Proxy Wars
Concentration in the investment industry has created many accidental powers. The financial crisis told us all about the power of the monoline credit insurers and the rating agencies. There are also the big three indexing groups (MSCI, S&P Global and the London Stock Exchange’s FTSE Russell) and the big three passive asset managers (BlackRock Inc., State Street Corp. and Vanguard Group). And then there is an increasingly contentious duopoly in proxy advice: Institutional Shareholder Services and Glass Lewis.
Passive managers contend ardently that they are active stewards of the companies that they own, even if they cannot threaten to sell the shares of corporations that misbehave, and they passionately contest any notion to the contrary. For their best publicity gesture so far, look no further than the Fearless Girl statue, moved this week to the New York Stock Exchange and originally designed to publicize State Street’s campaigns to get more women on to corporate boards.
What isn’t in dispute is that the rise of passive investing has given far more importance to the proxy voting process, in which shareholders exert their control without using the sanction of selling the stock. And as running a proxy campaign requires hard work and expenditures on research, this also creates cost issues for managers whose chief appeal is their low price. There are only two proxy advisers of any great size in the US market. Does this therefore mean that these two companies have become accidentally but dangerously powerful, like credit-rating companies before them?
Some recent academic research suggests that they have. The question was serious enough to prompt a hearing by the Senate’s banking committee last week. I strongly recommend reading the prepared testimony, available on the committee’s website, by Michael Garland, who heads corporate engagement for the New York City comptroller, and Thomas Quaadman, of the US Chamber of Commerce’s Center for Capital Markets Competitiveness. The Chamber has long been in a fight with what it regards as ideologically motivated institutional investors, particularly the pension funds run by labor unions. Meanwhile, the pensions funds of New York City, the nation’s third-largest system, are the most active investors in asserting their rights. Twenty years ago, the then New York City comptroller famously used the threat of divestment from Swiss companies to force Swiss banks into making a settlement with the relatives of Holocaust victims whose accounts had been allowed to stay dormant, in one of the most aggressive assertions of shareholder power on record.
So it shouldn’t be surprising that their differences went far beyond a detailed technical argument about proxy voting in a passive-dominated world. At issue is the bedrock controversy within corporate governance: Does the fiduciary responsibility of executives and directors entail a duty to improve shareholder value and nothing else, or does it go further than that?
From the Chamber’s perspective, investors shouldn’t be allowed to bring motions on environmental, social and governance (ESG) topics that can be at odds with corporate performance. These should be left strictly to politicians. This is Quaadman:
Public companies and their shareholders are increasingly targeted through the proxy system and other means over issues that are unrelated to — and sometimes, even 5 at odds with - enhancing long-term performance. Topics that should be reserved for the legislative and executive branches of government — including a variety of social and political issues that may not be directly correlated to the success of the company — are increasingly finding their way into proxy statements and being debated in boardrooms. This has created significant costs for shareholders and in many instances has distracted boards and management from focusing on the best interests of the company.
The man from the comptroller’s office begged to differ. As far as Garland was concerned:
As long-term owners, we expect companies to create long-term, sustainable value. We push them to address a range of environmental, social and governance risks that are fundamental to ensuring long-term profitability. This is part of our fiduciary duty as long-term shareowners. We believe sound corporate governance and sustainable business practices — the latter including responsible labor, human rights and environmental practices — are fundamental to creating and protecting long-term shareowner value and sustainable economies.
In other words, boards and managers shouldn’t assume that their sole responsibility is to raise the return for investors. This is a deep philosophical division. In recent years interest has grown in “universal ownership.” Big institutions control so much of the economy that they must think about the external impacts their companies have; and as investors on behalf of future pensioners, they can try to maximize their members’ chance of having clean air to breathe when they retire. Read through the testimonies and you find references to academic studies showing that investor activism both subtracts value and adds to it, and that concentrating on ESG goals both raises returns and lower them. This is a grand fascinating debate, which must continue.
A further issue is the existence of the listed company. Could corporate-governance issues become so onerous that companies decide that going public isn’t worth the candle? The Chamber suggests that they could. Some of this is outrageous special pleading, in my opinion, but it does contain a kernel of common sense:
Outdated SEC proxy rules have allowed motivated special interests to take advantage of this system to the detriment of Main Street investors and pensioners. The problems we face today have in part stemmed from a lack of proper oversight over proxy advisory firms and a failure to modernize corporate disclosure requirements. Activists have been able to hijack shareholder meetings with proposals concerning pet issues — all to the detriment of the vast majority of America’s investors. The deficiencies within the US proxy system must also be viewed against the backdrop of the sharp decline of public companies over the past two decades. The United States is now home to roughly half the number of public companies than existed in the mid-1990s and the overall number of public listings is little changed from 1983. While the JOBS Act helped arrest that decline, too many companies are deciding that going or staying public is not in their long-term best interest. There is little doubt that the current proxy system — which disadvantages long-term investors and creates serious challenges for companies — has made the public company model less attractive.
I doubt that the risk of a proxy fight over whether to appoint a woman to the board really counts significantly toward the decline of public companies, but corporate governance does matter. Thus the debate gets to the heart of whether shareholder capitalism can work in its modern form. That question is steadily moving from the corporate to the political agenda. For example, there is the proposal by the liberal senator from Massachusetts and likely presidential candidate Elizabeth Warren, who has suggested mandating that employees be represented on boards.
Away from the weightiest issue of the future of capitalism, the problem of regulating proxy advisers remains. Any concentration of power is worrying, and it is far too tempting for a manager trying to reduce costs to shield themselves from any trouble by saying they did whatever ISS told them to do. Just as nobody was ever fired for buying IBM, nobody was ever fired for voting with ISS. And it is necessary to be clear about how these companies should be regulated. The Chamber raises valid issues here. The two big proxy advisers have different regulatory regimes. ISS is registered under the Investment Advisers Act as a fiduciary, while Glass Lewis isn’t. ISS has a consulting business to issuers, while Glass Lewis doesn’t, citing potential conflicts of interest. To quote Quaadman:
We can think of no other area under the securities laws where two dominant market participants in the same industry operate under two completely different sets of rules and standards — with one of those participants choosing not to register with the SEC at all. While commenters will disagree as to the proper regulatory regime for proxy advisers, we think there should be broad agreement that allowing proxy advisory firms to choose their own regulatory model is not the right approach.
This is fair — but it must not be used as a Trojan Horse to force regulations that are utterly unnecessary and benefit only unscrupulous boards. As ISS itself said in a response,
Today’s system is structured so that the integrity of the research and analyses we conduct for investors is protected from undue influence by the companies being analyzed. ISS and its clients believe it is inappropriate to mandate that proxy advisers hand their work over to the management of the companies being analyzed for review and comment before it can be provided to the investor clients whom we serve. Yet this is one of the requirements now being contemplated.
It is also fair to point out that while many investors use ISS and Glass Lewis, they don’t always follow their advice. This survey was cited by Garland, representing New York City’s pension system:
According to Proxy Insight, which analyzes the voting records and policies of over 1,800 global investors and is the world’s leading source of information on global shareowner voting, “the number of investors delegating their entire policy and voting to a proxy voting adviser is actually very low — from a sample of 1,413 investors, 75% have their own dedicated proxy voting policy representing a significant 92% of 4 the assets under management.”
These are important issues to be sweated through at a technical level.
Ultimately, the cramped version of corporate governance and the rights of owners espoused by the Chamber strikes me as untenable. If I own a share in a company, I have a right to try to push it into whatever directions I see fit. This will mostly involve pushing it toward making me more money, but if it involves pushing it toward some good outcome for me that will cost me something in the short term, that is my decision. It might well be a good expenditure of my money.
Further, an extreme focus on shareholder value, with all the negative social consequences it can have, has driven a crisis of confidence in the workings of shareholder capitalism. Thus, making sure that institutions get unbiased advice to help them exert some form of shareholder democracy is ever more important. We can all agree on that. It would be good, therefore, if the issue of regulating proxy advisers could be handled as a technical one, without ideology. I’m not holding my breath.
Bears in a China Shop
Bears have long confidently predicted a Chinese economic crisis. Bulls have equally confidently dismissed the idea — and they have continued to be proved right. But the record of China bulls on the Chinese stock market is much more mixed. Over the years, the domestic Chinese A-share market has given its investors a painfully bumpy ride, with two massive bubbles so far this century. Over the last 20 years, it has barely outperformed US stocks despite China’s far superior economic growth.
Thus, it was interesting to talk this week to Andy Rothman, one of my favorite China bulls. Now on the buy-side with Matthews Asia, he previously spent time on the sell-side with CLSA, and in the public sector representing the US government in China. His confidence concerning the ability of China’s economy to continue its strong, but slowly decelerating growth has proven to be exactly right. And it is maintained. He points out that China’s debt, after “the largest Keynesian stimulus since Keynes, financed by bank loans” to tide through the effects of the 2008 crisis, was all extended at the direction of the state. There is no equivalent of Bear Stearns or Lehman Brothers Holdings Inc., and there is no key player who is subject to the pressures of mark-to-market pricing of debt. Thus, he suggests, there should be no need for a systemic crisis, even if the overhang of debt will help to ensure that growth continues to slow down gradually.
So why, I wanted to know, have Chinese stocks done quite so badly this year? This is how the main indexes have performed, all indexed to the beginning of the year and denominated in dollars. Stocks in the A-share markets of Shanghai and Shenzhen have fared far worse than New York-quoted American Depositary Receipts or “red-chip” stocks quoted in Hong Kong.
Note that A-shares have done far worse than shares quoted outside China. The fault for this, Rothman contends, lies with Donald Trump. (The president need not be unhappy about this). Chinese A-shares markets are driven to a very great extent by local retail investors. The gradual entry of foreign investors hasn’t changed this much, as yet. Chinese “Mom and Pop” investors understandably watch Trump in full flow on television, and decide that they don’t want to leave their life savings in stocks as long as the prospect for a trade war is real.
If Rothman is right about this, and also right that some kind of decent trade deal can be patched together next year, then that implies that a buying opportunity in A-shares could be coming along very soon. If the A-share market continues to behave with the physics of a rubber band, foreign investors might like to try betting that it zooms upwards again. It isn’t a relaxing or safe prospect, but the bulls could easily go charging back into the China shop if an agreement on trade is reached.
(Bloomberg)
