Tuesday, December 9, 2008

How Not to Get Better Corporate Governance

Professor Jonathan Macey of Yale Law School has written a book, "Corporate Governance: Promises Made, Promises Broken," which is the basis of his op ed piece today in the Wall Street Journal.

He proposes "market solutions" for improving governance. This certainly sounds like a well worn mantra. Then, he actually writes, "Hedge funds and activist investors...are the solution not the problem." Whether or not they are a problem can be debated, but it is unbelievable that they could be generically portrayed as a solution to corporate governance issues.

Hedge fund managers are transaction oriented, and they establish ownership positions with their agendas in mind. Witness, for example, Pershing Square Capital's ongoing dialogue with the management of Target Corporation. Perhaps in response to Pershing's first idea, Target sold off part of their credit card portfolio. Then came the "Big Idea," to sell off Target's entire real estate portfolio into a REIT and then to lease the properties back for seventy-five year terms! After lots of dueling press releases and competing analyst meetings, the company properly rejected the proposal as being against the long-term interests of the company, as it would reduce its financing flexibility, lower its debt rating, increase its expenses, and divert management attention from its core competencies of merchandising and retail management, all for a one-time payout.

The much ballyhooed combination of Sears and Kmart engineered by hedge fund manager Ed Lempert has been a disaster for both companies, their consumers, employees and investors. A merry-go-round of executive management changes has taken money and time, but produced nothing. This is better governance?

A well-run company, with a strong management team and an effective board of directors has to look to the long-term and not put the company at risk for a short-term transaction. News today of the Tribune Company's bankruptcy again shows the pitfalls of defining shareholder interests narrowly and exclusively, to the exclusion of other legitimate stakeholder interests, like employees. Those Tribune employees who took buyouts to facilitate a hare-brained transaction now stand to lose their promised payouts and stand in line as unsecured creditors. To treat important stakeholders like this is not enlightened good business practice and violates basic principles of fairness.

Hedge fund managers, and indeed many traditional, value-oriented institutional investors often come up with interesting thoughts for strategic initiatives in their portfolio companies. All of these suggestions should be listened to and considered thoughtfully. An open, constructive dialogue with the shareholders is something that benefits both parties. However, it is the responsibility of the board to keep its hand on the strategy tiller and to let management focus on execution and financial performance.

There are cases where an activist hedge fund has prodded a complacent company into better use of underperforming assets, most often through a transaction. However, the notion that hedge funds broadly are a panacea for better governance defies both history and logic.

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