Sunday, April 10, 2016

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.


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.


CP said...

Lots of governance problems at small companies.

CP said...

Neither the formal structure nor the history of the large public corporation suggests that it exists primarily to do the will of shareholders. Though shareholders are called owners, they have nothing like the rights or privileges of real owners: no inside knowledge of the firm and no practical say in most decisions. It takes astonishing effort for a popular shareholder movement to wrest control from current management. Such movements, even when they succeed, are almost never sustained. In the face of this de minimis sort of ownership, it requires an assertive force in the culture to sustain the idea that corporations are anything like “pass-throughs”–insubstantial vehicles of financial convenience assembled to manage the cycle of invest, produce, return-earnings-to-investors.

CP said...

"I can get detailed box scores from decades-ago college football games, but finding a 1975 annual report from a midsize company is surprisingly difficult."