idiots

Turning Corporate Governance Over to Idiots

idiotsThe Deal Professor, Steven Davidoff Solomon, recently discussed voting rules aimed at fostering “long-termism” in his post, France Answers Hostile Bids With the Two-Vote Share. While less damaging than dual-class shares issued at the IPO stage that continue ad infinitum, importing such a scheme to the United States would reinforce the behavior of idiots.

Rewarding Idiot Behavior

Two-vote shares after two years of ownership has a good intuitive feel. Why not reward long-term holders with more votes? But it also reminds me of arguments that students shouldn’t be able to vote in university towns because they are only temporary residents. I’m unfamiliar with the Florange Law, to which Solomon refers, and suspect I might find many aspects appealing, especially in the French context. 

However, if double counting shares held for two years were imported to the US it would give inordinate power to index funds, which trade less frequently than actively managed funds and are built around the idea of minimizing costs to “consumers” of shares. In contrast, activist funds make their money by monitoring boards and managers and taking action to increase shareholder value.

It doesn’t pay index funds to spend on monitoring, since they never ‘overweight’ any one company. Every dollar they spend monitoring is an expense only to themselves but every dollar earned from monitoring must be shared with all other shareholders. In contrast, activist funds concentrate their investments into a few companies and take actions to ensure value is realized by the market. See parts 1-3 of my post Agency Capitalism: Corrective Measures.

idiotsIdiot: Word Origins

In essence, the French law incentivizes “idiot” corporate governance, in the sense of the original Greek meaning of that term. Idiots in Athenian democracy were those characterized by self-centeredness, concerned almost exclusively with private—as opposed to public—affairs. Declining to take part in public life, such as democratic government of the polis (city state), was considered dishonorable. “Idiots” were seen as having bad judgment in public and political matters, since they devoted little time to such duties and thus were not up on the issues of the day.

Unfortunately, social norms have changed over the last couple of millennia.  Now too few citizens or shareholders view refusal to actively monitor and participate in civic or corporate governance as dishonorable. That’s too bad. French sociologist Émile Durkheim gave us the term ‘anomie,’ the condition in which society provides little moral guidance to individuals. Of course, social bonds between an individual and community require a two-way street. I’m not sure we should trust index funds to direct traffic and make our major economic decisions, since they are incentivized to be “idiots.”

Idiots Aren’t Working for Shareholders

To further of exame this quandary, read Michael R. Levin’s Thoughts on Big Institutional Investors and Activist Investing. His quotes from letters to portfolio companies of heavily indexed funds BlackRock and Vanguard are instructive (further abbreviated here). From BlackRock’s CEO Larry Fink:

In our view, the board is management’s first line of defense against short-term pressures. Our starting point is to support management, particularly during periods where performance has deviated from the long-term trajectory.

As Levin notes, “BlackRock views the BoD as defenders of CEOs rather than shareholders, and supports management even when it underperforms.” Sounds like idiot behavior to me. And from Vanguard CEO Bill McNabb:

We have no interest in telling companies how to run their businesses, but we have valuable governance insights to share with the board of directors.

McNabb goes on to propose that boards consider a “shareholder liaison committee,” which Levin justifiably sees as a redundant sideshow. In Levin’s assessment, “he emphasizes gentle engagement on corp gov, rather than serious discussion of strategy, finances, and operations. He lets CEOs off way too easily.”

Engagement in Corporate Governance is Critical

Let’s not give more votes to to those least likely to keep up on the issues, monitor and take action… the idiots. I don’t mean to sound pejorative; I know many in the mutual fund industry who do a good job considering the resources available to them. However, the incentives just aren’t there… especially for those that essentially index. Activist funds really do have an important role. Your comments welcome, as always.

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5 Responses to Turning Corporate Governance Over to Idiots

  1. James McRitchie June 22, 2015 at 8:52 pm #

    I’m not sure I like it, but Toyota’s Toyota’s “Model AA” stock, which locks owners in for five years seems like a better idea than dual class shares with different voting rights. The Toyota AA shares carry normal voting rights but aren’t listed on any exchange. At maturity, holders can sell the shares back to the company at the issue price or convert them to ordinary stock. During the lockup, Toyota will pay a guaranteed dividend that increases each year. See http://www.bloombergview.com/articles/2015-06-22/toyota-test-drives-a-new-hybrid

  2. Matthew Illian June 23, 2015 at 6:29 am #

    I’ve learned a good deal from your insights over the last few months but I think you’re missing the bigger picture here. By dismissing the largest stock owners (fund companies) as “idiots” you’re creating division in a battle for greater corporate governance sanity which needs every friend it can find. While you may not like the company of the indexers, I expect you’ll find that headline grabbing activist hedge fund managers make for a fickle bunch of friends of the common good when their reputation is on the line.

    There’s another group of permanent investors who prove that a more passive investment strategy does not determine a passive governance strategy. State pension plans have for a long time led the charge as thought and action leaders in the effort to reclaim good governance. Fund companies could learn from the efforts of the Council of Institutional Investors (CII) as the learn to take their corporate governance responsibility seriously.

    Vanguard will never replace Bill Ackman but this doesn’t mean their efforts are fruitless. They may be a bit late in turning up to the party but I expect they’ll become the most powerful voice in corporate governance in the next ten years. I think they’ve gotten away with being disinterested in corporate governance only because the general public could care less. Why would a fund spend precious resources on investments that have little public value? Well, the times, they are a-changin’. Fund companies are becoming more active in their oversight every year. To this point, I think if any reads the entire text of the Larry Fink and Bill McNabb letters to directors, they will see that the thrust of the message is far different from what is indicated above. These are men who are acknowledging that they have a responsibility to remind corporate boards that they all serve the shareholders. The longer a fund company waits to become engaged in corporate governance issues, the less likely they are to be viewed as a trustworthy fiduciary of investor assets.

    In fact, McNabb’s letter emphasizes a one share – one vote policy which recommends against a dual class stock. But I’m not even sure that it’s fair to look at the new French two vote per share law as a dual class system. It sounds to me like it’s one class that has increasing rights the longer it’s held. We don’t have this in the U.S. but we do encourage long-term investing by reducing the capital gains tax rate when a stock is held for a year. Two years may be too long but I generally believe we need to applaud efforts to reward and encourage long-term investment.

    I think we can both agree that for the last thirty years, too many stock holders have acted like slum lord property managers. This seems to me to be the most plausible explanation of skyrocketing executive pay and a race to the bottom when it comes to environmental sustainability. Our economy requires that all stockholders regain consciousness and take the responsibility of ownership seriously.

    • James McRitchie June 23, 2015 at 7:23 am #

      Of course everything you say is true and many in the index fund world are waking up to the need for more monitoring. However, the financial incentives still push toward minimalism. Activist funds not only monitor and research like crazy, they then need to convince the Larry Fink’s and Bill McNabb’s of the value of their recommendations.

      I was simply fascinated with the word origins of ‘idiot’ and parallels between ancient Greece and today’s corporate governance. Another line of exploration could be SRI funds, compared to traditional mutual funds. In ancient Greece the idiots were those who were too self-centered to care about the community. Citizens didn’t just amass wealth, they participated in the polis. Likewise, those who approach investing as full persons, rather than as economic robots are being less idiotic than their counterparts just out to make money… at least in the way the ancient Greeks used the term. Your analogy to slumlord management is a good one. We should be able to make money, while at the same time making a better world for all. Idiots were focused too much on themselves.

  3. Matthew Illian June 23, 2015 at 8:47 am #

    I agree that we should be able to make money while at the same time making the world a better place for all but I would settle at the moment if we could just agree to do no harm. I think it’s important to remember that the economic robots can be both passive and active managers. Some activist hedge fund managers haven’t yet sold their soul, and they are doing good work for their clients and the long-term economy.

    But I’d like to go back to your argument about the economic incentives of index funds. At the moment, Apple is valued at approximately $733.3B and Vanguard owns about 5% of this stock or approximately $36.7B. If improved corporate governance policy can add even the slightest bit of value, both Vanguard and their shareholders benefit. For example, if the growth of Vanguard can be improved from 10% a year for the next ten years to 10.1% a year, this will add $367.7M of added value to the shareholders and approximately $2M (charging a mere 0.05%) to the bottom line at Vanguard. If this small return increase can be replicated by just a quarter of the companies on the fortune 500, the benefits for Vanguard (or insert other passive fund company) would multiply. I expect that you’ll see Vanguard and BlackRock siding with activists more and more in the coming years.

    James P. Hawley argues in his book The Rise of Fiduciary Capitalism that passive funds have a huge incentive to be engaged in corporate governance because this is the only influence they have as perpetual owners. I expect that some combination of public outcry, fiduciary duty and economic incentives will push fund companies towards pursuing best-in-class corporate governance practices.

  4. James McRitchie June 23, 2015 at 2:14 pm #

    Sure, if Vanguard could move Apple’s stock they would benefit… but they would only get 5.7% of the benefit. A large part of the remainder would go to their competition. AND Apple is only 2.2% of Vanguard’s portfolio.

    SSgA gets 4.1% for no effort; BlackRock 3.9%; Fidelity 2.9%, Northern Trust 1.4%; Wellington 1%; Icahn Associates .9%. Will largely indexed funds spend real money on monitoring and activism. Yes, they’ll vote and we need their votes. Now they’re sending letters. That’s a good sign. However, of this list only Icahn is really economically motivated. Even though Vanguard has a 6 times the stake, Icahn’s stake represents 20.5% of his portfolio.

    I have never seen any of these large funds file a proxy proposal, let alone run a proxy contest. Maybe diversity should be limited to no more companies than a fund can handle to be actively engaged? I’m not sure what the answer is. I am glad that hedge funds make few investments and really engage. I am glad that public pensions, SRI, and union funds don’t feel the same constraints as the large mostly indexed private funds.

    I loved The Rise of Fiduciary Capitalism but universal owners aren’t going to save us. The large funds compete more on attracting customers than they do by earning them money. And they game the system by opening and closing funds to make performance look better than it really is. Hopefully, regular people will wake up someday and start comparing voting records… as well as economic performance records.

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