How corporate raiders coopted “shareholder democracy” for their own ends
This blog post draws on Jang-Sup Shin INET working paper, “The Subversion of Shareholder Democracy and the Rise of Hedge-Fund Activism,” which is in turn part of a forthcoming book with William Lazonick on predatory value extraction.
The casual observer can hardly comprehend the value-extracting power of hedge fund activists. Technically, they are no more than minority shareholders. Yet they exert enormous influence, often forcing these companies to undertake fundamental restructuring and to increase stock buybacks and dividends substantially. For instance, Third Point Management and Trian Fund Management, holding only 2% 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 both massive layoffs and the closure of DuPont’s central research lab, one of the first industrial science labs in the United States.
So how did hedge fund activists gain power so far in excess of their actual shareholdings?
In the 1980s, predatory value extraction was the province of the 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 that they could plausibly threaten to take control of the companies they targeted. 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 come true.
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 federal government implemented regulatory changes that set the stage for hedge fund activism.
The first set of regulatory changes was put into motion by Robert Monks, who in 1985 set up Institutional Shareholder Services (ISS), the first proxy-advisory firm, upon his resignation from the post of chief pension administrator at the U.S. Department of Labor (DOL). During his sole year in the Labor Department’s employ, Monks endeavored to make proxy voting compulsory for pension funds, using his position as a platform for public advocacy of the notion that the funds had an obligation to become responsible “corporate citizens” and actually exercise the power their financial holdings gave them over corporate management. In 1988, his former DOL colleagues established proxy voting as a fiduciary duty of pension funds by the so-called “Avon Letter.” 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 realizing the long-held goal of “shareholder democracy,” which, however, was all but irrelevant to proxy voting. A political project that had begun in the early 20th century, shareholder democracy was intended to lessen public distrust of corporations and to create social cohesion by distributing corporate shares to retail investors who had U.S. citizenship. Institutional investors were simply money-managing fiduciaries who, lacking the status of citizens, had never been seen as having any part in shareholder democracy. Moreover, voting in most countries is not legally compulsory, it is one’s right as a citizen. But Monks and his followers appropriated the banner of shareholder democracy to impose the voting of proxies on institutional investors as a fiduciary duty.
The consequence was the creation of a huge vacuum in corporate voting. Most institutional investors remained uninterested in voting and incapable of doing it meaningfully. The situation got worse with the increasing popularity of index funds, currently estimated to hold about one-third of all shares issued by companies listed in the U.S. Faced with the new requirement not only to vote but also to justify their voting decisions, institutional investors became heavily reliant on proxy-advisory firms. But these firms are often no more competent in making voting decisions than the institutional investors that hire them, and, as for-profit entities, are wide open to conflicts of interest. Some large mutual funds and pension funds, responding to public criticism that they are simply outsourcing voting decisions, have set up internal “corporate-governance teams” or “stewardship teams.” However, these teams are designed to do no more than pay “lip service” to voting requirements: they are minimally staffed and their decision-making resembles “the corporate governance equivalent of speed dating,” as the New York Times phrased it, rather than examining the concrete contexts of individual companies’ voting issues. The potential for cooperation with hedge fund activists is great: the current owner of ISS, for example, is itself a private equity fund founded by corporate raiders.
The second set of regulatory changes was proxy-rule changes in 1992 and 1999 that allowed “free communication and engagement” among public shareholders and between public shareholders and management, as well as between public shareholders and the general public. These proxy-rule 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 between public shareholders and management was already skewed decisively toward the former. Institutional shareholding of American corporations’ stock had already approached 50% by the early 1990s and, by 2017, was to reach nearly 70%. The proxy-rule changes further strengthened the power of public shareholders by allowing them to form de facto investor cartels and freely criticize management. Even if the SEC required those whose holdings of a given company’s stock reached a 5% share to disclose the fact publicly, hedge fund activists could easily circumvent that limit by forming “wolf packs”: soliciting the participation of other activists, whose holdings had not reached the threshold for reporting, in staging sudden, concerted campaigns against target companies.
Allowing free communication between shareholders and the public, far from evening the supposed imbalance between shareholders and management, intensified the influence of the former. Activist shareholders were freed by the SEC directives to allow them criticize a company’s management “as long as the statements [they made were] not fraudulent.” In contentious issues, management makes its decisions by weighing the advantages and disadvantages of the options available. But the directives have made it all too easy for activist shareholders to criticize management in public by simply emphasizing some of the disadvantages while remaining within the limit of not perpetrating fraud.
A third set of regulatory changes, which allowed hedge fund activists to gain even more power, followed from the 1996 National Securities Markets Improvement Act (NSMIA). Part of the financial market deregulation that took place during the Clinton administration, NSMIA effectively allowed hedge funds to pool unlimited financial resources from institutional investors without regulations requiring disclosure of their structure or prohibiting overly speculative investments. This threw the door wide open to co-investments between activist hedge funds and institutional investors who put their money into the hedge funds as “alternative investment.” For instance, the California Teachers Retirement System (CaLSTRS) cooperated in Trian Fund’s campaign against DuPont from the beginning by co-signing a letter supporting the hedge fund’s demands in 2015. It later turned out that CaLSTRS, a long-term investor in DuPont, was also one of Trian’s major investors.
In combination, these regulatory changes increased the incidence of predatory value extraction in the U.S. economy. For more than a decade, major public corporations have routinely disbursed to shareholders nearly all of their profits, and often sums equivalent to more than their profits, in the form of stock buybacks, dividends, and deferred taxes while investing less for the future and undertaking restructuring simply for the sake of reducing costs. It is now increasingly difficult to find incidents in which management rejects hedge fund activists’ proposals outright and risks proceeding to a showdown proxy vote in a shareholder meeting. As Steven Davidoff Solomon wrote in his New York Times column, “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.”
If a regulatory change is found to be misguided, it should be reversed or recalibrated. What would that look like in the context of activist hedge funds? Here are some suggestions for rebuilding the U.S. system of proxy voting and shareholder engagement such that it will support sustainable value creation and value extraction:
- First, the SEC should make it mandatory, when shareholders make a submission of shareholder proposals to a shareholders’ meeting, that they justify their proposals in terms of value creation by and capital formation for the corporation, rather than simply requesting distribution of company funds that could be made available by, for instance, disgorgement of free cash flows.
- Second, voting should be removed as a fiduciary duty of institutional investors. The compulsory voting of institutional investors, who tend to be both uninterested in voting and incapable of doing so meaningfully, has only given illegitimate power to proxy-advisory firms and hedge fund activists.
- Third, as a practical enforcement mechanism that will shape the thinking and behavior of shareholders so that they take sustainable value creation and value extraction into account, the regulatory authorities should allow differentiated voting rights that favor long-term shareholders.
- Fourth, the SEC should make it mandatory for both shareholders and management to disclose to the public what they have discussed in engagement sessions. Free engagement has been reserved to a restricted number of influential investors who have preferred to keep this communication private.
Fifth, hedge funds should be subject to regulations equivalent to those imposed on institutional investors. Hedge funds are already big enough to pose systemic risks to the economy, a lesson that might have been taken from the collapse of Long-Term Capital Management in 1998. 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 financial regulations applied to institutional investors when they are functioning as surrogate institutional investors.
 Jang-Sup Shin is professor of economics at the National University of Singapore and a senior research associate at the Academic-Industry Research Network. This blog post draws on his INET working paper, “The Subversion of Shareholder Democracy and the Rise of Hedge-Fund Activism,” which is in turn part of a forthcoming book with William Lazonick on predatory value extraction.