The European Commission Considers “Short-Termism” (And “What Do You Mean By That?”)
Statement made by Prof. John C. Coffee, Jr.∗ at the ECGI Policy Workshop on 'Directors’ Duties and Sustainable Corporate Governance' (11 November 2020).
The European Commission retained Ernst & Young (“EY”) to undertake a detailed study of “short-termism” and, implicitly, to report whether it was a major roadblock to more sustainable corporate governance. Their study was then presented at a three day international conference at Oxford on November 11 - 13. Professor Mark Roe of Harvard Law School and I were asked to make presentations. Professor Roe’s statement ran last week on the CLS Blue Sky Blog, and my statement is summarized below:
In a nutshell, the EY Report On Sustainable Corporate Governance for the European Commission describes a legitimate problem (one even more pronounced in the U.S.), but its proposed remedies are only tenuously and tangentially related to that problem. Bluntly, EY misses the forest for the trees. The real problem lies less with directors and more with shareholders -- or, more accurately, the professional institutional intermediaries who represent the ultimate beneficial owners of the corporation. Today these intermediaries occupy a range of positions on a continuum running from, on one pole, the activist hedge funds who tend to hold positions in companies for a one to two year period to, at the other pole, the “permanent shareholders” (typically diversified and even indexed asset managers, for whom BlackRock is the iconic example). A key point is to recognize that the former (the activists) tend to be the natural champions of shareholder primacy and generally hostile to sustainability, while the “permanent shareholders” tend to take the reverse positions (except when both sides occasionally agree and partner).
THE EVIDENCE AND THE PROPOSED REFORMS
What is the evidence that there is a short-termism problem? The EY Report chiefly focuses on the upward trend in shareholder payout as a percentage of revenues and the downward trend in capital investment (“CapEx”) and R&D as a percentage of revenues. This is alarming, but not dispositive (depending on whether new equity capital is being raised to replace it and whether all European nations have reasonable access to this process).
Aggravating this problem is the fact that the number of companies with a payout to revenues ratio greater than 75% has also soared. In a few countries (Slovakia and Belgium), this percentage appears now to be in excess of 100% -- with the result that companies in these countries are effectively liquidating themselves. I fully recognize that a neo-classical finance theorist will see these ratios as signs of efficient financial discipline that is forcing the payout of “free cash flow” and preventing inefficient empire building. Still, unless there is a compensating wave of European IPOs (of which I am doubtful because Europe lacks the venture capital industry to encourage IPOs), these payout ratios for European public companies imply that much of Europe may over time downsize its infrastructure and exit the world’s economic stage in favor of China and the U.S.
What is causing these high payout ratios? An initial cause is the popularity of stock buybacks. Behind this initial cause lies pressure from activist shareholders and the tax advantages to many shareholders of buybacks over dividends.
What solutions does the EY Report discuss in this light? Let’s briefly survey four:
(1) Abolish Quarterly Earnings and Discourage Earnings Guidance. In effect, this is asking shareholders to wear a blindfold. In response, shareholders will turn to securities analysts, and selective disclosure will become prevalent. Market volatility will rise, as shareholders are trading in the dark, and insider trading is likely also to increase. In any event, wealthy shareholders will get the information they need, but retail shareholders will have to guess.
(2) Restrict Executives So That They Cannot Sell Shares That They Receive As Compensation (At Least For A Lengthy Period). While this proposal is responsive, it could destabilize the executive labor market in Europe and lead to a migration of executives to less regulated American firms. Certainly, it would make European firms less competitive with their international rivals. But even if it made executives less short-term oriented, it would not change the shareholders’ preferences nor the incentive for activists funds to pressure for short-term results.
(3) Change The Composition Of The Board, In Particular Towards Greater Gender Equality. There may be many good reasons to support greater gender equality on the board, but this is possibly the poorest justification ever given. Its stereotypical assumption that females favor sustainability over profit will prove false if the new directors are chosen by a nominating committee composed of the old directors (which is the standard pattern). The existing board can easily find (and predictably will find) female directors who fully accept shareholder primacy and care little for sustainability. If you want directors who will faithfully favor sustainability, EY should recommend a mandatory VEGAN Director. I may be facetious, but this is more likely to work.
(4) Finally, The EY Report Stresses Changing The Legal Rules To Which Directors Are Subject, In Particular Stressing Sustainability Criteria And Duties To Stakeholders. Although I do not object to marginally revised legal rules, I am convinced the gains from this approach will be modest, and the impact will be primarily symbolic. First, the existing legal rules do not tell directors today that they must maximize value in the short-run or even that they must maximize shareholder value at all. In the U.S., Delaware requires shareholder wealth maximization only when the corporation is up for sale (the so-called “Revlon rule,” and other U.S. jurisdictions reject Delaware law on this point). Put bluntly, the manner in which directors behave is much more determined by custom and ideology, and in the U.S. both cause directors to believe they have a duty to maximize shareholder value (even though the law does not quite say that).
A second and even more telling problem exists with relying on statutory changes in directors’ duties to change directors’ behavior: European law does not threaten directors with liability the way American law does. As you are aware, the U.S. has a comparatively hyperactive litigation system, whose defining elements are class actions, contingent fees, jury trials, punitive damages and little fee-shifting against the plaintiff. But even in the U.S., we do not enforce the duty of care (but generally make it non-actionable).
I am not opposing the idea of modifying directors’ duties by statute, but careful corporate lawyers will predictably guide directors so that they make all requisite findings and satisfy all procedural requirements -- without changing any substantive outcome. Form will triumph over substance, as usual.
WHAT MIGHT WORK?
So if EY’s proposed reforms will yield little change, what might work?
First, if buybacks are the problem, here is a simple remedy: use the tax laws to chill buyouts. If shares sold in a buyback were taxed at a higher rate, shareholders would be less likely to demand or want buybacks. This is an example of “Ockham’s Razor”: use the simplest answer with the fewest moving parts.
Similarly, if short-termism is the problem and it is encouraged by activist shareholders who invest in the company for only a year or two, consider tenured voting -- a system under which longer-term shareholders receive more votes. Silicon Valley has long recognized that dual class capitalizations can also curb short-termism. Personally, I am not a fan of either option and think any tenured voting increase in voting power should be capped, but both are relevant and responsive actions.
My preferred strategy would focus on shareholders -- a topic largely ignored by the EY proposals. Here, there have been major changes. Not only do institutional investors own the vast majority of the stock (around 75% on a value-weighted basis in the U.S.), but ownership has concentrated extraordinarily in the last decade. Today, in the U.S., the “Big Three” (BlackRock, State Street and Vanguard) own 20% of the equity in listed corporations and vote 25%. More importantly, they regularly vote in common to support climate change shareholder proposals. All three are permanent shareholders who do not exit the company after they have compelled a change in policy (as hedge funds do).
Evidence that large diversified institutional investors do favor sustainability is easy to find. A leading example occurred in 2018, when a coalition of the Big Three and others compelled Royal Dutch Shell and BP to reverse long-held positions and significantly advance the date at which they would achieve carbon neutrality. Although they resisted fiercely for a time, the Big Three effectively held a gun to their heads and got the changes it wanted.
Even more interestingly, as I detail in an article now on SSRN, these large, indexed institutions are shifting from evaluating voting proposals in terms of their impact on the individual firm to evaluating their impact on the institution’s entire portfolio. Thus, a specific proposal on climate change might reduce the stock value of the subject firm, but raise the value of five other stocks in their portfolio. As others have also suggested this gives the large diversified institution an economically rational incentive to curb externalities (at least if the gains to the firms in its portfolio exceed the losses).
In marked contrast, activist hedge funds often do the opposite. As I detail in another article, Elliott Management, one of the largest activist funds, objected in 2017 when NRG Energy, the second largest producer of electricity in the U.S., announced a policy of shifting from “dirty” to “clean” energy for electricity production and began to buy solar and wind-based companies. In response, its stock price fell, and Elliott led a proxy fight that replaced the board of this company and returned it to a “dirty” energy policy. Here, we have a leading example of an anti-sustainability policy, and other examples initiated by activist funds can be identified.
In short, hedge funds and asset managers are both the leading allies and leading enemies of firms seeking to pursue sustainability policies. In response, a required board Committee on Sustainability might well regularly consult with these funds, courting allies and trying to mollify critics. Also, large diversified institutional investors (who hold portfolios in the trillions of dollars) have more expertise about sustainability than do individual boards and could provide realistic guidance.
More importantly, if we wish public corporations in Europe to be able to resist attacks by short-term oriented funds, the simplest approach might again be the use of the tax laws to tax at a higher rate sales where the fund has held the stock for three years or less. That would discourage the in-and-out activist fund that wishes to hold for only a year or two, but it would not adversely affect “permanent shareholders,” such as BlackRock and Vanguard. Paradoxically, shareholders are both advancing and opposing sustainability. “Permanent shareholders” (such as the Big Three) and the activist funds are locked in an undeclared intellectual war, except that they sometimes partner. Public policy should encourage the former, discourage the latter and always favor partnering. To be effective, public policy must take sides and support its allies.
∗ Professor Coffee is the Adolf A. Berle Professor of Law at Columbia University Law School, Director of its Center on Corporate Governance, and an ECGI Fellow.
John C. Coffee, Jr., “The Future of Disclosure: ESG, Common Ownership, and Systematic Risk,” (2020). (Available on SSRN at https://ssrn.com/abstract=3678197 )
Madison Condon, “Externalities and the Common Owner,” 95 Wash. L. Rev. 1 (2020).
John C. Coffee, Jr., “The Agency Cost of Activism: Information Leakage, Thwarted Majorities, and The Public Morality,” (2017). (Available on SSRN at https://ssrn.com/abstract=3058319)