The Forest for the Trees: the corporate governance “Atmospherics” and shareholder activism

Thursday, 13 September 2018

Last week we released a report on action and trends in shareholder activism for FY18.  It’s more narrowly focused than our usual Fishing With Dynamite corporate governance theory musings but if you’re interested in the space the link is here. It does draw out some fascinating thoughts though for the years ahead in corporate governance:

  1. activism is most effective in markets with strong commitment to corporate governance and active regulators (sound familiar?); and
  2. as activism itself as an industry (if you can call it that) matures, perceptions around damaging short termism may need to be revisited.

Shareholder activism and Corporate Governance – awkward but intrinsically linked bedfellows in the new “Atmospherics”

The seemingly relentless march of shareholder activism has really highlighted two learnings for corporate governance connoisseurs:

  1. Shareholder activism is getting more prevalent and more aggressive globally and in Australia.  The well-founded, well-researched and hard hitting activism that you see in the US is very much here now.  This means that corporate governance slip ups are being scoured by third party actors who stand to profit from a board’s misery.  The recent growth in activism from almost a standing start in Europe and Asia is instructive here. 
  2. Shareholder activism is most effective in heavily regulated markets with active regulators and severe punishment (in share price, reputation and regulatory consequences) for any governance failures.  Hello Australia.

Soren Aandahl (famous activist short seller whose Australian targets have been Quintis and BlueSky), has marvelled at Australia as a playing ground for short-selling.

"Australia has a good regulator, it's got solid rule of law, and protections for investors in the market Australia. That's attractive to us. One of the reasons Australia is an attractive market is that Australian investors care about corporate governance. There are markets where if you point out shareholders are being abused, there's no normative condemnation. But Australians care. When you find things that fall short of the standard, you know it's going to matter to people." Soren Aandahl, March, 2017.

Aandahl said that BEFORE these developments in the Australian corporate governance landscape that you may have heard of:

  1. the Royal Commission;
  2. APRA report into the CBA;
  3. BEAR; and
  4. the substantial rewrite of the ASX corporate governance principles (predominantly an expansion, not simply an edit).

We are calling all this the 2018 “Atmospherics”. 

If Aandahl’s theory of what makes a market attractive for an activist was correct before, this is only going to be amplified in 2018/19 and beyond.  Australia already has a continuous disclosure regime that punishes companies for honest mistakes, turns inherently uncertain but good faith forecasts or outlook statements into guarantees (obviating any responsibility on the market to accept risk on reliance or to form its own views on prospects) and market structures which facilitate turbo-charged short selling practices.  This is borne out in the figures: roughly 3.7% of the free float in the ASX 200 is short, higher than the US S&P 500 (2.7%,) Hong Kong Hang Seng (1.8%) and Japan’s Nikkei 225 (2.1%).  Once again, this is only going to increase in the post-“Royal Commission / APRA Report / BEAR”-world where scrutiny on, and nervousness amongst, boards around any perception of poor governance will be enormous.

The widely commented on spike in class actions, with the all-time record number of class action lawsuits (28) filed in the Federal Court last year, is another bell weather for this.  This increase has led to the Australian Law Reform Commission to consider whether (and to what extent) class action proceedings and 3rd party litigation funders should be subject to Commonwealth regulation.  Absent any such further regulation, the class action players will benefit from the Atmospherics as well.  Class action litigation and activists (especially short selling activists and net short debt activists) operate in the same ecosystem where they both benefit from the doom loop of bad publicity, regulatory scrutiny and share price falls. 

Once the dust settles on all of this (and that will take some time) the increasing interventions of activists will be another reason to take stock of the seemingly unrelenting slide of the role of a board from general oversight and leadership to a deeply compliance focused function.

To quote ourselves again:  “Is the director best equipped to deal with prescriptive regulatory requirements likely to also have an amazing entrepreneurial skillset? If you want to bring on a new director to fill a particular gap in your operational capability, what are the chances that person also knows how to monitor the implementation of a compliance framework that stands up to the highest scrutiny.”

That scrutiny is coming from everywhere now, not just regulators but also highly motivated profiteers. 

Shareholder activists – unfairly maligned short termists?

On a happier note, it appears that some activists in the US in particular are starting to have a positive impact on corporate stewardship.   Critics of activist investors traditionally charge them with forcing companies to focus on short-term returns at the cost of long-term value creation.  Many argue that the presence of activists in the market drives short-term behaviour from management of public companies. 

“The bulk of activism just wants a quick hit. They want the stock to go up next week” Warren Buffett, October 2015.

The allegation is that the myopic activist drives an over-emphasis on maximising distributions to shareholders (through dividends or share buy-backs) and distracts management from more important long-term strategic goals.

However, the average shareholding period of activists doesn’t necessarily support this argument any longer.  In the US, major activists, on average, now anecdotally hold positions for a periods of around 5 years, a considerably longer holding period than US mutual funds which, on average, hold shares for under 2 years.  This would suggest that, as a result of the evolution of US shareholder activism, activists now tend to have a financial interest in the success of a target company for a much longer period than many institutional investors.  Activists often also appoint new types of directors to the Board with exceptional skills in whatever the activist feels has been lacking, which has had the effect of adding real value.  So all up activism is going to grow in Australia, that is unavoidable, but if this longer term investment trend bears out in the Australian market, calls for boards to listen to their proposals may grow louder.

If the long-term value proposition of shareholder activism is proved up in Australia, perhaps critics will turn their attention back to more macro drivers of corporate short-term behaviour.  Rod Sims (the Chair of the ACCC) recently did just that, calling out a range of incentives that drive company behaviour, including: executive remuneration regimes, the absence of safeguards for management practices and a corporate culture to pursue profit at all costs.   All of this will be looked at as part of digesting the 2018 Atmospherics and how companies should respond.  It’s interesting to think that activists might actually add their weight to longer term focused reform.

POST SCRIPT: This really is an amazing time in corporate governance in Australia.  When we started this little ad hoc blog there wasn’t much mainstream media interest in corporate governance theory (understandably) – now there’s something new about it every day, from political or regulator pronouncements to industry body reports and corporate sector reactions and backlashes to those reactions.  The Atmospherics are captivating everyone’s attention.  Fascinating times and lots of grist for the mill!  And on that – one note on the brouhaha about “Social Licence” and the new corporate governance principles.  Our two cents is – it’s a worthy idea even though it’s tricky with our corporate law as it stands.  As we said back in April vis a vis this very issue and shareholder activism:

In Australia, directors must act in good faith in the best interests of the company as a whole.  Practice suggests that this is just the interests of existing shareholders (ie, the “Shareholder Primacy” view of the world).  …..

Former High Court Justice, Dyson Heydon, provided the High Distinction response in 1987.  In comparing Australia’s legal framework to the US’ he noted:

“Our law [Australia’s] perhaps goes less far than American in permitting consideration of such abstract matters as the national economic interest, the wishes of the government or the advancement of the environment.  But if those matters had a link with the interests of the company they could be considered.”

Building on this, in a 2016 legal opinion, Mr Noel Hutley SC argued that today, directors can, and indeed should, consider climate change risks – to the extent that those risks intersect with the interests of the company.  This qualification is where it starts to seem a bit theoretical to us.  As Hutley himself points out, merely listing the links in the chain of causation reveals the difficulty with relying on this approach: a corporation takes a particular course of action, this specifically impacts the environment (perhaps contributing to a stronger La Nina pattern), the resulting climate change detrimentally and demonstrably affects the corporation’s interests – all in the investment lifetime of its shareholders?  It seems like it would be hard to prove such a proposition in the face of hostile activist shareholders arguing based on simple evidence that say paying higher prices for more sustainable inputs hurt the bottom line in the here-and-now.

Those black letter law legal difficulties being said, taking into account a wider set of interests is clearly the right aspiration.  And given that, the proposed language in the Corporate Governance Principles shouldn’t be controversial - isn’t the point of non-binding best practice guidance to go beyond bare-boned compliance?  If governance principles just recited the law we wouldn’t need them – we already have a document that sets out the law: the Corporations Act.  Directors should not be required to pursue social matters at the expense of shareholder value – but nor is the proposed principle asking them to.  What it is saying is that, in this day and age, best practice corporate governance requires a broad perspective.  Business around the world is grappling with a loss of trust so some response seems perfectly sensible.  

If people worry about the way the role of a director is changing (and they should) then worry about constantly enlarging hard law and regulatory action, not to mention Australia’s devilish cocktail of severe continuous disclosure rules and a rampant and opportunistic class action litigation ecosystem.

Australian directors already faced this reality before politicians and regulators felt pressured to introduce even more regulation to reform a regime that, despite its strictures, was, in the eyes of the broader community, seen as inadequate.

In the face of all this change, if companies are being encouraged (in a non-binding way) to take a broader set of interests into account, that should be the least of their worries.  It will probably be a good business decision to boot. 

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