Some are more equal

Some are more equal The politics of shareholder activism

By Donald Nordberg Senior Lecturer in Strategy and Corporate Governance London Metropolitan Business School Honorary Visiting Professor of Journalism City University, London and Editor and Publisher of The BoardAgenda (www.boardagenda.com)

Correspondence address: PO Box 26231 London W3 9WN United Kingdom Email: [email protected] Original version: June 2008 This version: June 2009

Available at http://ssrn.com/abstract=1150130

Electronic copy available at: http://ssrn.com/abstract=1150130

Some are More Equal The politics of shareholder activism By Donald Nordberg*

Abstract: Shareholder activism is an exercise of power, sometime benign, sometimes threatening to the interests of corporate management, boards and other shareholders. The complexity of these combinations helps to understand how difficult it is for directors to operate in shareholders' interest. What we see, particularly in relation to the growth of hedge-fund activism, is greater dispersion of shareholder interests and growing questions about the legitimacy of how those interests are acted out in the political landscape of corporation governance. This paper offers a framework to examine the stance that shareholders take when exercising – or not exercising – their power. Anticipating the expression of shareholder power involves assessing their intentions along three dimensions: their attitude towards an individual stock (buy-hold-sell), their approach to activism (docile, "walkers", or activist) and their investment horizons (long-term, short-term, or ones it calls "perverse", where the economic interest of the shareholder does not coincide with its holdings).

Keywords: Corporate governance, shareholder activism, legitimacy, hedge funds, power, politics

Introduction By the middle of 2008, the big institutional investors had grown uneasy about their investments in the German carmaker Volkswagen AG. Owning the shares had become too political. More than 30 per cent of the shares were held by Porsche Automobil Holding SE. VW's supervisory board chairman, Ferdinand Piëch, was a member of the family that controls Porsche, which had become something of a corporate governance pariah, having refused to accept the unofficial norm of quarterly financial reporting in Germany. It had also irritated the country's Social Democrats by dropping the Aktiengesellschaft legal form in favour of the new European Union Societas Europeas form, which would allow it to reduce representation of German workers on the Porsche supervisory board. Moreover, Piëch had Donald Nordberg is Honorary Visiting Professor of Journalism at City University in London and Senior Lecturer in Strategy at London Metropolitan Business School. He also edits and publishes the newsletter The BoardAgenda (www.boardagenda.com). He is a member of the European Corporate Governance Institute and has been Senior Adviser to The Conference Board in Europe. *

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©2009, Donald Nordberg


Electronic copy available at: http://ssrn.com/abstract=1150130

ousted the VW chief executive in 2006 and then entered a court battle with the company's second largest shareholder. The state of Lower Saxony in Germany not only held more than 20 per cent in the company. It benefited from a special law giving it veto power over important managerial and board decisions, a statute recently reinforced by the Germany parliament after the European Court of Justice ruled parts of the old law illegal. The European Commission had said that the new version of what German news media like to call the "VW law" was illegal, and Porsche agreed. But attempts at the VW's annual meeting by other shareholders – including activist institutional investors – to seek to challenge Porsche's creeping control of its rival carmaker fell on deaf ears (Milne 2005, 2006; Milne et al. 2008). Within a few months Porsche used a derivative instrument known as a contract for difference to acquire an economic interest equivalent to about 75 per cent of the stock. Because it had not bought the shares themselves, it was able under German law to keep that fact secret. Speculators, including hedge funds that had expected a fall in the price of VW and sold short, soon faced a mad scramble to cover their positions. VW shares soared by 400 per cent, making it briefly the most valuable company in the world. Newspaper reporters began to liken Porsche itself to a giant hedge fund with a small carmaker attached (Schäfer and Mackintosh 2009). Shareholder activism is fundamentally a battle for power acted out in a political landscape that stretches from the boardroom to the halls of national legislatures and the deliberations of supranational organizations. The exercise of power by shareholders both shapes and is shaped by the political force-fields of corporate governance. When public policy concerning private-sector companies is set, some shareholders make their voices heard as well. Sometimes, the object is to ensure that shareholder power over management is strengthened. Sometimes, it is to avoid the erosion of power to employees or outside lobbies. Often, however, it is to wrest power away from other shareholders. An obvious fact sometimes overlooked when considering the forces that shape corporate governance is this: deciding what is in the interest of shareholders is often impossible. One shareholder's interests often do not coincide with the interests of others. Most of the time, it does not matter: shareholders only rarely vote on matters of corporate policy. But for directors, with their fiduciary responsibility to look after shareholder interests, it does. The competing interests of shareholders arise from different stances that investors take to their investments. It is a complex picture of rivalry for the high ground Some are More Equal, Version 2

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that shapes not only the way they vote at company annual meetings but how they vie with each other for the attention of directors, and how they seek to influence the public policy debate on a macro-political level about the future of enterprise. The discussion focuses mainly on the approaches that institutional investors take. They dominate the investment landscape, even in the United States, where the private persons we think of as retail investors give a greater sense of "democracy" to shareholder capitalism than in many other countries around the world. Those private persons – unless extremely wealthy and willing to take large risks – are only rarely able to gain a voice in the political debate that sets the policy of individual companies let alone the frameworks of law and regulation in which boards must operate.

Issues in shareholder activism Many people, including policymakers in major countries, believe that shareholders ought actively to engage with the managements and boards of the companies in which they invest. In Britain, for example, the government has encouraged institutional investors, which collectively own more than 80 per cent of the equity in UK listed companies, to vote their shares. Pension funds have been under pressure to publish how they vote so that beneficiaries can judge their performance. But in the minds of many corporate executives, there is a difference between shareholders being active and being activists. From its origins in the efforts of small shareholders not to be overlooked, shareholder activism has evolved and now often involves organized efforts among major institutional investors oust managements, change strategic direction or otherwise alter the course of the company's direction. With the addition of activist hedge funds to the mix in the past few years, we have come to a condition some call shareholder activism on steroids (Lipton 2008). Naming and shaming The practice has its roots in the United States during the 1940s, when a change in securities regulation gave shareholders the right to offer resolutions for consideration at corporate annual meetings. There were restrictions: proposals had to be "proper subject for action by securities holders" (for elaboration, see Gillan and Starks 2007:56). In the 1970s many such resolutions were the product of a handful of "gadfly" investors, private investors including Lewis and John Gilbert and Evelyn Davis, who demanded higher dividends or other shareholder-friendly changes in company policy through a combination of direct Some are More Equal, Version 2

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agitation at annual meetings and skilful use of the media to publicize their efforts. Some, however, came from religious groups, others from those espousing political causes, and they often followed the techniques of the gadflies (Marens 2002). In the mid-1980s, however, came the addition of research-led programs, backed by pension funds and other institutional investors to seek out underperforming companies and effect changes in direction. Robert Monks used his LENS asset management company and his research firm Institutional Shareholder Services to identify issues with corporate governance practices in companies. He built coalitions of investors including large, publicsector pension funds like the California Public Employees Retirement System, known as CalPERS, to demand changes from corporate managements as well as legislative and regulatory actions that would give shareholders a bigger say in setting corporate policy and selecting directors. Andrew Ward and his colleagues (2009) found such naming and shaming poor performers had an effect on share prices, as institutional investors reacting to the signal from a reputable source, in their case, the Council of Institutional Investors, another early Monks ally, and its focus list. But they found the investors' reaction was less pronounced in the case of companies with boards that were seen as independent of management. Those boards responded to the signal by changing management incentives to favour a change in direction. These efforts are often confrontational, as these activists, too, using the media to challenge corporate decisions and muster support from other investors to their positions. By contrast, in Europe much of this form of shareholder activism takes place behind closed doors. Asset managers occasionally join together to discuss issues they have with company managements, bearing in mind the rules about not seeming to act so closely together that they might be deemed to be "acting in concern" and so be forced to make a takeover bid. The Association of British Insurers and the National Association of Pension Funds in the UK, whose members have investments in financial markets around the world, will sometimes organize meetings with company executives and directors to seek to resolve issues or change the board's thinking. Seldom do these encounters reach the glare of public attention. "If our engagement ever reaches the front page of the Financial Times," one pension fund manager says, "that is because it has failed." A somewhat different approach, however, can be seen in perhaps the most vocal of European investment institutions. Following the model of CalPERS, the UK asset management firm Hermes, owned by the old British Telecommunications pension fund and Some are More Equal, Version 2

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the largest pension fund in the country, set up a special unit to conduct activist campaigns. Because of its size and its actuarial need to have investments reflect the whole of the UK economy, Hermes needs invest in the whole market. It justifies its activism as the providing only way to improve the performance of its investments. Again like CalPERS, however, it established a subsidiary to target underperforming companies, take a very large stake, and then press management for changes in policy and personnel, often in private but occasionally in a public way. A study of its performance showed that through engagement it could achieve abnormally high returns on its portfolio (Becht et al. 2008). The lesson: activism pays. Its success in the UK led Hermes to move into continental European markets and the US. Hedge fund activism These actions became in many ways the model for the new form of shareholder activism we see today. Activist hedge funds use detailed analysis of a company's business to identify weaknesses. They then build large stakes in the company's equity to build a stake in the company large enough to force management to listen. The biggest difference between the older-style activists like Monks and his allies on the one hand and activist hedge funds on the other is that the hedge fund exploit very high leverage. They also build positions in options and other derivative instruments in ways that traditional asset managers would not be willing or even allowed to use. As a result, the changes that hedge funds seek may be in policy designed to affect performance in the even shorter term than their more traditional counterparts. As a result, they are often portrayed in the press as rapacious. A Germany politician once likened them to "locusts" (see "Shareholder politics and markets", below). But are hedge funds, and especially the activist ones, the evil we see described in popular accounts? They may be aggressive, but do they deserve the fear that corporate investor relations officers seem often to show? April Klein and Emanuel Zur found that in the US investment strategies hedge funds took quite a different approach from traditional activist investors. Instead of targeting underperforming companies and seeking changes in direction, they sought to retract cash from generally well performing companies (Klein and Zur 2006). Activist strategies among hedge funds have, however, gained some support, albeit based on data during the heady days in investment markets in the mid-2000s. Alon Brav and colleagues (2006) found hedge funds working in much the way that large blockholders are often described: friendly interaction with management in striving for better financial Some are More Equal, Version 2

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performance. At other times they may confront managements they see as entrenched. Importantly, they found that the performance improvements they sought persisted after the hedge funds had exited their positions. "Unlike traditional institutional investors, hedge fund managers have very strong personal financial incentives to increase the value of their portfolio firms, and do not face the regulatory or political barriers that limit the effectiveness of these other investors" (Brav et al. 2006:37). Christopher Clifford (2008) found that target companies of hedge funds pursuing activist agendas performed better than a control group of investments they held passively. But Clifford's evidence suggests that the funds seek a greater liquidity buffer for activist portfolios: the lock-in periods for activist funds are typically longer than for those the hedge funds manage without engagement. The legal scholars Frank Partnoy and Randall Thomas (2006) found by studying the record of voting, litigation, and change of control contests that activism among hedge funds was more effective in inducing change in corporations than engagement by more traditional institutional investors. Moreover, David Haarmeyer believes that activism by hedge funds has accelerated the distribution of corporate cash in mature businesses, through dividends and share buybacks. "Hedge fund activists become catalysts for initiating and helping to execute the painful but critical process that moves resources into more productive uses and thus drives shareholder value creation and economic prosperity" (Haarmeyer 2007:38). Issue-based activism A more limited form of activism comes in agitation over particular issues, either in corporate policy or in company law and regulation. A topical case is the growing calls for new ways to address the persistent problem – as seen from the perspective of investors – of giving shareholders a "say on pay" of senior management. Since 2002 shareholders in the UK have had an advisory vote on compensation policy, an example where "voice" has made some difference. Practitioners argue that such efforts – copied in some other European jurisdictions and in Australia and a matter of heated debate in the United States – could undermine the board's discretion in setting pay levels. Keith Johnson, a former Wisconsin state pension fund manager, and Daniel Summerfield from USS, the UK's second largest pension fund, argue that giving shareholders a direct voice on pay should in fact empower the board, rather than undermine it. "Say on Pay leaves boards with full control over executive compensation while giving them increased support for a display of backbone when needed! … Muddling through is no longer an option" (Johnson and Summerfield Some are More Equal, Version 2

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2008:3). They see in the move at many US companies for majority voting to replace plurality votes as a step in the direction of creating greater shareholder voice on pay. A study of the outcome of the UK experience by Fabrizio Ferri and David Maber (2008) gives a more qualified view of the success that shareholder votes on pay might have on the level of executive pay. Their analysis suggests that say-on-pay increased the sensitivity to pay levels of executives in poorly performing companies, and especially among those that had high compensation before introduction of the law, the overall levels of pay were little affected by giving shareholders a voice. Giving shareholders greater rights, however, is only one part of the activist equation. For a director seeking to act in shareholder interests there is another question: what is it that interests shareholders?

Dimensions of shareholder politics A wide number of factors contribute to the interests that a single shareholder might have in the board's decision-making. It might be more interested in receiving dividends than capital gains, or want the board to avoid investments in genetically modified crops. Shareholders from one country may bring with them preconceptions about the best way to organize a business when they invest in a company based in a different country. These factors all contribute to the content of any recommendations they might make to the board. Taking a step back from the content of their interests, however, we can see that their political stance can be assessed across three dimensions: their attitude towards the stock, their approach to engagement and activism, and their investment horizons. Attitude At any given time, each shareholder has a simple view of the action it takes on each stock in its portfolio and on its watch-list: they buy, sell or hold. Investment analysts use a wider variety of categories in their research recommendations, to be sure, and these nomenclatures vary somewhat between investment banks. In the wake of the dot-com collapse in 2000-01, however, investment banks and the analysts they employed faced criticism for their use of arcane classifications in recommendations to their institutional clients, and for making them where the intended advice meant something different from words themselves (Dreman 2000). Legislation, litigation and new codes of ethics for research around the world ensued (for an example, see CFA Institute 2005). Some are More Equal, Version 2

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For many asset managers the investment decision rarely involves massive shifts towards or away from a particular stock, so a more nuanced version of the old "buy-sellhold" mantra has emerged: investors might accumulate, reduce, or maintain their exposure to a particular security. Activism Here, too, there are three stances that investors can take, either as a general inclination towards their investments as a whole, or towards a specific stock. Investors may be docile, passive in their approach to the company, its strategy and its management. That may involve routinely voting with management at shareholder meetings or perhaps not voting at all. This is frequently the stance of index-tracking funds, explicitly designed as low-cost operations. They seek to avoid the cost of voting as well as trading the shares they hold. A second approach is what we might call the "walkers", invoking a notion sometimes called the "Wall Street Walk" (Admati and Pfleiderer 2007). If unhappy with the direction of the company, they will sell their shares to avoid future price declines or to seek greater returns in an alternative investment. They can also walk into an investment: seeing a strategic decision they like or a change in the business environment that might be favourable to a particular stock or industry, they buy. This stance is often adopted by traditional active portfolio managers who seek to outperform the index or benchmarks by intelligent stock selection, based on superior research or a more enlightened gut instinct than other investors. But it is also used by a wide range of investors, whether of the traditional "long-only" asset management firms that buy and sell actively, individual investors looking for a gain, or leveraged investors seeking to turbocharge their holdings by buying stock on margin. "Walkers" can have an impact corporate policy and therefore governance. If the stock price is depressed by their decisions to sell, the company may find it harder to raise capital in equity or even debt markets. The resulting increase in the cost of capital, so the theory goes, makes the company less competitive, putting pressure on profitability and on management to change direction. Some writers find this an inefficient way of monitoring and controlling corporations, arguing that role should fall to certain types of investors, particularly pension funds and closed-end collective investment funds (for an example, see Coffee 1991). Alex Edmans, however, has modelled situations in which the use of exit rather than voice can itself be a form of activism. His particular interest was in companies where large blocks of shares are held by a investor, but not large enough to influence policy Some are More Equal, Version 2

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directly, for example through the right to a seat on the boards, nor so large that they were, in effect unable to exit the position (Edmans and Manso 2009; Edmans forthcoming). These investors' stakes are large enough that it pays to stay informed about the company's business and monitor performance of management, but not so large that their voice would be heeded. His work suggests that such use of exit as a form of voice need not lead to management becoming short-term in focus. The signals sent through such activism-withyour-feet could even stimulate boards and managements to take a long-term focus. There are funds, however, that fit neither of these categories, taking a different approach with respect to at least some of their investments. Activist shareholders seek to influence the direction of the companies in which they invest. They often use their voting rights to indicate displeasure with strategy or management, while lobbying occasionally with directors and senior management for a change in policy. Activists come in a variety of flavours. Some advocate specific policy changes on what they consider ethical grounds. This approach was commonplace as shareholder activism gained ground in the 1960s and 1970s as individual shareholders, churches and charities used their votes as shareholders to try to force changes in policy of companies towards investments in munitions and tobacco, or on trade with the apartheid regime in South Africa. Indeed, much of the early effort in the United States to develop what we now call corporate governance research arose from churches who sought to use their votes at shareholder meetings to express their displeasure with US policy and military actions in Vietnam. Other activists seek changes in management or shifts in strategy in poor performing companies. Others lobby for actions to give shareholders greater rights, say, to oversee executive pay policy, or to vote on potential acquisitions. Still others may seek to oust the board of directors and impose a new board and new management, or push through a merger or acquisition by another company hostile to the incumbent management and board. Some, by dint of the size of their holdings, can get private access to senior managers or members of the board to make their opinions known. Others, generally the smaller ones, resort to "megaphone diplomacy" as way to be heard, if not always listened to. A few – notably large pension funds in the US and UK – combine the two, using the latter when attempts with the former have showed few results. What these activists share is their active use of voting rights and often other ways of expressing the voice on policy. But they share another thing as well: all seek to assert what they see as their rights as owners to influence decision-making at the board and in management (Davis et al. 2006). Some are More Equal, Version 2

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Horizon Shareholders' intentions towards a stock also vary over time. It is self-evident that stocks they hold today are ones they might be inclined to buy again or sell at some time in the future. Beyond that, however, lies a general inclination towards the process of buying and selling. Index-tracking funds, for example, hold shares for as long as the company is a constituent of the index they track. Their actions are dictated, therefore, by index decisions. Only those on the cusp of the index are every likely to be traded, and so for most of the investments of these manager, the time horizon of the investment is quite long. Pension funds, looking to achieve sufficient yields over the lifetime of their beneficiaries, share a long-term orientation towards the market in general, though some may choose to manage their portfolios more actively. They tend, therefore, to be long-term investors, though their horizon for an individual stock may be short-term at any given point. The investment literature, like the tax code in some jurisdictions, draws a distinction between long- and short-term investing. The latter is more speculative in nature. For tax purposes capital gains and losses might be treated more like earned income for individuals or income from operations for corporate entities, rather than savings. Both academics and the taxman often set an arbitrary threshold to distinguish between them, say, one year. In practice it is hard to know whether an investment of thirteen months is very different from an eleven-month one, or indeed similar in any way to an investment that might be held in portfolio for decades. From a corporate governance perspective, as we shall explore below, long-term investors sometimes expect different treatment from the companies in which they invest, even if their attitude towards the stock at this time might involve an inclination or intention to sell. There has been a growth of speculative, short-term investing among traditional, long-only funds as institutional investors seek to build their businesses by outperforming rivals by beating their benchmarks on a quarterly basis. This has in turn put pressure on corporate managements to strive for better short-term performance, often at the expense of strategic decision-making (Tonello 2006). There is, however, a third stance we might consider under the rubric of horizon – the perverse orientation towards an investment. Here the horizon is often short-term, though it need not be. One version of this stance might involve buying and selling simultaneously, though with differing time horizons for the two actions. It is a stance often taken, for example, by otherwise "long-term" investors seeking to achieve capital gains but avoid dividend income. They will sell the stock on a "cash" basis over the dividend record and/or payment date, having arranged ahead of time to buy it back "forward" at a predetermined Some are More Equal, Version 2

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price. These stock "lending" activities have counterparties, of course. Sometimes they come in the form of investors seeking dividends to boost the yield of a portfolio pledging its beneficiaries a regular stream of income. These investors then capture the dividend in exchange for an interest payment to the lender. Depending on their separate tax positions, these approaches can produce benefits for both sides. There are corporate governance implications when these arrangements fall over the time of voting at the company's shareholder meeting. Who is the "real" owner? When both tend to be long-term in orientation, the governance implications might not be particularly large. Given the broad diversification of assets in many institutional portfolios, the borrower might well be a holder – or even a lender – of the same stock it has borrowed, so the implications for voting and corporate governance are perhaps of greater theoretical than practical concern. There are, however, other types of borrowers whose intentions are not neutral, one being the "short-seller". These "shorts" borrow the stock so they can deliver it to someone to whom they have sold. The intention in a short-sale is to buy the stock back at some point in the future before the pre-arranged return sale to the original lender. If the stock falls in the meantime, the short-seller makes a gain on the difference less the interest payment for having borrowed it in the first place. As a result, short-sellers can benefit from a fall in the share price and even more from a collapse of the company. For these reasons, various countries ban short-selling and other restrict its use. Before the banking crisis hit in the second half of 2008, many countries had begun to give short-sellers a freer hand. In the US, for example, the Securities and Exchange Commission experimented with a new rule in 2004 to lift the requirement that a short sale could only take place when the previous transaction in that stock was at a higher price than the one before, called the "uptick" rule (SEC 2004). Hong Kong, a market with a history of stock trading almost as old as London and New York, introduced short-selling, subject to an uptick rule, in 1994 and allowed "naked" short sales – when the seller does not first borrow the stock – a year later, and then lifted the uptick rule. After a cascading sell-off that Asian markets suffered in 1998, the uptick came back, only to be repealed again in 2007. Michael Mackenzie and Ólan Henry (2007) believe short-selling proves broad neutral over time, as heavy selling in one period was reversed in the next. In the UK, the Financial Services Authority broadly backs the practice, though incidents in the early months of 2008 led it adopt a temporary measure to tighten up reporting requirements when companies were in the process of issuing new capital through "rights" Some are More Equal, Version 2

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issues after a spate of new issues struggled to find buyers (FSA 2008). Australia, which had some curbs on the practice, launched a consultation in 2008 about how it might tighten them (ASX 2008), and in the weeks after the collapse of Lehman Brothers in September 2008, authorities in many jurisdictions, including the US, moved to curtail short-selling in the stocks of financial companies. While the US ban was quickly rescinded – the outgoing chairman of the SEC, Christopher Cox, even called the ban the "biggest mistake" of his tenure (Paley and Hilzenrath 2008) – constraints in other countries stayed in place for many months. In the last several years, the perverse stance has added a layer of complexity. Through the use of derivative instruments, including a device called a contract for difference, an investor may have a large economic interest – whether the share rises or falls – without actually buying or selling the shares themselves. These can pose governance issues for the companies involved as CfDs can be linked with an implicit commitment on the part of the counterparty – often an investment bank – to hold the equivalent number of shares and even vote them on the instruction of the derivative-holder. An example of the governance problem in this type of perverse relationship is the case of the 2004 bid by Mylan Laboratories to acquire King Pharmaceutical in the US, which resulted in so-called "empty voting". The hedge fund Perry was a major shareholder of King and stood to benefit from the transaction. However, shareholders in Mylan needed to approve the transaction, and opposition to the deal arose from some larger ones, including the activist investor Carl Icahn. To push the deal through, Perry bought a stake in Mylan, simultaneously hedging the investment with equity swap with two investment banks; indeed, the swaps more than covered Perry's exposure. That gave Perry 9.9 per cent voting rights at a time when it had a net negative economic interest in Mylan (Hu and Black 2006; Kahan and Rock 2006).

Shareholder politics and markets It is precisely these differences in approach that allow traders to make a market in company shares. Buyers need sellers, and even long-term investors sell sometime. Differences of tax positions can lead otherwise like-minded investors to take opposite stances towards the same stock. Even short-sellers – the most perverse of the perverse stance – perform a valuable function in providing sellers when others seek to buy. When coupled with an activist stance actions of short-sellers can raise serious governance Some are More Equal, Version 2

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concerns. There is, however, evidence that short-selling helps the market achieve the best price for corporate equity (for recent examples, see Charoenrook and Daouk 2005; Bris et al. 2007; Chang et al. 2007; McKenzie and Henry 2007; Curtis and Fargher 2008). Indeed, Lauren Cohen and her colleagues show that in markets with poor disclosure regimes, shortselling provides a useful mechanism for the transmission of private information (Cohen et al. 2007). Arturo Bris and his colleagues (2007) present a more nuanced picture. By looking at dual-listed shares that trade on markets that either permitted or restricted short-selling, they could control for country effects. Their evidence supports the notion that price discovery was better with short-selling. While short-selling does not cause a crash, however, it may affect its magnitude.

Accumulate Accumulate

© Donald Nordberg

Maintain Maintain

Perverse

Reduce Reduce

Short-term Long-term Docile

“Walkers”

Activists

Figure 1 - Shareholder stance

The variety of possible approaches along these three dimensions is summarized in Figure 1. The complex picture that emerges is one in which it is difficult for anyone to know what constitutes "shareholder value" when shareholder interests can be so fundamentally divergent on these structural grounds, irrespective of differences they might have about the business policies and future cash flows of any individual business. The balance between their different interests will change over time for individual companies as well as for the market as a whole. The growth of passive investment through index-tracking funds, for example, has led over recent decades to an expansion of funds that seek to maintain their stakes in companies over a long time-horizon. To keep costs Some are More Equal, Version 2

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down, many of them are docile, voting with management if they vote at all. With their rise has come a relative decline in the strength of traditional long-only, actively managed asset management firms that were the backbone of the "walkers" and activists taking a long-term approach to the horizon. While the growth of hedge funds in 1990s and the early years of the new century vastly expanded the number of managers taking a short-term view of their investments, hedge funds probably still represent a small proportion of equity ownership. Data concerning the size and shape of hedge fund investing are fragmentary at best. The industry is secretive and lightly or unregulated in many jurisdictions. Early versions of hedge fund strategies often involved taking a position in a stock and reversing it within the same day, speculating of intra-day price movements with any risk hedged through the use of derivatives, with little import for the companies or their boards. What created a new governance relationship – and a new set of politics to go with it – was the development of hedge-fund activism: asset managers taking a large, often highly leveraged stake in a company and holding it while agitating for a change in policy. Perhaps the most celebrated case in the brief history of hedge fund activism was the move by a fund with the cuddly name The Children's Investment Fund, or TCI, which rocked the tradition-bound world of German equities. When Deutsche Börse, the German stock exchange company, tried to take over the London Stock Exchange in 2004, TCI sensed an opportunity to prevent the merger and generate a higher share price for Deutsche Börse. The shares of the company making the bid often fall during or after a takeover, reflecting the premium paid for the acquired company. In cases of contested takeovers, the premium is likely to be even higher. TCI sensed that if it could thwart the merger, Deutsche Börse's share price would increase. It acquired a substantial stake and agitated for a change in direction through contesting the re-election of directors at the exchange company's 2005 annual meeting. The move attracted other hedge funds to follow suit, and soon a substantial minority and perhaps even a majority of shares in this most German of institutions was in the hands of foreigners, mainly UK- and US-based hedge funds. The tactic succeeded to a greater extent than almost anyone had imagined possible. Deutsche Börse not only abandoned its bid, it dismissed the chairman of its supervisory board as well as its chief executive and chief financial officer (Nordberg 2005). Germany's vice chancellor then famously warned about "locusts" invading the capital markets (Bovensiepen and Blechschmidt 2005), and a new term – hedge-fund activism – entered the corporate governance lexicon (Achleitner and Kaserer 2005). Some are More Equal, Version 2

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TCI's intervention in the case of Deutsche Börse was in the spirit of much of the activism of corporate raiders in the 1980s and 1990s, using leverage to invest heavily in a company and then using its voting power and an appeal to reason to persuade other investors to join it in seeking a change in strategic direction. We may never be able to tell whether it ultimately created value, as so many other changes in the company and its competitive landscape have ensured. TCI attracted support from other, traditional, longterm investors more associated with "walking" rather than activism, suggesting that its interest was not what we have called perverse. But its chosen approach – to get its slate of directors elected, rather than the one proposed by the company – shows it engaged in a play for power with the board and management of Deutsche Börse and with the government and their trade union allies that rose up to defend the status quo.

Power and politics between shareholders The array of potential political stances that shareholders might take shows how the lines of conflict might develop around both company-specific issues and the broader debate about corporate control and law. A few examples can help to illustrate the point. 1. Entrance versus exit: A venture capital fund that is normally a long-term investor has a fundamentally different view to company policy in the period shortly after the company has achieved a stock market listing than it had before. The pressure it places on management for short-term performance, so that it can find an opportune time to reduce its exposure, will also be at odds with the interests of the pension fund that acquired shares in the initial public offering and it looking for sustainable gains over a long time horizon. 2. One share, one vote: The founders maintained supermajority voting rights when their company floated on the stock market 25 years ago, with shares carrying five times the voting strength of those held by others. With only 10 per cent of the capital at risk, they have 50 per cent of the voting rights. The institutions that bought the shares now argue that the founders have retired and their disproportionate voting rights should be abandoned. The matter cannot be resolved in the boardroom or the annual meeting, so the institutional investors take their case to the government, seeking a new law banning disproportionate rights. Having been rebuffed by government, then turn to a supranational body urging it to propose a new legislative mandate to be imposed all member governments. Some are More Equal, Version 2

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3. One share, more votes: Aware of the rise of hedge fund activism on what we have called the perverse horizon, pension and insurance funds argue empty voting could lead to decision-making that would damage the economic interests of the company and perhaps even the sustainability of the business. They argue, first with the board, then at the shareholder meeting and then with government, for long-term investors to be given superior voting power over "mere" speculators. 4. Director nominations: To avoid the practice of a powerful Chairman-CEO creating around him a board of cronies, institutional investors agitate – first with the board, then at the shareholder meeting – for a change in the articles of association giving shareholders a voice in nominating candidates to the board. Unsuccessful, they turn to the securities market regulator for a rule opening the proxy statement. A lobbying organization representing CEOs makes representations about how damaging such a measure would be. Opening the nominations process would make companies throughout the country subject to an assault from single-issue lobbying organizations that would seek to get their own board members elected, who would pursue their own agendas, rather than those of the company. The regulator considers the arguments and proposes that only shareholders representing at least five per cent of the equity should be allowed right to nominate directors. These are not far-fetched examples; each is drawn from a real-life example of politicsin-action in corporate governance. Each case involves the assertion by one party that its interests are more important – or even more legitimate – that those of other shareholders. Each actor in this political system seeks to use its power over the others to enforce its view on the board's decision, the shareholders' decision, or the macro-political decision on public policy that is forced when micro-political decision-making fails to reach a solution. In these disputes, each side had a legitimate point, even when those points were sometimes in conflict with each other. Resolving them without resorting to physical force requires something else: the exercise of power depends crucially on its perception of legitimacy.

Legitimate power The changing nature of shareholder activism has led some to argue that activists should themselves be subject to more rigorous public scrutiny and accountability. Iman Anabtawi and Lynn Stout (2008), for example, argue that the increase in shareholder power should bring with it an additional fiduciary responsibility on activist fund managers, enacted Some are More Equal, Version 2

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through changes in company law and akin to that imposed by law on directors and officers. For its part, the International Corporate Governance Network, a loose association of asset management firms most of which adopt a long-term, traditional investment stance with a bent towards activism, has recognized the problem. Perhaps to head off too much intervention from the government side, it set itself the task of reforming the governance approaches of the firms themselves (Cadbury and Millstein 2005). Such calls suggest there is at least the perception of an issue with the legitimacy of the power that institutional investors hold. The sociologist Max Weber identified three bases for legitimacy in the exercise of power. Legitimacy arises in a pure way either through tradition, by an appeal to reason and legality, or in the charisma of the leader (Weber 1922/1947). The power of the chairman or CEO in dealing with activist investors comes mainly from the last of these, entrenched with a dose of legality as their board colleagues invoke company law to limit shareholder involvement in the day-to-day affairs and decisions of management. Tradition looms large in persistence of the unequal voting rights we see in many established continental European companies. But what do we make of the legitimacy of calls by one type of shareholders – long-term, activist asset management firms – that corporate boards and management should ignore the wishes of another type of shareholder – the perverse activist? Let us bear in mind that the long-term activists may often be outnumbered in voting strength by those perverse activists and the long-term, docile investors who might have lent them stock and other long- and short-term investors who have chosen to walk, leaving their stock and voting rights to the perverse activist? Whose rights are more legitimate, and on what basis? In these circumstances, legitimacy involves an appeal to reason. Can it be reasonable, as these investors plead with boards of individual companies and with government, that companies act in the interests of the holders of a majority of the shares when those interests are perverse? Is it not better – and better under all circumstances, they say – to pay heed to the wishes of the long-term investor, even if the short-term and perverse ones have control? Company policy cannot be set for all investors equally. It is hard enough to work out where the interests of the majority lie. Is it not better still, they contend, that those docile investors summon up the will to vote or pass their proxy-voting mandate on to other long-term investors who will, and not leave the decision in the hands of either those perverse investors or an unchecked and unaccountable board and management? Another political channel is open: appeal beyond the circle of shareholders, to government or another authority with greater legitimacy, to force accountability on the Some are More Equal, Version 2

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asset management industry, say, through mandatory share voting or mandatory reporting of how they voted. Legitimacy helps. But as the VW/Porsche case shows, in a crunch it comes back to raw power – legitimate or otherwise – and its skilful deployment in the politics of shareholder activism. In George Orwell's satirical allegory, Animal Farm, through the exercise of their greater might (an English word closer than "power" to Weber's Macht), the "pigs" gain superiority over the others, with vicious consequences. And what of equality? All animals are equal. Some are more equal.

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Some are more equal

Some are more equal

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