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Modern Capitalism and an Ownership Vacuum
June 2003 marked the 160th anniversary of “The Economist”, a weekly publication of usually thoughtful comment. In the 28th June issue the Editors reflected on the state of Capitalism and Democracy, a sort of a State of the Nation address from leading journalists and commentators. A number of trends were observed and the purpose of this article is to comment further on the “Ownership Vacuum” and what is to be done about it, if anything, and if its existence is important in any event. This article is not intended to be a detailed analysis and to the extent that examples and information are cited it will be anecdotal. Naturally as the author is a New Zealander and it is issued with the endorsement of The New Zealand Shareholders' Association Inc., the focus is on New Zealand markets and companies.
1. And who are the owners anyway?
It is generally accepted that a company is owned by its shareholders, however modern capital markets and the sheer size of corporate business has distorted the concept of ownership. One of the consequences of this is the rise of Stakeholder theories suggesting that corporates are accountable to the wider community, including employees, customers, suppliers, environmentalists, governments, shareholders and bankers. With all of these interested parties and their inevitable conflicting interests Financial Statements have lost their relevance to many as they seek to appeal to all. Out of this has risen Triple bottom line reporting . As a result some managers have become confused about whom they are accountable to if anybody.
It should be clear to all that if anybody owns a corporate entity it is the shareholders. This should end the debate on Stakeholder theory v Shareholder value, as management is accountable to owners, if anyone.. It of course goes without saying that a polluting business that hurts consumers and workers and mistreats suppliers won’t be around long enough to create shareholder value.
2. What are owners supposed to do?
In order to identify whether a vacuum exists we need to examine the role of ownership. It is almost impossible to define the role of modern shareholders in any meaningful way as most shareholders have become so distanced from the business activity of the companies as to almost be out of sight out of mind. Even analyzing the role of a major shareholder won’t get us to the answer as often the major shareholder is in competition with other shareholders to extract value for themselves. The most recent examples include GPG’s attempt to obtain preferential treatment from Tower by way of a share placement, and Rubicon’s attempt to obtain a premium over other shareholders to exit their stake in Fletcher Forests.
Prior to the emergence of the modern corporation, companies were relatively closely held, and shareholders took a direct interest in the business affairs of the company and were relatively hands on in adding value to the companies in which they invested. As companies grew and the number of shareholders increased this role was delegated to a Board of Directors elected by the shareholders. Boards were the shareholders' representatives and often major shareholders as well. Still shareholders took an interest in the businesses in which they invested attending meetings and vocally debating strategy and even business tactics with company Boards. While clearly nostalgic in a modern world it is the clearest definition of the role of ownership available.
In large corporates and modern capital markets the role of shareholders has been fully alienated to Boards who bridge the gap between owners and managers. The ultimate owner’s role has now been limited to:
- Voting on the appointment of directors.
- Voting on Directors’ remuneration.
- Appointing the Auditors and voting on the method by which they get paid.
- Voting on changes to the company’s Constitution, its contract with shareholders.
- Voting on major transactions, takeovers, capital reconstructions and limited other matters that may be prescribed by the Companies Act 1993, the company’s own Constitution, the Listing Rules, the Takeovers code or Securities Law.
- The most controversial of these is usually CEO pay when it exceeds the definition of material transaction in the Listing Rules.
- Attending and speaking at company general meetings.
- Questioning company management under the Companies Act 1993, and raising general shareholder business under the Company’s Constitution.
3. Is there an Ownership Vacuum?
The key role of ownership in modern capitalism is to vote on issues that are the prerogative of owners, to question management and to raise business at general meetings on notice.
3.1 Shareholder business on Notice:
Over the last four years across all public companies listed on the exchange there have been only 11 items of business raised:
Restaurant Brands: Private shareholder, retirement allowances to directors, successfully passed.
Restaurant Brands: private shareholder, franchise fee discussion move twice, withdrawn once and defeated on second attempt.
Contact Energy: private shareholder, retirement allowances, defeated.
Contact Energy: institutional shareholder, related party transactions, defeated.
CDL Hotels: NZSA, Directors' incentive remuneration, defeated.
Telecom: NZSA, Incentive fees for directors, retirement allowances, executive pay, and option programs, all defeated.
Auckland Airport, pressure group, environmental issues, defeated.
Only one item was passed and it was a fluke according to the Chairman, and only got passed because major shareholders did not vote, and the Chairman voted undirected proxies in line with the votes cast from the floor. All the rest defeated, and none were recommended by the relevant Boards. Major shareholders have only initiated one issue, the private shareholder concerned was the same in each instance and the remainder (5) were all initiated by the NZSA.
It could be that shareholders are entirely happy with the performance of corporate NZ, or alternatively shareholders in this regard are not doing their job and there is clear evidence of a void.
Retail ownership of the NZ market is low by international standards, so it is clear that shareholders are not happy with the performance of Corporate NZ.
3.2 AGM Questions:
AGM’s are not well attended. 250 shareholders attended Tower's recent EGM out of 117,000 shareholders. Those that attended asked the hard questions but generally did not get answers. At Telecom’s AGM in 2002, questions included, why the Wellington region’s telephone book was not in alphabetical order, and why did the company not give all male shareholders a tie pin and the women a broach to promote the company. While these questions were clearly important to those who asked them, it is symptomatic of the calibre of questioning by business owners. To the extent that shareholders speak at such meetings it is to clearly express pleasure or pain, more of a commentary on the company and the questioner, than the serious issues facing the company.
So I submit there is clear evidence of a vacuum in this regard also.
3.3 Voting.
Shareholder turnouts in person or by postal vote or proxy make local body elections look well supported.
At the last Telecom meeting 120m shares voted out of nearly 2b. At Tower's EGM, arguably an important meeting, 61m shares voted out of 179m, a good turnout. If however you take out the major shareholders (42m), only 14% of all other shareholders voted, and this was a high turnout of small shareholders. At the Fletcher Forests EGM, to approve the purchase of the CNIF forest estate, less than a third of shareholders voted.
Owners no longer vote, and often this includes the large shareholders who manage other people's money.
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- On all scores there is clearly an ownership vacuum.
4. There is a vacuum, so what!
There are a number of consequences of shareholders not accepting the responsibility of ownership.
New and unproductive industry created.
The first and most obvious is the whole debate over Corporate Governance protocols. Do you accept Black Letter Laws and regulation or flexible rules that allow Boards to customize their arrangements to their business? Historically NZ has taken the latter approach and is of late falling to the wave of international pressure to go for codification on all matters of Governance. This whole debate would not be necessary if shareholders accepted the responsibility of ownership and provided the necessary tension in the relationship between owners and management. If shareholders were acting as a check on management largess, rules would not be required to regulate management.
Most boards do not favour law and regulations but then equally they are loath to self regulate in any meaningful way either.
The end outcome of shareholders not doing their job and managers taking advantage of the void created is Black Letter laws seeking to regulate every conceivable situation. The end result of this is increased compliance costs, reduced performance and reduced shareholder value as a consequence.
Further, boards then seek to cover themselves by engaging governance consultants and lawyers at the shareholders' expense to protect themselves from breaches of the new laws. The consequence of this is that the Law profession makes more money selling advice to boards on how to manage their way through the morass of law created by well meaning legislators.
Then dubious boards engage lawyers at the shareholders' expense to work around the laws designed to protect shareholders and a whole new unproductive industry is created.
Finally, some boards are tempted to opinion shop to obtain advice to support whatever outcome they wish whether or not shareholders judge this to be in their interests. An example of this occurred when Tower obtained advice that they could pay their Directors fees from subsidiaries without shareholder approval and without traversing the Listing Rules. Tower was wrong, and the Stock Exchange took into account in Tower’s defence that they took advice and as a result failed to impose any penalty. While they did not have to opinion shop for this advice the outcome is that the advice sanctified the theft of shareholder funds.
No pain no gain, wealth destruction.
The less direct consequence is that when the natural tension that should exist between master and servant is eliminated, the servant becomes the master and becomes a master with absolute power. The end result of absolute power is absolute corruption at worst and ineptitude at best. In the USA they have suffered both. While there is no direct evidence of excessively sharp practice in NZ, or for that matter excessive largess in salaries, or super and mega options, there is reasonable evidence that the returns from business are declining over time. Whether the reducing business profits are a result of the economic cycle, increasing competition or lazy management is debatable. It is fair to say that when profits decline management is quick to blame the business cycle or external events for the company’s misfortune. I thought management were engaged to manage these things, such utterings are not reasons they are excuses. How can management get away with dressing up excuses as reason? Because they know that owners don’t vote and make them accountable, and will accept less than optimal performance.
Less than optimal performance then distorts investment capital allocations and reduces the efficiencies of capital markets. This ultimately costs the entire community through job losses, compressed salary and wages; trade opportunities mismanaged, and lower government taxes.
Negative feedback loop and confidence collapse.
Once shareholders are disconnected from the management of the businesses in which they invest, and confidence is shaken in the integrity of the management or even the financial markets in general, investors abandon the market in favour of other investments. This is best seen in NZ in the robustness of the property and bond markets. As a result companies have increasing difficulty in raising equity, and rights issues end up under subscribed. As a result the cost of capital rises and business investment is not only distorted, but becomes increasingly difficult to fund at any price. Investment opportunities are then lost, and the economy in general slows to everyone’s cost. There is little doubt that there is a relationship between the efficiency and strength of capital markets and the strength of an economy's performance. The ownership vacuum is contributing to this negative feedback loop.
5. Why has this happened?
Firstly the scale of modern business has ensured that capital has been spread widely and owners have become a fractionated interest group; Not dissimilar to the state of labour 100 years ago. Non unionized and divided. With ownership spread widely, individual owners pursue their own interests and defining common interest is impossible. Corporations, once a legal fiction now have a life of their own independent entirely of the owners' individual and diverse interests. Owners have, as a consequence, become deal takers not deal makers, excluding of course major shareholders who pursue the optimization of their own utility.
Secondly, management’s relationship with owners has become disassociated from the legal relationship. Management have come to regard the providers of equity as cheap limited recourse dumb bankers, rather than masters and for a considerable period of time have treated them as such.
Thirdly shareholders have ceased to function as owners and have begun to behave like term deposit holders or speculators. Or in the words of The Economist, “punters not proprietors”.
The first is structural and short of unionizing capital, which is both undesirable and unachievable, can not be fixed. The second two matters require some examination.
5.1 Management’s attitude to capital.
The interface between a modern company and its owners occurs in three ways:
- The Annual report and various other compulsory announcements and documents.
- The Annual meeting.
- Direct one on one interface between meetings and reports.
5.1.1 The Annual Report.
This document has been captured by the accountants and auditors and has been translated though various accounting standards into an increasingly incomprehensible document. If owners are to behave like business owners rather than promissory note holders matters that are important to business owners should be included in the annual report in a clear and concise manner:
- What is the business activity of the Company?
- What is its reason to exist and what is its strategy?
- What is the company’s competitive advantage and how is it maintained.
- Who runs the company and what is their track record.
- What are the driving business principles or ethics of management?
- What are the underlying economic results of the enterprise, perhaps EVA or even just VA.
- What are the risks attached to the business?
- What is management’s view of the business prospects?
- What problems have management encountered in running the business and how have they dealt with them?
Sure with a lot of hard work some of these questions can be answered and they are all fundamental to buying a business run by people you trust.
5.1.2 Shareholders' meetings.
The conduct of shareholders' meetings has become a process of disenfranchisement.
It is a common misconception that Boards are elected by shareholders.
Firstly there is virtually never a contest for board representation.
Secondly if a shareholder wanted to nominate a person for the board, they would need to know when the AGM was going to be held and count back 2 months. The Board can however call a meeting on 14 days' notice. It is therefore easy for shareholders to miss the boat. Even GPG, a seasoned shareholder, wasn’t able to get the timing right and only ended up getting its representatives appointed to the Tower board through the processes available for filling casual vacancies after, of course, they pressured the Tower Board into creating a couple.
Finally boards perpetuate themselves through a selection process controlled by the Board's chairman and a nomination committee, with shareholders only getting to ratify the process.
Ralph Nader summed it up: “The election of corporate board members is a Kremlin type election. It’s a self perpetuating system with the shareholders having no real power.” Time August 5th 2002
Shareholders appoint auditors and auditors are accountable to shareholders, is another one of those legal fictions.
The position of Auditor is never contested. In any event there are only four of them left. Management appoint, dismiss and pay auditors. The following quotes demonstrate the problem:
Sir Ron Brierley Email to NZSA 14th June 2003:
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- “I have long been dissatisfied with the performance of PWC and after the 2002 Audit, the board of GPG finally decided to make a new appointment.
- Personally, I have no faith in Auditors generally but obviously, some firms are more competent and responsive than others. We therefore hope that D &T will prove to be in a different category to PWC.”
D & T letter to NZSA 17th December 2002:
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- “In view of our specific responsibilities as auditors, it is our policy not to respond to requests from individual shareholders or third parties and to refer them directly to the Client Company."
·And finally there is the conduct of the meeting itself.
Usually the Chairman proceeds immediately to a poll on all matters even when the matter might have been decided by a show of hands of those present in a manner consistent with the poll data available to the board before the meeting. Why disenfranchise those that attended for no purpose?
The chairman will usually advise the meeting of the number of proxies held by the chair, and sometimes will even advise the meeting of the results of the directed proxy voting. In the case of the Tower EGM recently, a total of approximately 62m votes were cast, approximately 500k of those were on the floor, 500k were undirected proxies held by the chairman and the NZSA held 600k undirected proxies. Many shareholders react to the announcement of the board's proxies with resignation and accept that the only reason they are at the meeting is to enjoy the tea and buns, as with the weight of proxies held by the chair the result is already determined. Tower’s situation is not uncommon and the numbers support retail shareholder dismay.
While most chairmen will allow free and open discussion it is not universal. Some chairmen only allow one question per questioner, and do not allow the answers to be cross-examined by the questioner. Others allow a free discussion to occur. Chairmen generally respect shareholders' rights publicly, however sometimes even good chairmen fall into the trap of demeaning shareholders. At the 2002 AGM of Auckland Airport the chairman described Greenpeace as a “small and recent shareholder” as if size or timing made some difference to a shareholder's rights. The Chairman of Contact Energy at its 2002 AGM, in response to questioning from a major Institutional shareholders said words to the effect that if he felt it was in the company’s best interests he would bend the rules to fit whatever needed to be done. It is these attitudes that demean the relationship of shareholders with management.
The process by which boards self perpetuate, the sacking of auditors by management and demeaning comments fuel the view that directors are no longer the representatives of shareholders but rather the prisoners of management.
·Most chairmen will not allow shareholders to bring up even procedural business or minor amendments from the floor of the meeting. In some instances even acceptable motions are ruled out of order or just mishandled. For example it is always acceptable to raise a notion of no confidence at any meeting, and if it is passed it is no more than embarrassment, but it is still a valid resolution. It is of course always the chairman’s prerogative to call a poll; but then to rule that because it isn’t on the pre printed ballot paper, a poll can’t be held, so the resolution can’t be put is absolute nonsense.
And finally when a poll is held, the board then has the ability to alter the outcome of the shareholders' vote through the voting of undirected proxies. The effect of these is significant and can often be the difference between a resolution being passed and lost. In effect through the use of undirected proxies boards obtain the ability to appoint auditors, and themselves and at the same time determine how much they should be paid. They also get the opportunity with one hat to put matters to shareholders and then vote on the issue with other people's votes, undoing the basic internal control of managers propose and shareholders ratify, in respect of material transactions. In the case of Fletcher Forests they even get to do this with stock that hasn’t directly given them a proxy through that company’s ADR arrangements.
In essence an undirected proxy is an abstention, or a vote of confidence depending on your view. While a case can be made for a vote of confidence on some issues it should not extend to issues of self-interest. The existence of this opportunity for management is however a large contributor to shareholder disenfranchisement and the resultant ownership vacuum.
5.1.3 Relationship with shareholders between meetings.
·Many companies provide private briefings, sometimes through brokers to major shareholders and frequently though private meetings. If you are a small shareholder you have to wonder what is said at these meetings that could not be said to all shareholders directly or through market announcements. You begin to wonder what trading advantage these major shareholders have over the uninformed shareholder. Perversely managed funds and financial planners use as part of the selling pitch the availability of such contact with companies. They argue that fund managers are in a better position than retail investors to obtain, assess and act on information. It is almost an admission of industry wide insider trading. I guess you can argue that if it is industry wide there are no longer any insiders, but certainly some become outsiders.
Not all companies have a website, and those that do don’t always keep it up to date or even include relevant information to shareholders.
·Most companies do not have a dedicated senior officer to deal with investor inquires. This would be fine if the CEO or Chairman took calls from shareholders, but this is also unusual.
·Generally all written correspondence between companies and shareholders is dealt with appropriately but not always with the focus from the respondent of “I am dealing with a company owner”. Arrogance in replies is too common.
5.2 Shareholders Attitude to Shares and Business.
With investment becoming increasingly risky, and with the emergence of “Agency Risk” as it is defined in modern finance theory, investors became increasingly nervous and academics have played on this nervousness by developing a number of theorems to explain market conditions, and risk. The end outcome was the complication of investment activity through the provision of endless and often meaningless options and strategies with the objective being to improve the risk/return profile of investment activity. This process effectively disenfranchised many retail investors by further eroding confidence that they could understand the capital markets or investment at all and as a result many opted to pay others to manage their money for them.
Over the last 40 years Modern Finance theory has developed a number of theorems, all based on sound mathematical analysis, and designed to explain or manage human behaviour. Interesting that a hard science like math’s thought it could explain human emotions, a soft science, that is all a market is. Any mass market, like a sharemarket, is a daily trade in human emotions, yet theories such as the following evolved:
·Efficient market theory: Capital markets efficiently price the risk of any enterprise real time. Clearly this in not true real time and is even contestable over the long term. It is assumed that there are a lot of buyers and sellers pricing the risk, all the time, with full information. Even if this was true the assessment of that information requires subjective judgments but if a market is liquid enough extremes are dealt with. Very few markets are liquid enough to eliminate human emotion.
Warren Buffett On efficient markets:
“I’d be a bum on the street with a tin cup if the markets were always efficient” 3rd April 1995.
·Capital Assets pricing model and weighted average cost of capital: In assuming markets are efficient, that the volatility of share prices over time has some correlation with the intrinsic risk of the business, which in turn determines its cost of capital. Share price movements have an impact on the risk of the shareholder depending on the shareholder's time horizon but has got nothing to do with the underlying business and its risk profile.
Portfolio theory: A little bit of a lot is better than a lot of a little, and that the risk of your investments can be minimized by diversification. To a degree true, as an investor will never have all the information on which to assess various opportunities, so to mitigate this risk a number of researched investments should be made. Portfolio theory however comes with a high cost; reduced returns and high management costs.
Buffett on Portfolio Theory:
“Current Finance classes can help you do average” 6th May 1996
The end outcome of portfolio theory is that shareholders adopting this approach in its extreme are opting out of business ownership and begin to behave like term deposit holders. Small wonder that they scream when they take a loss. Others move heavily into managed funds, another systemic problem.
·Then out to the side another group of shareholders that think they can second-guess the market. These are the fundamental analysts or chartists. These are your punters. These people rarely vote and never behave like business owners. When these characters dominate markets or share registers, values get distorted and the total focus turns to the short term. These guys had their day in the US up to 2001 and were not blameless in the scandals that unfolded demanding as they often did quarter on quarter profit growth.
Warren Buffett on chartists:
“ For some reason, people take their cues from price action rather than values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.” 1st April 1990.
However irrational it might seem modern finance theorems have a large part to play in the ownership vacuum.
6. What can be done about it?
To the extent that anything can be done, only managers and boards, or less effectively regulation, can only do it.
The objective should be to get shareholders to behave like business owners and to provide them every encouragement to do so.
Berkshire Hathaway’s meetings are attended by thousands of shareholders why?
“ They come because we make them feel like owners.” Buffett 10th of May 1993.
7. Concluding remarks.
Leadership will only come from boards.
Change will only occur though having the courage to be the exception. Congratulations Telecom (auditor/advisor issue) and Infratil (Retirement allowances issue)
Participation will only come through confidence, and confidence will only return based on performance, and equity. On basic governance issues such as meeting conduct, modern capitalism has to meet modern democracy. |
