When Shareholder Groups Complain, Management Would Do Well to ListenPublished: March 28, 2001 in Knowledge@Wharton
It doesn’t take a scientific survey to know there are lots of unhappy stockholders in America this spring – plunging share prices tell you that. Now, with the annual-meeting season getting underway, shareholders will have a chance to complain to management face-to-face. Voting on proxies, they can even try to change directors and alter corporate policies.
These days, however, shareholders don’t have to wait for the annual meeting to vent their frustrations. Many, especially the big institutional shareholders like pension funds, are working year-round to get companies to adopt better business strategies.
But is shareholder activism really an effective way to boost stock performance?
There is no foolproof formula shareholders can use to assure better returns, of course. But shareholder pressures on management have paid off frequently enough to encourage more and more attempts not only to boost profits but to press social, environmental and other non-monetary agendas.
"If this power of investors is used effectively, it is without question good for the companies, good for the employees and good for investors," says Wharton management professor Michael Useem, director of the Center for Leadership and Change Management and author of a 1996 book entitled Investor Capitalism: How Money Managers Are Changing the Face of Corporate America.
Some shareholders have always sought to influence the management of public companies – shareholders are, after all, the owners. But activism became more intense in the 1980s and 1990s, and many who have studied it believe corporate managers have been forced to become more responsive to shareholder pressures, not just in well-publicized showdowns at annual meetings but in quiet negotiations behind the scenes.
Useem said shareholder groups rarely succeed with so-called gadfly motions focusing on things like pollution clean-up, improved union relations, canceling business with undesirable nations or granting benefits to same-sex partners. But he says shareholder groups have had some success on corporate governance matters like eliminating staggered terms for directors – the "classified boards" these groups see as devices for protecting poor-performing managers.
Annual studies by the Investor Responsibility Research Center have shown gradual progress on some issues shareholder groups hold dear. Outside directors rather than company executives now dominate boards of directors and the key committees that set executives’ pay. And there has been a steady rise in the use of stock options to compensate executives and directors, linking their interests to the interests of shareholders.
While activists rarely get majority votes on such issues at annual meetings, companies often agree to changes to avoid the embarrassment of public challenges that win substantial blocks of votes, Useem said. Even a 5% to 7% vote for a measure opposed by management may be seen as a public humiliation.
While activism in the first part of the 20th century was primarily aimed at improving shareholder returns, a 1970 ruling by the U.S. Court of Appeals in the District of Columbia opened the door for activists to demand that social issues be put to shareholder votes. That ruling arose from an effort to get Dow Chemical to limit napalm sales.
Activists became more influential after a 1993 SEC ruling that made it much easier for shareholders to act in unison, a change sought by major shareholder groups. Previously, shareholders faced regulatory hurdles, including the need for SEC approval to work in concert.
Another key factor in the rise of activism is the growing role of professional money managers. In 1980, only about 25% of U.S. stock was controlled by pensions, insurance companies, mutual funds and other "institutions." Today the figure is around 60%, largely because of the rise of mutual funds. Professional money managers know how to exert pressure, and they control enough votes to get companies’ attention.
"With that kind of concentration of economic resources, these guys are looking out there and seeing some big under-performers and saying to themselves, I bought this stock high and now it’s low. I can sell and lick my wounds or I can call the board and say, ‘Get that manager out of there!’" Useem said.
"Given their increasing dominance in the equity markets, it is perhaps not surprising that institutions have become more active in their role as shareholders," writes Stuart L. Gillan of the SEC’s Office of Economic Analysis, and Laura T. Starks, finance professor at the University of Texas.
In their 1998 study, A Survey of Shareholder Activism: Motivation and Empirical Evidence, they trace the current style of institutional activism to January 1985 when California State Treasurer Jesse Unruh founded the Council of Institutional Investors. The organization was formed to lobby for investor rights after a greenmailing case in which Texaco paid the Bass brothers of Texas $137 million. In the following years, the CII and its members, together and individually, started submitting proxy proposals aimed at changing the way targeted companies were governed.
Today CII is the most prominent shareholder group, representing 110 pension funds controlling about $1 trillion in assets. The organization still focuses on governance issues, opposing companies’ "poison pill" anti-takeover measures, pressuring to have all of a company’s directors face election at the same time and demanding that boards and their executive compensation and nominating committees be dominated by outsiders rather than company executives.
Also influential are the California Public Employees’ Retirement System, the State of Wisconsin Investment Board and the Teamster Affiliates Pension Plan. Some other organizations take less direct approaches. The Investor Responsibility Research Center, for instance, provides surveys and other services to money managers and other shareholders but does not take positions on specific issues.
Big mutual fund companies such as Vanguard and Fidelity exert powerful pressures on under-performing companies, but do it very quietly, Useem said. "The most active movers and shakers have been the public pension funds. They put out their lists of bottom dwellers," he added, referring to companies with disappointing stocks.
Each year the CII publicizes a "Focus List" of 20 to 30 companies whose returns have most seriously fallen behind their industry averages. Landing on the list earns a company special attention from CII and its members – proxy initiatives to change corporate practices, votes for competing slates of directors, public embarrassment, demands that top executives be removed.
"These lists are not good to be on," said Useem. "CII and other groups are using pressure by mortification. You seek to embarrass, to humiliate the company for being a bottom dweller."
In the 1990s, CII has put less emphasis on presenting issues for shareholder votes and more emphasis on negotiating with a company’s executives and directors – an approach sometimes called "relationship investing". Of course, harsher measures wait in reserve, giving executives good reason to compromise.
Does this work?
Yes, according to a 1995 study done for CII by Tim C. Opler of the Max M. Fisher College of Business at Ohio State University and Jonathan Sokobin of the Edwin L. Cox School of Business at Southern Methodist University. The study looked at 96 companies on CII focus lists from 1991 through 1993. It found that in the year after being placed on the list the average company’s share price rose 21%, compared to 9.5% for the market benchmark, the Standard & Poor’s 500. The study concluded that this market-beating return earned investors $39.7 billion more than they would have made by investing in the S&P 500.
To make sure this superior performance was caused by CII pressures rather than other factors, Opler and Sokobin also looked at several control groups. This included similar companies that had performed about the same as the focus-list group before the targeted companies were put on the list. These comparable groups did not rebound to the extent the targeted companies did, reinforcing the conclusion that shareholder activism had indeed pushed through change at the targeted companies.
Tallying the types of management moves the 96 companies made to improve performance, the researchers found that 29 instituted layoffs, 29 sold parts of the business, 24 cut costs and 20 made acquisitions. In addition, eight changed chief executive officers and 14 made other top management changes.
"The results are broadly consistent with the view that coordinated institutional governance activism is effective," the researchers conclude. Many firms on the focus list, they note, were subject to CII lobbying and negotiation rather than proxy battles. "It might very well be that management teams are most responsive to activism efforts which are private and done in the context of a long-term relationship," they write.
There is no way to be certain that the results were not due to some other influence, such as a fairly common rebound after a slump. Indeed, value investing is based on historical evidence this happens.
But Useem believes landing on a focus list does spur a company to change. "There’s a prima face case that to be targeted by these big guys really does put some starch into everybody’s shirt."