Thursday, June 28, 2012

Shareholder Primacy Myths

Equity shareholders can be a useful voice for all stakeholders in helping corporate managements to allocate capital better.  For example, Walgreen's overspending to acquire a stake in Boot's or HP overspending to acquire Autonomy are recent examples.  Big acqusitions, either for cash or for debt are not bond-holder friendly.  Just read any credit report on a company.  Yet, unless there are restrictive covenants attached to their instruments, bond holders can do little about free spending managements.

Equity shareholders can, and do, speak up directly and through analysts in the capital markets.  To the extent that they shine a light on big acquisitions or even discourage them, they perform a valuable service for all stakeholders by lowering the risk level for future free cash flows. 

Shareholders do not, however, have some divine right over and above other holders of corporate claims.  Common equity holders have a residual interest in the company, after all other claims have been satisfied.  The earnings can be retained or distributed as dividends, again not through some divinely communicated formula.  Bond holders would prefer that no dividends be paid, because there would be more cash to settle their claims; shareholders reasonably have other expectations.  The point is that the shareholder claim is a residual one.

We've written about the primacy of hedge funds within the shareholder base of many public corporations.  Their holding periods may be days or weeks, and their interests are not generally in the long term interests of the corporation, which is "to be in business forever."  (Those are Harvey McKay's words for McKay Envelope.) Short-termism and excessive risk taking have ruined too many public companies to list.  In fact, we are still crying about the excessive risks that bank CEOs took during the financial meltdown.

Yet, they took those risks precisely to satisfy shareholders with unsustainable earnings growth, and to feather their own nests through rent capturing compensation.  And we want to elevate shareholders by fiat to the top of the stakeholder pyramid? 

Nell Minow has been part of creating a large industry around the shareholder primacy mantra.  As a long time equity analyst and public company CFO, investors and shareholders were always important to me as customers and stakeholders.  Over time, however, I got to see up close and personal how pernicious the influence of certain bad actor shareholders can be to the interests of companies.  The other side of the aisle is represented by Lynn Stout of the UCLA Law School who writes on this issue in today's New York Times.

The shareholder primacy industry has just resulted in more mind numbing proxy boilerplate, more checklists for boards, more window dressing around egregious corporate compensation and has opened the door for meaningless, costly and sometimes harmful activism.  That this springs from a misreading of corporate law needs to be addressed for the benefit of all stakeholders.

Managements should actively listen to their shareholder concerns by looking them in the eye, not from on their knees in fealty.

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