Shareholder short-termism has become the focus of Congress, regulators and corporate governance experts as everyone dissects the reasons for the financial crisis of 2007-2008. So I figured what better time to bring together two of the most outspoken people representing both sides of the subject: Marty Lipton and Rich Ferlauto.
Lipton, a founding partner of Wachtell, Lipton, Rosen & Katz, earlier this year served on the drafting committee of The Aspen Institute’s report on shareholder short-termism that was released on Sept. 9. He specializes in advising major corporations on mergers and acquisitions and matters affecting corporate policy and strategy. The report, Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management, is part of a long-term project of the Institute’s Business and Society Program and its Corporate Values Strategy Group.
Ferlauto, who has served as the director of Corporate Governance and Public Pension Programs for the American Federation of State, County and Municipal Employees (AFSCME), will become deputy director of policy of Office of Investor Education and Advocacy for the SEC in January. He will have contact with thousands of individual investors each year, hearing their needs, answering their questions and helping to solve their problems. He is a well-known shareholder activist and media commentator on corporate governance issues. Also, he is founder and chairman of ShareOwners.org a nonprofit nonpartisan organizations that represents the interests of retail shareholders.
In separate discussions with me recently, Lipton and Ferlauto opined on the ramifications of short-termism:
What do you think led to the type of high-risk, high-reward thinking that is known as short-termism in the financial markets?
Martin Lipton: Companies were under pressure to produce short-term results. They are under pressure from shareholders and activist hedge funds, which makes management take more risks than they should take. Short-termism is a disease that infects American business and distorts management and boardroom judgment. The increase in stockholder power and stockholder pressure to produce unrealistic profits fueled the pressure to take on increased risk. It deters companies from investing for long-term value creation and success. It’s largely an American phenomenon. Companies in other countries, like China, are not subject to the same type of shareholder pressures. They are state corporations that are more concerned with long-term results.
Richard Ferlauto: There is plenty of culpability. I would say there were three factors:
1.) There was a move to equity awards through the rise of the option grant in the 1990’s that created the opportunity for huge payouts. Unfortunately, the grants were often seen as free because of the accounting rules that did not require fixed equity awards to be expensed. Moreover, under the guise of pay for performance, large option packages were awarded and they were not in fact performance based because executives could churn through their options immediately after exercise, and most included no real performance hurdles.
2.) We had a system develop which, in theory, had equity ownership delinked from risk through the use of derivative trading, credit default swaps and other complex final instruments. Rather than mitigating risk through financial innovation and diversification, the complexity of this newly created financial web of relationships hid volatility and, as we have learned, has exposed the whole financial system to profound systemic risk.
3.) I put part of the blame investors in their drive to earn outsized returns beyond the historical market averages. This would include institutional investors who sought to lower the contributions of employers in to pension accounts, pension systems, which bench-marked to historically high returns, and mutual funds and other asset managers, who often sacrificed prudent investment strategies through churning portfolios and trading strategies to attract investment inflows for the next quarter. In short, many market players were betting on short-term strategies at the expense of true long-term value creation.
Do you think short-termism played a role in the destruction of long-term shareholder value?
Lipton: Absolutely. Short-termism resulted in financial services companies taking undue risk, more so than in the past. They created more and more leverage. Businesses were generally borrowing on a short-term basis and subjected themselves to a liquidity crisis. Monetary policy created historically low interest rates and too many companies did not resist the “bargain.”
Ferlauto: The time horizons and its parallel investment orientation may be the most fundamental question that investors — especially fiduciaries for retirement funds — face today. Too many investors still think that they are better off with “Make the money and get out [of the market]’ or ‘Make the money now and not care about its longer term repercussions.’ You’re eating your seed corn for short term gains. Many firms are not competitive now because they didn’t make the investments in technology, human resources or internal development that in the long run contributes to wealth creation for shareowners and other stakeholders.
What other factors do you think affect short-termism?
Lipton: In addition to pressure from institutional investors and activist hedge funds, short-termism is caused, in part, by compensation programs that favor short-term results and do not depend on long-term performance and value creation, tax policy that does not discourage short-termism, the focus of securities analysts on quarter-to-quarter earnings increases and a failure of companies to resist short-termism and effectively promote the benefits to shareholders, employees, communities and all constituencies of long-term value creation. Finally, there is a failure of government to promote long-term value creation and the type of infrastructure investment that encourages long-term capital and research projects.
Ferlauto: I put the blame on the “Pay me now” mentality on the part of executives, boards and shareholders who do not think about what their actions mean for the day after tomorrow. We are left with a real lack of good strategic business planning on the part of boards and management. Boards need to create compensation structures that put new incentives in place for the implementation of strategic plans over the long term. This means that boards need to have 5-to-7-year strategic plan in place and use compensation so that management keeps its eye on the ball for this period of time.
What role should the board play in fending off such investment strategies stoked by hedge funds and activist investors? How sensitive should boards be to how business strategy decisions play on Wall Street?
Lipton: Boards have to be sensitive to everything. It’s not the board that is responsible; it’s management. The board should encourage management to pay attention to their portfolio. Management has to rein in the demands of hedge funds. They have to achieve a balance between short-term and long-term investment strategies. They have to resist the pressures to ramp up short-term returns through leverage where they borrow more than they should.
Ferlauto: I think we don’t have really strong boards. We have reactive boards, especially when it comes to compensation committees looking to recruit and retain CEOs. Directors need to be able to articulate their 5-to-7-year strategic plans. They need to put together an incentive plan that motivates top management to implement the strategic plan. Overlaid on top of that is an incentive plan for the board. If the plan is correct and incentives are on target with long-term shareholder interests, I believe that the board by reaching out to shareholders and communicating their position can fend off short-term “activists.”
What kind of distinction do you make between the different types of shareholder activists?
Lipton: I distinguish the hedge fund type activists who are looking to make a profit on their investment as soon as possible and have no interest in the long-term value of the companies in which they invest from the activists who believe that a company is under-managed and, with a change in strategy or management, would in the long-run return substantial value.
Ferlauto: There are two kinds of activists [shareholders]. There’s the “operational activists” – the ones who care about the business strategy and incentives plans for management and the board. These are usually long-termers. Then there are the “balance sheet activists” – the ones who are looking to strip assets. They are much more dangerous and can have a long-term negative effect on the company’s value.
You served on the drafting committee of a report produced by The Aspen Institute called “Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management.” Can you describe the genesis of this report? What was is it designed to do? Who is the intended audience?
Lipton: This is something that the Aspen Institute and corporate governance [organizations] have been focusing on for years. I’ve been speaking about this for 30 years. I think the genesis of this was the financial crisis and the concomitant effort to legislate greater shareholder power, which will only increase short-termism. Unfortunately, shareholders discourage long-term investment designed to achieve long-term rather than short-term stock market results. That’s a mistake.
The Aspen Institute took the initiative and recruited people to work on the drafting of this report. There was some outreach. Talks were held. Articles were written. The report is being aired in the court of public and political opinion.
The report has three calls to action: Encourage more patient capital, better align interests of financial intermediaries and their investors and strengthen investor disclosures. What is meant by patient capital?
Lipton: Patient capital is Warren Buffett not expecting a return today or tomorrow. It is the diametric opposite of short-termism.
What do you think about the report produced by The Aspen Institute called “Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management’s” calls to action and its focus?
Ferlauto: Investors need to take more responsibility for how they manage their assets and I think this is beginning to happen. First off we need a strong fiduciary duty standard so that broker dealers and investment advisors put communicate risk and return to their retail clients. We also need effective disclosure especially from mutual funds and all investment companies so that their trading strategies are more fully transparent to their underlying retail investors. We also need to take the pressure for short-term returns off some of the retirement systems in order to protect and enhance their role as patient capitalists. That’s capital that seeks a return over a 5-7 year period, and that you are willing to invest in instruments that are less liquid because they will [produce] a return over the long term.
Who is this report intended for?
Lipton: This report is for Congress, the SEC, the Fed, Treasury, shareholders, all right thinking people, The Conference Board, Gary Larkin, all of us.
Who should take these actions?
Lipton: I don’t think we can take these actions on our own. It requires government action. I think instead of focusing on increasing shareholder power, the government should rein in the power of hedge funds and short-term shareholders.
Ferlauto: Everyone needs to take action. Boards need to engage better strategic planning. Compensation Committees need to put in place incentive structures that reward bonuses only after real value is created and should promote hold through retirement programs for most equity awards. Investors manage their portfolios with an emphasis on long-term value creation. Regulators and legislators should create new fiduciary standards and transparency requirements that promote action and information with a bias towards long-term investments.
If there was one group that could have the most influence on reining in short-termism, which one would that be? Do you think it will take government or regulatory actions?
Lipton: The federal government. When all is said and done, that’s where the power lies. That’s the only way it can be accomplished. People are trying to blame others for the financial crisis. Politicians should think about the competitiveness of the U.S. in the global economy. We are in competition with state corporatism. Unless we are able to enable American businesses to invest in the long term, we will destroy the underlying basis of American democracy and economy. We used to be a country that made things and exported them. In the last decade, we have become a country that imports things.
Short-termism is the root cause of undermining the competitiveness of the United States.
Ferlauto: With the appropriate tools, it’s the “patient capitalists” many of whom are the public pension investors, who have even longer 20-to-30-year time horizons. If these investors have the right corporate governance tools — such as majority voting, proxy access and say on pay — that empower them as shareowners to influence board outcomes without a change in control, fewer of these investors would be tempted jump on the bandwagon with short-term activists looking to advance their own interests.
I would also put the onus on issuers who are afraid to step out on their own when it comes to empowering their ownership base, engaging their investors and increasing shareholder engagement. Many company leaders seem to look at their active shareholders as an enemy that needs to be confronted, rather than the resource which they can be. Lacking the leadership from individual companies on the short-termism question because no one firm is willing to break the model leads me to believe that we need to take a market-wide approach to reform. I think the government is the one [entity] that can make that happen.