Abstract

Institutional investors are the majority owners of most publicly traded companies but allow activist hedge funds with smaller positions to push through corporate changes. The author offers various reasons why institutional investors may be reluctant to actively participate in proxy fights but then suggests several practical forms of investor engagement that support long-term value creation. So, in future campaigns by hedge funds, institutional investors should actively participate to ensure that the outcome promotes long-term growth instead of temporary price spurts.

Across the world, a clamor is rising against corporate short-termism—the undue attention to quarterly earnings at the expense of long-term sustainable growth. In one survey of chief financial officers, the majority of respondents reported that they would forgo current spending on profitable long-term projects to avoid missing earnings estimates for the upcoming quarter.1

Critics of short-termism have singled out a set of culprits—activist hedge funds that acquire 1% or 2% of a company’s stock and then push hard for measures designed to boost the stock price quickly but unsustainably. 2 The typical activist program involves raising dividends, increasing stock buybacks, or spinning off corporate divisions—usually accompanied by a request for board seats.

Majority Owners Defer to Hedge Funds with Much Smaller Holdings

A substantial majority of the stock of most public companies in the United States is owned by a concentrated group of mutual funds, pension plans, and other institutional investors. 3 Many of the largest institutions, such as Vanguard and CalPERS, say they are focused on building long-term shareholder value rather than short-term profits.

So, an activist with 1% or 2% of a company’s stock has no power to get its reform program adopted unless it can win the support of the institutional investors that own a majority of the company’s stock. And if those institutions vigorously advocate a long-term approach to shareholder value, they should be able to block any program that does not meet that objective.

In fact, institutional investors usually do not take an outspoken position for or against proposals by activist hedge funds—with the notable exception of Laurence Fink, the CEO of BlackRock. In a recent letter, he warned US companies that they may be harming long-term value creation by capitulating to pressure from activist hedge funds to increase dividends and stock buybacks. 4

In many cases, however, company executives have given in to activist pressure by adopting new strategies or adding board members without holding a shareholder vote. For example, an activist named Harry Wilson with a relatively small position in General Motors pressed the company to deploy $5 billion of its cash to buy back its stock. 5 This move probably does not make sense in the long term since General Motors needs a large cash cushion to deal with possible downturns. Yet General Motors agreed to Wilson’s proposal without putting it to a shareholder vote.

Institutional Reluctance to Push for Corporate Reform

Perhaps institutional investors are merely talking publicly about long-term value as they privately root for the hedge funds to boost the short-term stock price. Nevertheless, there are systemic reasons why institutions are generally reluctant to be proactive in pushing for long-term reforms in corporate strategy or leadership.

Over 30% of US stock assets under management are now held in index mutual funds or exchange-traded funds that are based on indexes. Although large and diversified managers, such as State Street Global Advisors, may follow most of the stocks in the S&P 500 Index, many managers of index funds have no analysts with in-depth knowledge of most stocks in the particular index. Hence, such index funds are not in a good position to analyze an activist’s program for a specific company.

Actively managed funds tend not to publicly assert a strong position on either side of a proxy fight unless doing so meets a cost–benefit test. 6 The cost of participation is high because it includes management time and potential litigation. On the benefit side, even a holding of $400 million in one stock may be less than half of 1% of the fund’s overall assets.

The cost of participation is high because it includes management time and potential litigation. On the benefit side, even a holding of $400 million in one stock may be less than half of 1% of the fund’s overall assets. If either type of fund expends significant resources in supporting or opposing an activist’s program, it faces a serious free-rider problem. Although the fund incurs all the costs of the campaign, most of the benefits go to other shareholders who have not contributed to the costs.

Given these cost–benefit challenges, a number of asset managers have effectively outsourced their voting decisions to such proxy advisory firms as Institutional Shareholder Services (ISS) and Glass Lewis—which may or may not have a long-term perspective. According to Stanford University researchers, four sizable asset managers have disclosed that they uniformly follow the voting recommendations of one proxy adviser. 7

In contrast, activist hedge funds frequently concentrate a large portion of their assets in the stocks of a few target companies. Managers of these funds receive an incentive fee equal to 20% of realized gains. Thus, the cost-to-benefit ratio in proxy fights is much better for concentrated activist funds than for diversified mutual or pension funds.

Moreover, activist hedge funds can control a much higher percentage of proxy votes than their economic exposure to a target company’s shares through a practice called empty voting. For example, asset managers can lend their shares to a hedge fund and then not recall them for a contested proxy vote; 8 alternatively, hedge funds can cast a significant portion of the votes in a target company’s election while maintaining an economically neutral position by shorting the target’s stock.9

Encouraging Institutional Investors to Engage

So, what can be done to encourage institutional investors to take more vigorous positions on activists’ proposals? To begin with, securities regulators, CFA Institute, and other relevant groups should publicly stress that when institutional investors are the largest shareholders in a company, they should play a decisive role in determining the outcome of an activist campaign against that company. In other words, big owners should act like big owners.

In that role, institutions should carefully study any proposal’s impact on a company over many years, depending on the type of company and its history of delivering long-term results. The long term is much longer for electric utilities and drug companies than for software developers. The market has been supportive of mature companies that seem successful at long-term investments, such as Google and Shell. 10 Other companies, however, waste corporate capital in research projects or in huge acquisitions that are poorly conceived and/or executed.

In a 2014 bulletin,11 the US Securities and Exchange Commission (SEC) helpfully emphasized the duty of investment managers to diligently implement their proxy-voting policies. However, the bulletin expressly allows investment managers, with the consent of their clients, to adopt policies of voting consistently with the directors of a target company or certain types of activists—or of not voting proxies at all. Thus, the SEC guidance may inadvertently lead to less independent evaluation of activist proposals by small equity managers or to no proxy voting by index fund managers trying to minimize costs.

In a 2010 release, the SEC announced a major initiative to rethink the “plumbing” of the proxy process, including the subject of empty voting, but this project seems to have been delayed.12 Now is the time for regulators across the globe to examine the complexities of empty voting and adopt a well-designed rule against acquiring votes without comparable ownership. Even without any government action on empty voting, institutional investors can include in their stock loans a provision retaining the right to vote the stock in the event of a proxy fight.

But long before any proxy fight is in the offing, institutional investors should push for their vision of sustainable long-term growth through engagement with the companies they own. In the United Kingdom, for example, the Investor Forum was recently established to promote a long-term approach through shareholder engagement with British companies.13 At the request of either investors or companies, the Investor Forum will facilitate engagement on specific issues of value creation. More generally, it is promulgating guidelines on how investors can collectively discuss issues without running afoul of such legal rules as those that require filings by substantial shareholders acting in concert.

On the legal front, some US institutions have been especially concerned about the barrier imposed by SEC Regulation FD (Fair Disclosure) to in-depth investor engagement with publicly traded companies. A corporate target would be reluctant to provide material nonpublic information to selected shareholders, because Regulation FD requires it to promptly post that information on its website. However, this barrier can be overcome by an exemption in Regulation FD that allows a company to release nonpublic information to a select group, such as long-term institutional holders, if they sign an agreement to keep the information confidential—and not trade on the information until it becomes public.14

Another form of investor engagement is the participation of institutional shareholders in the process of nominating directors with a long-term approach to corporate growth. In Sweden and Norway, a public company must invite its five largest shareholders to join a meeting of its nominating committee to discuss the selection of directors. 15 Germany and other EU countries allow shareholders with at least 5% of a company’s voting stock to nominate a director to its board. Even in the United States, where a federal appellate court rejected the SEC’s proxy access rule on procedural grounds,16 several corporate giants (e.g., General Electric) now allow director nominations by shareholders owning at least 3% of their stock for at least three years.17

Perhaps most important, institutional investors can promote a long-term orientation by rejecting a company’s compensation plan if it puts too much emphasis on short-term results. In almost every country, shareholders can now vote on binding or advisory resolutions about corporate compensation reports.18 Most companies base their cash bonuses on only the prior year’s performance, although stock awards usually encourage a longer time horizon through vesting requirements. If institutional investors want companies to take a long-term approach to corporate growth, they should push for a three-year performance period for determining cash bonuses.

Conclusion

If institutional investors are dissatisfied with a company’s performance, they no longer have only two choices—sell the stock or oppose management. If institutional investors are serious about supporting long-term value creation, they can pursue this goal through various forms of investor engagement with the company. Then, if a hedge fund launches a proxy fight, they should vigorously participate to make sure the outcome promotes corporate growth over the next several years rather than the next few months.

1. John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper 10550 (June 2004).

2. See, for example, Natalie Mizik, “The Theory and Practice of Myopic Management,” Journal of Marketing Research, vol. 47, no. 4 (August 2010): 594–611.

3. Ronald J. Gilson and Jeffrey N. Gordon, “The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights,” Columbia Law Review, vol. 113, no. 4 (May 2013): 863–928.

4. Andrew Ross Sorkin, “Quit Bowing to Investors, Fellow Chief Urges,” New York Times (14 April 2015): B1.

5. Greg Gardner, “GM, Wilson Compromise, Agree on $5B Buyback,” Detroit Free Press (9 March 2015). Even worse, Wilson obtained a lot of information on General Motors through serving as a US government adviser during the company’s bankruptcy process in 2009.

6. Robert C. Pozen, “Institutional Investors: The Reluctant Activists,” Harvard Business Review, vol. 72, no. 1 (January–February 1994): 140–149.

7. David F. Larcker, Allan L. McCall, and Gaizka Ormazabal, “Outsourcing Shareholder Voting to Proxy Advisory Firms,” Stanford University Working Paper 2105 (June 2014). Four fund complexes—Charles Schwab, Neuberger Berman, Loomis Sayles, and Invesco—have publicly stated that they follow the proxy-voting recommendations of Glass Lewis. Similarly, two Pennsylvania State University researchers found that more than 25% of funds indiscriminately voted with ISS across all companies in their portfolios over a five-year sample period; Peter Iliev and Michelle Lowry, “Are Mutual Funds Active Voters?” Review of Financial Studies, vol. 28, no. 2 (February 2015): 446–485.

8. Paul Ali, Ian Ramsay, and Benjamin Saunders, “Securities Lending, Empty Voting and Corporate Governance,” CIFR Working Paper 023/2014 (May 2014).

9. Wolf-Georg Ringe, “Empty Voting Revisited: The Telus Saga,” Butterworths Journal of International Banking and Financial Law, vol. 28, no. 3 (March 2013): 154–156.

10. “The Business of Business: An Old Debate about What Companies Are for Has Been Revived,” Schumpeter (blog), Economist (21 March 2015): www.economist.com/news/business/21646742-old-debate-about-what-companies-are-has-been-revived-business-business.

11. SEC, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms,” Staff Legal Bulletin No. 20 (IM/CF), 30 June 2014.

12. SEC, Concept Release on the U.S. Proxy System, file no. S7-14-10/17 C.F.R. pts. 240, 270, 274, and 275 (14 July 2010).

13. See www.investorforum.org.uk.

14. See Regulation FD, 17 C.F.R. § 243.100(b)(2)(ii).

15. Gretchen Morgenson, “Time to Coax the Directors into Talking,” New York Times, bus. sec. (29 March 2015): 1, 6.

16. Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011).

17. Sarah N. Lynch, “General Electric to Allow Shareholders to Nominate Directors,” Reuters (11 February 2015): www.reuters.com/article/2015/02/11/us-general-electric-proxy-idUSKBN0LF2FE20150211.

18. Robert Pozen and Theresa Hamacher, “The (Advisory) Ties That Bind Executive Pay,” Financial Times (3 November 2013): www.ft.com/cms/s/0/eabb294e-4170-11e3-b064-00144feabdc0.html#axzz3cp7YQcQH.