Activists Redux

Recently, I wrote a piece analyzing the pros and cons for this country’s economy on Activists Investors, citing Marty Lipton versus Lucian Bebchuk of the Harvard Law School on the other side (see My conclusions, however, were based on a issue which, as far as I was aware, none of the analysts, journalists or academics had identified as the most important negative consequence resulting from the rising tide of Activists’ challenges to public company management and boards.

To quote from my piece:

The Root Problem: The Eclipse

The issue which I believe is continually overlooked is the existential problem for investors, asset managers and our capital markets, expressed in an article on the “eclipse” of our public company population, including the views of then Chancellor, now Chief Justice, Leo Strine on what he calls “short termism.” Who cares about the merit/demerits of activism if there are no live animals for the activists to feed on? Let me quote from Chief Justice Strine’s article in the 2010 Business Lawyer.

“The existing model of corporate law focuses solely on the duties the managers owe to stockholders. It does not address the reality that most ‘stockholders’ are now themselves a form of agency, being institutional investors, who represent end-user investors. There institutional investors now control nearly 70 percent of U.S. publicly traded equities, a figure that will continue to grow.

“For a variety of reasons these institutional investors often have a myopic concern for short-term performance … What is even more disturbing than hedge fund turnover is the gerbil-like trading activity of the mutual fund industry, which is the primary investor of Americans’ 401(k) contributions. The average portfolio turnover at actively managed mutual funds, for example, is approximately 100 percent a year … And a rough calculation using transaction activity and market capitalization data from the U.S. Statistical Abstract reveals that turnover across all U.S. exchanges reached approximately 300 percent in 2008.

“There is a limit to the ability to add more to the managerial agenda without compromising management’s ability to effectively perform its most important duties. With the proposal of ‘more’ things to do should come the responsibility to identify those preexisting that are ‘less’ important and should be dispensed with. Absent this sort of mature discipline, the proposal of more mandates will actually harm stockholders and society as a whole, by making it impossible for directors to effectively carry out their responsibilities, giving investors and the public unrealistic expectations about what can be asked of corporate managers, and dissuading qualified candidates from serving on corporate boards.

“In sum, real investors want what we as a society want and, we as end-user individual investors want; which is for corporations to create sustainable wealth. Until, however, the institutions who control and churn American stocks actually act and think like investors themselves, it is unrealistic to think that the corporations they influence will be well-positioned to advance that widely shared objective. So long as many of the most influential and active investors continue to think short term, it is unrealistic to expect the corporate boards they elect to strike the proper balance between the pursuit of profits through risky endeavors and the prudent preservation of value. Rather, to foster sustainable economic growth, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock prices.”

The case against Chief Justice Strine’s point of view is made by a colleague of Professor Bebchuk’s at Harvard Law School. Professor Roe argues that Chief Justice Strine and his colleagues are not “well equipped” to make judgments on the pros and cons of the Lipton vs. Bebchuk arguments.

“Fourth, courts are not well equipped to evaluate this kind of economic policy and should leave this task to other regulatory institutions, many of which have better remedies available than do corporate lawmakers and some of which are better positioned than courts to assess the extent, location and capacity for lawmaking to ameliorate the purported problem. For reasons similar to those that underpin the business judgment rule, courts should be as reluctant to make economic policy decisions as they are to second-guess unconflicted board business decisions.”

Bad news for the Delaware judges. After hearing this topic endlessly debated back and forth by $1,000 per hour lawyers and senior academic experts, based on facts on the ground in specific cases, they nonetheless are ill-equipped to decide which side has the better case. Professor Roe’s remedy is:

“Courts are poor places to make this kind of basic economic policy. They may even find it difficult to assess accurately whether the economy is too short-term, too long-term, or just right. If such considerations are to make their way into economic policy, these should be national policies, coordinated with tax policy, and perhaps implemented via the tax code and securities laws, and the rules that influence the size of stockholdings, not via parochial corporate law.”

If I am reading Professor Roe correctly, he would remit decision making to the U.S. Congress. I rest my case.

To sum up, the fear is that, despite a recent flurry as the market has been in a major upward cycle, IPO exits may well remain below their potential until and unless we can fix the problems from which U.S. public company status, of and by itself, suffers. To be sure, there have always been advantages and disadvantages inherent in public registration. The advantages are obvious … a liquid currency enabling Pubcos to make acquisitions, reward employees and raise capital. With prominent exceptions, e.g. Koch Industries, Cargill, behemoth companies are (or at least were) public and the owners (usually) well rewarded. The disadvantages include frictional expense and the loss of proprietary protection on items such as internal strategy, costs, pricing and like metrics of use to competitors, vendors and customers.

That said, the superfluous, non-essential detriments include “activists,” and the relentless criticism of executive compensation, so unpleasant and unproductive (except for the free riders) that it drives talented jockeys into remaining in the private firm space. The problem is exacerbated by the power of U.S. firms to remain (or go) private and yet provide their shareholders liquidity on secondary exchanges …. HPPOs (hybrid public private organizations) in the NVCA’s jargon … buoyed by the ability to remain private despite 1999 shareholders of record. What does this country look like as the world’s financial center if we continue to lose ground? To make the point, see a recent report on Yahoo Finance.

“There are fewer publicly traded companies on American exchanges than at any time since at least 1990. A larger proportion of this narrower market falls into the ‘small-stock; category. And established companies have been aggressively pulling their shares off the market through buybacks. Together, this amounts to a restricted supply of equities. To exaggerate slightly, there might not quite be ‘enough stock to go around’ to meet a slowly rising level of investor demand. No doubt, this is at least a factor for the steady lift in share prices.

“The total number of U.S. exchange-listed companies peaked near 8,800 in 997 and has since sunk to 4,900 as of year-end 2012, according to data furnished by Strategas Group. The ranks of public companies declined slowly into the 2000 market peak and then entered a steep downtrend in the early- and mid-2000s.”

It turns out that The Financial Times of Monday, June 29th reaches the same conclusion in an article on page 6 by Waters and Foley, “Inside the Winners’ Circle.” [1] To quote from the lead sentences in that article

“Eager to avoid Wall Street ‘short-termism’ and voracious activist investors, tech entrepreneurs are shunning the IPO market. But this means the wealth they create goes to those with the right access.”

I again, rest my case.

[1] Waters & Foley, “Inside the Winner’s Circle,” FT, June 29, 2015.

Joseph W. Bartlett

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