STOP SHORT-TERMISM NOW-SAVE AMERICA: November 2016

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 3^rd 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

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