What's wrong with the primacy of shareholders?

A lot, according to Lynn Stout, a law professor at the University of California at Los Angeles. Not only has the assertion of shareholder primacy in the US since the 1970s been presented a lopsided view of the corporation, it hasn't described very well what actually happens in companies in practice. Moreover, she contends, "governance experts who tout the 'U.S. model' abroad may, in fact, be exporting damaged goods." She sees a growing body of evidence, in practice and theory, suggesting that putting shareholder interests first is bad for shareholders.

Stout's pedigree as a scholar is considerable. With Margaret Blair, she authored a paper in 1999 that saw boards not as the representative of shareholders but instead as a mediating hierarchy between the conflicting and contesting calls on corporate resources. Board adjudicate those claims. Her work cannot, however, be pigeonholed as falling under stakeholder theory or corporate social responsibility, either, though it incorporates aspects of their conclusions without accepting all the premises.

In her new working paper, she contends that contrary to common assumptions, US corporate law and practice does not require directors to maximise shareholder wealth. Boards have a wide range of discretion, constrained only at the margin by market forces, to sacrifice shareholder wealth in order to benefit other constituencies. "Although recent 'reforms' designed to promote greater shareholder power have begun to limit this discretion, U.S. corporate governance remains director-centric," she asserts. Theory, too, points in directions away from the conclusions of agency theory. She outlines five other theoretical perspectives and explores why each gives us reason to believe that shareholder primacy rules in public companies have a perverse effect: such rules disadvantage shareholders.

Among her observations is one we've long shared: that shareholder value is a flawed concept when shareholders have such different time horizons. She concludes that the thinking that goes into shareholder primacy in its conventional form is "on the brink of intellectual collapse". What comes next will be a lot more subtle. This is a charmingly readable paper, as well as one that will challenge your thinking.

Source document: The working paper "New Thinking on 'Shareholder Primacy'," by Lynn Stout of UCLA, is a 28-page pdf file.

UK report urges, not orders, more women on boards

The report is finished and it contains few surprises. UK listed companies won't have to face a government-mandated quota of women directors. Any chance that government might follow the Norwegian example of a legislated, 40 per cent target – or similar measures now in force or under consideration elsewhere in Europe – has ended, for now.

The report by Lord Davies, a former trade minister, uses as its first full sentence, centred on a page by itself, this observation: "At the current rate of change it will take over [sic] 70 years to achieve gender-balanced boardrooms in the UK." Cynics might say that the report itself will do nothing to change that rate. In the top 100 companies on the stock market, only 12.5 per cent of directors are women, the report notes. Only 5.5 per cent of executive directors are. It's something of a mistake, however, to focus on this particular measure in the context of UK policy. Nearly a quarter of the companies in that group aren't even headquartered in the UK, but rather from as far afield as Kazakhstan and Chile. Moreover, with the pipeline of potential London listings filling up with companies from Russia, China, India and more, the FTSE100 will likely look less and less like Britain and less and less responsive to the urgings of its Department for Business, Innovation and Skills. That doesn't mean will should neglect the report, just that report-writers made need to widen their field of view, as the body of the report does with its focus on the top 350 and for some matters on all listed companies. Lord Davies justifies his urgings for more women directors in this way:

Corporate boards perform better when they include the best people who come from a range of perspectives and backgrounds.

The boardroom is where strategic decisions are made, governance applied and risk overseen. It is therefore imperative that boards are made up of competent high calibre individuals who together offer a mix of skills, experiences and backgrounds. Board appointments must always be made on merit, with the best qualified person getting the job. But, given the long record of women achieving the highest qualifications and leadership positions in many walks of life, the poor representation of women on boards, relative to their male counterparts, has raised questions about whether board recruitment is in practice based on skills, experience and performance.

Davies argues that the business case for expanding the participation of women in the boardroom is clear. Women do well as university and in their early careers, but "attrition rates increase as they progress through an organisation". Chairmen and CEOs need to do something about it, so Lord Davies makes several recommendations, among them:

• Company-own target: Chairmen of all of the top 350 listed companies should set a target of at least 25 per cent for female representation on the board in 2013 and 2015, and announce those "aspirational goals" by this September.
  
• Disclosure: "Quoted companies" – so presumably all those with shares trading on public markets – should be "required" to disclose annual the proportion of women on the board, in senior executive positions and in the company as a whole. Having to say something means having to think about it.
  
• Code changes: The Financial Reporting Council should amend the UK Corporate Governance Code to require companies to establish a policy on gender diversity. The FRC only just published a new version of the code in May 2010, when it rejected suggestions for stance of gender issues.
  
• Investor monitoring: Investors should "pay close attention" to the recommendations of the report, too, when they review company accounts and consider appointments to boards.
  
• Headhunters' code: Executive search firms should create a voluntary code of conduct for appointments related to boards of the top 350 companies.

This may mean something. In the time-honoured way in UK corporate governance, heavy reports sometimes sit on desks long enough to being to creep into corporate practice without ever having been read and digested. But in case that doesn't happen, the steering board that worked with Lord Davies will meet every six months to consider progress. If it doesn't see movement, there's a threat of legislation later.

Source document: The report microsite has links to the documentation and a podcast.

Italy demands more disclosure on pay, succession planning

Stung by the boardroom revolt last year at one of the country's largest financial institutions, Italy's securities regulator has decided it's time to demand much greater disclosure of executive pay and also plans for the succession of people in key posts. Consob issued a related package of new measures:

• Termination: Companies will need to have in place, in advance, terms of any indemnities in effect in the case of terminations from the board. All issuers are required to disclose the existence and main characteristics of these plans annually.
  
• Pay: All issuers are "invited" to implement more fully the existing rules on disclosure of pay, including the different elements of "emoluments for the office" and "other remuneration".
  
• Succession: :Large-capitalisation companies should disclose what plans, if any, they have for the replacement of executive directors and of the people involved in setting up the plans.

" Past experience has shown that the lack of complete and detailed information on key elements related to board functioning and incentive systems could harm investors and the correct operation of the financial system, reducing the attractiveness of the Italian market both for investors and for companies," it said.

Source document: The executive summary, in English, gives an overview of the decision.

Majority rules at Apple

Score another one for the shareholder activists. Under the leadership of the California public sector unions' pension fund, shareholders at Apple have pushed through a resolution to institute majority voting for directors of the computer and iTunes company. The California Public Employees' Retirement System, known as CalPERS, overcame opposition from Apple's board and won the vote. It may not matter, of course. As with most US shareholder resolutions, the result is not binding. That didn't stop CalPERS from celebrating a victory, however. "As a company that thrives on innovation, Apple should have the best governance practices possible,” said Anne Simpson, who heads the CalPERS corporate governance programme. "Good boards have nothing to fear in acknowledging a fundamental right of shareowner democracy to elect directors by a majority vote." The company currently operates a "plurality vote", meaning that shareowners who oppose candidates only to withhold votes, making it possible for election of an unopposed candidate by a single vote in favour.

Apple has become a particular target for activist shareholders as a result of the discomfort many have felt over the company's reticence concerning the illness of CEO Steve Jobs and the absence of information about a possible successor.

Source document: The CalPERS news release gives a bit more detail.

Empty creditors join empty voters in short-selling strategies

It's fair to say that short-selling gets a lot of bad press, despite the best efforts of practitioners and scholars to explain the value of having someone willing to provide the liquidity when markets seem to be headed in only one direction – up. This issues in short-selling comes, however, when the market is headed in the other direction and when short-sellers' actions seems to exacerbate the decline. According to a study done at the London School of Economics with a New York consulting firm, however, a more nuanced picture appears than the rapacious raiders of the popular press. Hedge fund strategies often involve trading in more than one instrument at the same time, even more than one security of the same issuer. The researchers investigated how the so-called "non-traditional" funds operate when dealing in the securities of distressed companies, ones that seem certain to be heading for a financial restructuring. In such cases, the strategy might involve selling the equity of the company short while retaining voting rights to the shares – a phenomenon known as empty voting. But if the fund is also a debt holder, its economic interest at a special shareholders meeting would be to press for a deal that would favour debtholders over shareholders. "This enables the funds to vote on the restructuring proposals of distressed firms, while at the same time they separate their voting rights from their economic exposure," they write. "The effect on firm value depends on the discrepancy between the markets for debt and equity, discrepancy in how each assesses the probability of a proposal being accepted. We show that if the assessments between the two markets are different then the presence of a non-traditional fund decreases firm value. Firm value, however, is unaffected if the assessments are the same." They call it empty creditors.

Source document: The working paper "Trading and Voting in Distressed Firms," by Konstantinos Zachariadis at the London School of Economics and Ioan Olaru of Cornerstone Research, is a 37-page pdf file.

'Tis the season to be socially responsive

It's proxy season again. Many, many companies around the world will soon be sending out the invitations to the annual meeting, inviting shareholders to vote on new directors and whatever other resolutions have made it to the agenda. In the US, where a large industry has developed around proxy voting, it has slowly become easier for shareholders to get companies to include resolutions that management of the company doesn't like. So the proxy season becomes a contest of wills, where even a heavy defeat is hailed as progress for shareholder rights. Among those keeping score is the non-profit organisation called As You Sow, a Biblical allusion that concludes: "so you reap", working on behalf of fund management companies with a strong orientation to social activism, environmental affairs and similar issues. As You Sow's preview of the proxy season this year expects these issues to dominate the proxy season. Last year, it says, nearly a fifth of all investors voted supported calls for more disclosure and action on social and environmental issues. This year, some 290 resolutions have been filed on such issues, out of a total of 340 shareholder resolutions filed to date. More than 130 of them have environmental themes at their centre.

The preview report from ISS Governance Services, one of the large proxy voting services, draws similar conclusions, but with a slightly different spin. This year's season sees a dearth in resolutions concerning political campaign contributions. One year after the Supreme Court ruling in the Citizens United case, there's no point in beating that drum again.

Source documents: The As You Sow report is a 72-page pdf file. The ISS social preview is a 30-page pdf.

Investors seek action for greater environmental disclosure

A group of 24 institutional investors have written to stock exchanges around the world urging them to require greater disclosure of environmental issues by companies listed on their trading platforms. Led by Aviva Investors, an arm of the insurance firm of the same first name, the investors are working under principles espoused by the Principles of Responsible Investment, an initiative backed by the United Nations. A suggestion particularly advocated by Aviva Investors is a listing requirement for companies to consider how responsible and sustainable their business model is. It wants companies to put a forward-looking sustainability strategy to the vote at their annual meetings. Aviva said the exchanges with the least number of companies disclosing such data were the Australian Stock Exchange, NASDAQ GS, Korea Exchange, Santiago Stock Exchange and Philippine Stock Exchange.

Source document: The Aviva Investors news release is strangely available only to professional investors.

Evidence of 'modest' impact of codes on pay, performance

What's the point of voluntary codes of conduct? It's not an easy question to answer, given the complexity of how people act and work in organisations. At the top of companies, where power and egos play large roles, the interactions are likely to be multifaceted and hard to measure. But with all the attention on codes of corporate governance, it's worth asking what evidence is there that codes solve the "agency problem" they were intended to address? In a paper for the European Corporate Governance Institute, two scholars from Tilburg in the Netherlands and Exeter in the UK examined data from before the Cadbury reforms in 1992 and after to see what happened to two measures of constraint on the freedom of top managers. They looked at CEO turnover and executive pay plans to see how sensitive they were to performance measures. If companies do poorly, you'd expect to see non-voluntary change at the top and constraint on pay levels. The implementation of the codes, with enhanced disclosure of executive pay and new board structures, didn't seem to influence whether a CEO stayed in post during bad times. Nor did the ownership structure: Companies with large shareholders didn't change poorly performing CEOs any more than those with dispersed shareholding. With regard to CEO remuneration, they sketch a nuanced picture. "[T]he regulatory effort undertaken in the UK over the 1990s has had at best a moderate effect on increasing executives' accountability and performance sensitivity of their turnover," they write. So much for codes.

Source document: The working paper "Managerial Remuneration and Disciplining in the UK: A Tale of Two Governance Regimes," by Luc Renneboog of Tilburg University and Grzegorz Trojanowski of the University of Exeter, is a 52-page pdf file.

Attacking the sharks – new twist in audit competition

If the European Union's internal market and competition authorities were looking for something to do, they've found it now. Four mid-sized accountancy networks have made a joint approach to Brussels to attempt to turn the heat up on the simmering issue of competition in audit. BDO, RSM, and Grant Thornton ranks fifth, sixth and seventh in the market for audit, but they are each a long distance behind the Big Four. Mazar's is even further behind. But the four firms think there is a "credible alternative to the status quo". They claim that voluntary market based initiatives that have been tried in some countries haven't done the trick, so a new approach is needed.

• Contractual constraints: The firms want prohibition of contractual clauses and other institutional bias in favour of the four dominant firms.
  
• Reassessment to prompt rotation: Companies should be required to undertake regular reassessment of audit appointments thereby ensuring that audit committees and shareholders determine whether the current audit offering meets their needs and to look at the approaches of alternative firms.
  
• Enhanced scrutiny: Authorities around the world should undertake "cooperative and global assessment" of significant mergers or acquisitions by globally dominant players whose consequence is to prevent others from developing international capabilities that will provide a real and credible choice.

Source document: The Mazar's version of the joint statement explains its thinking.

The marriage-go-round in trading venues goes around again

After a few years of worrying more about the health of the companies that trade on the world's stock exchanges, suddenly the exchange companies are worried about their own businesses again. In a sudden flurry, the London Stock Exchange announced a merger with the Toronto Stock Exchange, and then NYSE-Euronext said it was discussing a merger with Deutsche Börse, the company that owns the Frankfurt bourse and the Eurex derivatives market. That would put the Chicago derivatives company CME in an awkward position with both Liffe and Eurex in the same hands. The question on everyone's lips, though, isn't so much why is this all happening, but rather: why do these companies exist?

Exchanges grew up in a different economy, when traders met in person to come to trust one another (well enough, at least) to conduct business. The exchange was the venue for the meeting, and the landlord laid down rules of conduct. Now, regulators take on the rule-making, and networks and computers provide the meeting place. Who needs an exchange? Changes in regulation killed what little was left of the natural monopoly of bygone days, and those networks and computers provided the means by which investors could aggregate the information needed to see even the liquidity collected in dark pools.

Exchanges still hold some remnants of national identity: Witness the official French discomfort when the Germans seems to be gaining pride of place with Frankfurt, not Paris, as the European headquarters of the company that could be fetchingly called DBNYSE. The surprise here is that by market capitalisation, Deutsche Börse's shareholders would get 60 per cent of the shares in the merged company. How the Americans have been humbled! But these companies and the services they provide are less and less to do with national competitiveness and more and more to do with the speed and cost of executing block trades on behalf of hedge funds and other high-frequency traders in shares of companies based somewhere else in the world.

In London and Toronto, the merger is less political and more obviously commercial. But London's value as a trading venue has seen perhaps the biggest transformation. Its trading volumes have been affected by off-exchange platforms and order internalisation more than most. And its listing portfolio, especially of large companies, looks less and less like the country in which it happens to reside. This story is back, and it isn't over.

Source documents: The NYSE-Euronext news release tells its side of the story. The LSE statement explains its rationale for the deal.

The avoidable and inevitable in the banking crisis

What caused the financial crisis? The US government's inquiry has now closed and its report – all 662 pages of it, plus many supporting documents and studies – paint a picture that the members of the Financial Crisis Inquiry Commission itself could not agree upon. Three of the 10 members joined in a dissenting statement. Another wrote a separate dissent. The other six, writing as "the Commission", concluded that the crisis was avoidable, the result of human actions, inactions, and misjudgments. Warnings were ignored. "The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again."

The split was largely partisan: Democrats concurred, Republicans dissented. That isn't the best starting point for legislative or regulatory action, given the lack of consensus on Capitol Hill and with the White House in control of one party and the House of Representatives in the hands of the other. But whatever the political basis of the split, a deeper logic rests in the divisions. To what extent can we really foretell the future? How do we know where the limits to our foresight are?

It matters: "The Commission" wrote: "As this report goes to print, there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away."

It's emotive: Because it matters, those drafting the report let their language rip. The report points to the failure of regulation and supervision, and especially of the Federal Reserve Board, as the root of the problem. The spread of toxic mortgage was preventable. The Securities and Exchange Commission could have forced investment banks to hold more capital. The Federal Reserve Bank of New York could have "clamped down on Citigroup's excesses". Policy-makers and regulators "could have stopped the runaway mortgage securitization train". Where they lacked power the regulators could have sought it. "Too often, they lacked the political will – in a political and ideological environment that constrained it – as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee," the report says.

But there was more to it than that. Bank boards ignored issues in risk. "There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation," it says. AIG's senior management was ignorant of the risks of a $79 billion exposure to derivatives. Merrill Lynch's top management was surprised to find it held $55 billion of mortgage-related securities that were supposed to be "super-safe" and weren't.

Moreover, "there was a systemic breakdown in accountability and ethics." But to blame the crisis on greed and hubris would be simplistic, it said. Rather, the issue lay with the failure to take human weakness into account.

The dissenters: The three commissioners who joined in dissent included the vice chairman, Bill Thomas. They accused the majority of writing more than 500 pages of description, without really analysing why the crisis happen. The report is simply too simple: "Both the 'too little government' and 'too much government' approaches are too broad-brush to explain the crisis," they say. The housing bubble wasn't just in the US, and in other countries it wasn't tied to mortgage securitisation. How could the crisis be a result of political paralysis in Washington, if the same bubble characteristics can be seen in Dublin, Amsterdam and Reykjavík? "How," they ask, "can the 'runaway mortgage securitization train' detailed in the majority's report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States?" This wasn't a runaway train, they dissenter might have written, it was "Murder on the Orient Express" – everybody was to blame.

A different dissent: Peter Wallison thinks that's too easy an answer, and too difficult an explanation to guide policy. Other countries had housing bubbles, it's true, but they didn't suffer from the same collapse that the US did. Moreover, no major financial deregulation had occurred in the past 30 years, Even the repeal of part of the Glass-Steagall Act in 1999, which had prevented retail banks from affiliating with securities houses, seemed to have no connection to how the crisis unfolded. Wallison thinks there's a simpler answer: government policy of promoting home ownership by people who couldn't afford created the bubble. Expansive actions under both Presidents Clinton and Bush, efforts by Fannie Mae and Freddie Mac to boost volume, and policies of the Federal Housing Administration pumped up the market. The decision by government to orchestrate a rescue of Bear Stearns in early 2008 then led the market to conclude that the pressure was off. Government would rescue anyone who failed, so self-restraint vanished. Mark-to-market accounting then made many appear to have been weakened when little had happened.

So, what now? The policy implications of this analysis are far from clear. The split along political lines in the commission combined with the split in government will mean that no major initiative is likely to arise from all the testimony, reports and writing that went into this study. A pragmatist would look, therefore, for little things to do that might do something. That's were Wallison's dissent is instructive. Fannie Mae and Freddie Mac won't go back to business-as-usual any time soon. Government's role will get smaller because it can't get larger. Equilibrium will be restored to the housing market, we guess, but at a lower velocity. And perhaps that's good enough. For the next crisis won't be the same as the last. For that, the attention of policy-makers should be on education, innovation, and the imbalances in trade that makes a sovereign debt crisis loom on the horizon. Those have the look of the inevitable, not just the avoidable.

Source documents: The website of the commission has links to the conclusions and dissents as well as a library of the studies and comments that led to its findings. The full report is a 662-page pdf file.

What next, as SEC adopts 'say on pay'?

The controversy seems a little odd, from a European vantage point, where in several countries shareholders already have a right to vote on the pay policies of companies. As in the UK, those votes are mainly non-binding: companies don't have to accept shareholders' opinions on them, even though they do on a lot of other matters. In the US, however, almost all shareholder votes are non-binding and even director-elections are de facto non-binding as you cannot vote against a director. But at the end of January, the US Securities and Exchange Commission voted to require companies to give shareholders a "say on pay" and on the so-called "golden parachutes" that executives received when ejected from the pilot's seat after a takeover bid or other dismissals not-for-cause. The SEC was divided, along party lines, on the vote, with the Democrats winning the day. Shareholder meetings of larger companies happening on or after January 21 this year will have to let shareholders decide whether to have such votes every year, every two years or every three. Smaller companies won't have to comply for another two years. "I believe that this two-year deferral is a balanced and responsible way for the SEC to ensure that its rules do not disproportionately burden small issuers," said SEC Chairman Mary Schapiro. But it was this inclusion that led to the split. The Republicans wanted small companies excluded altogether. Schapiro said the two-year deferral would enable the SEC to adjust the rule if appropriate before it smaller issuers have to comply.

So far so slow. The enhanced disclosure of executive pay, pioneered in the US and now widely required by law and regulation in countries around the world, has done little to halt the upward spiral of top-management pay. If anything, it may have accelerated it, as a variety of academic analyses have concluded. Having a public vote on policy may embarrass a board into modifying its stance or thinking twice before proposing something likely to stretch the limits. Coupled with the end to broker-voting of shares held on account, shareholder activists could get a larger voice and more to shout about. But turnout will fall, putting the legitimacy of shareholder votes in doubt. When brokers were allowed to vote shares on behalf of silent clients, the legitimacy was anyway in doubt. But the percentages voted at least looked half-way legitimate. And now?

The bigger question is the disconnect between shareholders and the concept of ownership. To be sure, some institutional shareholders operate as if they cared about the companies in which they invest. But the combination of leveraged holdings, high-frequency trading and the ever-expanding layers of intermediaries between the end-beneficiary and the company mean the concept of ownership – let alone of "stewardship" – is strained. In the US it hasn't mattered before. Shareholders had so few rights that ownership wasn't an issue. That's why the activists embraced agency theory and its prescriptions of mechanisms to align incentives in pay with shareholder interest. The manifest failure of those mechanisms demonstrates that boards and directors aren't the machines that the behaviourist (and behaviouralist) thinkers thought they were. Ownership, in any traditional sense, implies accountability in both directions, and that requires dialogue. This say-on-pay, exercised by lobbyists and fly-by-wire traders, will be at best a dialogue of the deaf.

Source document: The SEC news release has a link to the video of the chairman's statement.

What to watch for as US shareholders vote this year

The annual guessing game – and it's not such a big guess – is on. What topics will dominate the annual meeting season? In the US, a lot of the issues are those raised by the proxy voting agencies, whose clients then ensure that at least a degree of interest will be taken when the proxy statements arrive with their shareholder resolutions and the management resolutions that the agencies don't like. This debate is likely to intensify as shareholders gain greater "access" to the proxy statements, and we see already in this year's issues thinks likely to grow in importance in the future. According to two communications and proxy solicitation firms, the patterns are in evidence:

• Just say no: Campaigns are appearing for shareholders simply to vote against any management proposals or withhold votes from incumbent directors seeking reappointment.
  
• New voters and non-voters: In the past, boards have often been able to count on stockbrokers to help them out. Brokers that hold shares on account of end-investors have long been able to vote the shares as they choose, unless the clients had specifically requested to vote themselves. Broker voting is no longer permitted, so the votes of passive investors, once exercised by management-friendly investment banks, won't count, giving the activists more clout.
  
• Fast reporting: It's not quite "real-time" reporting, but US companies now have to report the outcome of shareholder votes within four days of the annual meeting.
  
• Old chestnuts: Executive pay will provoke a lot of concern, as it has ever since shareholder activism emerges as a force in the 1980s. But there's new impetus, linked to …
  
• New chestnuts: Pay is linked increasingly to risk, and risk management disclosures – including the board's role in risk – need to be made. In this context will come at least a risk-based view of climate change.

And more. You don't have to read the financial newspapers to know that investors have been upset by the secrecy surrounding the medical leave of absence that Steve Jobs has taken from Apple. Succession planning will be on the minds of investors even more than on the proxy statements.

Source document: The briefing note by Robert Berick of Dix & Eaton and Rachel Posner of Georgeson appeared originally in The Corporate Board.