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Shareholder Eugenics in the Public Corporation
Posted By Edward B. Rock On February 13, 2013 @ 1:01 am In Cornell Law Review, Uncategorized | No Comments
In a world of active, empowered shareholders, the match between shareholders and public corporations is more important than ever before. A good match can increase firm value, while a bad match can have the opposite effect. But can publicly held firms choose their shareholders? Warren Buffett posed the challenge decades ago:
Mrs. Astor could select her 400, but anyone can buy any stock. Entering members of a shareholder ‘club’ cannot be screened for intellectual capacity, emotional stability, moral sensitivity or acceptable dress. Shareholder eugenics, therefore, might appear to be a hopeless undertaking.
In this Article, I examine the extent to which publicly held corporations can shape their shareholder base, the extent to which “shareholder eugenics” is possible.
Two sorts of approaches are available: direct/recruitment strategies and shaping/socialization strategies. Direct/recruitment strategies seek attract “good” shareholders to the firm and include: going public, targeted placement of shares, traditional investor relations, the exploitation of clientele effects, and “de-recruitment.” Shaping/socialization strategies aim to transform shareholders of a “bad” or unknown type into shareholders of the “good” type and include: choice of domicile, choice of stock exchange, the new “strategic” investor relations, and capital structure.
A decision by a firm to go public is a decision about who its shareholders will be. In doing so, the company embarks on a process in which existing shareholders (employees, venture capitalists, private equity investors, or other private investors) will be replaced with shareholders of a very different sort. Institutions like mutual funds, pension funds, insurance companies, and charitable endowments rarely invest directly in privately held companies, but often do in public companies. Similarly, most individual investors do not and cannot invest in private companies, but often are quite keen to invest in newly public companies.
Underwriters’ efforts to place company shares with “long-term” investors serve two related purposes. By limiting the number of initial buyers who immediately resell, share placement facilitates the underwriting process by limiting the number of shares that come back on the market. Further, by placing shares with investors with a longer-term time horizon, future volatility is somewhat reduced.
Privately negotiated equity investments in public companies provide another example of direct recruitment. A recent example is Buffett’s $5 billion investment in Goldman Sachs during the height of the financial crisis. But the practice has existed for decades, whether under the name of “relational investing” or, more recently “PIPE investing,” that is, “Private Investment in Public Equity.”
The key challenges include identifying a good type of investor and then ensuring that the good type stays good, as well as negotiating the price for being good. As the Buffett example shows, a good relational investor can provide substantial value to the firm. Because Goldman’s interest was in securing Buffett’s support at the lowest price it could pay, while Buffett sought a profitable investment, the arm’s-length bargaining protected shareholder interests. Buffett’s reputation and his limited ability to exercise any control bonded his commitment.
But relational investing can also go wrong. Sometimes it fails because the contract negotiated by the firm and the investor creates a misalignment of incentives. Thus, in the toxic convertible PIPEs cases, the conversion option gave investors an incentive to act in ways that hurt the company. Sometimes relational investing serves the interests of the managers (e.g., by providing “takeover protection”) without serving the interests of the shareholders. In this sort of relational investment, arm’s-length negotiations—the typical hallmark of a fair transaction—will not suffice to protect the shareholders. As in any protection racket, while arm’s-length negotiations will occur—the buyer of protection (the managers) will seek the lowest price for the most protection from the seller (the relational investor), who has opposite goals—those negotiations will not assure that the agreement reached benefits the shareholders.
Traditional investor relations can also be understood as a key part of a firm’s strategy to attract and keep particular sorts of shareholders. Investor relations – “a strategic management responsibility that integrates finance, communication, marketing and securities law compliance to enable the most effective two-way communication between a company, the financial community, and other constituencies, which ultimately contributes to a company’s securities achieving fair valuation” (National Investor Relations Institute) — is a function fulfilled at almost every public company, yet not generally thought of as part of “corporate governance.” For little known companies, IR can increase liquidity (and thereby reduce the cost of capital) by providing information to analysts and investors. For well-known and widely followed companies, IR, as the key point of contact with the capital markets, can serve different functions, including, as BP’s IR officer has argued, providing an independent “market view” of the future of the company’s core businesses. This information can be incorporated into internal planning models, at least as a check, and potentially as an independent source of information.
IR can also provide the means of outreach to key investor constituencies. As firms accept that empowered shareholders are here to stay, proxy statements are beginning to attempt to educate shareholders through something like a “Directors’ Discussion and Analysis” section as a supplement to the mandatory “Management’s Discussion and Analysis” in annual reports. Likewise, with the rise of hedge funds and other “disruptive” investors, IR offices share the task of explaining to the shareholders why management’s plans are, in fact, better than the alternatives hedge funds present.
But, as Berkshire Hathaway has shown, IR can be a mode of shareholder eugenics in a different way. Warren Buffet’s annual shareholder letters provide a straightforward and consistent description of his investment approach and of Berkshire Hathaway’s results. Equally important are the communications Berkshire Hathaway does not provide: no quarterly or annual guidance on revenues, earnings, or other financing information; no conference calls, analyst meetings, or investor conferences. By intentionally constricting the flow of information, Berkshire Hathaway seeks to discourage short-term shareholders from investing.
Regulation shapes IR. The SEC’s Regulation Fair Disclosure (2000), by prohibiting “selective disclosure,” changed how IR officers and analysts did their work, and replaced informal and confidential communications with open conference calls. The 2003 Global Research Settlement, by seeking to eliminate equity analyst conflicts of interest, also had the effect of limiting cross subsidies. Whatever the purpose, the result of these legal changes has been the dramatic reduction in the number of analysts covering small public companies. This has exacerbated the already severe governance problems that afflict smaller public companies.
Finally, the most subtle and unexpected mode of shareholder eugenics is the exploitation of “clientele” effects, that is, the ways in which investors sort themselves according to their interests and needs. Because individual investors prefer to own dividend-paying stocks, a firm’s decision to pay dividends will shift its shareholder base towards individual investors. Likewise, “home bias” — the tendency of investors to invest in “local” companies (including companies listed on their own country’s stock exchanges) – can be a tool for shaping the shareholder base. Firms that desire the kinds of investors who buy shares on NASDAQ can go public on NASDAQ. Firms seeking a European shareholder base, perhaps because the firm’s product marketing is focused on Europe, can help achieve that by going public on a European exchange.
Most surprisingly, and intriguingly, liquidity itself affects clientele: short-term investors, who trade in and out, gravitate towards shares with a narrow bid-ask spread, while longer term investors take advantage of the higher returns available from shares with wider bid ask spreads. Can firms exploit this effect to attract the “long-term” investor who managers claim to seek? To a degree: by avoiding measures that increase liquidity such as quarterly earnings calls and, more controversially, stock splits.
Another kind of recruitment is “de-recruitment,” that is, eliminating or barring disruptive shareholders from the company. Again, somewhat surprisingly, some firms do, in fact, adopt such strategies. U.S. airlines are the most prominent example. Under the Aviation Act, only a “citizen of the United States” may carry passengers on domestic routes, with “citizen” defined as including a U.S. chartered corporation “under the actual control of citizens of the United States, and in which at least 75 percent of the voting interest is owned or controlled by persons that are citizens of the United States.” Airlines, to maintain their license, must therefore limit foreign shareholders. They do so in a variety of ways including charter provisions, separate stock registers, voting and ownership caps, and the power to nullify nonconforming transfers. This raises the intriguing question whether a firm that had a reasonable basis for believing that particular classes of shareholders posed a threat to the corporation could adopt similar measures to limit or exclude their ownership stakes. Delaware law is unclear.
While recruitment strategies take shareholder type as given, shaping strategies seek to transform shareholders into a desired type. This can be done in a variety of ways.
First, capital structure itself will affect how shareholders act. In a firm with a controlling shareholder, the role of non-controlling shareholders is limited in one direction but expanded in another. The limitation, obviously, is that all key decisions will be made by or with the acquiescence of the controlling shareholder. The expansion of role is less obvious. Corporate law, by imposing various obligations or conditions on controlling shareholder actions and transactions thereby creates a role for non-controlling shareholders: policing interested party transactions either through decision rights or litigation. In doing so, the legal rules will have a shaping effect (potentially turning unknown shareholders into litigious monitors of the controlling shareholder) and a selection effect (attracting shareholders who wish to perform these roles).
Choice of corporate domicile or stock exchange shapes the shareholders’ role in a different way. The U.K. has a much more shareholder-empowering corporate law than Delaware. These differences may affect how shareholders act, even if shareholders’ preferences, skills, or investment in activism stay constant. Institutional investors like Fidelity or TIAACREF might do more as shareholders in U.K.-incorporated or LSElisted firms simply because they can do more things.
To the extent that Investor Relations engages strategically with key shareholders, it can be part of an overall shaping strategy. A few pioneers with deep contacts among institutional investors have begun to play an intermediary role between issuers and their shareholders. In contrast to traditional IR efforts, the continuous communication function described above, this “New Investor Relations” function tends to be more episodic, led by high-level outside actors, and involves the highest levels of the company. This version of “managing the shareholder relationship” takes seriously the current importance of empowered shareholders and seeks to shape that relationship.
The two most prominent examples of this new approach are John Wilcox and Christopher Young. Wilcox, for many years a senior figure (and chairman) at the proxy solicitation firm Georgeson & Company, subsequently moved to TIAA-CREF, a leading institutional investor, where he was Senior Vice President and Head of Corporate Governance. Now chair of European-based Sodali, Wilcox “help[s] companies anticipate, understand and deal effectively with the expectations of investors, minority shareholders and the financial markets.” In this role, indeed, in his career, Wilcox merges IR and corporate governance by helping firms and shareholders better communicate with each other.
Christopher Young provides another glimpse over the horizon. Formerly ISS’s director of M&A and Proxy Fight Research, Young joined Credit Suisse to become head of the Takeover Defense practice within the M & A group. To his new role, Young brings a rolodex full of shareholder contacts and a strong sense of their concerns. This knowledge puts Young in a position to alert companies to emerging shareholder dissatisfaction and allows him to work with companies to better explain themselves to their key shareholders. The idea seems to be that investors, who know and trust Young from his days at ISS, will still be willing to return his phone calls.
A final shaping strategy emerges from alternative capital structures. Dual-class shares, like other controlling shareholder structures, cast non-controlling shareholders in a very particular role. Less well known, “tenure voting,” also known as “time-phased voting,” gives long-term shareholders more votes than short-term shareholders. By shifting voting power within the shareholder group, tenure voting allows more subtle tailoring of the shareholder roles.
Shareholders occupy one vertex of the corporate governance triangle. As the metaphor suggests, and as I have argued above, the identity of the shareholders and their fit with the board of directors and the managers (the other two vertices) are potentially important to firm value. What, then, are the implications of this analysis for legal policy and firms? Are there practical takeaways? I think there are several.
First, rather than passively accepting whatever shareholder base emerges and then complaining about it, public companies should think about who they want as shareholders and why. As I show above, companies can do quite a lot to select and shape a productive shareholder base.
Second, once companies decide what sort of shareholders they want, they should think systematically about how to create the desired shareholder base. Given the potential effect of shareholder base on firm value, crafting the optimal shareholder base is a strategic decision for the firm. Choice of corporate domicile, stock exchange, public image, disclosure policy, stock price and liquidity, and many other factors, affect what sorts of shareholders are attracted to a given company. For example, before splitting shares, a board should think about how it will affect the composition of the shareholder base, and, in particular, whether the benefits of increased liquidity will offset any harms from a shift to shorter-term shareholders.
Third, the IR function, in its various forms, is a key part of shaping a shareholder base. Building relationships around fundamental issues of corporate strategy and policy rather than quarterly earnings reports holds the potential for changing an adversarial relationship into a more cooperative and productive one. There are a variety of proposals for how this might be done. A “Directors’ Discussion and Analysis” section of the proxy statement or annual report would be a starting point. Regular meetings between the board and major investors on topics such as corporate strategy, risk control, compensation, ethics, CEO succession, and ESG (environmental, social, and corporate governance) could be a useful way to create good shareholders.
Fourth, corporate architecture can be a powerful force. In Churchill’s words, “We shape our buildings, and afterwards our buildings shape us.” If a firm’s structures empower (or pacify) shareholders in particular ways, it will attract particular sorts of shareholders and shape the ones it attracts. A legal rule that casts shareholders as the monitor of conflicted transactions will produce shareholders willing to sue over conflicted transactions. We should remove regulatory barriers that block architectural experimentation such as the prohibitions on midstream departures from one-share, one-vote.
Fifth, the law needs to avoid chilling communication and transforming the shareholder–board relationship into a lawyer-driven, sterile interaction. For example, creating a safe harbor from Regulation FD for a defined set of “high level” topics would facilitate productive communication. The model should be the sort of relationship that exists between private equity funds or venture capitalists and the managers in a private company, with the exclusion of price-sensitive information like earnings.
Sixth, managers, boards, investors, and regulators need to rein in their distrust of all things new or unusual. We need not be suspicious of every communication between boards and shareholders. Directors are not necessarily going behind the CEO’s back. Investors are not necessarily seeking to trade on material nonpublic information. Large investors do not necessarily disadvantage small investors when they get privileged access to directors and managers.
Seventh, productive relationships between investors and companies are likely to be company specific and thus unlikely to be susceptible to “checkthebox,” “one-size-fits-all” solutions. “Best practices” may be a useful starting point, but investors and companies should be open to alternative approaches.
Finally, intermediaries (e.g., lawyers, bankers, consultants) may want to stop bemoaning the arrival of active and empowered shareholders and instead find ways to profit from the transformed landscape.
Although there are good reasons to believe that the composition of the shareholder base and the firm–shareholder relationship matter, concerns with the shareholder base have largely fallen outside of the corporate governance debate. This Article is an attempt to bring these matters into the discussion. Indeed, once one starts thinking about how firms shape their shareholder base, it turns out that there are numerous ways to do so. Sometimes the law helps; sometimes it hinders. In this preliminary inquiry, I have sought to map the landscape and to appreciate some of its salient features. As Buffett suggests, contrary to first impressions, shareholder eugenics is not an entirely hopeless undertaking.
Edward B. Rock is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Law School.
This essay is based on Edward B. Rock, Shareholder Eugenics in the Public Corporation, 97 CORNELL L. REV. 849, 906 (2012).
Copyright 2013 Cornell Law Review.
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