Tag Archives | Leo Strine

Jill Fisch: Index Funds Investors Can Switch

Jill Fisch, et al. addresses a central myth around index funds and investors in Passive Investors (June 29, 2018). Her research has implications applicable to recent analysis and recommendations by Delaware Supreme Court Chief Justice Leo E. Strine Jr., Professor Lucian Bebchuk and others.  The following is the central highlight:

Our key insight is that although index funds are locked into their investments, their investors are not. Like all mutual fund shareholders, investors in index funds can exit at any time by selling their shares and receiving the net asset value of their ownership interest. This exit option causes mutual funds – active and passive – to compete for investors both on price and performance. While the conventional view focuses on the competition between passive funds tracking the same index, our analysis suggests that passive funds also compete against active funds. Passive fund sponsors therefore have an incentive to take measures to neutralize the comparative advantage enjoyed by active funds, that is, their ability to use their investment discretion to generate alpha. Because they cannot compete by exiting underperforming companies, passive investors must compete by using “voice” to prevent asset outflow.

In the case of Strine’s concerns with political contributions, use of “voice” would be voting in favor of measures requiring shareholder approval or at least transparency of political contributions. While Strine’s paper was based on actual behavior, Fisch points to potential, if funds operate logically. The potential for “voice” to ensure competitiveness with active investors also addresses, at least in part, some of Bebchuk’s concerns.

Fisch also points out in another paper (Shareholder Collaboration) that passive investors are increasingly engaged in information production of their own, not “just as ‘reticent’ supporters of initiatives undertaken by activist hedge funds.” Because of their size, huge passive index funds often cast deciding votes. Because of their market-wide focus, they often have information the firm insiders do not have. In many cases the potential rewards for index funds can be disproportionately high, compared to their investment in time, since they typically hold a significant portion of the outstanding stock at most large firms.

Fiduciary obligations are complicated.  “Mutual funds’ fiduciary duties require them to vote in a manner that benefits their investors, not each company that they hold in their portfolio.” (Passive Investors) For example, holding both target and bidder might lead to a different vote than holding only one.

Most troubling was the following:

Delaware law provides shareholders with the right to vote their shares as they see fit and does not impose any obligation on shareholders to vote unselfishly or to further the economic interests of the corporation. [See, e.g., Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling, 53 A.2d 441, 447 (Del. 1947) (“Generally speaking, a shareholder may exercise wide liberality of judgment in the matter of voting, and it is not objectionable that his motives may be for personal profit, or determined by whims or caprice, so long as he violates no duty owed his fellow shareholders.”).]

Given that funds operate within such a weak standard, it is important that individuals, the real Main Street investors in index funds, have ready access to voting records in an easily compared format. Keith L. Johnson, et al., point out the importance of fiduciaries conducting “congruity analyses of proxy votes” with public statements statements by delegated fund managers.

As an example of how such potential inconsistencies might present, BlackRock states in its Investment Stewardship 2018 Annual Report, “During our direct engagements with companies, we address the issues covered by any shareholder proposals that we believe to be material to the long-term value of that company. Where management demonstrates a willingness to address the material issues raised, and we believe progress is being made, we will generally support the company and vote against the shareholder proposal.” (Emphasis added.)

On the surface, this stated practice of voting against shareholder resolutions that have been determined to be in the best interests of the company suggests there is a preference for supporting management over the interests of clients in improving company performance as soon as practical. The resulting disconnect between value creation and proxy voting sends mixed signals to clients, the company and the marketplace. It could have the practical effect of giving companies more room to ignore or delay value enhancing actions.

Fisch argues that index fund investors can switch and some can. However, many employer sponsored 401(k) and other plans provide few choices. Main Street investors are often, as Strine notes, “forced capitalists.” If their 401(k) plan administrators take little or no initiative to investigate potential conflicts or breaches of fiduciary duty, how would they know? Like index funds themselves, the only tool “forced capitalists” might have is “voice.” However, like index funds, they need information before they can voice concerns.

Under the current system, proxy votes only need to be disclosed once a year and can be in a format that makes sorting and analysis difficult. More frequent, transparent and user friendly proxy voting records would make it easier for employees to argue for investment options better aligned with value creation. Such information would also make it more difficult for employers to ignore their fiduciary duties.

Real-time, or close to real-time, proxy voting disclosures using an internet window into each fund’s existing proxy voting platform would facilitate the ability of Main Street investors, the beneficial owners, to hold companies accountable through the complex chain of ownership. Several public pension and “socially responsibe” mutual funds have made such disclosures for many years. (See an incomplete list in our Shareowner Action Handbook.)

I will address more of the rationale and benefits of “real-time” disclosure in an upcoming post. Check back or subscribe to email notifications.

   

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Video Friday: Quadruple Feature Thanks to CorporateAffairs.tv

BrocRomanekBroc Romanek‘s CorporateAffairs.tv has started with a bang and plenty of early content in the form of brief videos that even those of us with attention deficit disorder can watch without missing a beat. Some in the ‘entertainment’ category are not so much for me. Still, it is great to see Broc and friends having fun. We’re too often in jobs or situations where there is far too little of that.

In the education category, a couple of my favorites include Birth of the Securities Act of 1933 and Shareholder Proposals: Who Submits Them? Continue Reading →

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Video Friday: Replace the Goldman Sachs Muppets

Goldman Sachs has come under fire for placing its interests above those of clients, lack of transparency and insensitivity  regarding its compensation practices. Goldman has been the target of numerous investigations, enforcement actions and private litigation. Key governance flaws include executive compensation and business practices that create financial and reputational risks. Continue Reading →

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Strine Rocks Stanford

The last time I covered an event sponsored by the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford I complained that it was just attended by a few Stanford students. Such a program would have packed the house at Harvard, with students coming from all over the Boston area. (Stanford Rock Center Proxy Access Forum) This time I don’t know where they came from but the auditorium was packed… standing room only. Maybe it was the featured speaker who may just have more influence on corporate governance than anyone else in the whole world. (Disclaimer: These are my recollections of the event. I don’t type quickly and I didn’t record it, so there are bound to be errors. Let me know if you spot any. Oh, and sorry about the poor quality photos; I lost most in a download glitch.

Ron Gilson

Ronald Gilson introduced the Honorable Leo E. Strine, Jr., Vice Chancellor of the Delaware Court of Chancery, noting the Chancery is the closest to a common law court that we have in the US. He praised the court for linking experience and logic. Judges at the Chancery come over time to deeply understand their subject matter and many of the leading cases have been written by Strine over his 12 years at the Court. Not only is he widely known and respected for the opinions he has rendered, he is also one of leading scholars on corporate governance based on published articles.

Gilson also likened Strine to Groucho Marx.  I don’t recall if Gilson elaborated on that comparison but I presume it is based on Strine’s quick wit and rapid fire monologue. Strine welcomed the comparison, saying he had just watched Duck Soup (a political farce) again the other night. He played to his audience with quips, such as Harvard being “Stanford East.” He made cultural references from Leave it to Beaver and Gilligan’s Island to current rock tune lyrics. Weaving humor and popular culture references into his talk gave a light tone to an important subject that impacts us all.

Strine began talking about the long tradition in the Delaware Chancery of being immersed in both the academic and real world. He related a story or two that conveyed to the audience that he believes government has an important role to play. Water, the Internet, etc. allow commercial exploitation of public technology. Government does make a contribution.

Leo E. Strine, Jr

The generation of durable wealth is (or should be) the primary goal of for-profit business.  The law provides investors limited liability to encourage wealth generating innovative behaviors that involve risk. Isn’t technology great. You can look at beautiful people on your laptops or iPad at the same time you listen to me speak, he said.

Strine made it clear that he favors a republican model of corporate governance over a democratic model, that is corporations are  representative democracies, as opposed to direct democracies. In corporate governance, shareowners elect the board and the board represents the shareowner’s interests in their relationship with management. Shareowners may be required to vote on mergers and in other rare circumstances but primary authority is left to directors. The investor’s firm specific risk can then be diversified through many investments, which take only minimal involvement.

Direct democracy would refocus management’s attention from the actual business to meeting shareowner demands. Managers would become politicians.  (Sidebar: See Toward A True Corporate Republic: A Traditionalist Response To Bebchuk’s Solution For Improving Corporate America, Harvard Law Review, 2006, which is written by Strine but “should not be confused” as representing his own opinion. It is offered as the perspective of “an open-minded corporate law ‘traditionalist.’ My description of this perspective attempts to describe fairly a school of thought about the American corporate governance system that not only has many adherents among investors, but also pervades the two major political parties whose members populate Congress and state legislatures,” says Strine. So, although the viewpoint is disclaimed as Stine’s, it appears he believes it is held by just about everyone else of any importance, except Lucian Bebchuk.)

Because corporations are republics, we have an interest in the fairness of elections, especially the election of directors. Indexed funds have no option to exit; they hold bad companies all the way down, until they’re out of the index. Investors are (or should be) looking for boards to ensure a sound corporate strategy, avoiding imprudent risk. There are collective action problems. Affordable challenges to management and entrenched boards (he didn’t use that term) are important in letting the market work. Strine appears to approve of an enhanced Rule 14a-8(i)(8), opt-in option for shareowner director nominees… not surprising, since that’s what Delaware adopted. (see SEC Commissioner Troy A. Paredes’ 5/20/09 speech on the subject) Strine believes the rules regarding shareowner nominees should be “investor driven,” rather than mandated by government. That would make better use of the corporate treasury by avoiding nuiscance campaigns. Investors should decide issues like when challengers would get a subsidy. Majority (of shares) should decide for themselves.

Then Strine took aim at investors with short time horizons. It isn’t just managers and directors who have a role to play if the system is to work. Shareowners must also fulfill their role with their own long-term interests in mind, based on their usual time-frame for investing, saving for the college expenses of their children and for their own retirement. Strine talked about the “separation of ownership from owners,” with more and more stock being held through intermediaries.

What are the most widely held companies in America? They’re not companies that actually make something, they’re funds like Fidelity and Vanguard. Here, as I recall, he made an indictment central to the whole talk; the more rights have been given to “alienated shares” (since they’re owned indirectly through funds), the more we are driven to short-term strategies of investing and governance.

His points then began to come in rapid succession, so I started taking them in bullet form.

  • stockholders who make substantive proposals should have substantial long-term interests… $2,000 threshold far too low
  • disclosure requirements should be updated regularly, 13D requirements are a joke; the English have figured this out
  • Adolf Berle – embraced by right wing-nuts. Strange reinterpretations out of Chicago. Adolph Berle discussed separation of ownership from management and control but now we have separation of ownership from ownership. Too many fund managers are looking out for their own interests, rather than those of beneficial owners. He doesn’t believe in an unregulated market. Concerned about dispersed weak stockholders. Managerial class could become dominant (but now we should be more concerned with fund managers?). We’re obsessed with agency costs… could be “part of a drinking game.” Separation of ownership from ownership is one of the very big problems.
  • Vanguard, Fidelity and other funds have the most stockholders (implication, with very little voice)
  • 70% stock controlled by institutional investors…. subsidized by tax breaks…. limited choice through your typical 401(k) plan
  • mountains of money flowing to these funds.
  • hedge funds – good news you may get to invest in them through your pension fund because they’re “sophisticated investors.” But your pension trustees are not and they’re investing in hedge funds with an average 300% turnover.
  • Mutual funds – 100% turnover a year turnover… pension funds similar
  • 138% turnover in 2008 but then I thought he said 300% in 2008 across all exchanges. Anyway, point is too much turnover.
  • High speed trading strategies are inconsistent with likelihood of beating the market…. Strine’s an indexed investor.
  • Unfortunately, the time horizon of many institutional investors is one year or shorter.
  • Owning Intel 10 times in 8 years isn’t long-term investing.
  • The most rational investors are the least represented.
  • Hedge funds, pressured to deliver 30% returns, are going to focus on short-term.
  • Fund families normally vote together. Indexed funds within family echo the voice of family’s active funds, even though time horizon longer.
  • Easy to press for votes because of internet.
  • Excessive leveraging, accounting, managing risk (Says, won’t find these as corporate governance strategies — but actually I think TCL and GMI have been strong in these areas)
  • Got CEO link to pay only after pressure from institutional investors and pay then soared.
  • Reduction in takeover defenses, pill, majority voting (70% of largest firms now have)
  • Short-term investors pressed for stock buy-backs, CEO turnover.
  • Strong market for corporate control. Boards have never been more responsive. Excessive risk, under investment in firm.
  • Contradictory to fight for shareowner rights and long-term growth since 100% turnover each year.
  • Also fueled by ISS, which has a 2 year time-frame for their policy.
  • Capital gain tax policy based on 1 year equated with long-term holding.
  • If given more clout, it is vital that institutional investors be more accountable to beneficiaries and fund holders.
  • Fund managers must compete on qtrly basis, since we buy into what’s hot and trade out of those that are prudent.

Strine ended by quickly throwing out some reform ideas to consider. (some of these may have been from a keynote at Directors Forum 2010) I didn’t get them all down but here are a few:

  • Pricing and tax to discourage short-termism and fund hopping.
  • Informed voting mandate has been potent. Unfortunately, there has been no informed investing mandate. Fundamental risk should be factored in.  Build fundamental risk analysis into corporate governance measures. We need balance in risk compared to voting.
  • Compensation of investment managers should be based on the horizons of beneficiaries and beneficial owners. Incentives should be based on long-term holding.
  • 401(k) and college plans consistent with those time horizons. Stop mixing altogether. Create funds that focus on those objectives
  • Indexes should act and vote consistent with long-term — stop giving vote to short-term buybacks and other strategies that temporarily bump up stock but actually rob from the company’s future.
  • Limitations on leveraging and disclosure by hedge funds. Decrease ability to push companies into risky business.
  • Proxy advisory services – “shouldn’t have to pay for the recipe.’ Should be able to read the cook book (can’t you? — You can at RiskMetrics, they even invited comment before finalizing for season). Can’t rely on voting advice unless their horizon is at least 5 years.
  • Fixing the definition of “sophisticated investors.” Many trustees aren’t sophisticated investors and shouldn’t be able to take their funds into unregulated pools. If pools dry up, that may lead hedge funds to disclose, since they need that capital. County pension funds are generally not sophisticated investors…. its your money…. publicly subsidized. They are not effective monitors. Chasing returns is digging deeper holes. Yet, they insist they want access. There aren’t as many personal sophisticated investors…. if they don’t qualify as someone who can easily afford to lose their money, they should be banned or trained and certified.
  • We need to know more about hedge funds – positions, voting policies, etc.

Nonbinding annual say on pay (Microsoft proposed a more sensible every three years), election reform, how much further can we go? Further incursions on the republican model create a public forum for pet concerns. Just how much direct democracy do we want?  Constititons promote stability. The Senate is the oldest classified board. More important to promote long-term outcome.

Californians should have a special ability to identify with the problems of direct democracy because some of the mess out here (my words) is proposition driven. Companies (management) should have more leeway not less. 14a-8 voice nonbinding plebicite. $2,000 stock, no filing fee. Issues of corporate governance claiming to link to corporate profit should only be introduced in resolutions by shareowners with millions of dollars in holdings and a $2,000 filing fee. The current process ties up directors and officers with issues de jour without substantial benefit to the company or most investors.

Boards are working harder but not on the right things. We’ve mandated too many independent committees. The boards priorities have shifted to accomplish what is legally mandated first. You get what you mandate. New laws and mandates tell boards what more they are required to do but not what they can now do less of. How do we give them time to focus on what’s important?

Humans are fallible, especially when given too much to do. When given more, say what they should be doing less of. They should be focusing on what preserves value long-term. We can’t have everything. There must be tradeoffs. With choices come costs. Stop blaming those who run companies. We can’t expect managers to deliver long-term when the market is driven by gimmicks. People are seeking profits in too many stupid ways. Investors should look in the mirror for what needs fixed.

I think there was an implication that if proxy access is needed anywhere, it is needed at mutual funds. We won’t have optimal corporate governance until institutional investors can be held accountable. Investors should focus less on leverage and gimmicks, more on real cash flow and perfecting business strategies. Let’s get away from checklist proposals.

(Sidebar: See also Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management, The Aspen Institute. Also of note is Governance at Fortune’s 100 Best Companies to Work For, The Corporate Library Blog, 2/5/10. Most of the companies which excel in the employee satisfaction are privately held. Among those that are public, company founders or families have a disproportionate ownership stake. These firms feel less pressure to meet quarterly expectations and can take more of a long-term perspective.)

Leo Strine Answers Questions

Q/A: Someone, I think a student, asked about rating agencies – choice A & B. Investor is interested in green rating. Strine answered there is too much risk tolerance for equity investors and the cost of externalities is too high for society, so he seemed to be endorsing a green strategy, other things being equal.

I asked a question about TransUnion or Smith v Van Gorkem. The Chancery had ruled against the board for gross negligence but then the Delaware legislature almost immediately took an action that could be considered overruling the Court because they enacted provisions in their General Corporations Code that allow directors insurance to cover gross negligence (Delaware General Corporation Law, section 102(b)(7)).

Even though I was listening intently, I didn’t hear a direct answer. Maybe criticizing any decision made in the Delaware legislature, even one made 25 years ago, is impolitic for a judge in the Delaware courts. I don’t know. He seemed to say that without such coverage, companies would have a hard time attracting director candidates. Additionally, I think he said something to the effect that protecting against corporate externalities was the more important issue.

Gilson raised the issue that AIG, before it imploded, had one of the best corporate governance ratings. He listed several strong features, including hold until retirement provisions. Strine said that there has been too much emphasis on independent directors and independent committees. We should be anticipating what the investor is looking for.  Much of corporate governance standards are noise that only hurt a board’s ability to do its job. The electorate doesn’t want corporations to seek silly risky short-term gains with long term losses but investors aren’t out to protect society… they’re out to get money.

The problem at AIG was a “cult” that owed allegience to one person. Expertise to do exotica is lacking. They didn’t have an extermal monitor. Old style boards may have been fatter, happier, involved more employees, and the community. Board may have included a banker, members from related industries, a lawyer; they worried about the long-term. Now, there is an expertise gap. The need for independent monitors is higher. The derivatives at AIG were so complex they couldn’t be monitored. If you don’t know how your company makes money, you shouldn’t serve on the board.

Gilson followed up with something about the UK’s Walker Commission and how they’d maybe gotten it right, with an emphasis on risk management.  I think Strine replied with something about bubble behavior not being new but some of the vehicles are, like credit default swaps. In many states you can’t bet on football but can bet on a company going down. Complexity is a risk in itself. What Lehman could get, now everyone can get.

There was another question asking if value and stock price are completely disconnected?  Strine answered that prices are informative. Unfortunately, too many people trade on the greater fool theory.  There’s plenty of evidence of not engaging in long-term investment because of the (hot?) market. Head injured investor behavior, is compounded by empowering them. If you tell people you’re going to get them a 30% return, you’re going to have press for short-term gains.

In the old days boards might tell you to get lost (Strine used stronger language). Now days they don’t stand and fight. Independent directors have become too much like politicians out to make a deal to keep ISS/RMG happy. Better to elect hedge funds to the board. At least it keeps them locked up. “It is the drive by shootings that get me.” There is a tendency that the market will over value what’s hot. Stock option backdating isn’t good idea. People do things (maybe especially bad things?) in herds. When markets reward companies for risk and fail to discipline too often, it distorts everyone’s approach.

The last question came like a bit of a bombshell considering the huge applause Strine had been given (more than I have ever heard for anyone else at these events) and the general deference he had been given. The question was something like, Isn’t it disingenuous to go after institutional investors, as if they were responsible for the recession? You say that shareowners have all this power but they’re only on the cusp of reaching what they’ve been going after, namely proxy access. Strine was essentially being accused of Blaming the Victim.

Strine responded that there is plenty of blame to go around but that institutional investors largely hadn’t faced up to their contribution. If you create an incentive structure built on short-term profits, you’ll get more risk taking than healthy returns. There was a failure of prudential regulation the wrong profit incentives. Investors have been trying to blame managers but they didn’t temper their own risk. Takeover defenses are way down, options were their idea (ed: institutional investors, because options linked pay to performance… but only in one direction). There are more independent directors. Plenty of blame.. bond rating agencies. His main point seemed to be that investors weren’t out there temporing risk, but were instead rewarding it.

I would have loved for the conversation to continue around this core issue but the program had already gone on longer than expected, so another good evening ended too soon. My own assessment is that Strine had many excellent points. Shareowner pressures for higher returns do shift costs to society in the form of externalities. The idea of tying pay to performance has largely backfired. The problem of churn is huge. While I agree with Strine that shareowners have gained power through a number of recent reforms like majority voting at very large companies, it is also true that shareowners have little direct control. Even if they win proxy access, the current proposal is to allow no more than 25% of any company’s nominees to come directly from shareowners.

There’s no question that Strine has emerged as the hardest-working, wittiest and most outspoken judge at the Delaware Chancery. He’s also been very innovative, like when he ordered Tyson to complete a merger with IBP or when he negotiated a deal between PropleSoft and its hostile acquirer, Oracle. However, Strine wants Delaware’s opt-in model, rather than a mandate from the SEC on proxy access. I can’t help thinking that is because his ship is tied to Delaware. Not only do a fifth of their revenues come from franchise taxes on corporations, Delaware also has a substantial revenue stream from unclaimed dividends and abandoned accounts held by brokers incorporated there, which Strine helped to negotiate for a former governor.

Corporate governance expert Charles Elson said the Dodd provisions requiring a majority vote for directors and providing greater legal backup to the SEC’s proxy access proposal could spell “the beginning of the end” for the state.  A corporate exodus could leave the state in a “severe fiscal crisis,” searching for new revenue through dramatic increases in income taxes or a new sales tax, he said. “What everybody is worried about is things [getting] chipped away,” said Rich Heffron of the Delaware State Chamber of Commerce. “A company might say, ‘Why do I have to be in Delaware? I could be in Colorado.’ ” (Wall St. reforms could bite Delaware, The News Journal, 5/19/10)

I still tend to think real shareowners have too little, not too much, power. I couldn’t disagree more with his idea that shareowner proposals should be limited to those with millions of dollars in holdings who must pay a fee of $2,000 to get their item on the ballot. What’s next, a poll tax? Some of the most important reforms have been led by so-called gadflies like Lewis Gilbert and John Chevedden.

However, the problem of short-term investment horizons is real. Strine calls on tax policies to discourage short-termism but he certainly didn’t elaborate. Let’s get specific. What about taxing speculative gains (held less than 90 days) at 60%, less than a year at 35%, two years at 25% and thee years or more at the current rate of 15%? Even three years isn’t really long-term, but at least that would head us in the right direction. We could also make use of a Dutch auction system mandatory in IPOs or at least encouraged, so that companies begin public life with more long-term shareowners, rather than speculators.

Strine says risk isn’t factored enough into proxy voting decisions. I agree. One problem is that proxy advisors, like RiskMetrics, don’t have the staff to really dig into most companies. They tend to rely too heavily on governance policies applied broadly to most companies. A proposal recently revised for reintroduction by Mark Latham would allow shareowers to vote funding to advisors, based on the quality of their advice. Since the proposal essentially spreads the cost to all shareowners and avoids free-riders, it should result in far more money being spent, resulting in more in-depth research. (see Ultimate Proxy Advisor Proposal, Voter Media Finance Blog, 5/15/10)

For more from Leo Strine, see Why Excessive Risk-Taking Is Not Unexpected, New York Times DealBook, 10/5/09 and Toward Common Sense and Common Ground? Reflections on the Shared Interests of Managers and Labor in a More Rational System of Corporate, Harvard Law School John M. Olin Center for Law, Economics and Business Discussion Paper Series, 05/2007.

It was great to see a packed house. I hope it set a solid precedent for future events put on by the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford. See you there next time. In the meantime, check out this and other recorded events as they are posted.

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