Commentary: Shareholder Activism in a Post-Lehman World
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As the global economy gradually recovers from the impact of the worst global financial crisis since the 1930s, companies continue to lay off thousands of employees and financial institutions are expected to write down trillions of dollars of toxic assets. In addition, governments have spent or committed to spend exponential sums of money in order to stabilize their economies. Investors have been particularly affected by the consequences of the financial crisis, having suffered a significant reduction in the value of their investments in a number of companies. According to the World Federation of Exchanges, as of February 2009, the global equity market capitalization was estimated to have reduced by $31 trillion since the peak prior to the crisis.
The major cause for the financial crisis, which culminated in the collapse of Lehman Brothers, was the bursting of the housing bubble. This was driven not only by easy credit conditions, but also by poor corporate governance practices in a number of financial institutions. These practices include poor risk management, poor management oversight, irrational financial innovation, reckless and predatory lending practices, and a compensation regime that encouraged short-term risk-taking at the expense of long term value creation. One major reason why these activities continued unabated is because of the limited engagement by shareholders with the management of these institutions, as investors opted to take a more passive approach.
The breakdown in corporate governance outlined above highlights the classic agency problem in which management teams sometimes pursue objectives which, though attractive to them, often conflicts with the goals of the shareholders. Due to the disengagement of shareholders in the management of these entities, it was easy for the management to engage in activities that did not maximize the long-term value of the business.
In the aftermath of the financial crisis, there have been calls by regulators, governments, investors, and market participants for greater shareholder engagement with the management teams of companies. Furthermore, there has been an increase in shareholder activism in different parts of the world.
There are a number of benefits to be derived from increased shareholder engagement. It promotes better corporate governance. Furthermore, it could lead to improved returns for shareholders as value-destroying activities are discouraged, thereby enabling management to embark on value-enhancing activities. It could also lead to improved profitability for the business. Moreover, it also helps bridge any misalignment between the objectives of management and shareholders.
In order to reduce the intensity and occurrences of similar financial crises, it is essential that shareholders take a more active stance with the management team of the companies in which they invest. With lessons learned from the current financial crisis, there is likely to be a dramatic change in shareholder activism in a post-Lehman world, and shareholders will play an important part in engineering better corporate governance.
How is shareholder activism likely to evolve in a post-Lehman world? What changes in engagement between shareholders and management should we expect in the aftermath of the 2007–2009 financial crisis?
We are likely to see institutional investors play a more prominent role in shareholder activism. Even though institutional investors championed shareholder activism a couple of decades ago, in recent years hedge funds have been at the forefront of shareholder activism. For corporate governance to improve in public companies it is essential that institutional investors become more engaged. In most parts of the world, including Europe, the UK, and the United States, institutional investors hold a sizable percentage of shareholding in listed entities. This concentration of ownership and voting power positions institutional investors at the vanguard for influencing change in corporate governance practices. In the last couple of months, institutional investors have become more vocal on corporate governance issues as demonstrated by the recent activist stance taken by investors at Kraft, Mitchells & Butlers, Infineon, and Siemens.
Another change expected is that shareholders will begin to adopt a more proactive approach to shareholder activism. Usually the clamor for increased shareholder engagement is greatest after the occurrence of a major financial crisis. For instance, it had to take the bursting of the technology bubble and now the bursting of the housing bubble to generate increased calls for more shareholder engagement.
At the corporate level, shareholders do not usually take an activist stance until after a corporate scandal or a run of poor results. This reactive approach increases the risk of poor corporate governance negatively impacting business performance. Going forward shareholders are likely to engage with management on an ongoing basis, even when the company is performing well, as this is in the best interest of both management and the investor. Equally as important, investors should try to identify problems at an early stage rather than waiting for the problem to become uncontrollable.
Investors will need to take a more active stance in relation to their investments in financial institutions. Despite taking a more activist stance in nonfinancial sectors, institutional investors took a passive investment approach toward their investments in financial institutions in the run up to the crisis. A number of institutional investors failed to challenge financial institutions on risky practices and compensation structures. Investors rarely voted against ineffective resolutions proposed by bank boards.
Three areas are likely to involve greater future interaction between investors and the management teams of financial institutions. The first area will be the compensation structure in these institutions. Overcompensation of managers is something that will be keenly looked into by shareholders. Furthermore, management will be under increasing pressure to revise the remuneration structure to encourage long-term value creation. The second area of focus will be on the risk management framework. The third area will be on the strategy adopted by these institutions.
Strategic acquisitions would also have to be properly justified. One of the most prominent value-destructive acquisitions in the buildup to the crisis was the RBS acquisition of part of the business of ABN Amro. Rather than challenging the acquisition, most of the institutional investors approved it.
In addition, governments and regulators will continue to review, update, and amend current regulatory and legal frameworks in order to provide a more conducive environment for effective engagement between shareholders and companies. The reforms have started in a number of countries. For instance, the SEC proposal to adopt a new Proxy Access Rule should give power to shareholders to nominate their candidates to the board. In the UK, the Financial Reporting Council recently issued a consultation paper on a Stewardship Code, which it hopes will help to bring about more effective engagement between companies and shareholders. In Canada, the Toronto Stock Exchange has mandated companies to seek shareholder approval for takeovers involving substantial issues of stock.
Investors will also need to be more creative when engaging with management to unlock value. Prior to the financial crisis, some investors put pressure on management to adopt financial engineering strategies to ensure value maximization. These strategies, which included altering the capital structure of companies through increased use of debt, sometimes resulted in value destruction, which negatively impacted institutional and retail investors in addition to the general public. In a post-Lehman world in which credit is likely to be limited and as companies deleverage their balance sheets, investors will have to focus increasingly on longer-term strategies in order to unlock value.
As retail investors pick up the pieces, they are likely to be more vocal on corporate governance issues. Though this category of investors owns a lower percentage of the ownership structure of listed companies in key global markets, they are more likely to engage management and other larger investors. The emergence of online shareholder activism sites such as moxyvote.com, proxydemocracy.org, and shareowners.org will provide individual investors with a platform to advocate proper corporate governance. These portals and other new technologies such as blogs, electronic shareholder forums, etc., will enable individual investors to mount campaigns against large companies, which would have been unimaginable a couple of years ago.
In a post-Lehman world there will be greater alliance among shareholders as investors seek more effective methods to put pressure on management to affect changes to unlock value. This will become necessary as shareholding in listed companies is dispersed and entering into collaboration on issues of common interest will give shareholders a louder voice. In recent weeks we have seen instances of this emerging trend. For instance, a couple of weeks ago Hermes championed a proposal in conjunction with other shareholders, which resulted in a change in the leadership at Germany’s Infineon. Likewise, in the UK, a number of institutional investors collaborated in order to effect a leadership change at the pub group Mitchells & Butlers.
An issue that will increasingly be on the agenda of activist-shareholders will be the independence of the board. Gone are the days when shareholders will be comfortable with a board that is influenced by management. Shareholders will advocate for strong independent boards that will challenge and oversee managers in the performance of their duties.
In the past, shareholders were preoccupied with enhanced returns with little regard to the risk component. However, in the aftermath of the present crisis, there will be an additional focus on companies risk management practices especially as the current financial crisis involved a massive failure to manage risk. Management teams should expect requests from investors on greater disclosure on how specific risks affect the company. However, investors will need to bear in mind that management need to take risk in order to generate reasonable returns.
Finally, activist investors will rely less on the use of general meetings to influence corporate governance reforms especially as a majority of votes is often required in order to pass a resolution that is binding on management. As a result, there will be an increasing use of other tools for effecting and influencing change such as private discussions with management, vocal criticism of management in public, media pressure, and judicial action where necessary.
As we draw the curtain over the 2007–2009 financial crisis, management teams of listed entities will have to get used to dealing with an increasingly demanding and less tolerant group of investors.
–Ahmed Sule, CFA, is an investment strategist at Diadem Capital Partners Limited. The views expressed in this article represent his personal view.
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