Short-Termism
Its Causes, Effects and Possible Remedies
Andrew D. Hendry
Retired Vice Chairman, Chief Legal
Officer and Secretary
Colgate-Palmolive Company
Introduction
This paper will discuss short-termism and its causes, effects and
possible solutions.
By way of background, I have been practicing law for almost 45 years, about
35 as a lawyer/ businessman for public companies (including more than 25 years
as the chief legal officer of two global Fortune 200 companies). Through that
experience, I have witnessed first-hand how short-termism has changed corporate
America and continues to damage America business and our economy. This has been of great concern to me and so
for a number of years I have worked with The Conference Board and others developing
possible solutions.
What is Short-Termism?
Short-Termism requires that a public corporation deliver quarterly
results meeting Wall Street’s quarter-by-quarter expectations, even if so doing
damages its business health and the long-term best interests of the
corporation. It is a harmful practice which is stunting the growth of American
companies by:
·
Preventing investments needed for long-term
growth in order to protect quarterly earnings
·
Excessively using corporate funds for dividends
and stock buy-backs to prop up “TSR” (Total Shareholder Return or, in other
words, stock price appreciation and dividends) to meet Wall Street’s
quarter-by-quarter demands
·
Pursuing corporate transactions (like mergers,
acquisitions, spin-offs, divestitures, inversions, etc.) which may enhance
stock price or free up cash for distribution to shareholders, but compromise
the health/growth of the company’s business long-term
·
Excessive cost-cutting and restructuring, enhancing
earnings and freeing up assets to meet Wall Street’s short-term demands, but
mortgaging the company’s ability to build for the future
·
Distracting corporate management from long-term
growth, as they are preoccupied with meeting Wall Street’s short-term demands.
The result of this short-term Wall Street focus is to
hobble corporations by diverting assets that are better and rightfully directed
at supporting the corporation’s long-term growth, which will benefit customers,
employees and communities, as well as shareholders. Short-Termism is having disastrous effects
on the long-term health of American corporations and the American economy.
What Are the Causes of Short-Termism?
There are many factors that contribute to Short-Termism.
We read about these (executive compensation, high-speed trading, hedge funds
and others) in the media frequently. However, beneath it all, are two realities
of the current corporate environment which are the foundation upon which Short-Termism
is built:
1. Shareholder Value Governance
Over the last 30 years, the Shareholder Value Doctrine
has become the model for American corporate governance. This doctrine (sometimes
called the “agency theory” reflecting its erroneous view that directors are
agents of the shareholders) provides that the Board of Directors and management
must govern the corporation with the objective of increasing shareholder value,
giving little or no regard to the interests of other stakeholders like consumers,
employees and communities. Like trickle
down economics, this theory is based on the belief that everyone will benefit
if shareholders do.
The Shareholder Value Doctrine, which Jack Welch is
reported to have once described as the stupidest idea ever, is widely believed
to be a legal requirement. As eloquently
explained by Professor Lynn Stout in her book, The Shareholder Value Myth,
it is not. Rather, this corporate governance theory has been promoted over time
by mis-guided academics, self-interested parties and others. Over time, a “shareholder value industry” comprised
of academics, activist shareholders, hedge funds, institutional investors, Wall
Street analysts, the financial media, executives, lawyers, accountants, proxy
advisers, compensation consultants and others has developed. This “industry” wields
great power over corporations and their Boards and managements and demands
unquestioned loyalty to the doctrine.
As a result, the Shareholder Value Doctrine has all but
totally replaced the previous stakeholder approach to corporate governance. That
earlier approach, which governed thinking for decades, recognized that the duty
of the Board and management of a corporation was to the corporation as a legal
person and its best interests. It recognized that the duty required providing a
fair return to shareholders and protecting their long-term interests, but also espoused
as consistent with that goal supporting the interests of employees, consumers,
communities and other non-shareholder stakeholders. According to this Stakeholder
Doctrine, Boards and managements of corporations should act to protect and
develop the corporation for the long-term and through that investors, as well
as employees, consumers and communities, would prosper.
Now, however, Shareholder Value thinking has become so
ingrained in corporate governance that boards and management are in many cases
not even aware that they have the freedom (perhaps even the duty) to take a
more balanced long-term approach, focusing on the long-term interests of the
corporation for the benefit of its shareholders and consistently the interests
of other stakeholders.
2. Wall Street -- for traders, not investors
At the same time that shareholder value became the almost
exclusive focus of corporations, Wall Street moved from an investment community
to a trading community. For example, in 1960 the average holding period for stock
exceeded nine years. By 2000, this was down to a little over a year and in 2010
it had decreased to six months. The stock market moved from a community composed
significantly of individual and small investors investing in companies for the
long-term to a market dominated by large institutions, the vast majority of
which are focused on making returns through short-term trading, not long-term
investment.
Consequently, since the Shareholder Value Doctrine
demands that corporations be run to increase the value to shareholders and the
shareholders want short term gains, Boards and managements are compelled to
govern the corporation to produce short term increases in shareholder value. And,
although they might not be willing to admit it, they are compelled to do this
even at the expense of the long term best interests of the organization and its
business, and regardless of the impact on long term investors, workers, customers
and communities.
What Are the Consequences of Short-Termism?
People talk about the dry recovery like it is the result
of some unknown virus which invaded America and which the CDC has been unable
to identify and stop. It is certainly not that and it is not at all mysterious.
Although Short-Termism may not be the only culprit, it is a major if not the
principal contributor to this most serious problem.
The statistics are staggering. US real household median income
dropped from 1999 to 2010. Between 2000
and 2010, those living in poverty in this country rose by a third to over 15%.
On the other hand, the Dow soared from around 7000 in 2009 to over 18,000 in
2015. Having once had a middle-class which was the envy of the world, America
now finds itself as the only place in the world expected to have a shrinking
middle class over the next decade.
This cannot continue. It is not possible to have a well-functioning
democracy where the fruits of its industrial strength are siphoned off for the
benefit of an elite group primarily in the financial sector, depriving
America's business organizations of the resources needed to grow and keep the
United States the economic leader it is. Non-financial business investment has
declined and as one report asked: " so what have companies been doing with
their cash?" The answer is simple: they have been using it to respond to
the demands of Short-Termism. It has been reported that from 2003 to 2012, 449
public companies in the S&P 500 used 54% of their profits for stock buy-backs
and 37% for dividends, leaving a paltry 9% for reinvestment in the business. A
little private study of some companies I know that I did at the end of the 3rd
quarter of 2015 showed that all 5 companies paid out more cash to stockholders
in dividends and buy-backs than they took in from operations, one by over
200%. Every American knows what happens
eventually if you keeping paying out more than you take in. Unless corporations begin again spending a
substantial portion of their earnings on investment for long-term growth, there
is no question that they will not be able to provide the product and other improvements
that American society deserves or the opportunities for its workers
(particularly the young) that this country has been so famous for and that
America's citizens are entitled to.
How Can This Be Fixed?
Unfortunately, there is no quick fix to Short-Termism.
Short-Termism took decades to develop and fixing it will involve a journey to
move the corporate community and Wall Street to a long-term growth focus. In an
ideal world, voluntary action by corporate boards and management and Wall
Street toward a long-term growth focus would go a long way to solving the
problem. However, Short-Termism and the Shareholder Value Industry are now so ingrained
in our business environment, it is unlikely that without some government
intervention things will change.
The Current Debate
A substantial debate about income inequality in America
is taking place.
Some suggestions of changing the capital gains tax to encourage
long-term investment and imposing a tax on short-term, high-volume trading. Of
course, the devil will be in the details but fundamentally both of these
proposals can help solve the problem.
There has been much talk about raising the minimum wage. Raising the minimum wage may be a needed
short-term fix given the appallingly low wage rates of many hard-working
Americans, but it is no long-term solution. Anyone who has taken a basic
economics course or worked in business knows that the reaction to that will be reduced
employment to control costs. And absent price controls, prices will eventually rise,
as increased costs and demand push corporate managers to raise prices,
eliminating any benefit of the higher wages over the long term.
Ideas to Explore
Below are some ideas which could be explored to help end Short-Termism
and bring back into balance short-term and long-term planning and the use of
America's corporate resources for investment in the future as opposed to
current returns to Wall Street traders:
·
The SEC Could Enhance Disclosure To Bring More
Focus On The Long Term: One possibility is to increase disclosure about the
long term. Currently, American public
corporations devote enormous effort focusing on short-term results. They report
quarterly and annual results and discuss them at length in their MD&As;
they discuss these results and forecasts in quarterly analyst calls and make
presentations about them at investment conferences. There is precious little or
no discussion about long-term strategy, forecasts or valuations, or other
long-term factors.
The SEC could substantially
increase disclosure requirements about the long-term. For example, ’34 Act
filings or proxy statements could contain a comprehensive report (including formal
projections) on the long-term strategies and prospects for the company, like the current CD&A does for executive
compensation. Of course, long-term projections are less certain and will of
necessity evolve over time. But creating transparency in this area would encourage
corporations and Wall Street to focus on the long-term as a key measure of
success and a key criteria for investment decisions.
·
Restrict Quarterly Forecasting: Another
proposal which has been made would prohibit public corporations from giving
quarterly earnings guidance. Proponents of this idea argue that it would free
up corporate managers to focus more on the long-term by making them feel less
responsible for meeting Wall Street's quarterly estimates and make them less
inclined to adjust expenses to meet quarterly forecasts. Although the proposal
has merit, it could make Wall Street's quarterly targets less reliable and
thereby increase volatility. Also
corporate managers will still feel driven to meet Wall Street's quarterly expectations
even if they had little to do with setting them.
·
Improve Corporate Governance: Corporate
governance is largely a matter of state law. However, particularly since
Sarbanes-Oxley and Dodd-Frank, there is much precedent for the Federal Government
involvement in public company governance. Here are some ideas of things that might be
done:
o Directors
of public companies could be licensed (as lawyers and accountants are) and/or
required to take director education courses, both designed to bring focus on their
duties as directors to promote the long-term health of the corporations
o Recognizing
that excessive stock buybacks are a form of gradual liquidation of the company
to the detriment of creditors and other stakeholders, the SEC could issue a
rule (like the NYSE 20% rule) requiring stockholder approval if buybacks exceed
a certain percentage
o The
German model of governance where representatives of other stakeholders in
addition to investors are represented on the Board could be considered. (See,
for example, how Lufthansa is governed)
·
Reign In Activist Investors: In principle,
there is nothing wrong with activist investing.
If a substantial investor finds that a company is being mismanaged, it
should have the ability to take action to correct the problem. However, that is
not what activist investing means today. Using the above principle as cover and
America's current cheap money as funding, many activist investors are invading
American companies for the purpose of generating short-term gains. For example,
in 2014 activists gained board seats at 107 companies. From late 2008 to
mid-2015, there were 220 public activist campaigns to increase payouts to
shareholders, largely through increased stock buybacks. A recent study estimated
that not more than 2% of activist campaigns are focused on improving long-term
performance. The consequences of these activist campaigns are dire, busting up
properly functioning companies with good futures, draining corporate resources
to improve TSR, firing employees unnecessarily, cutting R&D, all justified
by the current Short-Termism and Shareholder Value Governance Doctrines. More
than others, activist investors are the enforcers of short-termism.
Sadly, the activist plague has
been left unchecked. They are essentially unregulated by the SEC. Much could be done to impose appropriate
regulation on their activities. For example, the imposition of Regulation 13-D
disclosure requirements on activist investors would give companies fair warning
and an ability to prepare to deal with them. Instead, activist investors are
now allowed to act in unregulated "wolf packs" as opposed to
regulated Section 13-D groups. They are allowed to exercise their right of
“free speech” and put out highly inflammatory and questionable white papers
without any disclosure controls, all to put pressure on Boards and managements
to yield to their demands. Expanding merger preclearance requirements (H-S-R)
to include an evaluation of the impact of an activist transaction (such as the
current Dow-DuPont or Kraft-Heinz mergers) on consumers, workers and the public
would help prevent the negative impacts of these transactions. Basically, a set
of regulations that ensures that activist investors are not corporate raiders,
crippling and dismantling America’s industrial base, is needed.
·
Wall Street Needs To Be Made More Transparent:
It has always struck me as ironic that institutional investors have for decades
pushed to increase corporate transparency, while they themselves are among the
most opaque institutions. When I think
about Main Street’s relationship to Wall Street, I am reminded of the line from
Shakespeare's Julius Caesar "the fault, dear Brutus, is not in our stars,
but in ourselves..." In many cases,
it is the money of Main Street invested in Wall Street’s institutions which is
being used to promote the very Short-Termism harming Main Street. Needless to
say, it would be a complicated process to develop a system of transparency for
Wall Street giving Main Street investors more control over how their money is
being used, but one has to wonder why that wasn’t done a long time ago.
·
Improve Wall Street’s Governance Of Its Investments: The lack of Wall Street transparency is
compounded by the way many institutional firms vote the shares of public
corporations they hold. For example, many firms effectively delegate the
decision as to how to vote on executive compensation (“Say on Pay”) and other
matters to Institutional Shareholder Services (“ISS”). ISS is an unregulated,
for-profit corporation which can through its recommendations effectively control
as much as around one-third of a corporation’s shareholder vote on any matter.
Therefore, ISS’s views heavily influence executive pay and other corporate governance
proxy proposals. The question becomes whether a for-profit, unregulated
organization accountable to no one should have this much influence on executive
compensation (see discussion below) and other corporate governance matters.
·
Executive Compensation Should Be Made More
Long Term: The strong tie between short-term stock performance and
executive compensation was developed in an effort to create a "pay for
performance" environment, aligning the interests of management with those
of the stockholders. Unfortunately, the pendulum has probably swung too far.
With Wall Street focused on short-term results, many of the aligned
compensation systems (such as options, restricted stock programs and 3-year
“long term” bonus programs) also focus on short-term results, many tied to Wall
Street by being tied to earnings per share or stock price performance. Much of
the design work of executive compensation programs is done by a small handful
of compensation consultants. They are heavily influenced by the practices of
peer companies and by the guidelines of ISS (described above). The result is
very much a follow-the-leader approach resistant to change. Using the tax laws,
the Federal government does have the power to influence the short-term nature
of executive compensation, such as was done by Section 162 (m) to address
non-performance based compensation or Section 280G for golden parachutes.
·
Tax Policy Can Be Used To Encourage Long-Term
Planning: Tax policy (as opposed to direct regulation) can be used as a
tool to implement many of the above suggestions and promote long-term corporate
governance.
Conclusion
Short-Termism and Shareholder Value Governance are
crucial social problems for America which if not addressed will continue to
damage the industrial base and with that increase poverty in America and the
growing disparity between haves and have-nots. As set forth above, there are
many possible tools available to the Federal government to address these
issues. The extent to which their use is
necessary will depend on the response by Wall Street and corporate directors
and management to the growing outcry about this problem and the prospect of
increased regulation.
Andrew D. Hendry
January 25, 2016
(Updated November 11, 2016)
andrewdelaneyhendry@gmail.com
