The D&O Diary was in Palo Alto, California this week for the annual Directors’ College at the Stanford Law School (depicted to the left). The keynote speaker on Tuesday morning was SEC Commissioner Daniel M. Gallagher, who recently announced that he will be stepping down from the Commission when his successor has been confirmed. As was the case with many of the panels at the conference, the focus of Gallagher’s speech was on the questions and concerns involving activist shareholders. The text of Gallagher’s June 23, 2015 speech can be found here.
Gallagher began his speech by rhetorically posing the question of whether shareholder activism is good or bad, a question that he contends is all too often answered based on a “binary view of the world” in which shareholder activism is viewed either as all good or all bad. For Gallagher, this view “is convenient, but it is also far too simplistic.” The question that needs to be answered in determining whether a specific instance of shareholder activism is either good or bad is whether or not it is aimed at creating long-term shareholder wealth and whether or not that effort is successful.
As for whether or not the SEC should be in the business of determining which activism is good and which is not, he said that “it doesn’t, and shouldn’t.” It is the SEC’s role to “create a level playing field, chiefly through disclosure”; it is up to the states to determine the substantive rights of shareholders. As for the SEC, while it has been a faithful groundskeeper over the years, the prudent division of responsibilities between the agency and the states has been eroded over the years as a result of marketplace changes and due to “our own overzealous implementation of legislative enactments.”
Shareholder activism is one of the areas where Gallagher sees the balance of responsibilities as having changed. In discussing this topic, Gallagher drew a distinction between shareholder proposal activism and hedge fund activism. With respect to shareholder proposal activism, Gallagher asserted that the current SEC process for administering the process is broken, both for shareholder activists and for the companies that they target. Specifically, Gallagher said, “the SEC’s shareholder proposal rule, Rule 14a-8, is being abused by special interest groups to advance idiosyncratic goals that may directly conflict with the interests of most shareholders.”
Gallagher would prefer to see the SEC get out of the business of policing shareholder proposals, and leave the entire issue to the respective states under their governing corporate laws. In the interim, which awaiting these types of changes, he would like to see the current Commission “no action” letter process, which is administered at the staff level, to be “jettisoned” and converted into a process involving Commission advisory opinions, in which the Commission itself would issue opinions on major policy issues. The buck, Gallagher said, should stop with the political appointees at the Commission.
Hedge fund activism, by contrast to shareholder proposal activism, Gallagher said, is at least driven by profit motivation, but “the key question here is whether activist hedge funds drive long-term value creation, or whether short-term gains to activism are at the expense of long-term corporate growth.” Gallagher noted the debate within the academic and legal communities about the value of shareholder activism but expressed his doubt that answers to the value of activism can be found in econometrics.
The SEC’s role with respect to activist investors begins with its administration of the Section 13 reporting obligations that are triggered when an investor’s ownership share exceeds the 5% threshold. Gallagher observed that in the current trading environment an activist investor can quickly accumulate a 5% stake in a particular company, often using trading mechanisms and ownership structures. However, even with a 5% stake, 95% of the ownership remains elsewhere and the activists are still subject to the requirements of the other investors.
The question then, according to Gallagher, is “how the other investors are conducting themselves vis-à-vis activists, and whether the SEC has done enough to ensure the integrity of this process.” In particular, Gallagher noted, institutional investors could make or break activist interventions, but they “paying insufficient attention to their fiduciary obligations to their clients when they determine whether to support a particular activist’s activity.” All too often the funds are simply deferring to the proxy advisory firms. The states and SEC are not doing enough to police the funds. The funds are “fiduciaries, they are in the markets we oversee, dealing with SEC registrants, and they should be held accountable for their activities.”
Gallagher said that better policing of advisors and funds is “hard, and it is controversial, ” but it “falls to the SEC and the states to figure out how to empower the individuals and give them the information they need to hold their advisers to account, and to take action against the institutional scofflaws.”
Gallagher then turned to the topic of proxy advisory firms. He said that too many institutional investors simply rely on the proxy advisory firms. He said that the proxy advisory firms have done too little to address concerns about their sometimes shoddy research. The proxy advisory firms’ lack of progress could and probably should result in further action on the SEC’s part.
He then turned to corporate boards and management, which obviously have a critical role in the activist debate. In discussing the role of boards and management, Gallagher observed that there are two models of shareholder involvement, the first of which is based on a model of pure democracy in which the corporation is directly controlled by shareholder voting, by contrast to the republic model in which the shareholders elect the directors and the directors control the company. Which of these two models is to be preferred is a matter of state law. Gallagher said that the SEC action increasingly has disrespected that distinction and has become biased toward direct shareholder democracy. Gallagher said the SEC’s rules should be flexible enough to accommodate both approaches.
The pressure toward more shareholder democracy comes when boards are perceived as falling short. There may be, Gallagher noted, company boards that have become stale or too chummy with management, but a vigorous board that drives change “moots” the need for direct shareholder democracy. Boards that are out in front and engaged with shareholders by “communicating your company’s strategy and how the board is overseeing management’s execution of that strategy to investors, and in turn hearing what’s on your investors’ minds, can help demonstrate to the SEC that boards are a tool for investor protection, not an impediment to it.” This approach can also allow companies to get out in front of activist investors.
All of these constituencies can coexist on a level playing field, with activists putting pressure on companies that fall short. The problem, Gallagher said, is that the activist campaigns can involve short-term goals rather than a long-term focus. In the current low interest rate environment, activism has become popular, motivated by the desire for returns. In this environment, investors become focused on the short term, and so too are managers as they seek to stave off activists. The SEC, Gallagher said, has played a role, as its corporate governance rules are contributors to the short-termism. There is, Gallagher says, “enough blame to go around.”
Gallagher said that the pendulum may have started to shift as a bi-partisan view is emerging that the pervasive short-termism is destructive of long-term shareholder value. But as of yet there are no bi-partisan consensus on what to do about it. There are a number of ideas and proposals circulating. Gallagher referred approvingly to the proposals of Harvard Law School Professor Guhan Subramanian in his March 2015 Harvard Business Review article “Corporate Governance 2.0” (here), in which Subramanian suggested that using principles drawn from basic negotiation theory that concerned parties should engage in a process to re-conceptualize overall corporate governance, to develop an alternative to the activists’ incremental approach to corporate change.
Gallagher said that he hoped that the SEC “give life” to Professor Subramanian’s proposal and host a roundtable “where representatives from interested groups can sit down and try out this approach.” The agency is uniquely situated to provide a neutral forum could lead to the outline of a consensus. He noted that while it is this type of roundtable meeting unlikely to take place before his departure as Commissioner he hoped that his colleagues will “take up this banner and run with it if they so choose.”
I am grateful to have had the opportunity while at the conference to participate on a panel on the topic of Indemnification and D&O Insurance, with my good friends Priya Cherian Huskins of Woodruff-Sawyer and Jim Kramer of the Orrick law firm, as pictured below.
The conference overall was great. It is always interesting to hearing the perspective and questions of the directors themselves. Congratulations to Stanford Law Professors Joseph Grundfest and Joe Siciliano and to the Directors’ College staff for another successful conference.
Stanford University is so beautiful, it is a pleasure just to be there (note the circle of students enjoying the tree shade):
At Dinner in Palo Alto with my good friends Winnie Van (ABD) and Mike Hoy (Socius):
Scenes from Glen Canyon Park, San Francisco:
A view of the San Francisco Skyline, from Billy Goat Hill in Glen Park, San Francisco: