The Subversion of Shareholder Democracy and

the Rise of Hedge-Fund Activism1

Jang-Sup Shin2

Working Paper No. 77

July 2018

ABSTRACT

This paper explains how hedge-fund activists are exerting power over corporate resource allocation far in excess of the actual voting power of their shareholdings. The power of these “minority-shareholding corporate raiders” derives from misguided regulatory “reforms” carried out in the 1980s and 1990s in the name of “shareholder democracy”. Sanctioned and overseen by the Department of Labor (DOL) and the Securities and Exchange Commission (SEC), these reforms include the introduction of compulsory voting by institutional investors and proxy-voting rule changes that greatly facilitated hedge-fund activists’ aggregation of the proxy votes 1This paper is drawn from my collaborative research with William Lazonick on hedge-fund activism, corporation and economy that resulted in a book manuscript, Value Creation and Value Extraction: The Manifesto to Reclaim Sustainable Prosperity. I thank Bill for his continued encouragement and intellectual companionship. I also thank Matt Hopkins for his inputs on hedge funds. Funding for this research came from the Institute for New Economic Thinking under Grant IN017-00013: “Value Creation and Methods of Value Extraction in US Firms”.

2 National University of Singapore

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of institutional investors. In addition, the introduction of the 1996 National Securities Markets Improvement Act (NSMIA) that allowed hedge funds to draw funds from institutional investors effectively with no limit also played an important role in the rise of hedge-fund activism. The paper concludes with policy proposals to rebalance value creation and value extraction by rebuilding the engagement and proxy voting system including (1) making it mandatory for shareholders to submit justifications in shareholder proposals on value creation or capital formation of corporations concerned; (2) removing voting as a fiduciary duty of institutional investors; (3) introducing differentiated voting rights that favor long-term shareholders; and (4) making it mandatory for both shareholders and management to reveal to the public what they discussed in engagement sessions.

JEL Codes: G18, G28, K22, L21, M10, N22

Keywords: Shareholder democracy, Hedge-fund activism, Compulsory voting of institutional investors, Engagement and proxy rules, Proxy advisory firms, New Deal financial regulations, Sustainable value creation and value extraction.

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1.Introduction

Thevalueextractingpowerofhedge-fundactivistsishardlycomprehensibletocasual

observers.Theyaremere“minorityshareholders”.Yettheyexertenormousinfluenceoverthe

governanceofcorporations,oftenforcingthemtoundertakefundamentalrestructuringandto

increasestockbuybacksanddividendssubstantially.Forinstance,ThirdPointManagementand

TrianFundManagement,holdingonly2%ofoutstandingstockofDowChemicalandDuPont

respectively,engineeredamerger-and-splitofAmerica’stoptwochemicalgiantsattheendof

2015,resultinginmassivelayoffsandclosureofDuPont’scentralresearchlab,thefirst

industrialsciencelabintheUnitedStates.3CarlIcahn,afteracquiringabout1%ofApple’sstock

in2013,pressedthemostvaluablecompanyintheworldatthetimetorepurchasearecord-

breaking$80billionofitsoutstandingstockin2014-2015,andtook$2billionofprofitfor

himselfwhenhequietlysoldhisentirestakein2016.4

ElliotManagement,whoseeffortstoenforcefullpaymentofbondsissuedbypoorcountries

inAfricaandLatinAmericathroughlitigationandothermeasureshadalreadyattractedwide

attention,purchasedabout0.5%ofoutstandingstockofSamsungElectronicsinearlyfiscal

2016.Itthendemandedthatthelargestelectronicscompanyintheworldbyrevenuesplit

itselfintoaholdingcompanyandanoperatingcompanywhileradicallyincreasing

“shareholder-friendly”measuresbypayingoutspecialdividendsofabout$26billion(KRW30

trillion).Thishedge-fundattackledthecompanytoembarkonabout$8billion(KRW9.4trillion)

ofadditionalstockbuybacksontopofabout$9.9billion(KRW11.3trillion)ofstockbuybacksit

hadbeendoingoverthepreviousyear,apparentlyas“compensation”foritsrejectionof

3Gandel(2015);‘DissectingtheDowAndDuPontDeal,FromMergerToSplit?’Forbes,August30,2016(https://www.forbes.com/sites/greatspeculations/2016/08/30/dissecting-dow-and-dupont-deal-from-merger-to-split/#1414e3286967);‘DowDupontNamesItsThreeNewSeparateBusinesses’,ChemistryWorld,March1,2018(https://www.chemistryworld.com/news/dowdupont-names-its-three-new-separate-businesses/3008721.article).4Lazonick,HopkinsandJacobson(2016);‘BillionaireIcahnExitsAppleStakeAfterThreeYears’,Bloomberg,April29,2016(https://www.bloomberg.com/news/articles/2016-04-28/billionaire-icahn-exits-apple-stake-almost-3-years-after-buying).

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Elliott’sdemandtosplitthecompanyandpayaspecialdividend.5Itisnowincreasinglydifficult

tofindincidentsinwhichmanagementgoesagainsthedge-fundactivists’proposalsoutright

andriskproceedingtoaproxyvotingshowdowninshareholdermeetings.AsStevenSolomon

commented,“companies,frankly,arescared”and“[their]mantra…istosettlewithhedge

fundsbeforeitgetstoafightoverthecontrolofacompany.”6

Thispaperexplainswhyandhowhedge-fundactivistshaveacquiredpowerdisproportionate

totheiractualshareholdinganddiscussestheimplicationsofthispowerforgovernmentpolicy

andcorporatemanagement.Hedge-fundactivistsaredescendantsofthecorporateraiders

whosejunk-bond-fueledattacksonUSbusinessesinthe1980swereatthecenterofwhat

becameknownasthe“dealdecade.”Withthecollapseofthejunkbondmarketinthelate

1980s,corporateraidersreinventedthemselvesas“hedge-fundactivists.”7Bothcorporate

raidersandhedge-fundactivistsexploittheirpositionsasshareholderstoextractvaluefrom

companies.Theyareonlydifferentinthattheformerdidsobybecoming(orthreateningto

become)majorityshareholderswhereasthelatterdosoaswhileremainingminority

shareholders.

Thispaperarguesthatthepowerofthese“minority-shareholdingcorporateraiders”derives

frommisguidedregulatory“reforms”carriedoutinthe1980sand1990sinthenameof

“shareholderdemocracy.”SanctionedandoverseenbytheDepartmentofLabor(DOL)andthe

SecuritiesandExchangeCommission(SEC),thesereformsincludetheintroductionof

compulsoryvotingbyinstitutionalinvestorsandproxy-votingrulechangesthatgreatly

facilitatedhedge-fundactivists’aggregationoftheproxyvotesofinstitutionalinvestors.In

addition,theintroductionofthe1996NationalSecuritiesMarketsImprovementAct(NSMIA)

5‘SamsunginCrossHairsofAmericanHedgeFund’,NewYorkTimes,Oct.5,2016(http://nyti.ms/2dxarIk);‘TheCurrentStateandDirectionofSamsungElectronics’StockBuybacks’(inKorean),MiraeAssetDailyReport,Sept.15,2017.6Solomon(2015).7Corporateraidersinfactbifurcatedintohedge-fundactivistsandprivate-equityfunds.Inthelatter,traditionalmethodsofcorporateraidingbybecomingmajorityshareholderscontinuedtobepracticedalthoughtheconventionalterm,“hostiletakeover,”gavewaytosimple“takeover”ashostiletakeoveractivitieswereestablishedasanorminthecorporateandfinancialworld.Inthispaper,Iamonlyfocusingontransformationofcorporateraidersintohedge-fundactivists.

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allowedhedgefundstodrawunlimitedfundsfrominstitutionalinvestorstoconducttheir

attacksontargetcorporations.

Underpinningtheseregulatorychangeswastherapidgrowthofinstitutionalshareholding,

withsomepensionfundsengagingintheirownbrandofshareholderactivism.Inhistorical

perspective,institutionalactivismisarecentphenomenon.TheNewDealfinancialregulations

ofthe1930senforcedpassivityoninstitutionalinvestorsintheirrelationswithcorporate

management.Thenormofinstitutional-investorpassivityonlybeganchangingfromthemiddle

ofthe1980s.Tomakesenseoftherecenttransformationoftherelationbetweenbusiness

corporationsandinstitutionalinvestors,itisnecessarytounderstandwhyinstitutional

investorswereoriginallyunderheavyregulation.

2.ThemovementforshareholderdemocracyandNewDealfinancialregulation

WhentheU.S.publicstockmarketwastakingshapeintheearly20thcentury,thosewho

cametoownpublicsharesweremostlyretailinvestors−thatis,individualhouseholds.Each

holdingaminisculepercentageofacorporation’ssharesoutstanding,theyhadnoabilityor

incentivetoengagewithcorporatemanagement.Theirgeneralwillingnesstoleavecontrolto

managersstemmedinpartfromthepriorrevenue-generatingsuccessesofthosecorporations

undermanagerialcontrolandinpartfromthetrusttheshareholdershadinfinancial

intermediarieswhohadpersuadedthemtobuycorporatestock.But,morefundamentally,this

willingnesstoabdicatecontrolderivedfromtheconfidenceofpublicshareholdersthatthe

sharestheyheldwereliquidandthattheycouldthereforesellthemonthestockmarketatany

time,amaneuverthatbecameknownas“theWallStreetWalk.”Anotherreasontheywere

willingtoholdpublicstockswasthattheirownershipstakeinacompanyentailedcommitment

ofneithertheirtimeoreffort,whiletheirliabilitywaslimitedonlytothecashthattheyhad

paidforthoseshares.Theywouldnothaveboughtthesharesinthefirstplacehadtheybeen

obligedtoprovidesuchcommitmentortoassumethecorporation’sfinancialliabilities.8

8LazonickandO’Sullivan(2000);Lazonick(2014).

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Thosewhofromtheearly20thcenturyhadembracedandpromoted“investordemocracy,”

or“shareholderdemocracy,”werenotatallinterestedinencouragingthesepublic

shareholderstoinfluencemanagementdecisions,thehallmarkofcurrent-dayshareholder

activism.AsJuliaOtthasarguedinWhenWallStreetMetMainStreet:TheQuestforInvestors’

Democracy,themainconcernof“intellectual,political,corporate,andfinancialleaderswho

embarkedonaquestformassinvestment”washowtobuildastableandprosperouspolitical

systeminthefaceofnotonlypublicdistrustof“corporatepowerandaccountability”butalso

ofpoliticalchallengesofinternalintegrationfrom“mountingeconomicinequality,surging

immigration,ethnicdiversity,JimCrowsegregation,andwomen’sdemandsforsuffrage[that]

sparkedfundamentaldebatesaboutcitizenship.”Theyhopedthat“[m]assinvestmentcould

shoreupthepropertiedfoundationsofcitizenship,preserveeconomicmobilityandautonomy,

enhancenationalprosperity,andmakecorporationsaccordwiththewillofthepeople.”9Atits

inception,shareholderdemocracywaspremisedonretailshareholderswhohadpolitical

citizenshipinthecountry.Institutionalinvestorssuchasinvestmenttrustsandmutualfunds

wereonlybeginningtoemerge.Theyweresimply“moneymanagers”,whowerenotseenas

havinganypartinshareholderdemocracybecausetheywerefiduciaries,notowners,anddid

nothavethestatusofcitizens.10

TraditionalregulationsoninstitutionalinvestorsemergedintheNewDealeraasapolicy

responsetotheturmoiloftheNewYorkStockExchangecrashof1929andthesubsequent

collapseofeconomicactivity.TheSecuritiesActof1933andtheSecuritiesExchangeActof

1934,thesecondofwhichestablishedtheSecuritiesandExchangeCommission(SEC),soughtto

regulatefinancialmarkets.Thespecificregulationofmutualfundshadtoawaitpassageofthe

9Ott(2011:4).Forinstance,Clark(1900)envisionedthattheshareownershipbyworkerswould“blur,orperhapsdisappear…theoldlineofdemarcationbetweenthecapitalistclassandthelaboringclass”andargued“Thesocialistisnottheonlymanwhocanhavebeatificvisions”(QuotedinOtt(2011:25)).Thisvisionhascontinuedintothe1920sandJohnRaskob,forinstance,madehisfamousstatementin1929,"Everyoneoughttoberich",bylayingoutproposalsforworking-andmiddle-classwealthbuildinginanarticleinLadiesHomeJournal(JohnJ.Raskobpapers(Accession0473),HagleyMuseumandLibrary,Wilmington,DE19807,https://findingaids.hagley.org/xtf/view?docId=ead/0473.xml).10Thepromotersofshareholderdemocracyofacenturyagoalsomadeitclearthattheydidnotthinkofitashavingrelationtoraisingcapital.SoOtt(2011:4)statesthatthey“didnotviewmassinvestmentasaparticularlyefficientorprofitablemeansofraisingcapital”andpointsout“[c]orporateneedforcapitaldidnotcallforthpopulardemandforfinancialsecuritiesspontaneously”.

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InvestmentCompanyActof1940.TheNewDealfinancialregulationsembodiedthreeenduring

principlestoguidetherelationbetweenshareholdersandcompanies:(1)that“fraudand

deceit”,includingprofitingfrominsiderinformation,beprohibited;(2)thatinvestorsactingasa

groupbeheavilyregulatedandtheformingofinvestors’cartelsprohibited;and(3)that

investorsbeencouragedtodiversifytheirportfoliosanddiscouragedfromexertinginfluence

overmanagement.

Underthefirstprinciple,theregulationsrequiredpubliccompaniestomakeregular,

accurate,andtimelypublicdisclosureoffinancialinformationtoshareholderswhilebarring

shareholdersandmanagersfromprofitingfrominsiderinformationandmisappropriating

corporateresources.Theyspecificallyprohibited“fraudordeceit”and“manipulativeor

deceptivedevicesorcontrivances.”11Todeterinsidertrading,theyrequiredthosewhowere

deemedinsiders,whethermanager-ownersorinvestors,to“reportallpurchasesandsalesof

companysecurities”.Inaddition,theystipulatedthat,shouldinsiders“profitbybuyinga

company’ssecuritiesandsellingthemwithinsixmonthsorbysellingandrebuyingwithinsix

months,theymayberequiredtoforfeitthoseprofitstothecompany.”12

Underthesecondprinciple,theformationofa“votinggroup”byinvestorswasconsidered

torepresentaninvestorcartel,apracticethatwasheavilyregulated.Ifthecombinedsharesof

agroupofinvestorsexceededaspecifiedthreshold,itsmemberswereplacedunderthesame

regulationsasinsiders.Inviewofthefactthatinvestorsintendingtoformagroupwouldneed

tocommunicatewithoneanotherinadvance,communicationamonginvestorscameinfor

strictoversight:TheSecuritiesExchangeActof1934ruledthat“Ifoneinstitutioncontacted

enoughothers,thecommunicationswouldbedeemedaproxysolicitation.…Filingwouldhave

tobemade;thefilerswouldhavetogivethosecontactedtheinformationspecifiedinSchedule

14A.Similarly,thesecuritiesactstriggerliabilityofcontrollingpersonsforillegalactionsbythe

controlledcompany.Groupsthatcontrolcouldbeliableforthemisdeedsofthecontrolled

portfoliocompany.”13

11Blair(1995:51)12Blair(1995:51)13Roe(1990:17).Blair(1995:71)pointsoutthatthisregulationmadeit“difficultforshareholderstocommunicatewitheachotheratall…withouttheapprovalandsupportofmanagement.”

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Inlinewiththethirdprinciple,institutionalinvestorswereencouragedtodiversifytheir

portfolioswhilebeingdiscouragedfromseekingtocontrolmanagement.The1934Pecora

Report,theproductofaSenatesecuritiesinvestigation,explicitlywalledinstitutionalinvestors

offfrommanagement,makingclearthatmutualfundswereallowedtoengageininvestment

only.14ThisprinciplewasalsoembodiedintheTaxCodeof1936:“anothersafeguard…isto

preventaninvestmenttrustorinvestmentcorporation[from]beingsetuptoobtaincontrolof

somecorporationandtomanipulateitsaffairs.”15InenactingtheInvestmentCompanyActof

1940,ahigh-rankingSECofficialeventestifiedthat“amutualfund’sonlypositivefunctionwas

toprovidediversification;anyextensionriskedthievery.”16

Thisregulationthatclearlyseparatedmanagementfrominstitutionalinvestorsansweredin

parttotheneedtoremovethepotentialforconflictofinterest:Ifinstitutionalinvestorswere

allowedtocontrolcorporations,theywouldtendtoutilizetheirpositionfortheirownprofitat

theexpenseofothershareholders.Moreimportant,behindtheregulationwasaclear

understandingthatinstitutionalinvestorsandmanagementperformfundamentallydifferent

functions:Whiletheformerisbasicallyspeculatorsand/orsaverswhohelpindividualsinvestin

corporatestockthroughutilizingtheirsizeanddiversification,thelattercreatesvaluein

corporationsbyproducinglow-costand/orhigh-qualityproductsandservices.17Themutual

fundindustrythendidnotopposetheregulationsimposedbythegovernmentand,onthe

contrary,theindustryreadilyacceptedtheregulationsbecauseit“wantedtosellitsproducts

andneededacodeofconducttocertifytheindustrytothepublic.”18

Thesethreeprincipleshadbeenwellenoughestablishedthattheywentunchallengeduntil

the1980s.Forinstance,thesameprincipleswereupheldwhentheEmployeeRetirement

IncomeSecurityAct(ERISA)wasintroducedin1974asapolicyresponsetothegrowingneedto

regulatepensions.First,ERISArulespreventedself-dealingbehavioronthepartofemployers

andfundmanagers.Second,theydiscouragedpensionfundsfromtakingexcessiverisksand

14Roe(1990:12).FordetailsonthePecoraReport,refertoPerino(2010);U.S.SenateCommitteeonBankingandCurrency(2009).15Roe(1991:1483).16Roe(1991:1488).Theemphasisisoriginal.17Fordetailsonthis,refertoLazonick(2015)andLazonickandShin(2018forthcoming,Chapter2).18Roe(1991:1489).

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encouragedthemtodiversifyinvestmentportfoliosverybroadly.Third,pensionfundswere

requestedtorefrainfromexercisingcontrolovercompaniesintheirportfolio;iftheytriedto

doso,theycouldlosetheirtax-exemptstatus.19Inthiscontext,PeterDruckerpointedoutthat

pensionfunds“havenobusinesstryingto‘manage’…Tositonaboardofdirectors,for

instance,andaccepttheobligationsofboardmembership,isincompatiblewithdutiesas

‘trustees’…whichhavebeensharplyandstrictlydefinedinthePensionFundReformActof

1974[ERISA].”20

3.Theprogressionofinstitutionalactivism

Beginninginthe1980s,however,theseprinciplescameincreasinglyunderassault.Aswillbe

elaboratedbelow,shareholderactivistsadvancedthenewcredosof“corporatecitizenship”

and“relationalinvesting,”andregulatoryauthorities,suchastheSEC,theDepartmentofLabor

andDepartmentofTreasury,startedtosidewiththeactivists.Underlyingthetransformation

wastherapidlygrowingpowerofinstitutionalinvestorsincorporateshareholdingonwhich

shareholderactivistsfoundwaystoleverage.21AsshowninFigure1,institutionalshareholding

ofU.S.publicstockswasatonly9%in1950,butincreasedto14%in1960,22%in1970,32%in

1980,45%in1990,55%in2000,and63%in2015.Ifoneincludeshedgefundsandprivate-

equityfundsininstitutionalinvestors,theactualinstitutionalshareholdingwouldbe

substantiallyhigherthanFigure1shows.22

19Blair(1995:157).20Drucker(1976:83).21Thetransformationwasalsolegitimizedbythebroadacceptanceofagencytheory,whichunderpinnedtheideologythatacompanyshouldberuntomaximizeshareholdervalue.22In Figure 1, drawn from the Federal Reserve data set, hedge funds and private-equity funds are classified as“households”,notas“institutionalinvestors”,despitethefactthatmostofthemarefunctioningasinstitutionsbypoolingandmanagingotherpeople’smoney.Thisconventionaldefinitionofinstitutionalinvestoralsoarosefromloopholesinfinancialregulations(Dayen2016).

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Figure1.TheGrowthofInstitutionalShareholdingintheUnitedStates

Source:FederalReserveBoard

Therewerevariousgroupsofactivistswho,inthe1980s,pursuedcorporatereformsto

obtainwhattheyconsideredpublicbenefits.Atthesametime,thereweregroupsofinvestors,

includingcorporateraiders,whodidnothidetheirdeterminationtoprofitfromtheprocessof

“reforming”corporations.Inthenameof“shareholderdemocracy,”thiscoalitionofreformers

andraiderssucceededinbringingaboutmajorchangesinthetraditionalNewDealfinancial

regulations.23TheupshotoftheregulatorychangesispresentedinFigure2.

23Ontheevolutionofcorporategovernancediscourse,refertoCheffins(2013).

0%

10%

20%

30%

40%

50%

60%

70%1945

1948

1951

1954

1957

1960

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1966

1969

1972

1975

1978

1981

1984

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Figure2.Changesinregulationsontherelationbetween

institutionalinvestorsandcorporations

TheNewDealfinancialregulationsinthe1930s

•Establishedtheprincipleofseparationbetweenpublicshareholdingandcorporatemanagement

ERISAregulationin1974

•MaintainedtheNewDealprinciples

Formalizinginstitutionalactivismin1985-86

•EstablishmentofCouncilofInstitutionalInvestors(CII)(1985)

•EstablishmentofInstitutionalShareholderServices(ISS)(1985)

•LaunchofUnitedShareholderAssociation(USA)(1986)

AvonletterandDOL-DOFdirectivesin1988-9

•Compulsoryvotingforpensionfunds

SECproxyrulechangein1992

•Allowingdefactoinvestorcartels

•Unlimitedfreedomof“communicationandengagement”

SECfinalruleonproxyvotingin2003

• Compulsoryvotingformutualfundsandotherinvestmentadvisers

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3.1.RobertMonksandISS:CompulsoryvotingofInstitutionalInvestors

RobertMonks,laterdescribedas“anentrepreneuroftheideaofcorporategovernance”or

“anagentofchangeincorporategovernance,”24wastheprincipalideologueandadministrator

toprovidejustificationforinstitutionalactivismaswellasabusinessmantoprofitfrom

establishingInstitutionalShareholderService(ISS),themostprominentproxyvotingfirm,by

almostsingle-handedlymakingproxyvotingafiduciarydutyofinstitutionalinvestors.Aclose

considerationofhisargumentsandhiscareerilluminatestheevolutionandconsequencesof

institutionalactivism.

MonksjoinedtheDepartmentofLaborasAdministratoroftheOfficeofPensionand

WelfareBenefitProgramsin1984,afterpreviouslyworkingasalawyer,businessman,and

banker,andhavingbeenanaspiringpolitician.“TheonlyreasonMonkstookthisjobwasto

advancehisgovernanceagenda,”accordingtoHilaryRosenberg,hisbiographer.“Hismain

concern[was]establishingthepositionthatpensionfundshadfiduciarydutiestoactasowners

ofcorporations.”25Fromthebeginningofhistenure,heintendedtoserveonlyoneyearasa

pensionadministratorandtoleveragehisexperienceingovernmentforabusinesscareerin

corporategovernance.26

Inaspeech,“TheInstitutionalShareholderasaCorporateCitizen”,laterconsideredseminal

amongcorporate-governanceactivists,Monkstoldpensionplanofficersthat

“itseemstometobeaself-evidentproposition,thatinstitutionalinvestorshavetobe

activistcorporatecitizens.…Giventhehugeblocksofstocksownedbyinstitutionsinallof

ourmajorcompanies,itisnotalwayspracticaltoquietlysupportmanagementor…sellif

youdon’tapproveofmanagement’shandlingofthecompany.Iwouldsuggestthatit24Rosenberg(1999).25Rosenberg(1999:83-84).26Rosenberg(1999:80),borrowingMonks’sownwords,detailsthisdecisionasfollows:“Onthetakingthepensionjob,Monksvowed–tohimselfandhisfamily–thathewouldstayinthepositionforjustoneyear.…hetoldhiswife…‘Trustme’,herememberssayingtoher…‘Iknowmyowntemperamentinthegovernment.Ihaveasingleagendaforthis.I’mnotgoingintothisbecauseIwanttobeacareerpublicservant.I’mgoingintothisbecauseit’sinaidofmylong-termprojectintryingtocreatechangeinthewaythatcorporationsfunction.Ican’taffordmorethanayear’stimehere.’”

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behoovesinstitutionalinvestors,intheexerciseoftheircorporatecitizenship,totakethe

leadinproposing,andpassing,provisions…Evenifyouwantedtorunawayfromapoorly

managedcompany,youcouldn’tdoitatonce…Solikeitornot,…asapracticalbusiness

matter,institutionalinvestorsaregoingtohavetobecomemoreandmoreactive

shareholder-owners,andlessandlesspassiveinvestors,…”27

Twoaspectsofthisspeechdemandourattention:thecallforstrongeractivismandtheuse

oftheterm“owners.”Astothefirstpoint,Monkstookforgranted,asdidlatercorporate-

governanceactivists,thatwiththegrowthofinstitutionalshareholding,ithadbecomemore

difficultforinvestorstoresorttothe“WallStreetwalk.”Theadvocacyofstrongerinstitutional

activismwasacorollaryofthisgrowingdifficulty.Fromtheperspectiveofthetraditional

regulationsoninstitutionalinvestorsthatencourageddiversification,however,thisargument

putsthecartbeforethehorse.Diversificationwasencouragednotonlytospreadoutrisks

acrossaportfolioofassetsbutalsotomakeiteasierforinstitutionalinvestorstotaketheWall

Streetwalkbysellingoffblocksofsharesinaportfoliowhentheneedwouldarise.As

institutionalshareholdinggrew,themarketforsellingblocksofsharesbecamemoreliquid,

actuallymakingiteasierforaninstitutionalinvestortotaketheWallStreetwalkbysellingits

sharestootherinstitutionalinvestors.Giventheliquidstockmarket,therearenogroundsfor

sayingthatanyparticularinstitutionalinvestoris“stuck”withcertainportfolios.ButMonks

employedthegrowthofinstitutionalshareholdinginaggregateasapretextforclaimingthat

theirshareholdingsareilliquidandthereforestrongerinstitutionalactivismwasneeded.

Acrucialtacticinadvancingthisargumentforstrongeractivismistoportrayinstitutional

investorsasiftheyarehomogeneous.Theyare,however,adiversegroupthatincludespension

funds,mutualfunds,sovereignwealthfunds,universityendowments,insurancecompanies,

27Rosenberg (1999: 92-93). Rosenberg (1999: 101) also quotes his similar speech at the Financial AnalystsFoundation (FAF) as follows: “Like it ornot,pension fundswerepermanent investors in corporateAmericaandbecomingmoresobytheday.Increasingly,theywerethedecidingfactorinongoingbattleforcorporatecontrol.”

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banktrusts,andotherinvestmentcompanies.28Institutionalinvestorsareingeneralcompeting

fiercelywitheachothertoimproveinvestmentperformanceandattractmorecustomers.

Treatingthemasagroupandurgingthemtostrengthentheiractivisminregardtocompanies

borderedonrequestingthemtoforminvestorcartels.

Astothesecondpoint,itisanintentionalmisrepresentationtosaythatlargeblocksofstock

are“owned”byinstitutions.Institutionalinvestorsarefiduciariesortrusteesofthose

householdsororganizationswhosemoneytheyaremanaging.Asalawstudent,Monkshimself

wasclearlyawareofthislegalsituationandusedtheterm“fiduciaries”notinfrequentlyinhis

writingsandspeeches.Atthesametime,however,heoftenusedtheterm“owners.”This

rhetoricaltactictoportrayinstitutionalinvestorsas“owners”hassuccessfullycontributedto

thebroadacceptanceofaverticalrelationof“ownerversusmanager”;thatis,thatcorporate

managersareagentsofinstitutionalinvestorswho“own”thecompanies.29Infact,corporate

managersarebusiness-managingfiduciariesasmuchasinstitutionalinvestorsaremoney-

managingfiduciaries,andtheirrelationisahorizontalonebetweentwodifferentfiduciaries.

Monks,aswellasothershareholderactivists,nonethelessdistortedthisrelationinpublic

discourseandincreasinglyinmindsofpolicy-makers,academics,andevenbusinesspeople.

AnothersignificantcontributionofMonkstoinstitutionalactivismandlatertohedge-fund

activismwashisestablishmentoftheproxyadvisoryfirmISS.Hesetupthecompany

immediatelyafterresigningfromtheDepartmentofLaborin1985.30Hehadalreadyproposed

theideaofISSwhilehewasthechiefpensionadministrator,arguinginaDecember1984

speech:“Currentfiduciarieshaveneithertheinclinationnorthetrainingtoactasproprietors.

Eithertheyhavetoacquirethem[capabilitiestovote],oranewinstitutionwillbe

developed.”31Helaterprovidedmoredetailsregardingthis“newinstitution”ataLabor

28Evenamongpensionfunds,overwhichMonkshadinfluenceasthechiefU.S.governmentpensionadministratorin1984-1985,theinvestmentobjectivesandapproachesofprivatepensionfundsdifferfromonetoanotheraswellasfromthoseofpublicpensionfunds.29Thistacticwassupportedbytheconcurrentriseofagencytheoriesandthemaximizingshareholdervalue(MSV)viewinthe1980s.30Initially,itsnamewasInstitutionalInvestorsServiceandMonkschangedthenametoInstitutionalShareholderServicesinthesameyear.31Rosenberg(1999:102).

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Departmenthearings,saying“[i]twastime…forcorporate,ERISA-coveredpensionfund

sponsorsandtheirmanagerstoassignthevotetoathird,neutralparty.”32

Monkswasnotonlyashareholderactivistinhispresumedpublicinterest,butalsoa

businessmanwhowantedtoprofitby“sellingtheideaofacompanythatcarriedoutvoting

tasksforfunds.”Hehadmadeitclearfromthebeginning–tohisfamily,atleast–thathe

wouldstaywithDOLforonlyayear,andthenpursuehiscorporate-governanceagendainthe

businesssector.OnefundmanagerdirectlyadmonishedMonksforhisconflictinginterestsin

hiscampaignfora“third,neutralparty”toadviseproxyvoting:“Monks,goddamnyou.Guys

likeyou,yougointogovernmentandstartaforestfireandthenyoucomeandtrytosellusall

fireextinguishers.”33

This“doublehelix”activismofMonkswasrealizedbyregulatorychangesthatprogressively

definevotingasafiduciarydutyofinstitutionalinvestors.34Thefirstofthechanges,carriedout

byhiscolleaguesremainingatDOL,wastheso-called“Avonletter”in1988thatclarifiedthe

Department’spositiononthefiduciarydutyofpensionfundsunderERISA.35Thispositionwas

reiteratedin“StatementsonPensionFundsInvestment”issuedbytheDepartmentofLabor

andtheDepartmentoftheTreasuryin1989.36Throughtheseadministrativedirectives,proxy

votingwasestablishedasafiduciarydutyofpensionfundmanagers,andtheywererequiredto

voteinwhattheyregardedasthe“economicbestinterestofaplan’sparticipantsand

32Rosenberg(1999:103).33Rosenberg(1999:117)continuedtosay,“Monkswasastonished.Herewassomeonewhosawrightthroughhim.Hewasindeedinterestedinsellingtheideaofacompanythatcarriedoutvotingtasksforfunds.”34Monkshimselfemployedthisanalogyofdoublehelixtojustifyhispersonalprofit-seekingascompatiblewiththepublicbenefitofshareholderactivism.PointingtothestructureofDNA,whichconsistsoftwostrandsofmoleculesarrayedasatwistedladder,hearguedthatonestrandrepresentedthe“mission”ofactivism,theotherstrand“money”tobeearnedfromactivism.Monkssaidhewantedto“pursuethedevelopmentofcorporategovernancethroughthestructureofaprofit-makingbusiness,”explaining:“Asabusiness,myideahadtobemaderelevanttopeoplewhowereaccustomedtopayingonlyforsomethingthatwasinfactvaluabletothem.Ihadtodemonstratethatyearinandyearoutgoodgovernancewasgoodbusiness.…Theparallelspiralforcesofthedoublehelixdonottouchbutareindispensabletoeachother.”(RefertoRosenberg1999:118).35ThelettersentbyadeputyassistantsecretaryatDOLtotheRetirementBoardofAvonProductsInc.statedasfollows:“Thedecisionastohowproxiesshouldbevotedwithregardtotheissuespresentedbythefactpatternarefiduciaryactsofplanassetmanagers.”Inasubsequentspeech,thethen-assistantsecretaryofDOLassertedthat“tomeetthisobligation,pensionplansponsorsunderERISAmustdrawupdetailedpoliciesgoverningproxyvotinganddocumentallvotesandthereasonsbehindthem."(Rosenberg1999:165)36TheAvonletterhasthusbeen“widelycitedastheLaborDepartment’sofficialpositiononfiduciaryobligationsofpensionfundmanagerstovotethesharesundertheirmanagement.”(Blair1995:158)

15

beneficiaries.”37ISSwaslosingmoneysinceitsinceptionbecausepensionfundswerenot

interestedinhiringISS’sservice.Notoftheirownaccordbutunderthenewregulation,

however,pensionfundsnowfacedthenecessityofseekingprofessionaladvicefromthe“third,

neutralparty.”ThebusinessofISSthentookoff.

Thisfiduciarydutyofvotingimposedonpensionfundswasextendedlatertoallother

institutionalinvestors,includingmutualfunds,underanSECregulation.Initsrulingonproxy

votingin2003,theSECmadeclearthat“…anadviserisafiduciarythatoweseachofitsclients

dutiesofcareandloyalty…,includingproxyvoting”andrequiredadvisers“toadoptand

implementpoliciesandproceduresforvotingproxiesinthebestinterestofclients,todescribe

theprocedurestoclients,andtotellclientshowtheymayobtaininformationabouthowthe

adviserhasactuallyvotedtheirproxies.”38UntiltheSECrulein2003,ISSwasamonopolyproxy

advisor.GlassLewis,nowthesecondlargestproxyadvisoryfirm,enteredtheproxyadvisory

marketinthesameyear.

Throughhisinitiativetomakeinstitutionalinvestors“activecorporatecitizens”,Monks’

businessambitionswerelargelyfulfilled.AfterbeinginvestigatedbytheSECforpotential

conflictofinterest,heleftISSonpaperin1990,transferring$3millionworthofhissharesin

thecompanytoanirrevocabletrustandmakinghisnephewNicholasHigginsandhisson

Robertthetrustees.39Hethencontinuedhiscorporate-governanceactivisminthe“double-

helix”fashionbysettingup“corporate-governancefunds”liketheLensFund.40ISSsuccessfully

grewintoaglobalcompanythatcurrentlymaintains“approximately900employeesspread

across17officesin12countries,coveringapproximately39,000meetingsin115countries

yearly,deliveringproxyresearchandvoterecommendations….[for]morethan8.5million

ballotsrepresentingtwotrillionshares.”41However,itisextremelyquestionablewhether

Monks’attempttoservethepublicinteresthasbeenfulfilled,aswillbediscussedinSection4.

37Blair(1995:158).38SEC(2003).39Rosenberg(1999:211-14).40Corporate governance funds aims at increasing investment yields by applying pressure to improve corporategovernanceoftheirportfoliocompanies.41ISSwebsite,https://www.issgovernance.com/about/about-iss/.AccessedonApril10,2016.

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3.2.Shareholderactivistsactingtogether:Publicpensionfunds,CIIandUSA

IfRobertMonkswasmainlyanideologuewhopromotedinstitutionalactivismthroughhis

corporate-governanceagenda,publicpensionfundswereitspractitioners,takingdirectaction

againstcorporations.Thistheydidbybringingtobeartheirrightsandinfluenceasshareholders,

settingupumbrellaorganizationsfortheiractivism,andlobbyingtheU.S.governmentto

changeregulationsinwaysthatwouldstrengthenactivism.Theywere“themostvocal

advocatesofcorporategovernanceintervention”inthe1980s,and,conductingthemselvesasif

theywererule-setters,theydraftedcodesof“bestcorporategovernancepractices”fortheir

portfoliofirmstoadopt.42

Fromthe1950s,pensionfundsemergedasthebiggestgroupofinstitutionalinvestorsinthe

UnitedStatesbecauseoftherapidexpansionofbusinessandgovernmentpensionsystems.By

1975,theyheld16%ofU.S.corporateshares,fourtimesmorethanmutualfunds.Amongthem,

privatepensionfunds,thoughinaggregatemuchlargerthanpublicpensionfunds,werenot

interestedininstitutionalactivism.Mostofthemwererunbybusinesscorporationsonbehalf

oftheiremployees,anditwasunthinkablefortheirtopmanagerstotakeactivistpositions

againsttheirowncompaniesoragainstothercompaniesingeneral.43Unlikethoseofcorporate

pensions,stockinvestmentsofpublicpensionswerenotrepresentingpensionersinthe

businesssectorandhencetheirmanagerswerefreertotakeactivistpositionsregardingtheir

portfoliocompanies.Theretirementbenefitsoftheirclients,public-sectorworkers,werealso

moreorlessguaranteedbythestateorfederalgovernment,andtheyhadrelativelyless

sympathywithcorporate-sectorworkers.Thisfactmadethemfreertofavorshareholder

interestsoverlaborinterests,whenthetwoconflicted,evenbyadvocatingcorporate

restructuringledbycorporateraidersthatbroughtaboutmassivelayoffsanddivestitures.44

42Cheffins(2013:55).43Corporatepensionsheld13%ofthemarketvalueofU.S.corporatestockswhereaspublicpensionsheld3%ofthe stocks in1975. The corresponding figureswere20%and5% respectively in1985and18%and8% in1994.(Blair1995:46,Table2.1)44Geltner(2013:40).

17

Moreover,publicpensionsmostlyheldontodefined-benefit(DB)plansandwereveryslow

tomovetodefined-contribution(DC)plans—atransitionthatoccurredwithincreasing

momentumatbusinesscorporationsduringandafterthe1980s.DBplansexposetheemployer

tothepotentialforunderfundingoftheirpensionplans,whereasDCplansdonot.Public

pensionfundadministratorstriedtoavertthispotentialfundingshortfallbyusingtheir

collectiveshareholdingpowertoseekhigheryieldsfromthestockmarketbystrengthening

shareholderactivism.Publicpensionfundsalsohadbetteraccesstoregulatoryauthorities

becausetheywereregulatedbystatesandexemptedfromthefederalERISAregimeregulating

privatepensionfunds,andbecausealargernumberoftheiradministratorsandboardmembers

werelocaladministrators,politicians,andlaborunionists.Itwas,therefore,relativelyeasyfor

themtosupportregulatorychangesthatwouldallowthemtoincreasetheratioofstockto

otherholdingsintheirinvestmentportfoliosandtothenuseshareholderactivismtoseek

higheryieldsontheirportfolios.45

Amongpublicpensionfunds,theCaliforniaPublicEmployees'RetirementSystem(CalPERS)

emergedastheleaderininstitutionalactivisminthe1980s.Asthelargestinstitutionalinvestor

intheworld,itssizegaveitthepotentialpowertoinfluencecorporateboardsandtheir

resource-allocationpolicies.Moreover,becauseithadbecomeoneofthemostexpensive

pensionsystems,CalPERSwasunderpressuretoboostitsinvestmentyieldsbyexpandingits

investmentsinstockandbybecomingactiveininfluencingitsportfoliocompanies.46Having

introducedannualcost-of-livingadjustmentsin1968,twoyearslaterthefundadoptedavery

generouspensionformulaunderwhichitpaidworkerswhoretireatage6590%oftheirfinal

salaryforlife.FollowingCaliforniavoters’approvalofa1966ballotmeasure,CalPERShadbeen

allowedtoinvestupto25%ofitsportfolioinstock,andintheearly1980sitaskedfor

permissiontoincreasethatlimitto60%.Althoughthevotersrejectedthisproposal,they

approvedadifferentonein1984that,whileit“likewiseletCalPERSexpanditsinvestments[in

stock],”itrefrainedfromspecifyingapercentagelimitand,forcosmeticpurposes,putin“a

45RefertoGelter(2013).46Inthiscontext,Strine(2007:7)observesasfollows:“Interestingly,someofthedemandforoutsizedreturnshascomefrominstitutionalinvestors—suchaspublicpensionfunds—facingactuarialrisksbecauseofunderfundingandpastinvestmentmistakes.”

18

clausethatheldCalPERSboardmemberspersonallyresponsibleiftheydidn’tactprudently.”47

Thispermissiveregimecontrastedwiththerestrictionsplacedonotherpublicpensionfunds,

manyofwhichhadfeworevennoequitiesintheirportfoliosuntilthemid-1990s.48

From1986,CalPERSstarteditsmajorshareholdercampaignsinclosecollaborationwiththe

CouncilofInstitutionalInvestors(CII),whichhadbeensetuptheyearbeforeasanumbrella

organizationtoespousethecollectiveinterestofinstitutionalinvestors.CalPERSledindrafting

thelistofcompaniescharacterizedby“poorperformance”tomakeiteasyforCIImember

institutionstoidentifytargetsfortheiractivistcampaigns.49Italsocreatedashareholders’bill

ofrightsestablishingtheprinciplethatallshareholdershaveequalvotingrights;demanded

thatcorporationsseekshareholderapprovalbeforepayinggreenmailorsettinguppoisonpills;

andcalledforamajorityofoutsidedirectorstoapproveanyextraordinarybonusesorother

paymentstocorporateexecutives.CalPERSitselfinitiated,in1989,amovementtochange

traditionalproxyrulesthatledtotheSEC’slandmarkproxy-ruleamendmentsin1992,which

willbedetailedbelow.

IfCIIwascrusadingforshareholderactivismamonginstitutionalinvestors,theUnited

ShareholdersAssociation(USA),launchedbycorporateraiderT.BoonePickensin1986and

comprisingmorethan65,000members,wasostensiblyrepresentingtheinterestsofsmall

shareholders.TheUSAputpressureoncorporationsbyproducinganannual“Target50”listof

companiesthatwerenon-responsivetoshareholders.50Itattemptedtonegotiatewithtarget

companiestomodifytheirgovernancestructuressothattheywouldbecomemoreresponsive

toshareholderinterests.Italsomobilizeditsmembers’votestosponsorproxyproposalsifthe

targetcompaniesdidnotcometoagreementwithitsdemands.AlthoughtheUSAclaimedto

representretailshareholders,severallargeinstitutionalshareholders,suchasCalPERS,the

47Malanga(2013).48Gelter(2013:39).49Individualactivistpensionfundsalsodraftedtheirownlist.Forinstance,CalPERSproducedthelistofthe"FailingFifty."Firmsinthe“FailingFifty”arethenanalyzedfurtherandtheInvestmentCommitteeidentifiesapproximately12 targets and one corporate governance structure issue (for each target) that it will pursue in the form of ashareholder resolution. Shareholder resolutions have included creating shareholder advisory committees,changingthecompositionoftheboardofdirectorsanditscommittees,andrestructuringexecutivecompensation.RefertoSmith(1996).50Stricklandetal.(1996:320).

19

CollegeRetirementEquitiesFund(CREF),andtheNewYorkCityEmployeesRetirementSystem

(NYCERS),sponsoredproposalsontheUSA’sbehalf.

3.3.The1992Proxyrulechange:Allowing“freecommunicationandengagement”

Whileestablishingproxyvotingasafiduciarydutyofinstitutionalinvestors,institutional

activistspushedforchangesinregulationsgoverningtheproxysystemthatwouldallowtheir

collectivevoicetobeheardmoreeffectivelybycorporatemanagementandthepublic.Itwas

CalPERSthatinitiatedthemovein1989bysendingalettertotheSECrequestinga

comprehensivereviewoftheproxysystem.Theletter“proposedforty-eightseparatechanges

totheproxyrules”,andCalPERS’smainpurpose,itclaimed,was“toeventheimbalance

betweenshareholdersandmanagementconcerningthefilingandprocessingofproxy

materials.”51

TheCalPERSpetitionwasfollowedbythoseofothergroups,includingCIIandUSA.For

instance,theUSAsentasimilarlettertotheSECarguingthat“reformoftheproxyprocessto

allowshareholdersameaningfulcorporategovernancerolecouldforgeafundamental

realignmentofthenowconflictinginterestsofmanagementandshareholders.…[S]uch

realignmentwouldmaximizevalueonaconstantbasis,ratherthanthroughone-time

restructuringtransactions.”52Thisproxy-rulechangewasmadeduringtheperiodwhen

corporateraiderswereinretreatowingtothejunk-bondmarketcollapse,withsuchprominent

figuresinthejunk-bondmarketasIvanBoeskyandMichaelMilkenbeingjailed.State

governmentshadpassedregulationslimitinghostiletakeoversand,withdevicessuchasthe

“poisonpill,”corporationshadstrengthenedtheirdefensesagainstcorporateraiders.The

suddenchangeinthemarketforcorporatecontrolinthelate1980smadecorporateraiders

andothershareholderactivistsvigorousinlobbyingtochangethefederalproxyregulations,as

“oneofthefewremainingvenuesforeffectingcorporatemanagement”53

51ShararaandHoke-Witherspoon(1993:336).52ShararaandHoke-Witherspoon(1993:337).53CalioandZahralddin(1994:466).

20

Afteroverthreeyears’deliberationduringwhichtheSECmadetwoproposalsandreceived

commentsfromvariousgroupsandindividualsinresponse,theSECfinalizedthewatershed

amendmentstoitsproxyregulationsin1992.54Thefactthat,in1993,immediatelyfollowing

theamendments’adoption,USAdeclared“missionaccomplished”anddisbandedtestifiedto

thesignificanceofthischangeforshareholderactivists.55Whyweretheamendmentsso

important?

Itshouldbenotedthattraditionalregulationsoninstitutionalinvestorswereunambiguous

aboutprohibitingtheformationofinvestorcartels,definingcommunicationamonginvestorsas

a“proxysolicitation.”56Itwasthereforeillegalforanyshareholdertodiscusscompanymatters

withmorethantenothershareholderswithoutfirstfilingwith,andobtainingtheapprovalof,

theSEC.The1992amendments,however,largelyderegulatedproxycommunication,notonly

amonginvestorsbutalsowithcompanymanagementandthepublic.Thischangeflewinthe

faceofthewholespiritoftheNewDealregulations,overturningtheminthenameofallowing

“marketforcestorestoreabettersenseofbalancetoAmerica’sboardrooms”throughthe

freerflowofcommunicationandengagement.57

Thenewrulesloosenedrestrictionsonpublicshareholdersinthreeways.First,those

investinginagivencompanywerenowallowedtocommunicatefreelywithoneanotherif

eachheldlessthan5%ofitssharesandhadnospecialrelationshiptothatcompany.Inother

words,theywerepermittedtoforminvestorcartelswithinthe5%limit.58Second,theywere

nowallowedto“engage”freelywithmanagementwithoutworryingaboutpotentialbreachof

accessinginsiderinformation.Thisfreerengagementwasexpectedtoprovideinvestorswith

moreandbetterinformationaboutcorporationsandperhapsleadto“relationshipinvesting.”59

Third,theywereinadditiongiventhefreedomnotonlytomakepublicstatementsonproxy-54SEC(1992);ShararaandHoke-Witherspoon(1993);Bainbridge(2005).55Blair(1995:73).56RefertoSection1ofthisChapter.57CalioandZahralddin(1994:466).58Butthenasnow,thislimitdidnotreallyconstraininvestors,especiallywhentheywereholdingsharesinlargepubliccompanies. Institutional investorshavegenerallyheld lessthan5%ofthesharesoutstanding,withonlyafew amassing more than a 5% share. To cite a recent example, as of April 21, 2016, there were only twoinstitutionalinvestors,VanguardGroup(9.9%)andStateStreetCorp.(6.7%),thatheld5%ormoresharesofAppleInc.(http://www.nasdaq.com/symbol/aapl/ownership-summary).59Ondefinitionandprosandconsof“relationshipinvesting”,refertoBlair(1995,ch.5).

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votingissuesbuteventoannouncetheirvotingintentionswithoutviolatingtheproxy-filing

requirements.

TheSECmadeitclearthatitwasremovingitselffromthejobofproxycensorshipbecauseit

believedthatcontestantsinproxyvoting“shouldbefreetoreplyto[anopponent‘s]statement

inatimelyandcost-effectivemanner,challengingthebasisfortheclaimsandcounteringwith

theirownviewsonthesubjectmatterthroughthedisseminationofadditionalsoliciting

material.”60Someinstitutionalactivistsarguedfortheproxy-rulechangeseveninthenameof

removingrestrictionsontheconstitutionalrightoffreespeech,andtheSECeventually

concurredwiththeargument.

In1999,theSECaddedtotheproxyrulesnewelementsthatfullyliberalized

communication.61Investorswerenowallowedtoconductunlimitedsolicitation,notonly

amongthemselvesbutalsowiththepublic,includingintheformofpressreleases,evenifthey

abandonedproxyfilingintheend.Oralcommunicationswerealsofreelypermittedwithno

need“tobereducedtowritingandfiled.”Thisrulechangeallowedinvestorstoengagemore

freelywithcorporatemanagementandthepublicwithoutincurringanyobligationtostate

theirintentionsinadocumentthatislegallybinding.62Inparticular,thisruleallowedactivist

shareholders“togaugethelevelofsupportfromothershareholders”beforefilingaproxy

statementandtherebyto“mitigatetheriskoflosingacostlyproxycontest.”63

3.4.The1996NSMIA:Allowingunlimited“alternativeinvestment”inhedgefunds

Animpetusforthephenomenalgrowthofthehedgefundindustryandtheconsequentrise

ofhedge-fundactivismwasprovidedbythe1996NationalSecuritiesMarketsImprovementAct

(NSMIA),whichwaspartoffinancialmarketderegulationduringtheClintonadministration.

AccordingtoDavidDayenwhodelvedintoNSMIA’simplicationsforhedgefunds,theregulatory

change,“largelyunnoticedatthetime”and“advancedwithbroadWallStreetsupportand

60QuotedinBriggs(2007:687).61Rule14a-12.62Briggs(2007:689-690).63Lu(2016).

22

almostnoresistanceinCongress,”effectivelyallowedhedgefundstopoolunlimitedfinancial

resourcesfrominstitutionalinvestorswithoutregulationsthatwouldhaverequireddisclosure

ofthestructureoftheirfirmsorprohibitedoverlyspeculativeinvestments.64

TobeexemptfromregulationundertheInvestmentCompanyActof1940asaprivatefund,

ahedgefundhadtoservefewerthan100“high-net-worth”investors,whowerepersonswitha

networthofatleast$1millionorwhohadgeneratedincomeofatleast$200,000annuallyfor

theprevioustwoyears.65However,Section209oftheNSMIAmodifiedtheInvestment

CompanyActof1940toremovethelong-existingregulationonthenumberofclients,creating

anexemptionforanunlimitednumberof“qualifiedpurchasers”thatcouldincludeany

individualinvestorwithanetworthof$5millionormoreoranyinstitutionalinvestorwith

financialassetsof$25millionormore.66The1996NSMIAthereforecontinuedtotreathedge

fundsasprivateentitieswhilegrantingthemtheabilitytodrawfundsfromasubstantially

largerpoolofinvestors,especiallyfrominstitutionalinvestors.

AsFigure3shows,ittookonlysevenyearsaftertheenactmentofNSMIAforhedgefunds’

assetsundermanagement(AUM)toincreasemorethantenfold,from$118billionin1997to

over$1.2trillionin2004.Sincethattime,ithasmorethandoubledtoover$3trillionin2016.67

Amaincontributortothisexplosivegrowthwasinvestmentbyinstitutionalinvestorsfollowing

the1996NSMIA.AccordingtoPreqinGlobalHedgeFundReport,about5,073institutional

64Dayen(2016).65Hedge funds are notable (and definable) largely by their strategy of organizing outside existing financialregulationsapplicabletolargerinstitutionalfunds.Astheyareorganizedinthisway,hedgefundstodayhavenoreal restrictionontheirsize.Theirmajorbenefits includetheability toutilizeperformancepayschemes(“2and20”),2%annualfeeand20%performancefee,aswellastradingstrategiesconsideredtoospeculativeandriskyforinstitutional investors. Hedge funds and other private funds are structured specifically to avoid thresholds thatwouldtriggercertaindisclosurerulesandotherregulations.Forexample,undertheSecuritiesActof1933ahedgefundseekingtobeaprivate(i.e.,unregistered)fundcannotpubliclysolicitprospectiveclients,therationalebeingthat“privateplacement”attractsinformed,experiencedinvestors.66Existingregulationsunderthe1934SecuritiesExchangeActwouldforceregistrationwiththeSECwhenand ifthetotalnumberofinvestorsreached500oriftotalassetsexceeded$10billion.Inpractice,then,thepost-NSMIAenvironmentcreateda“threshold” forhedge fundsandan incentive to limit theirpopulationof investors tonomorethan499institutionsorverywealthyindividuals.67WhileA.W.Jones’hedgefundmanagedapproximately$70millionin1966(over$500millionin2016dollars),todaythereareseveralhedgefundsmanaginginexcessof$1billion.ThelargesthedgefundintheworldtodayisprobablyRayDalio’sBridgewaterAssociates,withabout$160billionundermanagement.

23

investorsallocatedfundingtoabout60percentofhedge-fundassetsin2016.68Theleading

sourcesofinstitutionalfundsarepublicandprivatepensionfundsandendowments,

representingabout53percentofthetotalassetsofhedgefunds.69

Figure3.Thegrowthofthehedge-fundindustry,1997-2016

(AUM,$billions)

Source:BarclayHedge.

Theriseofhedge-fundactivismwasaphenomenonthatreflectedtheexplosivegrowthof

theoverallhedge-fundindustrythatbeganinthe1990s.ItisestimatedthatthecombinedAUM

ofactivisthedgefundsincreasedmorethantenfoldinsixyears,from$15billionin1997to

$117billionin2003,andthenmorethanquadrupledinnext11years,toreach$507billionin

2014,asFigure4shows.70

68Preqin(2016).69Forinstance,oneofeveryfiveuniversityendowmentdollarsisnowinvestedinhedgefunds(TheNationalAssociationofCollegeandUniversityBusinessOfficers(http://www.nacubo.org/Research/Research_News/2013_Endowment_Study_Final_Report_Released.html.)70LazonickandShin(2018forthcoming).FollowingtheSEC’s(2017)conventionofincluding“distressed/restructuring”assetsand“riskarbitrage/mergerarbitrage”assetsin“event-driven”assets,Lazonick

118143189237322

505

826

1,2291,361

1,713

2,137

1,4581,554

1,6941,710

1,799

2,157

2,5082,721

3,005

0

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1997

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Figure4.Theexpansionofactivisthedgefunds,1997-2016

(AUM,$billions,%)

Source:BarclayHedge.

Theincidenceofactivistcampaignsandtheirsuccessratiohavealsoincreasedsharply.13D

filingswiththeSECareoftenusedasaproxyforactivistcampaignsbecauseSchedule13Dmust

befiledwhenaninvestoraccumulatesa5percent-or-greatershareofacorporation’s

outstandingstock,whichalsotriggersarequirementthattheinvestordisclosethepurposeof

itsaccumulation.71Theincidenceof13Dfilingsforactivistpurposesincreasedfrom10in1994

andShinestimatedtheAUMofactivisthedgefundsbycombining“event-driven”assets,“distressed”assets]and“mergerarbitrage”assetsinBarclayHedgedataabove.ThenumbersthenbecomesimilartothoseoftheSEC[wheretheoverallsizeof“event-driven”assetsis$430billion.Foley(2016),FoleyandJohnson(2014),Marriage(2013),andChandler(2016)alsoequateactivistassetswiththeoverallassetsdevotedtoanevent-drivenstrategy.Theoveralltrendinthegrowthofhedgefundactivists’AUMismoreorlessthesameinthoseestimates.71For instance, an investor should disclose whether it demands a change in management, stock buybacks orspecialdividends,aseatontheboard,etc.Incontrast,investorsfileschedule13Gwhenassumingapassivestakeof5%ormoreinapubliclytradedcorporation.

0

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EventDrivenHedgeFundAUM DistressedSecuriyesAUM MergerArbitrageAUM

25

to212in1997.72Itthenincreasedto353in2008.AfterasharpreductionduringtheGlobal

FinancialCrisisof2008-2009,theincidencerecoveredto355in2015.In2003,39percentof

proxyfightsforboardseatsresultedinsettlementsorvictoriesforactivists.Thissuccessrate

soaredto60percentin2013.73

4.Institutionalactivismgoneastray

ForoverthreedecadessinceinstitutionalactivismbeganintheUnitedStates,thereisno

empiricalevidencetoestablishthatitcontributedtoimprovingcorporateperformanceinthe

mediumorlongrunalthoughitmovedstockpricesintheshortrun.Instead,thereisstrong

evidencethatitresultedinpredatoryvalueextractionfromcorporationsandcontributedto

theworseningincomedistributionanddisappearanceofmiddle-incomeclassintheUnited

States.74EvenMonksadmitted,towardtheendofhislongcareerasacorporate-governance

activist,“It’sbroke,”“Ownershipisafiction,governanceamirage”.75Orashealsoputit:“The

fundamentaldynamicsofCorporateGovernancehavebeendilutedintovirtual

meaninglessness.”76

Figure5broadlyshowstheeffectofinstitutionalactivismoncorporatefinance.Duringthe

heydaysofcorporateraidersinthe1980s,netoutflowoffundsfromcorporationsbecame

prominentforthefirsttimeduringthepostwarperiod.77Sincetheriseofhedge-fundactivism

72The SEC requires purchasers of corporate stock to file form 13D within 10 days of the date on which theirownershipstakecrossesthe5%threshold.Theformrequiresdisclosureoftheintentoftheacquisitionofstock.73Laide(2014).74Fordetailsontheempiricalresearch,refertoLazonickandShin(2018forthcoming,chapter7).Forinstance,Karpoff(2001)concludesasfollows:“Mostevidenceindicatesthatshareholderactivismcanpromptsmallchangesintargetfirms’governancestructures,buthasnegligibleimpactsonsharevaluesandearnings.Tobesure,someempiricalresultsaremixed.Butmuchofthedisagreementamongresearchersreflectsdifferencesinthemetricsemphasized.Researchersemphasizingchangesintargetfirms’governancestructurestendtocharacterizeshareholderactivismasa‘successful’tooltoimprovefirmperformance.Mostofthoseemphasizingchangesinsharevalues,earnings,oroperations,incontrast,characterizeshareholderactivismashavingnegligibleeffectsontargetcompanies.”SimilarconclusionweremadebyGillanandStarks(2007);Bainbridge(2005);Becht,Franks,GrantandWagner(2015);Briggs(2007);CheffinsandArmour(2011);CoffeeandPalia(2015).75Monks(2013).76Monks(2015).77NetequityissuesarenewcorporatestockissuesminusoutstandingstockretiredthroughstockrepurchasesandM&Aactivity.

26

fromthemiddleofthe1990s,thetrendofoutflowoffundsfromcorporationsstrengthened

evenmorealthoughthetrendwasreversedbrieflytwiceintheearly2000sduringtheburstof

dot.combubblesandinthelate2000sduringtheGlobalFinancialCrisisduetotheneedto

recapitalizecrisis-hitcorporations.Thenetoutflowoffundshascontinuedtoincreaseboth

absoluteandrelativeterms:During1976-1985,itwas$290.9billionamountingto0.4%ofGDP.

Itthenincreasedto$1,002.5billionduring1986-1995(1%ofGDP),to$1,524.4billion(1.09%of

GDP)during1996-2005,andto$4,466.6billion(2.65%ofGDP)during2006-2015.78

Figure5.Netequityissues,U.S.nonfinancialcompanies,1946-2016

Source:BoardofGovernorsoftheFederalReserveSystem,FederalReserveStatisticalReleaseZ.1,“Financial

AccountsoftheUnitedStates:FlowofFunds,BalanceSheets,andIntegratedMacroeconomicAccounts,”TableF-

223:CorporateEquities,June8,2017,athttps://www.federalreserve.gov/releases/z1/current/.

Ithasnowbecomea“newnormal”thatmanyofAmerica’slargestcorporationsroutinely

distributemorethan100percentofnetincometoshareholders,generatingtheextracashby

reducingcashreserves,sellingoffassets,takingondebt,orlayingoffemployees.Forinstance,

the459companiesintheS&P500IndexinJanuary2016thatwerepubliclylistedovertheten-78Fordetails,refertoLazonickandShin(2018forthcoming);Lazonick(2015;2016).

27

yearperiod2006-2015expended$3.9trilliononstockbuybacks,representing53.6percentof

netincome,plusanother36.7percentofnetincomeondividends.Muchoftheremaining9.7

percentofprofitswasheldabroad,shelteredfromU.S.taxes.79Whyhasinstitutionalactivism

goneastray?

4.1.Uninterestedandincapable,butstronginstitutionalinvestors

Animportantsuppositionofinstitutionalactivismisthatinstitutionalinvestorshavethe

capability,interest,andlegitimacytofixcorporateproblems.However,thisassumptionis

seriouslyflawed.Morethananythingelse,institutionalinvestorsarespeculatorsand/orsavers

whoseprofessionalcapabilityprimarilyliesinportfoliomanagement,whichincludesstock-

picking,markettiming,andtrackingstock-pricemovements.Thesestock-tradingcapabilities

areverydifferentfromthemanagerialcapabilitiesrequiredforvaluecreationbyproducing

low-costand/orhigh-qualitygoodsandservices,asNewDealpolicy-makersalreadymadeit

clearnearlyacenturyagowhenintroducingregulationsoninstitutionalinvestors.Byvirtueof

theworkthattheydo,fundmanagersarehardlycompetentordedicatedfixersofcorporate

difficulties,especiallyinrelationtooperationalperformance.

Moreover,characteristicsofinstitutionalshareholdingevolvedfarawayfromtheidealof

shareholderactivists.Theymaintainedtheoutdatedoutlookof“dispersedownership”and

portrayedinstitutionalinvestorsasweak“minorityshareholders”whodidnothaveeffective

meansofvoicingtheirconcernsto“all-powerful”corporatemanagement.Theythensoughtto

strengthenthepowerofinstitutionalinvestorsagainstmanagementbychangingregulationsso

thattheycaneasilyaggregatetheirvotingpowerbyallowingdefactoinvestorcartels,with

“freecommunicationandengagement”.

Institutionalshareholdingsurpassed32%markin1980andapproached45%in1990,

however,alreadymakinginstitutionalinvestorsthemostdominantcorporateshareholdersand

itwascertainthatthetrendwouldonlystrengthenlater.Moreover,institutionalshareholding

hasbeenextremelyconcentratedinthehandsofrelativelyfewlargeinstitutionalinvestors.In79Fordetails,refertoLazonickandShin(2018forthcoming);Lazonick(2015;2016).

28

mid-2016,forexample,the25largestinstitutionalinvestorsheldstockvaluedat$12.3trillion,

whichwas56%ofthevalueofallpubliclyheldequitiesintheUnitedStates.Evenamongthese

25,thedegreeofconcentrationisremarkable.The10largestinstitutionalinvestorsheld$9.3

trillioninpublicstocks(42%),withtheiraverageshareholdingover60timesthatofthe11th

through25thlargestinstitutionalinvestors.Andnearlyone-third(31%)oftotalU.S.public

stocks,withatotalvalueof$6.8trillion,wasconcentratedunderthecontrolofthefivelargest

institutionalinvestors(Table1).TheU.S.stockmarketisdominatedbywhatVanguardfounder

JohnBoglehascalledthe“KingKongofinvestmentAmerica”.80

Table1.ConcentrationofShareholdingamongInstitutionalInvestors(2016)

Rank InstitutionalInvestors TotalHoldings($billion)

1 BlackRock,Inc. 2,044

2 VanguardGroup,Inc. 1,553

3 FidelityInvestments 1,272

4 StateStreetCorporation 1,090

5 CapitalGroupCompanies,Inc. 857

6 T.RowePriceGroup,Inc. 814

7 JPMorganChase&Co. 456

8 TheBankofNewYorkMellonCorporation 410

9 WellingtonManagementGroupLLP 389

10 TIAA-CREF 373

Top5Holders 6,818(31%)*

Top10Holders 9,261(42%)

Top25Holders 12,307(56%)

Top100Holders 16,995(78%)

Source:CapitalIQ

*PercentageoftotalequityassetsintheU.S.

80Bogle(2005:76).

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These“KingKong”investorshaveamassedunprecedentedvotingpoweroverindividual

companies.Forinstance,BlackRock,thelargestinstitutionalinvestorintheworldwith$4.7

trillionofAUMinmid-2016,held5%ormoreoftheoutstandingsharesineachof2,610

companiesaroundtheworld.VanguardandFidelity,thesecond-andthird-largestinstitutional

investors,held5%ormoreofthesharesineachof1,872companiesand1,173companies,

respectively(seeTable2).Inanarticleentitled“TheGiantofShareholders,QuietlyStirring”,the

NewYorkTimesreportedin2013thatBlackRockwas“thesinglelargestshareholderinoneof

everyfiveU.S.companiesincludingExxonMobilandChevron;AT&TandVerizon;JPMorgan

ChaseandCitigroup;GE;andmorethan800others.Italsoholds5%ormoresharesof1,803

U.S.-listedcompanies,about40%ofroughly4,300totalU.S.-listedcompanies.”81The

dominanceofthelargestinstitutionalinvestorsisstrongeroverlargercompaniesthansmaller

onesastheyprefertoholdlargercompaniesthathavebiggerimpactonindex.AccordingtoJan

Fichtnerandothers,ifrestrictedtotheS&P500companiesin2015,“theBigThree[BlackRock,

VanguardandStateStreet]combinedconstitutethelargestownerin438ofthe500most

importantAmericancorporations,orroughlyin88percentofallmemberfirms.”82

Table2.NumberofCompaniesinwhichanInstitutionalInvestorHasa5%orGreaterStake

(2016)

InstitutionalInvestorNumberofglobal

companies

BlackRock,Inc. 2,610

VanguardGroup,Inc. 1,872

FidelityInvestments 1,173

CapitalGroupCompanies,Inc. 465

WellingtonManagementGroupLLP 439

T.RowePriceGroup,Inc. 414

81Craig(2013).82Fichtneretal.(2017:15)

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JPMorganChase&Co. 191

StateStreetCorporation 178

TheBankofNewYorkMellonCorporation 98

TIAA-CREF 24

Source:CapitalIQ

Theirvotingpoweroverindividualcompaniesismoreremarkablewhenweconsiderthefact

thattheselargestofinstitutionalinvestorsarethemostdiversifiedstockinvestorsinworld

history.Leadingmutualfundsandpensionfundsrelyheavilyonholdingsinindexfundsand

exchange-tradedfunds(ETFs),bywhichtheyeffectively“ownthemarket”,asthenumberof

portfoliocompaniesinafundsometimesexceeds10,000.Eventhoughtheirportfoliosare

oftencharacterizedas“excessivediversification,”theyarestillthesinglelargestshareholdersin

agreatnumberofpubliccompanies.

Atthesametime,theportionofshort-termtradinghasincreaseddramatically.OntheNew

YorkStockExchange,high-frequencytrading(HFT)currentlyaccountsforabouthalfofthetotal

tradingvolumeafterpeakingatover70%in2008.Theaveragestockholdingperiodwas

shortenedfrom57.1monthsin1980to15.4monthsin2000,and4.8monthsin2009.83The

financialmarketiscurrentlyfloodedwithreportssuchas“AlgorithmsTakeControlofWall

Street,”“A.I.ControlstheStockMarket,”“TheU.S.StockMarketBelongstoBots.”84JPMorgan

Chaseestimatedin2017thatAI,includingindexingandHFT,controlsabout60%ofstock

tradingintheUnitedStatesanddiscretionaryequitytradingaccountsforonlyabout10%ofthe

totaltrading.85ItisimpossibletoexpecttheseAIstobehaveasresponsibleandcapable

“corporatecitizens.”

Thischangeoftheshareholdingstructurerevealstheschizophreniaofshareholderactivists.

Intheirzealforactivism,theyenvisionedanewworldwhereinstitutionalinvestorsbecome

moreactiveandcapableofinterveningincorporatemanagement.Butinstitutionalinvestors

haveevolvedtowardbeinglessinterestedandlesscapableinengagementandproxyvoting.

83Wong(2010).84SalmonandStokes(2010;Danneman(2017));Burger(2017).85Burger(2017).

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Ironically,thelegitimacyofinstitutionalinvestors’engagementandproxyvotinghaserodedas

theirpowerovercorporationshasincreased.Indenialofthisnewrealityand,atthesametime,

sensingandexploitingthegrowingpowerofinstitutionalinvestors,shareholderactivistshave

onlypressedforstrengtheningactivismbyaggregatingpowerofalreadypowerfulinstitutional

investors.

4.2.Misdirectedcompulsoryvoting:Powertoproxyadvisoryfirms

Monksinvokedtheconceptof“citizenship”frompoliticaldemocracywhenhepushedfor

compulsoryvotingofinstitutionalinvestors.Likehim,mostadvocatesofshareholder

democracyhavetendedtoemployanalogiestakenfrompoliticaldemocracy.ButMonks

criticallyerredinusingthisanalogybecausecompulsoryvotingisnotanormofpolitical

electionsinmostcountries.Hedidnotexaminewhyitisnotsoorwhatitsimplicationsarefor

shareholderdemocracy.Moreimportantly,hefailedtoassess,whatrealeffectsimposing

compulsoryvotingasafiduciarydutywouldhaveonthebehaviorofinstitutionalinvestors.

(1)Incorrectandarbitraryanalogywithpoliticalvoting

Inapoliticalelection,compulsoryvotingcertainlyhasitsprosandcons.Itcanhavethe

positiveeffectofaugmentingthepowerofrepresentationbyincreasingtheturnoutofvoters

attheballotbox.However,itcanhavenegativeeffectsonanelectionoutcomebecauseit

increasesblank,randomlymarked,andspoiltballotsfromvoterswhoarenotinterestedinthe

electionanddonotknowaboutthecandidates.Theseuninterestedvotersarealsomoreprone

tocasttheirvotesinresponsetohot-buttonissuesofthedayorpoliticalscandals,ratherthan

tryingtoaligntheirvotingwithideologicalorpolicypreferences.86

Thepoliticalrealityaroundtheworldisthat,whateverthetheoreticalbalanceofprosand

cons,thereareonlyafewcountriesthathaveadoptedacompulsoryvotingsystem.In2015

thereweretencountries,includingAustralia,Brazil,andSingapore,wherecompulsorynational86RefertoBirch(2009);BrennanandHil(2014);Singh(2015).

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votingwasineffectandtwolocalgovernmentsthathadmadevotingcompulsory.87Most

countriesconsidervotingasaright,notasadutythattheyshouldenforceontheircitizens.

Manycountriesalsotakethepositionthattoabstainfromvotingisalsoanexpressionof

politicalpreferencethatshouldbeallowedinaccordancewiththeconstitutionalrightof

freedomofspeech.Thefactthatmostcountriesdonotadoptcompulsoryvotinginpolitical

electionstellsusthattheyaremuchmoreconcernedwithitsconsthanwithitspros.

Yetadvocatesofcompulsoryvotingforinstitutionalinvestors−includingMonksandother

corporategovernanceactivists,aswellasregulatoryauthoritiesliketheSECandtheDOL−in

adoptingthisposition,presentedonlyitspotentialpro,withoutconsideringorpresenting

eitheritsconsorwhattheneteffectofthoseprosandconswouldbe.Ifonelooksintothe

natureandprocessofproxyvotingbyinstitutionalinvestors,itisnothardtofindthatthecons

ofcompulsoryproxyvotingarealotmorepronouncedthanthoseofcompulsorypolitical

voting.

Inapoliticalelection,thesecretballotisthenorm:Votersareguaranteedsecrecyoftheir

ballotsandnotcompelledtoexplaintheirvotingdecisions.Inthissituation,thenegativeeffects

ofvotingatrandomcanbemitigatedbythelawoflargenumbers.Inproxyvoting,however,

institutionalinvestorsarerequirednotonlytodeclarehowtheyvotedbutalsotoprovide

justificationfortheirvotingdecisions.Thismeansthatuninterestedinstitutionalinvestorsare

obligatedtocreatejustificationsfortheirvotingdecisions,topurchasethosejustificationsfrom

thirdparties,orboth.Eventhosewhoareinterestedinvotingmaydecidetovoteagainsttheir

ownpreferencesifstrongpublicbacklashagainsttheirvotingdecisionsappearslikely.

Moreover,thereisnoroomforconflictofinterestsinpoliticalvoting(unlessonecandivide

aperson)whereasproxyvotingiswideopentoconflictofinterests.Infact,thephenomenal

growthofboththecapitalmarketandinstitutionalinvestmenthasgreatlylengthenedand

complicatedthechainofintermediariesinvolvedininstitutionalinvesting.Inpension-fund

investments,forinstance,thechainextendsfrompensionerstopensionadministrators,

pensioninvestmentadvisers,fundsoffunds,externalassetmanagers,andothers.Therelation

87Wikipedia, https://en.wikipedia.org/wiki/Compulsory_voting#Current_use_by_countries. Accessed on April 16,2016.

33

amongthoseintermediarieshasalsobecomeverycomplexbecause,evenwithinonemutual

fund,therearenumeroussub-funds.Consideringthelengthandcomplexityofthischain,itis

questionablewhetherthoseattheendofthechainwouldreallyexercisevotingrightsover

corporationsonbehalfofthecustomerswhohadputmoneyintotheircustody.Fardetached

fromtheoriginalcustomers,institutionalinvestorshaveopportunitytocasttheirvotesintheir

owninterestratherthanintheinterestofthosewhoseproxiestheyhold.Thispossibility

becomesgreateriftheoriginalcustomershavelittlepowertoreplacetheirintermediaries,as

typicallyisthecasewithpublicpensionfunds.

Nonetheless,theSECexpressednaïveexpectationaboutthebenefitsofcompulsoryproxy

votinginthe“Finalrule”in2003andthisstancehasnotchangedsofar:

“Althoughwerecognizethatcomplianceprograms,includingproxyvotingprograms,may

requireadviserstoexpendresourcesthattheycouldotherwiseuseintheirprimary

business,weexpectthattherulesandruleamendmentsmayindirectlyincrease

efficiencyinanumberofways.Adviserswouldberequiredtocarryouttheirproxyvoting

inanorganizedandsystematicmanner,whichmaybemoreefficientthantheircurrent

approach.Requiringalladviserswithvotingauthoritytoadoptproxyvotingpoliciesand

procedures,andmeetrecordkeepingrequirements,mayenhanceefficiencyfurtherby

encouragingthirdpartiestocreatenewresourcesandguidancetowhichindustry

participantscanreferinestablishing,improving,andimplementingtheirproxyvoting

procedures.”88

TheSEC‘spositionisbasedontheoptimisticexpectationofinstitutionalinvestors’

developinganalyticcapabilitiesthatwouldenablethemtomakevotingdecisions“inan

organizedandsystematicmanner,”andthat“thirdparties”wouldbecompetentandobjective

inprovidingadvice.Realityhasshownthisoptimismtohavebeenunfounded.Farfromtaking

complianceseriously,thelargestinstitutionalinvestors,especiallyindexfunds,limitedtheir

effortstosettingupskeletalresearchunitsthatbarelypaidlipservicetothenewrule.Nordid88SEC(2003).

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the“thirdparties”,theproxy-advisoryfirms,equipthemselvesadequatelyfortheirtask;still,

theyexertunduepowerovervotingdecisionsofinstitutionalinvestors,andtherebyover

corporations.Inaddition,theyhaveaseriouspotentialforconflictsofinterest,aswillbe

detailedbelow.

(2)“Corporate-governanceteams”inlargeindexfunds:Lip-servicevotingorganizations

Mostlargemutualfundshadrarelytakenpartincorporatevotingbeforeitbecame

compulsoryin2003.Thatwasanaturaland,inmyview,appropriateposition,consideringthe

factthatthelargerportionoftheirassetswasheldinindexfunds.Simplytotrackindex

movementsratherthantoresearchindividualcompaniesconstitutesthecriticalcompetitive

edgethathasenabledmutualfundstochargeverylowmanagementfeesand,consequently,to

rapidlyincreasetheirAUM.

WhentheSECruledproxyvotingtobeamongtheirfiduciaryduties,themutualfunds

initiallyreliedheavilyonrecommendationsfromproxy-advisoryfirms;inotherwords,they

“purchased”proxy-votingdecisionsandrelatedjustifications.However,criticismssoon

emergedofboththispracticeandtheproxy-advisoryfirms.Largemutualfundsweretherefore

underpressuretodemonstratetopolicy-makers,theirowncustomers,andthepublicthatthey

weredutifullyfulfillingthisnewfiduciaryobligation.Manyofthemthenadoptedthetwo-

prongedapproachofseparatingthevotingdecisionsoftheactivefundsandpassivefunds

undertheirmanagement,andofsettingupacorporate-governanceteamorstewardshipteam

forthelatter.

BlackRockprovidesanilluminatingcaseinthisregard.In2014,itsindex-relatedfunds

amountedto$3.3trillion,constitutingabout70%ofthetotalAUM.BlackRockdividesitsvoting

decisionsbetweenactive-managementfundsandpassive-managementfunds.Theproxy

decisionsoftheformeraremadeprimarilybythefundmanagersinchargeoftheportfolio

firmsconcerned.Incontrast,theproxydecisionsofthelatterareunderthecontrolofits

corporate-governanceteam.Tooutsiders,thiscorporate-governanceteamisportrayedas

beingequippedtomakeinformedvotingdecisionsandtoengageprofessionallywithportfolio

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companies.Thereality,however,liesfarfromthisrosypicture.Inthe2012proxyseason,the

teamconsistingofonly20peoplevotedon129,814proposalsat14,872shareholdermeetings

worldwide.89Theonlyfeasiblewaytodealwithsomanyvotingdecisionswithsuchlimited

personnelistoapplysomegeneralcorporate-governancemetricsratherthantoexaminethe

concretecontextsofindividualcompanies’votingissues.

TheNewYorkTimesthusdescribedtheteam’sdecision-makingas“thecorporate

governanceequivalentofspeeddating”andreportedasfollows:“Theseanalystshavea

languageoftheirown,casuallythrowingaroundtermslike‘overboarding,’forwhendirectors

serveonmultipleboards,possiblyspreadingthemselvestoothin;‘engagement,’whena

problemreachesacriticalstageandmeritsavisitfromaBlackRockanalyst;and‘refreshment’,

whenengagementdoesn’tworkandadirectorneedsaheaveho.”90Aglanceattheinternal

operationofthecorporate-governanceteamonlystrengthensthesuspicionthatkeepingthis

teamassmallaspossibleisacheap,andprobablytheonly,optionforthelargestindexfundsto

demonstratetothepublicthattheyarecarryingouttheirfiduciarydutyofproxyvoting

sincerely.91Inthissense,onemaysaythatcorporategovernanceteamsare“lip-service”units

thathaveresultedfromtheimpositionofcompulsoryvotingoninstitutionalinvestors.92

(3)ISS,theproxy-votingmonster:Itsinadequacy,bias,andillegitimatepower

89Loomis(2014).90Craig(2013).91BlackRocklaterchangeditsnameto‘InvestmentStewardshipTeam’andincreasedthenumberofitsstafftoabout31in2017(‘BlackRock,VanguardandStateStreetbulkupgovernancestaff’,FinancialTimes,January29,2017.https://www.ft.com/content/657b243c-e492-11e6-9645-c9357a75844a).ButthiswasonlyinaccordancewiththeincreaseinitsAUM.Attheendof2017,BlackRock’sAUMwas$6.28trillion.92Someresearcherssupposethatthelargestindexfundspursuecertain“activestrategies”forprofitmaximizationbycoordinatingtheirvotesacrossportfoliocompanies.Forinstance,Schmalz(2017;2018)arguesthatthese“commonowners”discouragecompetitionamongtheportfoliocompaniesinordertomaximizecombinedprofitsofportfoliocompanies.Similarly,Fichtneretal.(2017:23)mentionsasfollows:“passiveindexfundmanagersarguablyhavelittleinterestinfiercecompetitionbetweentheirco-ownedcorporations,becausethisconstitutesazero-sum(orevennegative-sum)gameforthem.Rather,theyhaveindustryormarket-wideinterests.”Itwillrequirefurtherresearchtodeterminethisbehaviorofindexfunds.However,itisdoubtfultomethatcorporategovernanceteamsorstewardshipteamsofthoselargestmutualfundshavecapabilitiestostretchtheircorporate-governance-relatedagendatosuchinterventionsintheirportfoliocompanies.Consideringtheirminimalsize,itlooksmorenaturaltothinkthattheysimplylackcapabilityandinteresttointerveneinindividualcorporateaffairsinsuchsystematicmanners.

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Norhavetheabilitiesofproxy-advisoryfirmsturnedouttobemuchmoreimpressivethan

thoseoftheinternalcorporate-governanceteamsofthelargestinstitutionalinvestors.ISS

currentlycontrols61%oftheproxy-advisorymarket,whileGlass,LewisandCo.controls35%,

makingthemarketavirtualduopoly.Initsinfluenceoverlargeinstitutionalinvestors,however,

ISSisunmatched,havingclaimedatonepointtobeadvising“24outofthetop25”mutual

fundsand“17outofthetop25”pensionfunds.93Consideringthedominanceithasenjoyedin

theproxy-advisorymarket,focusingexclusivelyonthecaseofISSwillsufficeforourpurposes

here.

AlthoughISScurrentlyrecommendsyes-or-nodecisionsonmorethan9.6millionballots

representing3.7trillionsharesayearin115countries,itonlyhas1,100employees,its

administrativestaffincluded.94Howcouldithavedevelopedcapacityandexpertisetomakeso

manyinformedvotingdecisionsonsuchdiverseissuesinsomanycompaniesaroundtheworld?

Companymanagementsandshareholdersbringtoshareholdermeetingsproposalsmainly

becausetheyarecontroversial.Itisnotdifficulttodraftareasonedreportjustbycomparing

theprosandconsofsuchcontroversialissues.Butitisverydifficulttowriteareportthat

determinesaclear“yes”oraclear“no”onsuchissues.ItstrainscredulitytothinkthatISS,with

sofewemployees,hasbeenabletoassemblethecomplex,high-levelexpertisecapableof

makingauthoritativerecommendationsonsomanyissues.Inreality,ISStendstoapplygeneral

andmechanicalcorporate-governancemetricstoitsvotingrecommendations,justasthe

largestindexfunds’corporate-governanceteamstendtodo.Institutionalinvestors,itsmajor

customers,actuallydidnotcareaboutorrelyuponISSbeforetheywererequiredtovote.

Formostindexfunds,justfollowingtherecommendationsofproxy-advisoryfirmsisthe

mostconvenientwaytofulfilltheirfiduciaryduty“becausetheycan’tjustifytoshareholders

whytheyinvestintheirownanalysis.”95Onlythelargestindexfunds,suchasBlackRockand

Vanguard,setupin-housecorporate-governanceteams.Lesserindexfundshavenoalternative

93Rose(2007).94ISSwebsite.AccessedonMay4,2018.95Bew and Fields (2012: 15). In this context, Winter (2011: 10) argues that voting by institutional investorsfollowingproxyadvisoryfirms’recommendations“isessentiallyaformofemptyvoting”because“[t]heexerciseofthevotingrightisdeterminedlargelybyproxyadvisorswhodonothaveashareholdinginterestthemselves.”

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buttorelyheavilyonproxyfirms’advice.Evenmanyactivefundstendtofollowthe

recommendationsofproxy-advisoryfirms;combingthroughproxyfirms’analysesandvoting

recommendationsisanormalfirststepforfundmanagers.Inaddition,aninternalconvention

atmostinstitutionalinvestorsdictatesthat,iffundmanagerswanttogoagainstproxyfirms’

recommendations,theyprovidealengthyreporttotheirsuperiorstojustifytheirdecisions–

somethingtheydon’tneedtodoiftheysimplygoalongwiththerecommendations.Going

againstproxyfirms’recommendationsthusrequirescourageandeffortonthepartoffund

managerswhoarebusyattemptingtomakeprofitabletradesfortheportfoliostheymanage.In

thisrespect,therootofthepowerandinfluenceofISSisnotreallythequalityofitswork,but

rathertheconvenienceitprovidestoinstitutionalinvestorsbylighteningtheburdenof

performingtheunwantedobligationofvotingproxies.

Moreover,proxyfirmsarewideopentoconflictsofinterestbecause,asunregulatedprivate

businessentities,theyareresponsibletonobodyexcepttheirownbusinesses.Theynormally

combineproxy-votingadvisoryserviceswithconsultingservices.Whenthereisaproxycontest

betweenoneoftheircustomersandanon-customer,itishardlydifficultforthemtosidewith

theircustomer,packagingtheirsupportasan“objective”assessment.Asprivateand

unregulatedentities,thereisnowayforoutsiderstodeterminewhetherthevoting

recommendationsoftheproxyfirmsweremadeobjectivelyorshapedtoservetheirown

businessinterests.

Thereisalsoatendencyforproxyfirmstoprovidevotingadvicethatreflectstheinvestment

philosophyoftheirowners.Setupbycorporate-governanceactivistRobertMonks,ISSwould

belikelytosidewithanactivistfundinacontroversypittingsuchafundagainstcompany

management.ThecurrentownerofISSisVestarCapital,aprivate-equityfundthatwas

foundedbycorporateraidersfromFirstBoston’sleveraged-buyoutteam.Itwouldbeonly

naturalforISStosupportactivisthedgefundswhentheyhaveproxybattleswithindustrial

companies.

Ineffect,compulsoryvotingforinstitutionalinvestorshasgivenISSillegitimatepower.

Officially,itisonlyan“advisory”firmlackinganylegitimatebasiswhatsoeverforexerting

influenceonmajorcorporatedecisionsofthekindthatmustbeapprovedinshareholder

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meetings.Itsinfluencecannotbeignored,however:AnegativerecommendationbyISSona

managementproposalhasbeenfoundtoreducethesupportofinstitutionalinvestorsbyat

least13.6%and,atmost,by20.6%.96Corporateexecutiveshavetotakeatwo-digitpercentage

differenceveryseriously,asitisoftenthecasethattheeventualvotingoutcomeisdecidedby

adifferenceoflessthan10%inshareholdervoting.PeterIlievandMichelleLowryreportthat

over25%ofmutualfunds“almostentirely”relyonISSrecommendationswhentheycast

votes.97Itisthereforenotanexaggerationtosaythat“[powerful]CEOscomeonbendedknees

toISStopersuadethemanagersofISSofthemeritsoftheirviews.”98

Theillegitimatepowerofproxyfirmsarosepartlybecauseoftheproxy-advisorymarket’s

beingaduopolyandbecause,evenbetweenitstwomembers,ISSiseasilythedominantone.If

therewereanumberofproxy-advisoryfirmswithsimilarreputationsandifinstitutional

investorscouldchoosefromamongtheirdiverserecommendations,theirservicemightbe

definedas−andconfinedto−“advice”.However,whentheimpositionofcompulsoryvoting

madeitnecessarytofillthevacuumofinstitutionalvotesthathadpreviouslyexisted,thelarger

partofthisjobfelltoISS,uponwhichnobodyhadconferredlegitimatepowertoinfluence

votingdecisionsinthecorporatearena.ISSisamonstercreatedbycompulsoryvoting.No

corporationanywhereintheworldsendsISSaformalinvitationtotakepartinitsshareholders’

meeting,butiteffectivelyattendsthesemeetingsandcastsvotes.NobodydarestoexpelISS

forexercisingillegitimateinfluenceonvotingoutcomesofthemeeting.Monksmaynothave

beensuccessfulinachievinghisactivistagenda,ashehasadmitted,butthereisnodoubtthat

heisasuccessfulentrepreneurwhocreatedthevotingmonsternoonecouldeverhave

imagined.

96BethelandGillan(2002:30).97IlievandLowry(2015).98Strine(2005).

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4.3.Consequencesof“freecommunicationandengagement”

Inbringingaboutthe1992proxy-ruleamendments,shareholderactivistsalsoemployedan

analogyfrompoliticaldemocracy.Theyportrayedcorporatemanagementasautocratswho

ignoredpopulardemandsforfreedomofspeechandfreedomofassemblywhileinstallingstrict

censorshipintheformofproxy-filingproceduresthat,theycharged,unfairlyfavored

management.Incontrast,theyportrayedthemselvesasendeavoringtorealizea“true

shareholderdemocracy”byabolishingthecensorshipandthusobtainingtherightoffree

communicationandengagement.Theythenjustifiedtheproxy-rulechangesbyarguingthat

theywouldcorrecttheimbalancebetweenshareholdersandmanagementandbringabouta

moreefficientmarketoutcome.

However,suchexpectationsarebasedonthecriticalassumptionthatfreerandeasier

exchangeofinformationhasanefficiency-enhancingeffectinthemarket,anassumptionthat

followsfromconventionaleconomicmodelsofcompetitivemarkets,whichareinturnbasedon

theassumptionthatinteractionamongplayerswhohaveequalcapabilityandequalaccessto

informationisthekeytoensuringanefficientoutcome.Butmarketsingeneral,andthestock

marketinparticular,donotfunctionaccordingtothisneoclassicalmodel.Marketsmaybe

undulyinfluencedbystrong“moversandshakers,”andthestockmarketinparticularisprone

tomanipulation.Asitturnedout,theverypracticesthatthetraditionalregulationsweremeant

todeterbypreventingfreecommunicationandengagement,“fraudordeceit”and

“manipulativeordeceptivedevicesorcontrivances”,becamemorewidespreadbecauseofthe

proxy-rulechangesandcompulsoryproxyvoting.99

Aboveall,the“wolf-packphenomenon”—suddenconcertedcampaignsofhedgefunds

againsttheirtargetcompanies—hasbecomeanewnormalsincethe1992proxy-rulechanges.

Wolfpackscanonlybeseenasdefactoinvestorcartels.Inconventionaleconomics,cartelsare

consideredprimeobstaclestorealizingtheefficientallocationofresources,andtheyare

thereforeregulatedheavilyinmostcountrieswithcapitalisteconomies.Theexistenceof

unregulatedwolfpacksistestamenttothefactthatwiththeproxy-rulechangestheSEC99RefertoSection2ofthispaper.

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effectivelygaveupitsdutyasamarketregulator,employingtherhetoricofpromoting“market

efficiency”tohidethisfailure.

TheSECmighthavenaivelythoughtthatfreelyallowinginvestorcartelsmadeupof

shareholders,noneofwhichheldlessthan5%ofthetargetcompany’sstock,wouldnot

undermine“marketefficiency”.However,inlightofthebroaddispersionofshareholdinginbig

publiccompanies,thosewitha5%stakecaneasilyexertastronginfluenceonmanagement.

Moreover,the5%ruleiseasilycircumventedthroughtheformationofwolfpacks.Itisnowa

commonpracticeforhedgefundstocollaborateamongthemselvesorwithotherinvestors

aroundatargetcompanyandcoordinatetheirstrategiesandtactics.Evenifeachofthose

collaboratingmayholdlessthan5%ofthetargetcompany’soutstandingshares,their

combinedstakecaneasilyelevatethemtothestatusofcontrollingshareholders.Itisalso

possibleforoneleadwolftotakeashareexceeding5%,makepublicitsintentionofcampaign,

andthenrecruitother,unidentified,wolves,eachholdinglessthan5%shares,tosupportits

attack.InthefightovercontrolofBarnesandNoble,forexample,theleadactivistinvestorheld

an18.7%stakeinthecompany,butitturnedoutthattheactualwolfpackcontrolleda36.14%

stake.100InthecampaignthatforcedthesaleofKnightRidder,“[w]hatstartedoutasa19%

stakeeffectivelygrewto37%injust48hours.Thecampaignsucceededalmostinstantly.”101

Moreover,makingiteasiertoformwolfpacksinturnmadeiteasiertomanipulatethe

marketthroughthe“wolf-packeffect”.Upontheannouncementorleakingofinformation

abouttheformationofawolfpack,thestockmarketgenerallyreactspositively.Forinstance,

aninternationalstudyonthewolf-packeffectreports“abnormalannouncementreturnsof7%

fortheUnitedStatesduringa(-20,20)daywindow”andof“6.4%and4.8%,respectively”,for

EuropeandAsia.102Thoseinthepackcaneasilydeveloptradingstrategiesinadvancebecause

theyexclusivelyknowwhentheywilltriggerthewolf-packeffect.Themarketwillalsoreactto

thewayinwhichthewolvesaremovingtogetheraftertheformationofthepackbecomes

publicknowledge.Thoseinthepackagainhaveadvanceknowledgeofhowtheywillactand

100Lu(2016:778).101Briggs(2007:698).102Bechtetal.(2015).

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canprofitfromfront-runningthemarketmovementstheycreate.Thedevelopmentofthe

derivativesmarketmadeitaloteasierforthemtoprofitfromfront-running.

Ifboththeanti-cartelspiritofthe5%ruleandtheanti-manipulationspiritaresoeasily

compromised,theSECshouldtightenuptheproxyruletomakeitdifficultforwolfpacksto

formandtoprofitfromwolfpacteffects.ButtheSEChassofarneitheradmittedthefailureof

theproxyrulechangenordoneanythingtoreversetherule.Thisinactiononlystrengthens

suspicionthattheSEC,supposedlya“self-regulatingbody”,isineffectfunctioningasa

promoteroffinancialinterestscapturedbyshareholderactivistswhosimplyclamorformore

powerandfreedomforthemselves.

Allowingfreecommunicationandengagementwithmanagementhassimilarlyfailedto

bringabout“marketefficient”outcomes,mainlybecauseshareholdersdonotallhaveequal

accesstomanagement.Whilecorporateexecutivescanillaffordnottobeseriousin

communicatingandengagingwithbiginstitutionalinvestors,theycansimplyignoreoroffer

perfunctoryrepliestothedemandsofsmallshareholders,wholackthelargerplayers’

resources.Acriticalquestionhereiswhetherbiginstitutionalinvestorsandotherinfluential

activistsengagewithmanagementasimpartialrepresentativesofthegeneralinterestsof

shareholdersorexploittheiraccesstomanagementmainlyfortheirowngain.Commonsense,

aswellasbroadanecdotalevidenceofinstitutions’self-servingutilizationofcommunication

andengagementwithmanagement,favorsthelatteranswer.103

CalioandZahralddin’sresearchpointedoutthatfreecommunicationandengagementwith

managementprovidesinstitutionalinvestorswitha“tacticaledgeoverthemanagementand

smallshareholdersbecauseitoccursbehind-the-sceneswithoutmediascrutinyorindividual

investorawareness.”104Cioffisimilarlyconcluded:“The1992proxyrulechangesappeartohave

103Forinstance,somepublicpensionfundadministratorsexploitedtheoccasionofengagementsfortheirowncareerdevelopment.“Romano(1993)relatesthatmanypublicpensionfundmanagersdesireelectiveofficeandthereforeenhancetheirpoliticalreputationsbybecomingcrusadersagainsttheinterestsoflargecorporations.Specifically,shetellsaboutatrusteeforNewYorkCity'spensionfundswhotrumpetsherdoggedshareholderactivismwhilecampaigningtobenominatedasacandidatefortheUnitedStatesSenate.”Casesofhedge-fundactivists…104CalioandZahralddin(1994:522-523).Immediatelyaftertheproxyruleamendments,engagementbecameamorefavoredmethodthanproxycontest.Forinstance,“TIAA-CREFreportedin1994thatithadsubmittedeighteenproposalsduringtheproxyseasonsbuthad“successfullynegotiatedawayfourteenofthem”before

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encouragedgreatergovernancebyinstitutionalinvestors,butattheexpenseoftransparency.

Institutionalinvestors,withsomenotableexceptions,preferredtovoicetheirconcernsand

criticismstomanagementinprivatecommunicationsthatwouldnotbecomepublic.These

communicationsthusbecameoccasionsformanagerstodisclosesignificantinformationtothe

representativesofinstitutionalinvestorsandanalystsassociatedwithinvestmentbanksand

brokerages.”105

Inaddition,allowingfreecommunicationbetweenshareholdersandthepublic,farfrom

eveningtheaforementionedimbalancebetweenshareholdersandmanagement,intensified

theimbalanceskewedtoshareholders.Activistshareholdersarenowfreetocriticizethe

company’smanagement“aslongasthestatements[theymake]arenotfraudulent.”106In

contentiousissues,managementmakesitsdecisionsbyweighingtheiradvantagesand

disadvantages.Butactivistscanjustfocusontheirperceiveddisadvantagesandfindwhatever

faultswithmanagementwithintheboundaryof“notbeingfraudulent.Itisevenpossibleto

criticizemanagementfornotachievingbetterperformanceinthenameofmaximizing

shareholdervaluewhenthecompanyconcernedhasbeenperformingwell.Ontheotherhand,

itisnotofteneasyformanagementtocriticizethecompany’sactivistshareholdersunlessit

findssomethingseriouslywrongwiththeirstatementsortheirbehavior.

Owingtothefree-communicationrule,ithasnowbecomeaconventionamonghedge-fund

activiststocriticizemanagement,notonlybysendinglettersbutalsobypublishing“white

papers”andevenconveningpressconferences.Thiskindofpubliccriticismputsenormous

pressureonmanagementand,ratherthancontinuingthepublicwarfare,companyexecutives

tendtoprefermakingcompromiseswithactivistsbyyieldingtosomeoftheirdemands,as

StevenSolomon’scommentintheintroductionreveals.107

voting”and,withoutwagingaproxycontest,“FromNovember1992throughDecember1993,IIshelpedforceturnoverintopmanagementatAmericanExpress,Borden,GM,IBM,KodakandWestinghouse.”(Blair1995:171-172)105Cioffi(2005:17,fn.12).106CalioandZahralddin(1994:522-523).107DanielLoeb’s(ThirdPoint)attackonDowChemicalisanexample.LoebopenedawebsitespecificallydesignedtocriticizeDowmanagementandtheiralleged“brokenpromises”.Dowmanagementgaveinandacceptedtwodirectorsnominatedbyhiminreturnforaone-yeartruceincludingtheclosureofthewebsite.Thesetwodirectors

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4.4.“Co-Investments”betweenhedge-fundactivistsandinstitutionalinvestors

Amajorreasonthathedge-fundactivistsexertinfluenceovercorporationsinfarexcessof

theirshareholdingisthatinstitutionalinvestorsoftensupportthemimplicitlyorexplicitly.The

closetiesbetweenhedge-fundactivistsaremulti-faceted.Asfinancialinvestors,theysharea

similarworldoutlookthatisfocusedonshareholdervalue,whichisdifferentfromcorporate

managerswhosemainresponsibilityistocreatecorporatevaluebyproducinghigh-quality,

low-costgoodsandservices.Fundmanagersininstitutionalinvestorsarenormallyevaluatedby

theirshort-termperformanceeveniftheyclaimtopursuelong-termgains.Inthisincentive

structure,theytendtoallywithhedge-fundactivists.108

The1996NSMIAprovidedastrongimpetustoconvertthepotential“co-investments”

betweenhedge-fundactivistsandinstitutionalinvestorsintotheactualco-investments.As

institutionalinvestorsarenowsupplyingabout60%ofhedgefunds’AUM,theysharenearlythe

samecommercialinterestwhenhedge-fundactivistscampaignagainstcorporations.Ofcourse,

institutionalinvestorsclaimthattheyvoteindependentlyofhedge-fundactivists,whichiswhat

theyaresupposedtodo.However,itishighlylikelythat,ifaninstitutionalinvestorholdsshares

bothinacompanytargetedbyanactivisthedgefundandinthehedgefunditself,itwillknow

thehedgefund’sintendedactionsinadvanceandwillhaveanincentivetocooperatewithitin

ordertoraiseitsyieldfromthehedge-fundinvestment.Anecdotalevidenceofco-investment

abounds.

Forinstance,itwasrevealedduringtheproxybattlebetweenDuPontandTrianPartners

thattheCaliforniaTeachersRetirementSystem(CaLSTRS)--aleaderamongstpension-fund

activistsandcurrentlythethird-largestpensionfundintheU.S.,withAUMof$198.7billionas

wereunderLoeb’s“goldenleashes”andsoonplayedacentralroleinpushingDowChemicaltoconcludethemerge-and-splitdealwithDuPontinDecember2015.108AFortunereportfollowingthereleaseofalettertoCEOsfromBlackRockheadLaurenceFinkurgingalong-termapproachoffersavividillustration:“[T]akingaverysmallsurveyofcompaniesintheS&P500,[we]immediatelyranintotwothatsaidtheBlackRockanalystscoveringthemhadtheirownshort-termdemands–forgoodquarterlyresults.’Myguy’safanatic,’reportedtheCEOofoneofthosecompanies.SoitcannotbesaidthatFink’sletterhaseveninfluencedthewholeofBlackRock.”(Loomis2014).

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ofJanuary2017--hadcooperatedwithTrian’scampaignfromthebeginning.DuPont’s

managementhadneverthoughtofthispossibilitybecauseCalSTRSwasalong-term

shareholderandthecompany“generallyhadacongenialworkingrelationshipwiththepension

fund”.ButCalSTRSco-signedanearlylettersupportingTrianwhenthelatterattackedDuPont

in2015andturnedoutlatertobeoneofthehedgefund’smajorinvestors.IndetailinghowDu

PontwenttowarwithTrian,Fortunemagazinereportedthat“[t]ieslikethathavemadeit

harderforcompanieslikeDuPonttoarguethatsidingwithactivistsisn’tintheinterestof

shareholders.”109

Themostdetailedaccountofco-investmentrevealedinpublicsofarhasprobablybeenthat

betweenCalSTRSandRelationalInvestorsLLC,anactivisthedgefundsetupbyRalphV.

WhitworthandDavidH.Batchelder,whousedtoworkwithT.BoonePickensasfellow

corporateraiders.CalSTRScommitted$1billiontoRelational,$300milliontoTrian,and$100

milliontoStarboardin2013.Workingintandemfromthebeginning,RelationalandCalSTRS

increasedtheirparticipationinTimken,afifth-generationfamilybusinessproducinghigh-

qualitysteelandbearings,untiltheholdingofeachreachedthe5%thresholdfora13Dfiling.

AspartoftheirattempttopushtheTimkenfamilyintobreakingthecompanyintotwo

separateentitiesandincreasingstockbuybacks,RelationalandCalSTRSsetupawebsite,

“unlocktimken.com”,thatcriticizedTimkenmanagementpublicly.Aninvestmentofficerfrom

CalSTRSjoinedaroadshoworganizedbyRelational,flyingtoNewYorktomeetfellowpension-

fundmanagers.AseatontheTimkenboardwasfilledbyaCalSTRSrepresentative,and“the

pensionfund,longachampionofbettercorporategovernance,madethecasethatTimken’s

boardwasdominatedbyfamilymemberswhopaidthemselvesliberallyandputtheirown

interestsaheadofshareholders’interests.”110InApril2012,threeweeksbeforetheproxyvote,

RelationalandCalSTRSputoutanewsreleasecallingTimTimken’s$9millionpaypackagein

2011“grosslyout-of-linewithotherexecutivechairmeninTimken’speergroup.”111Their

109Gandel(2015).110Schwartz(2014)111RelationalInvestorsandCalSTRSpressrelease,“RelationalInvestorsLLCandCalSTRSUrgeTimken’sBoardtoTakeActiontoSeparatetheCompany’sBusinessestoUnlockShareholderValue,”February19,2013,at

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proposaltosplitthecompanyintoTimkenandTimkenSteeleventuallygarnered53%of

shareholdervotes.112

5.Conclusions–Rebuildingtheengagementandproxyvotingsystem

Thecompulsoryvotingimposedoninstitutionalinvestorscreatedalargevacuuminthe

corporateproxysystembyforcingthosewhoareuninterestedinandincapableofvotingto

casttheirvotesby“creating”or“purchasing”justificationsfortheirdecisions.Thisvacuum

providedhedge-fundactivists,“minorityshareholdingcorporateraiders”,withamajor

playgroundtoexploitfortheirownprofits.Thepowerofhedge-fundactivistswasenhancedby

theproxyrulechangestowards“freeengagementandcommunication”thatmadeiteasierfor

themtoaggregatescatteredvotesunderthebannerofmaximizingshareholdervalue.The

1996NISMAprovidedastrongimpetusfor“co-investments”betweenhedge-fundactivistsand

institutionalinvestorsbyallowingtheformertoattractalternativeinvestmentsfromthelatter

effectivelywithnolimit.

Thecombinedconsequenceofthoseregulatorychangesispredatoryvalueextractioninthe

U.S.economy.Majorpubliccorporationsroutinelydisbursenearlyalloftheirprofits,andoften

more,toshareholdersintheformsofstockbuyback,dividendsanddeferredtaxeswhile

investinglessforthefutureandundertaking“restructuring”simplyforthesakeofreducing

costs.Thisistantamounttolootingindustrialcorporations,andisaprimecauseofthe

disappearingmiddleclassasemploymenthasbecomeunstableandinsecure.Attheheartof

thesenegativeconsequencesliethedistortedrealitybetweenfinancialinvestorsandcorporate

managementandthedistortedapplicationofpoliticaldemocracytoshareholderdemocracyon

whichthoseregulatorychangeswerepremised.Thechangeswereostensiblygearedto

correctingthe“imbalance”ofpowerbetweenpublicshareholdersand“autocratic”corporate

managementbutthepowerrelationwasalreadyskewedtowardtheformerinthe1980sand

http://www.businesswire.com/news/home/20130219006721/en/Relational-Investors-LLC-CalSTRS-Urge-Timken%E2%80%99s-Board. 112Schwartz(2014);Orol(2014);Denning(2014).

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thisimbalancehascontinuedtobestrengthened.Thedistortedapplicationofpolitical

democracytoshareholderdemocracyprovidedajustificationtoimposevotingasafiduciary

dutyofinstitutionalinvestorsandallowedeasyaggregationofpublicshareholders’voteson

thepretextof“freeengagementandcommunication”.Thisfurtheramplifiedtheimbalanceof

powerbetweenpublicshareholdersandcorporatemanagement,andmadeitamantraforthe

latter“tosettlewithhedgefundsbeforeitgetstoafightoverthecontrolofacompany”.

Ifaregulatorychangedoesnotbringabouttheeffectsitintended,itshouldbereversedor

recalibrated.ThethreepillarsoftheSECmissionare(1)toprotectinvestors,(2)tomaintainfair,

orderly,andefficientmarkets,and(3)tofacilitatecapitalformation.Whatiscurrently

happeningintheengagementandproxy-votingsystemdoesnotmeetanyofthesethreepillars

oftheSECmission.(1)Onlystrongandactiveshareholdersareprotected;(2)Insteadoffair,

orderlyandefficientmarkets,wehaveunfair,unrulyandmanipulatedmarkets;and(3)value

extraction,withoutcapitalformation,isfacilitated.Followingaresomeofmysuggestionsto

rebuildengagementandproxyvotingsystemthatwillsupportsustainablevaluecreationand

valueextraction.

First,theSECshouldmakeitmandatoryforshareholderstosubmitjustificationsintheir

proposalsonvaluecreationorcapitalformationofcorporationsconcernedsothattheycanbe

discussedopenlyinmakingvotingdecisions.Whenactivistshareholdersproposeto“disgorge

freecashflows”throughincreasingstockbuybacksordividends,theyonlyarguethat,basedon

theirownarbitrarycalculation,certainamountofcashflowis“free,”thatis,ithasnoeffecton

runningthecorporation.Theyhardlyprovidejustificationsforwhythe“disgorging”isgoodfor

valuecreationandsustainabilityofthecorporation.Indeed,theevocativeterm“disgorge”

betraysalackofinterestinthevalue-creatingcapabilitiesofthecompaniesthathave

generatedthiscashflow.

Thisnewregulationwillalsoforcecorporateexecutivestothinkandbehaveinlinewith

sustainablevaluecreationandvalueextraction.Ifitismandatoryforpublicshareholdersto

providejustificationsforvaluecreation,corporateexecutivesshouldbepreparedtorespondto

thoseclaimsmadebypublicshareholders.Theproxyvotingsystemwillthenturnintoanarena

todiscusspracticalwaystopromotesustainablevaluecreationandvalueextractionbetween

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shareholdersandmanagement.Thisnewregulationisalsoconsistentwiththegeneral

understandingofthepurposeofcorporationsinthelegalprofession.AsLasterand

Zeberkiewiczpointout,“theexistenceofthetypicalcorporationisperpetualandthecapital

providedbycommonandpreferredstockholdersispermanent”and“theblockholderdirector’s

dutiestothecorporationrequirethatthedirectormanageforthelongterm”.113

Secondly,votingshouldberemovedasafiduciarydutyofinstitutionalinvestors.The

combinationofcompulsoryvotingandopenvotingbyuninterestedandincapableinstitutional

investorshasgivenillegitimatepowertoproxyadvisoryfirmssuchasISSandopenedwidethe

roomforhedge-fundactiviststoexploitthevacuuminproxyvotingfortheirlootingof

industrialcorporations.IftheSECacknowledgesthisdeviationoftherealityfromtheidealof

institutionalactivismandthenegativeconsequencesofcompulsoryvoting,itisanaturalcourse

ofactionnottoimposecompulsoryvotingoninstitutionalinvestors.Likepoliticalvoting,itwill

befinetoletthemdecidewhethertovoteornot.Onlythoseinstitutionalinvestorswhoare

keentocontributetosustainablevaluecreationandvalueextractioncanthenjointheproxy

votingarena.

Thirdly,asapracticalenforcementmechanismtomakeshareholderstothinkandbehavein

termsofsustainablevaluecreationandvalueextraction,Isuggestthattheregulatory

authoritiesallowdifferentiatedvotingrightsthatfavorlong-termshareholders.Valuecreation

orcapitalformationtakestimeinovercominguncertaintiesthroughexercisingstrategiccontrol,

organizationalintegrationandfinancialcommitment.Itisthereforenaturalthatlong-term

shareholdersaremoresupportiveofvaluecreationthanshort-termshareholders.However,

currentfinancialregulationsdonotdistinguishbetweenlong-termandshort-termshareholders

althoughmanypolicy-makersandseniorSECofficialsvoicetheirconcernsabout“short-

termism”.Iftheyarereallyconcernedaboutit,theyshouldtakeactionstocorrectit.

ManyEuropeancountriesareinfactpracticingdifferentiatedvotingrightsystemsnotonly

forsharescontrolledbymanagementbutalsoforthoseheldbypublicshareholders.For

instance,FranceadoptedtheFlorangeActin2014,wherebysharesthatareregisteredfortwo

yearsautomaticallyreceivedoublevotingrights.Similarly,Italyintroducedthemechanismof113LasterandZeberkiewicz(2014/2015)

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loyaltyshares,allowinglistedcompaniestograntuptoamaximumoftwovotespershareto

thoseshareholderswhohavecontinuouslyheldtheirsharesforatleasttwoyears.Netherlands

andNordiccountrieshavelongexerciseddifferentiatedvotingrights.InEurope,theprincipal

purposeofthedifferentiatedvotingrightsystemaccordingtoholdingperiodistoencourage

longer-termholdinganddiscourageshort-termism.114

IntheUnitedStates,dual-classsharesaregivenonlytocompanyfoundersandmanagers

beforetheylisttheircompanies.Differentiatedvotingrightsarenotallowedtoshareholders

whoholdthesharesafterthelisting.Thiscleardivisionindifferentiatedvotingrightbeforeand

afterthelistinghascontributedtotheconventionalunderstandingthatdual-classsharesare

essentiallyforprotectingentrenchedfoundersandthemanagement.Thiswouldbealsoa

majorreasonthattheCouncilofInstitutionalInvestors(CII)haslongadvocatedtheabolitionof

thedual-classsharesystem.115Ifinstitutionalinvestorsaregivenmultiplevotingrights

proportionatetotheirholdingperiodlikeinEurope,however,manyofthemarelikelyto

supportit.AccordingtoarecentMcKinseystudy,short-terminvestorsholdonly25%ofU.S.

stockswhilelong-terminvestorshold75%ofthem.116Onecanenvisagetheestablishmentof

“holyalliance”betweenlonger-terminstitutionalinvestorsandvalue-creatingexecutives,

replacingthecurrent“unholyalliance”betweenactivistshareholdersandvalue-extracting

executives.Thisnewsystemtoencouragelong-termshareholdingisalsoconsistentwiththe

interestsoftheultimatecustomersofinstitutionalinvestorssuchaspensionersandordinary

savers.

Fourthly,theSECshouldmakeitmandatoryforbothshareholdersandmanagementto

revealtothepublicwhattheydiscussedinengagementsessions.“Freeengagement”isonly

freeandexclusivetosomeinfluentialinvestorsandtheyprefer“privatecommunicationthat

wouldnotbecomepublic”,makingengagementsessions“occasionsformanagerstodisclose

significantinformation”.Thissituationisdirectlyagainstthespiritofshareholderdemocracyas

114Ventoruzzo(2015);Shearman&Sterling(2017);Stothard(2015);Shin(2015);ISS(2017)115Itstatesasfollows:“CII'scorporategovernancepoliciesendorsetheprincipleof"oneshare,onevote":eachshareofapubliccompany'scommonstockshouldhaveonevote.”(CIIwebsite,http://www.cii.org/dualclass_stock,accessedonMarch20,2017)116DarrandKoller(2017)

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wellastheSEC’smission“toprotectinvestors”and“tomaintainfair,orderlyandefficient

markets”.Fundmanagerswhosecompensationpackagesaremostlydependentontheir

tradingperformancehaveeveryincentivetoexploitundisclosedinformationfortrading.But

corporatemanagers,eveniftheyrecognizethosefundmanagersareutilizinginsider

informationacquiredfromengagementsessions,cannotreportittoregulatoryauthorities

becausetheywillbepenalizedbythefactthattheyhadrevealedittothefundmanagers.

Prohibiting“fraudanddeceit”,includingprofitingfrominsiderinformation,hasalwaysbeena

criticalpartoftheSEC’smission.Thereisnoreasonwhyengagementshouldbeanexceptionto

themission.

Fifthly,hedgefundsshouldbeputunderregulationsequivalenttoinstitutionalinvestors.

Hedgefundsarealreadybigenoughtoposesystemicriskstotheeconomy,aswewitnessed

fromthecollapseofLong-TermCapitalManagement(LTCM)in1998.Sincethepassingofthe

1996NSMIA,hedgefundsmanagealargeportionofinstitutionalinvestors’fundsforthe

benefitoftheirultimatecustomers,includingordinaryworkersandpensioners.Thereisno

plausiblereasonwhyhedgefundsshouldbestilltreatedas“privateentities”andfreedfrom

financialregulationsappliedtoinstitutionalinvestorssincetheyarebasicallyfunctioningas

institutionalinvestors.

AsDavidDayenpointsout,“[t]heiremergencewasanaccidentofhistory,agifttowealthy

families.Buttheby-productofthatgifthasnowgrowntooutsizedproportionsandshoved

itselfintopracticallyeveryaspectofeconomiclife.”117Inparticular,activisthedgefundsservea

smallgroupofaffluentpeopleattheexpenseofordinarypeoplethroughitsdeleteriouseffects

onvaluecreationanditspowertoengageinpredatoryvalueextraction.TheSECshouldput

hedgefundsundertheInvestmentActof1940,andmandatedisclosureoftheirshareholdings

andregulatetheiruseofleverageaccordingly.

Sixth,theSECshouldraisebarriersagainst“wolfpacks”and“co-investment.”The1992

proxyruleamendmentsallowedinvestorcartels,resultinginfrequentemergenceof“wolf

packs”and“co-investments.”Thepolicyofencouraginginvestorcartelscannotbejustifiedby

theSEC’smission,letalonefromtheperspectiveofvaluecreation.Itshouldthenberepealed.I117Dayden(2016).

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proposeloweringthe5%thresholdsignificantly,say,upto2%.Theten-daywindowthat

Section13d(1)givesto“insurgents”shouldbealsoreducedsignificantly,say,totwobusiness

days.IalsoproposethattheSECmakesitmandatoryforhedgefundstorevealtheir

institutionalinvestorswhoalsoholdsharesofthecompaniesagainstwhomtheycampaign.

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