as many similarly situated companies take note of the wider implications of a hedge-fund attack for their own companies. Moreover, conduct by hedge-fund activists can have a significant impact on the community and economy as whole. (See, e.g., this PubCo post.) In engaging with hedge-fund activists (a practice Lipton recommended after study of the activist proposal at the board level), Lipton advised that the role of the board was most important, particularly in the board’s interactions with institutional investors. (See this PubCo post, regarding a study showing that alliances with sophisticated long-term investors can help blunt the corrosive effects of short-termism.) In light of changes in communications, Lipton advocated speeding up the due date for Schedule 13D to impede the activities of “wolf packs” trying to game the system. Peltz opposed the change, arguing that he needs time to accumulate big holdings to pursue management challenges and that he worried the SEC would go too far.
What is a “wolf pack”? As discussed in this post from Columbia Law Professor John Coffee, a “wolf pack,” is “a loose association of hedge funds (and possibly some other activists) that carefully avoids acting as ‘group’ so that their collective ownership need not be disclosed on Schedule 13D when they collectively cross the 5% threshold.” Coffee observes that, for the past decade or so, wolf packs have often relied on “offensive” tactics (i.e., where the hedge fund purchases shares “specifically to challenge management”) that, in effect, seek to engineer stock price increases, such as through stock buybacks. One of the wolf pack tactics that Coffee identifies is the practice of “conscious parallelism.” As discussed in this PubCo post, citing a WSJ article, members of the pack often use the 10-day window prior to disclosure to tip their plans, profiting from the use of material nonpublic information. An analysis by the WSJ demonstrated that, in the “10 trading days before bullish activists revealed in regulatory filings that they had bought particular stocks, the stocks rose an average of 3.2% more than the overall market…. Similarly, an analysis of 43 announcements by bearish activists… found that in the preceding 10 trading days, shares of targeted companies fell by an average of 3.8% more than the market as a whole.” The hedge-fund activist can then exploit these changes in share price. The practice of tipping other investors, the article charges, “is part of the playbook. Activists, who push for broad changes at companies or try to move prices with their arguments, sometimes provide word of their campaigns to a favored few fellow investors days or weeks before they announce a big trade, which typically jolts the stock higher or lower. In doing so, they build alliances for their planned campaigns at the target companies. Those tipped—now able to position their portfolios for price moves that often follow activist investors’ disclosures—benefit in a way that ordinary stockholders who are still in the dark don’t.” As Professor Coffee points out, these wolf pack “profits are nearly riskless.” Coffee indicates that the market reaction to a 13D filing that announces formation of a wolf pack substantially exceeds that for 13D filings by other activists — a 14% abnormal gain as opposed to 6% — and attributes this reaction to a market perception of a higher likelihood of a takeover premium or a “bust-up” sale. He also cites two recent studies that show there is a more than 75% probability of success for wolf pack campaigns, as he contends in this post from January 2016, because of an abnormal trading gain of 6% to 8%. See this PubCo post.
Lipton and Peltz were in “violent agreement” in commending the Fink letter, with regard to both its focus on the long term and its redefined “purpose” of corporations to include responsibility to multiple constituencies, not just shareholders. Peltz observed that positive performance with regard to ESG issues can be a marker for better performing companies. He also agreed with Fink’s recommendation that companies be more transparent regarding their long-term strategies and the related timeframes—if they take a short-term hit on their stock prices, he promised to give them cover! Lipton also concurred with Fink’s recommendation that companies make clear their boards’ review of and commitment to their long-term strategies to help cultivate shareholders’ confidence in the board members.
The next panel, composed of academics, discussed the “dark side” of the increasing ownership levels of institutional investors. One panelist discussed whether the influence of proxy advisors ISS and Glass Lewis actually caused changes in votes or whether the changes just reflected a correlation (i.e., the shareholders decided independently). She concluded that, for say on pay, about 25% of the vote was based on proxy advisor recommendations, mostly affecting medium and smaller institutions. But perhaps, she ventured, the effect is to crowd out independent research. Another panelist discussed how the growth in ownership by large institutions and index funds affected competition. His theory was that, because many institutional investors hold significant stakes in a number of companies in the same industry, these large institutions have no incentive to demand increased competition. The third panelist observed that, as advocated in the Fink letter, boards need to be “thickly” involved and fully engaged to provide information to institutions. However, he believed that many modern challenges caused by technological and other disruption are not really short-term/long-term issues that can be addressed by institutions, but rather require more participation by government.
The third panel addressed the role of investors, especially passive investors, in the engagement process. A representative of BlackRock maintained that, consistent with Fink’s letter, society demands that companies take different constituencies into account for the long term, particularly as investors in index funds need to plan for longer retirements. In addition, for purposes of corporate/shareholder engagement, BlackRock prefers to engage year-round and to speak with at least one director to ensure that the board is actively engaged. A representative of CalSTRS said that companies were more likely these days to respond to letters from CalSTRS, but if the company were ultimately unresponsive, a shareholder proposal could be valuable. She also noted that some social issues, such as the opioid crisis, that may be reflected in shareholder proposals may represent long-term risks for some companies. Commenting on the shareholder proposal process, a representative of the Society of Corporate Governance advocated raising the resubmission thresholds to help avoid tyranny of the minority. However, an ISS representative argued that it was important not to lock out retail shareholders, who often get the ball rolling on corporate governance issues. With regard to engagement and voting, the ISS representative suggested that ISS benefits institutional institutions by allowing then to conduct triage. The ISS representative predicted that proxy access will have a significant impact, while the BlackRock representative viewed proxy access as a purely academic issue because it was unlikely to be used