Archive | March, 2009

Rights of Public Shareholders

Lawrence E. Mitchell just published a very thoughtful paper, The Legitimate Rights of Public Shareholders. He argues that shareholders don’t contribute capital to finance industrial production but are, instead, net consumers. Since their investment incentives "significantly distort the behavior of corporate managers," leading CEOs to value stock price at the expense of long-term business health, shareowner rights should be eliminated, instead of expanded or enhanced.

The article reminds me a of Marjorie Kelly’s The Divine Right of Capital, which argued that instead of maximizing the return to shareholders, corporations should maximize total return …a concept I have been advocating at CorpGov.Net since 1995. Total return implies the long term efficient use of all resources, both natural and human.

I agree with both Mitchell and Kelly that, generally, stockowners aren’t providing capital to a company. We are buying shares from another stockowner, gambling the price will rise. We aren’t really investing, in the traditional sense. We’re buying the right to extract wealth in the future. I liked Kelly’s argument that efficiency is best served when gains go to those who create wealth. That puts an emphasis on brain power and knowledge workers.

Of course, the revelation that shareholders don’t contribute much isn’t new. Back in the 1960s Louis Kelso asserted that 99.5% of corporate capital came through internal earnings and debt. This insight led him to advocate employee stock ownership plans (ESOPs). Norm Kurland took up the cause with a call for a Capital Homestead Act. Kelly endorsed a similar idea and a renewed look at charters and other stakeholder reforms. Making every citizen a shareowner, especially in a broad-based basket of stocks, has appeal. Everyone would benefit from the wealth corporations develop. Yet, if ownership were universal, there would be little incentive for owners to externalize costs onto society.

Mitchell is less imaginative in this paper. He’s not sure if the problems can be solved by electing directors for five-year terms, letting creditors also vote, or by eliminating shareowner votes on all but except directors. This contribution is worthy, not in recommendations, which he says are beyond its scope, but rather in documenting a dramatic increase in off-balance sheet debt, the rise of stock buybacks, the fall in dividends and retained earnings and, more generally, the shift from "achieving gains from production to using the corporate machinery to manipulate stock price."

Yes, the shift from dividends to capital gains has distorted incentives in a way that "encourages managers to harm the long-term health of their corporations’ businesses in order to satisfy current shareholder demands." Yes, many forces have moved investors to think of themselves as simple gamblers based on speculative future value, rather simply extracting dividends from actual earnings. Yes, interested parties pushed more churning because it meant more commissions and fees.

However, I don’t think it follows that we should now begin to rely more heavily on the market for corporate control, especially one where shareowners are given less power. As an article in the FT points out, in the US overall debt reached an all-time peak of just under 350% of GDP, 85% of it private, up from 160% in 1980. (Seeds of its own destruction, 3/9/09) Like global climate change, we need to develop more sustainable models, both for corporations and for a salubrious environment.

Doing away with shareowner proposals under Rule 14a-8 won’t make companies more responsible. Shareowners raising issues through such resolutions serve as a better proxy for the public than reinforced insulation of CEOs and boards. After all, if the market had listened to ICCR’s warnings over many years and 120 resolutions on subprime lending and securitization, we probably wouldn’t be in the current financial mess. The fact that only 5% of retail shareowners are now voting under e-proxy is a sign that proxy voting must be made more meaningful, not less meaningful.

We should be looking at how to address short-termism and conflicts of interest that lead to gaming of numbers and the entire system. Perhaps long-term shareowners should have more voting rights. Maybe if more employees were shareowners we’d have a few employees on boards who are more likely to take a longer term perspective than day trading investors. Additional fiduciary duties on boards for the welfare of employees, the economy in general or for a salubrious environment might add a bit of stability and long-term thinking.

Why not look at the increase in off-balance sheet debt, the rise of stock buybacks, the fall in dividends and retained earnings and other shifts to manipulate stock price and address them directly? Mitchell had a better idea in The Speculation Economy: How Finance Triumphed Over Industry. There, he proposed the terms of capital gains taxes be tied to industry. For the auto industry that might be a tax on 90% of gains if sold in the first month, tapering to tax-free after seven years. "Perhaps the right time period is two years in the software industry, or four years in computer hardware." At least that solution actually attempted to address fundamental problems. Disenfranchising shareowners does not.

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Corporate Rescue Law

With the growing number of bankruptcies in industries ranging from financial, manufacturing, to retail, what could be more timely than Corporate Rescue Law – an Anglo-American Perspective? Gerard McCormak’s review of practices in the two countries concludes there is more convergence than is generally recognized. the us moving is in a UK direction with regard to disposal of profitable components, rather than carrying on through the bankrupt corporate entity.

Both shareowners and creditors generally come out ahead when debt is restructured privately, rather than through Chapter 11. Such private restructuring is more likely to succeed when commercial banks or other sophisticated investors are involved and is facilitated when debt is concentrated, as through trading by vulture funds who are advantaged by private settlement, rather than going to court, which tends to be a more costly and time-consuming process.

McCormak provides an overview of recent law and legal thought, explaining the fundamental features in both the US and UK, entry routes to changes in corporate control, moratoriums on creditor enforcement actions, mechanisms to address financing difficulties, the role of employees, and restructuring plans themselves.

The US debtor has more rights to formulate a reorganization plan, has more prescriptive rights with regard to dividing creditors into classes, has cram down capability in exceptional circumstances to force acceptance by creditors, and has traditionally focused on getting the corporate vehicle in working order.

However, McCormak finds that a growing number of bankruptcies, at least among larger companies, have been essentially pre-packaged deals involving going-concern sales of company components blessed by the court to ensure conduct that brings the highest price. in contrast, the UK approach largely leaves matters to creditors, respecting the values of “simplicity and economic self-determination.”

Economics Of Corporate Governance and Mergers

This is a wide-ranging reader, with theory and empirical studies, domestic and international well represented. For example, one paper casts doubt on the frequent assertion that common law countries have better shareowner protection than civil law countries. Another examines the role of directors and the question of emphasis (monitoring vs. participants in management). Central to corporate governance are issues of mergers and acquisitions. If internal governance mechanisms are ineffective, which I have argued for decades, hostile takeovers can act as the avenue of last resort to discipline managers, although this all too often comes at the expense of acquiring shareowners.

Stephen Martin looks at five waves of mergers and finds irrational exuberance often plays a crucial role, concluding that although reasons for such waves may vary, results do not generally benefit shareowners. Another paper by Mike Scherer provides evidence that mergers do not generally increase productivity, despite glowing predictions by management. As the editors note, the findings of accounting data contrast sharply with those of the finance literature, short-term stock market event studies. Rises in merger activity are likely attributable to empire building by managers.

Examining Japanese mergers, Hiroyuki Odagiri finds mergers generally hurt relative profitability. A UK study finds that acquisitions, after implementation of the Cadbury Code, experience better long-run returns but the driver remains CEO ownership. Gerhard Clemenz creates a theoretical model to study the impact of vertical mergers between producers and retailers, finding that integrated firms should be better able to monopolize markets and drive up retail prices. A study of 13 indicators on competition for 29 countries finds economic performance best predicted by the degree of competition.

Not all the authors take a shareholder maximization of value view of the firm. Branston, Cowling and Sugden, for example, explore redesign of company laws based on wider membership and creation of more democratic forms. In “Corporate Governance and the Public Interest,” they call for greater participation by the public in strategic decision-making, especially mergers in the financial, IT, and communication sectors. Here, I found convincing arguments that an educated and participatory democracy can only be obtained with a communication revolution, since advertizing revenue now allocates coverage and interest.

The editors conclude that “corporate governance systems that better align shareholders’ and managers’ interests lead to better corporate performance” and “there is an important relationship between corporate governance structures and the quality of firm decision making,” especially with regard to mergers and acquisitions. Since most are suboptimal for both shareowners and society, “the suspicion remains that corporate governance systems and mechanisms are not yet optimal.” Masters of understatement but the volume includes a good collection of important reading and commentary.

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