Corporate Governance Roundup

Shareholder Proposals

The most significant development of the 2019 proxy season occurred when the largest pension fund in the world supported a resolution submitted by an individual investor.

The support by the world’s largest fund for a shareholder resolution calling for annual election of all directors filed by an individual investor is a development of enormous significance, especially since it was announced ahead of the vote in order to nudge other investors to vote in favor as well.

This is especially important because, as the proponent of this resolution, Jim McRitchie points out that corporate funded firms like the Spectrem Group complain that a large number of shareholder proposals are submitted by a small group of individual investors with modest holdings.

This already well-documented data is not new or relevant. The only meaningful factor is the level of support for these resolutions from large, sophisticated financial institutions that may not be willing to file shareholder proposals, but are committed as fiduciaries to supporting them. We note that Spectrem, whose echo of “Main Street” in the title of its report suggests a likely connection to the dark money fake front group Main Street Investors Coalition, purports to be speaking on behalf of individual investors in calling for “reform,” but the paper is authored by a law school professor whose program is funded by the Kochs, reportedly also backers of the Main Street Investors Coalition.

A Perverse Lawsuit

Oddball shareholder resolution of 2019: “An enormous zeal for the overdog” is a good description of one professor’s effort to force the shareholders of Johnson & Johnson (“J&J”) to waive their right to file shareholder lawsuits – permanently.

     Over the past two years, some senior officials at the Securities and Exchange Commission have indicated that they would be open to corporations foisting mandatory arbitration on their shareholders, and now a team of pro-corporate players are ready to put them to the test. Two lawyers have joined with a high-profile Harvard professor on a pivotal case [The Doris Behr 2012 Irrevocable Trust v. Johnson & Johnson] that could strip away shareholders’ rights to sue public companies. The Harvard professor, Hal S. Scott, runs a Wall Street advocacy group supporting deregulation. The lawyers both made their names busting labor unions; one of them, Jonathan Mitchell, is a current Trump nominee, and social media posts link the other, Wally Zimolong, to discriminatory views.

     A trust run by Scott, an emeritus professor at Harvard Law School, sued Johnson & Johnson in a New Jersey federal court last month, seeking to force the company to allow shareholders to vote on a proposal that would take away their right to sue the company in court. Johnson & Johnson, relying on a determination by the SEC that such a measure would risk violating New Jersey state laws, declined to present the proposal to shareholders in advance of its April 25 annual meeting. On March 26, the trust sought a court injunction to force the company to include the proposal. [Recently], U.S. District Court Judge Michael A. Shipp denied the injunction but allowed the litigation to proceed.

     The Doris Behr 2012 Irrevocable Trust lawsuit is in some sense perverse: a shareholder is seeking to restrict shareholder rights. But Scott has long decried class-action shareholder lawsuits as a boondoggle for lawyers and a burden on shareholders who bear the costs of defending and settling the suits. As president of the Committee on Capital Markets Regulation, he was an early proponent of rescinding shareholders’ rights to sue, suggesting in 2006 that shareholders be allowed to decide whether the companies they invest in should force arbitration. The Committee, according to a 2010 nonprofit filing, has been funded by such Wall Street titans as Goldman Sachs, Citigroup, Fidelity Investments, Deloitte, Pricewaterhouse Coopers, and hedge fund billionaire Kenneth Griffin. In an op-ed in February, Scott said that most shareholder class actions “have no merit, damage shareholder interests, and tarnish the attractiveness of our public capital markets.”

     Scott, who did not respond to an email query, has taken strong, sometimes curious, positions against other forms of corporate accountability. In a 2015 op-ed, he disparaged the idea of forcing companies to admit wrongdoing when they settle a regulatory case. What does an admission of guilt accomplish “other than again imposing additional penalties, by perhaps damaging the reputation of a firm?” he asked.

SEC Chairman Jay Clayton endorsed exclusion of a shareholder proposal on mandatory arbitration of shareholder claims against a public-traded company.

A domestic, publicly-listed company has received a shareholder proposal that would require the company to take steps to adopt mandatory arbitration provisions. The company has asked the staff of the Division of Corporation Finance for informal guidance on whether the company may exclude the proposal from its proxy statement. Specifically, the request seeks the staff’s view on whether, under Rule 14a-8(i)(2), the company may omit from its proxy statement a shareholder proposal relating to mandatory arbitration of shareholder claims arising under the federal securities laws. Rule 14a-8(i)(2) permits exclusion of a proposal that, if implemented, would cause the company to violate any state, federal or foreign law to which it is subject. The company has argued that the proposal, if implemented, would result in a violation of both federal and state law.

     This is a complex matter under both federal and state law, and it has been interpreted differently by the company (arguing that such a clause would violate both state and federal law) and the proponent (arguing that such a clause would not violate state or federal law). The staff considered in its analysis the arguments made by the company, the proponent and the Attorney General of New Jersey, the state’s chief law enforcement officer and legal advisor. The staff issued a response stating that it would not recommend enforcement action should the company decide to exclude the proposal on the grounds that it would violate New Jersey state law. In the context of Rule 14a-8, the staff does not independently adjudicate the legality of any provision of state law, and it is not doing so in this matter. Here, the parties have each asserted different interpretations of state law, neither party has identified New Jersey case law precedent directly on point, and the Attorney General has provided an opinion that implementation of the proposal would violate state law. In light of the submissions, and in particular the letter of the Attorney General of New Jersey, I believe the approach taken by the staff – to not recommend enforcement action in this complex matter of state law – is appropriate.

Stock Buybacks

The record-setting trillion dollars of stock buybacks in 2018 have raised some concerns.

Senators Chuck Schumer and Bernie Sanders have a proposal to restrict stock buybacks by requiring companies to have a $15/hr minimum wage before they can buy back stock.

     First, stock buybacks don’t benefit the vast majority of Americans. That’s because large stockholders tend to be wealthier. Nearly 85 percent of all stocks owned by Americans belong to the wealthiest 10 percent of households. Of course, many corporate executives are compensated through stock-based pay. So when a company buys back its stock, boosting its value, the benefits go overwhelmingly to shareholders and executives, not workers. Second, when corporations direct resources to buy back shares on this scale, they restrain their capacity to reinvest profits more meaningfully in the company in terms of R&D, equipment, higher wages, paid medical leave, retirement benefits and worker retraining. . . .

     That is why we are planning to introduce bold legislation to address this crisis. Our bill will prohibit a corporation from buying back its own stock unless it invests in workers and communities first, including things like paying all workers at least $15 an hour, providing seven days of paid sick leave, and offering decent pensions and more reliable health benefits.

     In other words, our legislation would set minimum requirements for corporate investment in workers and the long-term strength of the company as a precondition for a corporation entering into a share buyback plan. The goal is to curtail the overreliance on buybacks while also incentivizing the productive investment of corporate capital.

     Some may argue that if Congress limits stock buybacks, corporations could shift to issuing larger dividends. This is a valid concern – and we should also seriously consider policies to limit the payout of dividends, perhaps through the tax code.

ValueEdge Advisors Vice Chair Nell Minow responded on the Harvard Law School Blog:

     We may not need a government solution to the issue of excessive corporate stock buybacks. We most certainly do not need the solution proposed by Senators Chuck Schumer and Bernie Sanders, requiring companies to adopt minimum wage requirements for hourly workers before buying back stock. What we need is a capitalist solution, removing misaligned incentives, moral hazards, and diversion of assets to make sure the market’s buyback decision is the right one.

     The conventional thinking about stock buybacks is that when corporate managers and directors believe the stock is undervalued and do not have a better use for excess capital they should return it to shareholders. No one can argue with that; it is vastly preferable to the usual alternative, overpaying for acquisitions that are not core to the company’s business. That’s a whole different discussion of misaligned incentives.

     But as we have often seen, most recently with mortgage-backed derivatives, good ideas can be abused and become destructive. In this case, the excess cash was not the result of operating efficiencies but a windfall from President Trump’s tax bill. The corporate tax cuts were sold as a way to increase compensation for workers and support strategic initiatives like research and development. Instead, 2018 saw record buybacks, over $1 trillion worth, much of it at the top of the market, so it was difficult to justify an argument that the stock was undervalued or that there was no better strategic use for the money.

     A study by Tim Swift in the Academy of Management Proceedings found that stock buybacks suppress innovation. A real-world example is Sears, where $6 billion buying back stock that was collapsing into bankruptcy could have been deployed to improve operations. And a 2017 study reached a troubling conclusion that companies are not clear with their boards or their investors about the basis for the decision to buy back stock. “Few companies publicly disclose details about buyback decision-making and very few state the reasons for a specific buyback program.”

     Why would directors and executives approve buybacks when the stock is not undervalued and there are worthwhile opportunities to invest the cash in support of long-term strategies? One reason is revealed in another study of buybacks, this one conducted by SEC Commissioner Robert Jackson, who found that “right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.” And it is almost unheard of for companies to adjust their EPS targets for incentive compensation to reflect the reduction in shares from a buyback. There are two ways to reach earnings per share goals, by increasing earnings or reducing outstanding shares. But only one of those has real long-term benefits to shareholders. Executives do better from buybacks than retail investors, the exact opposite of what incentive compensation is supposed to accomplish. This is not just bad for the long-term viability of the corporations; the agency costs involved undermine the credibility of our system of capitalism.

     Therefore, the solution is to re-align the incentives. And that is the job of the corporate boards, especially their compensation committees.

     First, compensation committees should not allow a stock buyback unless the incentive compensation EPS goals are adjusted accordingly. Indeed, this is yet another reason that all stock and option awards should be indexed to the peer group or the market as a whole to prevent just this kind of manipulation.

     Second, compensation committees should require all insiders – executive or director – to hold all of their shares, including exercised options, until three years after the most recent buyback.

     And if they do not, then it is up to the investors, meaning the large institutional investors, to vote against compensation committee members who fail to insist on these provisions, and, if necessary, run their own candidates to replace them.

     Shareholders may need to remind boards of directors that their decisions should be based on what will benefit shareholders over the long term. The key metric is not whether corporate insiders think their stock is a good investment; the key is whether the outside shareholders do.

     The artificial inflation of stock prices via buybacks is by definition a short-term boost and a trick that cannot be endlessly repeated. We have discussed this in detail many times and will continue to raise our concerns. An article in CNBC states:

     Buybacks have gotten a bad rap from both Republican and Democratic lawmakers this year. But the stock market would be trading at a much lower level without them.

     Data compiled by Ned Davis Research shows the S&P 500 would be 19% lower without buybacks. The firm looked at the S&P 500’s performance between the first quarter of 2011 and the first three months of 2019. Then they subtracted the amount of net monthly repurchases to arrive to that conclusion. The broad market is up more than 125% in that time while net buybacks have totaled about $3.5 trillion.

     “Without focusing too much on numbers, we can say that the S&P 500 index would probably be lower today if not for buybacks versus other uses of cash,” Ed Clissold, chief U.S. strategist at Ned Davis Research, wrote in a note last month.

Corporate Reform

Lawyer Michael Peregrine writes in Forbes about how the upcoming political season may raise more issues about the role of corporations than any other in history:

     Progressive oriented politicians – including several who are running for President – are promoting a series of bold, innovative, ambitious and thoroughly controversial policies and legislative proposals intended to recast elements of the economy and address perceived social imbalances.

     These proposals are being injected into the 2020 political campaign and may become “litmus test” issues in individual races. They are also eliciting substantial skepticism from politicians and media on the opposite end of the policy spectrum.

The four areas he highlights are: social/environmental, health care, accountability (“these include legislative proposals for the federalization of large corporations; statutory board diversity quotas, corporate public benefit requirements, and the right of employees to select a portion of a corporation’s board directors”), and income/opportunity equality (which he calls “rebalanced wealth distribution”).

Corporate Political Activity

Lobbying, political contributions and dark money are the key distortion factors in the United States and increasingly in other places as well, such as the Mercer family’s involvement in the Brexit campaign.

Reporting/Remuneration

Proposals to link pay metrics to SASB reporting or other ESG indicators.

“Ideological Diversity”

Conservative groups have submitted a few shareholder proposals to support corporate lobbying expenditures, object to corporate backing of environmental regulation, and promote “ideological diversity” like a proposal at Apple, arguing that its directors do not display “diversity of thought” but instead “operate in ideological hegemony that eschews conservative people, thoughts, and values. This ideological echo chamber can result in groupthink that is the antithesis of diversity. This can be a major risk factor for shareholders.” The proposal received only a 1.7% vote in favor.

Fiduciary Standard

The House of Representatives’ subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing on the SEC’s proposed Regulation Best Interest for broker-dealers, and all but one of the witnesses were opposed, often scathingly critical. “The brokerage business model, with all of these and other perverse incentives, is set up to pit broker against client. These incentives reward bad advice that harms investors. What’s truly shocking is that brokers are allowed to engage in harmful conflicts of interest all while leading investors and policymakers to believe they are trusted financial advisors who will do what’s best for investors,” Dina Isola, investment advisor representative at Ritholtz Wealth Management, said at the hearing. She added that the broker-dealer industry is “caught up in a web of toxic incentives.”

Board Chair/CEO Splits

“The percentage of S&P 500 companies whose chief executives also serve as chairman reached 45.6% in 2018, compared with 48.7% the year before and the lowest percentage in at least a decade, according to data compiled for The Wall Street Journal by ISS Analytics, the data intelligence arm of proxy adviser Institutional Shareholder Services Inc.”

Activism in 2018

Lazard’s review of shareholder activism in 2018 has some striking data. Some of the highlights:

• A record 226 companies were targeted in 2018, as compared to 188 companies in 2017.
• A record 131 investors engaged in activism in 2018, reflecting the continued expansion of activism as a tactic.
• 40 “first timers” launched activist campaigns in 2018, as compared to 23 “first timers” in 2017.
• Activist investors won 161 Board seats in 2018, up 56% from 2017 and 11% higher than the previous record of 145 seats in 2016.