Ruminations On Corporate Governance

Just noticed that FactSet sells a database about “takeover defenses”:

SharkRepellent.net is a corporate governance research tool focused on takeover defense, corporate activism, and proxy related issues. Defense profiles are available for U.S. public companies which we compile from a company’s articles of incorporation, bylaws, state takeover law and shareholder rights plan, illustrating how a company has chosen to defend itself from potential unsolicited takeovers and proxy contests.

This database looks like it would be worth exploring. Sad, however, that its marketing uses the word “shark” to describe company owners who have decided to attempt to work with fellow owners to convince managements (their employees!) to take actions that they feel would be beneficial.

Also, the term "takeover defense" is euphemistic and misleading. How about calling it “management entrenchment”? Or “principal-agent accountability disruption”?

Good corporate governance is, to a large degree, the inverse of the “takeover defense” and anti-“activist” devices that have been created over the past decades to entrench management agents at the expense of their owner principals.

Here’s a piece called “Structural Defenses to Shareholder Activism” [pdf] that contains quite a few of these devices. We would posit, then, that good governance would consist of the absence of these devices from the company’s bylaws and practices. Notice this horrifying statistic from the piece:

“In 2014, there have been only two hostile takeover bids for U.S. companies to date and there were only five hostile takeover bids in 2013. This is compared to 160 in 1988, when every board lived in fear of a hostile takeover fight."

How can it be beneficial to shareholders to have such a drastic curtailment of interest from third parties who can imagine a more productive use for their property?

From a press release put out by Marcato Capital that contains their letter to Buffalo Wild Wings, Inc.:

It has now been more than seven weeks since Marcato—a 5.2% stakeholder in BWW—requested a limited amount of information for the purpose of communicating with fellow shareholders. As I’m sure you know, Marcato has an unassailable right under Minn. Stat. § 302A.461 to receive this information. Other public companies routinely provide such information to shareholders without question or delay when presented with similar requests. This is in fact the very same information that BWW is already using itself—we are merely seeking to have a “level playing field” with the Company. It should not take nearly two months to produce.

The Company initially refused to acknowledge that Marcato owned any BWW shares. Specifically, Company counsel stated that the Schedule 13D which we filed with the U.S. Securities and Exchange Commission on August 17, 2016, a copy of which was enclosed with our request, was “insufficient to demonstrate that any particular entity was a shareholder of BWW as of [August 22, 2016].” 

Company counsel insisted that we provide a brokerage account statement evidencing Marcato’s ownership. When asked to explain, our attorneys were told by your counsel that Marcato “could have sold all of its shares” since the 13D filing. To put it another way: management appears to have envisioned a scenario in which Marcato submitted a shareholder list request after it sold all of its BWW holdings, without disclosing the sale in a subsequent 13D amendment.

The Minnesota statute governing shareholder information requests is here.

This is an excerpt from a book about Exxon, mentioned on Phil Greenspun’s blog:

Clinton introduced Diane Sawyer. She summoned to the stage members of a panel to talk about women’s issues; the panel included Tillerson and Lloyd Blankfein, the chief executive of Goldman Sachs, the investment bank with a public reputation as much in need of repair as ExxonMobil’s. The ballroom atmosphere suggested the laying on of liberal, globalized hands to cleanse sinful multinational corporations. “These are some of the power hitters,” Sawyer said of Tillerson and Blankfein. Tillerson talked about ExxonMobil’s charitable initiatives to support girls and women in some of the poor countries where the corporation extracted oil. “Technology comes very natural to ExxonMobil,” he said. “What are the technologies that will provide them [girls and women] capabilities to undertake their daily activities in a more effective and efficient way?” Sawyer later asked him: What is the responsibility of a multinational corporation to make the world better through charitable activity? Is it a tithe of 10 percent? How much? “Ultimately,” Tillerson said, “this is our shareholders’ money we’re spending. It’s not my money to tithe. It’s not the corporation’s. It’s our shareholders’.”

A New York Times piece pointing out that index fund managers may be violating current antitrust laws.

Such ownership patterns are already illegal. Section 7 of the Clayton Antitrust Act makes firms that buy stock in other firms liable if “the effect of such an acquisition may be substantially to lessen competition, or to tend to create a monopoly.” In 1957 the Supreme Court noted that such prohibitions hold “even when the purchase is solely for investment.” Unfortunately, because the antitrust implications of institutional investment were not recognized until recently, legal action has not yet been taken.

However, indiscriminate application of these laws would disrupt an industry that many Americans rely on for (often) low-fee, diversified savings. To avoid such disruption, the government should enforce the Clayton Act against institutional investors while recognizing a safe harbor for those that either take a small stake in an oligopolistic industry (less than 1 percent of each company) or invest in no more than one company per industry. BlackRock could own a large stake in United or Delta or American or Southwest, but not all of them.

Horizon Kinetics has done very good work on unintended consequences of the index investing boom. We note that the regulations that govern mutual funds may have adverse effects on corporate governance. For example, the Investment Company Act of 1940 requires that investments made by a diversified fund be “limited in respect of any one issuer to an amount not greater in value than 5% of the value of the total assets of the fund and to not more than 10% of the outstanding voting securities of the issuer”. This is probably the real reason why these institutions have invested in multiple companies per industry. And the result is actually that the big fund managers have invested an amount in each company that is too small to care about and too small to exert much influence.

Looking Back at Texas Vanguard Oil (TVOC)

I wrote about Texas Vanguard Oil in March 2011 - it was a great micro cap value idea. I guess at the time it was trading at $8.50 and seemed to be worth comfortably more. Today I was taking a look at what had happened to it subsequently. Management liquidated it at the top of the market in 2014 and paid out $13.11 per share:

The Merger is part of a plan to liquidate the Company and distribute the assets to shareholders. In the Merger, shareholders other than the majority shareholder and Chairman of the Board, Linda R. Watson (who owns a majority of the stock through Robert Watson, Inc., a company controlled by her), will receive cash in exchange for their shares, and their shares will be canceled. The Company will then own the non-operated oil and gas properties, some furniture and equipment, and the remaining cash that has not been distributed to minority shareholders in the Merger.

The amount per share to be paid to minority shareholders in the Merger will be approximately $13.30 per share, which is the estimated value of the Company (including the estimated value of the non-operated oil and gas properties, furniture and equipment) divided by the total outstanding shares.

After the Merger, the surviving company will pay cash bonuses to long-time employees and consultants as compensation for their past services. The surviving company will then pay all remaining liabilities of the Comp any and liquidate the Company by distributing the remaining cash and the non-operated oil and gas properties, furniture and equipment to the sole remaining shareholder.

The board of directors believes that this is a good time to liquidate the Company. We sold our operated oil and gas properties in 2013 because prices for properties like the ones we owned were near historic highs. In fact, prices are so high that we have concluded that it would be very difficult to purchase new properties to add to our portfolio, and to replace our properties that are being depleted through production, at prices that would yield a good return on investment given our small size and asset base. We believe that the best alternative for our shareholders is to liquidate our holdings and distribute the proceeds.

We have chosen this plan of the Merger followed by a liquidation because we want to accomplish two goals. First, as stated above, we want to liquidate the Company and distribute the proceeds to shareholders. Second, we want to pay long-time employees and consultants for their years of faithful service, but we do not want to have those payments reduce the proceeds to be paid to minority shareholders. We have never had a stock option or incentive compensation plan . The majority shareholder believes there is an obligation to compensate these employees and consultants, and she is willing to do so solely from her share of the assets of the Company. To accomplish this, we will (i) value the Company’s assets prior to making the compensatory payments, (ii) cash out the minority shareholders based on this valuation, (iii) make the compensatory payments, and finally, (iv) distribute the remaining assets to the majority shareholder.

When the liquidation/merger closed in fall 2014, the oil market had already collapsed, but the properties were sold in July 2013 when crude oil was over $100.

What great management and governance. I've never seen anything like it.

Review of The Synergy Trap by Mark L. Sirower

We have an entire category of Credit Bubble Stocks posts about the principal agent problem at companies. One major principal-agent problem that occurs is when managements decide to grow through acquisitions. The problem is that managers of larger enterprises get paid more - in fact, management pay is in some sense a function of asset size or of equity size. (Also, status is a function of size.)

So, management can buy themselves a larger company by making an acquisition. Unless the managers are significant shareholders, the increased compensation they can expect will outweigh any effects on them from overpaying for another company. From the M&A academic research, we see that,

"Mergers are the quickest and surest way to grow, and thus may be undertaken by managers even if they do not promise profit and shareholder wealth increases."

One of the concepts that these managers use to justify, or "sell", a desired acquisition is the concept of "synergy": the idea that the combined companies will have higher revenue and/or lower costs, resulting in higher combined earnings than as separate companies.

Sirower's book, The Synergy Trap, explores a hypothesis that these synergies rarely materialize. Acquirers will universally claim that an acquisition will result in benefits from synergy, yet they will often make a purchase before putting together any sort of detailed plan for integrating the two companies' operations.

Every time there is an M&A boom, tons of shareholder value of acquiring firms is destroyed. One example in the book happened exactly 20 years ago. Did you know Snapple was once owned by Quaker Oats? 

"Closing one of the worst flops in corporate-merger history, Quaker Oats Co. agreed Thursday to sell Snapple Beverage Corp. to Triarc Cos. for $300 million, only 27 months after Quaker spent $1.7 billion to buy the maker of trendy drinks. (March 28, 1997)"

Triarc sold it to Cadbury Schweppes for $1.45 billion in September 2000, and then in 2008 it was spun-off and continues as a stand alone entity. Meanwhile, in 2001 Quaker was bought by Pepsi, which wanted to get its hands on Gatorade!

And as I've mentioned in the past, the mining and oil industries went on a debt-fueled acquisition boom during the peak of the "commodity supercycle" in 2011. Most of these companies had to restructure during the past two years, meaning that the acquisitions were not just harmful to shareholders but wiped them out entirely.

One very interesting point by Sirower is that the U.S. legal system encourages acquirers to overpay. As a shareholder of a company that makes a stupid acquisition, you have no recourse. The managers are protected by the business judgement rule. But the shareholders of the target have much more protection against their corporation being sold "too cheaply". The equilibrium result is that acquisition prices are too high and transfer value from acquiring firm shareholders to target shareholders.

Speaking of the unintended consequences of U.S. law on corporate governance, a Mises reviewer of Sirower's book makes a great point as well,

The key question that the author fails to ask here is, why is the company willing to pay top dollar on every share when it could buy so many shares at much lower prices on the stock market, and thus preserve a great deal of its own shareholder’s value? Regulation causes this anomaly because it prevents companies from acquiring large blocks of stock in companies, without registering their intentions with the government and alerting the market to their intentions. The government protects these “target firms” from “hostile takeovers.” [...]

Ultimately, the author is led to an explanation of mergers based on economic irrationality. Company executives make “value-destroying acquisitions” as a form of gambling that has their own self-aggrandizement as its goal.

I've made the point about takeover defenses in my review of Dear Chairman. These are state laws or bylaw provisions that make it difficult, slow, and expensive for an investor who purchases shares to translate that ownership into control. These mechanisms stand for the idea that if corporate mismanagement attracts an investor who thinks he can do a better job, he faces serious obstacles in simply buying shares from beleaguered owners and implementing a new plan.

Finally, the whole subject of acquisitions makes me think of a recent discussion of Sitestar on COBF:

"Roll ups of HVAC have been tried a number of times and nobody has cracked the code.  The problem is that they are largely mom and pops who's success is tied to an owner/manager who lives the business.  The customer relationships and employee loyalties are tied largely to that owner.  Once they sell out and move on, those relationships slowly dissipate and die - especially when employees are now reporting to an Area Manager and have to focus on budgeting and targets and other 'corporate' metrics.  There are very few synergies with the exception of some systems and purchasing but those tend to take more effort to integrate than they achieve in savings."

It is really stunning how often an acquisitive strategy will impress investors before flaming out. Bill Ackman alone has had two just in the past couple years: VRX and PAH.

3.5/5

Review of Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism by Jeff Gramm

Who "owns" a corporation? Supposedly, the common shareholders do. The profits belong to them and they vote for the board members who make decisions and hire and fire management.

Except this does not seem to be the case in real life. Instead, there is a cozy network of CEOs and board members, often with interlocking boards, who make the decisions. They may own little stock, and anyway the present value of their sinecures (which are senior to shareholders' interests) is higher than the value of their shares.

This means that management's economic interests are often not aligned with shareholders'. The natural result is that they make decisions that don't maximize the present value of common stock. This is why public companies have overpaid managements and private jets. This is why they want to grow and make acquisitions even if that means overpaying. That gives them more power, plus the default way of thinking is that the manager of a bigger company should be paid more.

Unlike the owner-operator managers, the non-owner public company managements are clearly a form of parasite. They bleed as much money as they can get away with, even when they are not doing something breathtakingly stupid and negative sum like buying their competitors at the top of their industry cycle.

Why are these managers with no skin in the game so entrenched? Why don't shareholders simply sweep out the parasites? I can think of some reasons: "takeover defenses", rules regarding mutual fund ownership concentration, and asset manager proxy voting rules.

Takeover defenses are state laws or bylaw provisions that make it difficult, slow, and expensive for an investor who purchases shares to translate that ownership into control. Takeover defenses are completely illegitimate: devices like poison pills, classified boards, the state anti-takeover statutes. These mechanisms stand for the idea that if corporate mismanagement attracts an investor who thinks he can do a better job, he faces serious obstacles in simply buying shares from beleaguered owners and implementing a new plan.

The Investment Company Act of 1940 [pdf] put in place well-meaning rules regarding mutual fund ownership concentration which may inadvertently be contributing to poor corporate governance. Investments made by a diversified fund are "limited in respect of any one issuer to an amount not greater in value than 5% of the value of the total assets of the fund and to not more than 10% of the outstanding voting securities of the issuer".

If you look at the holders list of a public company that's not an activist or hedge fund favorite, the odds are that the largest holders are five big asset management companies that each own a single digit percentage of the company. An amount that is too small to care about and too small to exert much influence even if the managers of the mutual fund took notice.

What about cooperation between mutual funds? Can't they exert influence that way? Sure, except for the well meaning idea of a Section 13D filing requirement. If two mutual funds exchange correspondence and agree that a company they own does not need a Gulfstream G650, are they a "group" that must make Section 13D filings? Who knows [pdf]!

In yet another instance of unintended consequences of regulation, well-meaning rules surrounding the voting of client shares by investment managers have essentially lead the managers to outsource the voting to firms like ISS. Isn't it amazing that a mutual fund company will outsource one of the most important functions of an owner of capital (oversight of management), while retaining functions like marketing?

This is the context - a corporate governance crisis - in which activist investor Jeff Gramm's book Dear Chairman takes place. He offers case studies of some successful (and one unsuccessful) activist campaigns to deliver value to shareholders, value which had been usurped by managements. It is inspiring because in most of the examples the good guys (activists) won.

The best tale in the book is Ben Graham's activist campaign against Northern Pipeline. This was a pipeline company which had amassed a securities portfolio that dwarfed the value of the pipeline operations. As is often the case with over-capitalized companies, the shares traded at a significant discount to the value of the operations plus securities because of well-founded fears about what management would do with the capital. Graham bought shares, talked to fellow shareholders (including the Rockefeller Foundation), and was ultimately successful at getting the company to distribute surplus capital.

The other great campaign was Robert Young versus the New York Central Railroad. The railroad had many retail owners, and Young carpet bombed them with his message:

"One distinct advantage for Young in refining and then delivering his message to Aunt Jane was time. [Incumbent] William White was constrained by having to run a large, under-performing railroad. His campaign team met only twice a week to discuss strategy. Young, on the other hand, was working every day on the proxy fight. He held daily press conferences and even spent hours working the phone bank himself. His barrage of attacks strained White's ability to respond promptly, and when the responses came, Young condemned White for spending time on the proxy fight rather than operating the company."

The book was good but it's actually a bit light on details (although it does reproduce letters sent by the activists to the managements). I have yet to find a book that covers the nuts and bolts of an activist campaign or proxy contest.

4/5.

Credit Bubble's Corporate Governance Principles

• The job of the board and management is to maximize the present value of expected cash flows to shareholders.
• The board of directors should literally represent (that is, be constituted of) shareholders and their representatives. At a company with five board seats, shouldn't a 40% owner have two and three 20% owners each have one?
• So-called “takeover defense mechanisms” drive a wedge between ownership of the company by shareholders and the rightful exercise of that ownership through control of the company’s operations. This makes way for a parasite class of non-owner management to usurp wealth.

Better Corporate Governance Coming?

From the latest Fortune:

"Traditional pensions are dwindling. Back when almost every big company maintained a pension fund that it parceled out to asset managers, those managers recoiled from getting involved in companies’ affairs or voting their shares against management’s wishes (after all, it could cost them business). Now old-style pension plans are mostly gone, replaced by defined-contribution plans in which employees direct their own investments. Asset managers are unshackled to say what they want and vote as they wish."

One other observation about this same article.

Having $3 trillion of assets under management puts you in the top handful of asset management firms. Owning $1 trillion of treasury debt (like China or Japan) makes you one of the largest holders. Who, then, is going to be buying the $3 trillion a year that federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls??

I see this sparking a bond bear market, which leads automatically to a bear market in other assets, because all assets are priced off of bond yields.

WSJ on Singapore

Wealth Over the Edge: Singapore

"the world's economic center of gravity—measured by looking at income averages across more than 700 places worldwide—has shifted east over the past 30 years, from the Transatlantic Axis to somewhere across the Arabian Peninsula. If current growth trends continue, this center will move in another three decades to a resting point between India and China—just about where Singapore is, meaning its potential as the world's economic center may not even be fully realized.

what really checks all the right boxes for many of the world's ultra-rich is Singapore's obsession with order, predictability and control, all of which give comfort to individuals whose fortunes have recently gone down the drain in many parts of the world. It doesn't hurt that Singapore has some of the lowest taxes in the world, including none on capital gains and most foreign dividends. But it also has relatively secretive private banking laws and zero harassment from paparazzi or protesters, whose activities are narrowly proscribed by Singaporean authorities, further creating an aura of order and stability. Ronen Palan, a professor of international political economy and an expert on offshore wealth and tax havens at City University in London, believes that while Switzerland is 'clearly suffering' from the pressure put on its private-wealth sector from the European Union and the U.S., Singapore is a 'very secretive location' where many—Asians in particular—believe their wealth will be spared scrutiny from Western regulators."

Paper: "Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts"

I was just reading a paper by a Federal Reserve economist, "Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts". A welcome relief, as I have thought enough about macroeconomics now for one lifetime. From the abstract:

"This paper uses rich, new data to examine the fleets of corporate jets operated by both publicly traded and privately held firms. In the cross-section, firms owned by private equity funds average jet fleets at least 40% smaller than observably similar publicly-traded firms. Similar fleet reductions are observed within firms that go private in leveraged buyouts. [...] Results thus suggest that executives in a substantial minority of public firms enjoy more generous perquisites than they would if subject to the pressures of private equity ownership."

One of the big problems in corporate governance and in politics is the difficulty of motivating one party to act on behalf of another: the principal-agent problem. The question at public companies is, are the jets saving the executives’ valuable time and functioning as an efficient form of compensation, or are executives overusing corporate aircraft because shareholders are unable to monitor the executives effectively?

There is empirical evidence that private equity portfolio companies create economic value by operating more efficiently, so this author (Jesse Edgerton) interprets the private equity portfolio companies' jet fleets as a benchmark of efficiency against which to compare the fleets of public firms. [A classic example of private equity operating a company more efficiently is the story of RJR Nabisco, which was taken private in a leveraged buyout in 1988.]

The paper finds that:

"In a sample of all public and private U.S. firms with 2008 sales greater than one billion dollars... PE-owned firms operate significantly smaller jet fleets, even when controlling for size, industry, and location in a variety of flexible ways. Estimates suggest that PE-owned firms are at least 25 percent less likely to operate a jet. Conditional on operating at least one jet, they have smaller fleets as measured by total passenger seating capacity. Overall, PE-owned firms average a ratio of jet seats to firm sales more than 40 percent lower than observably similar public firms."

He also examined the changes in jet fleets within a panel of 69 buyouts of large, standalone public firms that were taken private between 1992 and 2008, and found that:

"buyout targets are about 32% less likely to have a jet in the three years after their LBO than in the year before, even after controlling for changes in firm size following the buyout. Their average seats-to-sales ratio falls by more than 40% over the same period."

So, it seems pretty clear that executives at public companies waste money on corporate jets. Public ownership leads to agency problems, especially when the companies are owned by retail investors or by long-only mutual funds that are asleep at the switch because they have hundreds of positions. This is the problem that activist hedge funds have been invented to solve.