Shareholder activism debate: A force for good or bad?

Shareholder activism: The panel

The following debate took place in front of an audience of market participants, other stakeholders and the financial media.

BC (University of Cambridge) Only a decade ago, share ownership in UK public companies was dominated by a handful of fund managers investing on behalf of pension funds and insurance companies. Shareholder activism was defensive. Institutional investors owning large stakes in companies were prepared to arm-twist boards on topics such as dividend policy and rights offerings, and to orchestrate the removal of chief executives in troubled companies. Rarely, however, was there offensive shareholder activism. Building up a stake in a publicly quoted company with the intention of agitating for change was futile because among institutional investors the default rule was to back management.

Over the past decade, pension funds and insurance companies have wound down their holdings. The vacuum has been filled by shareholders less inclined to back management, such as hedge funds and international institutional investors. It’s also commonplace for investors to buy equities with the intention of supporting initiatives proposed by insurgents. The result has been a surge in offensive shareholder activism.

This surge could fall victim to the credit crunch. Pressure on companies to take on debt to repurchase shares or make large dividend payments is potentially less credible as borrowing has become so much more expensive. Lobbying for companies to break themselves up is arguably a less viable strategy now that private equity firms’ capacity to carry out buyouts is constrained. However, shareholder activism does not seem to be a passing fad, as indicated by Eric Knight’s campaign for change at HSBC.

AS (Kinetic Partners) Now is the time for a code of conduct for activists. There are two drivers for this; the global political environment, and a desire among activists for more clarity about market abuse regulation.

The G8 is chaired by the German authorities, some of whom described the hedge funds as locusts during the Deutsche Börse takeover a couple of years ago.

Many in the German political establishment have concerns about hedge funds. Those concerns revolve around financial instability and shareholder activism.

There is already a code of conduct for financial instability but there is a gap in shareholder activism. German authorities are pushing to have more regulation of hedge funds. If the industry wants to head that off it needs to propose a code of conduct.

So far the Germans have not got far. The UK and the US have pushed back any attempts to bring in further regulation. But the events of the summer will strengthen the Germans’ hand. Although these events are related to leveraged credit funds – entities such as CDOs and CLOs – rather than hedge funds, that subtlety will not carry much weight with the Germans at the G8. They will see this as justifying their concerns about unregulated offshore funds and their ability to threaten the stability of the global financial system.

It’s time for European regulators to get their act together on CFD [contracts for difference] disclosure. We’ve had the upheaval and cost of implementing the Markets in Financial Instruments Directive. A framework is in place for shareholder notification through the transparency directive. All it would require is for the Committee of European Securities Regulators to bring in Level 2 measures to have consensus across Europe on CFD disclosure.

I detect a desire for more clarity in the industry. The Market Watch article issued by the FSA in May is a manifestation of that.

Activists have been so successful that if they publish a letter to a board calling for change, they’re almost certain that the share price will move. Should there be a blackout period before issuing such a letter, during which they are unable to trade? It could be seen as a form of insider trading. In the article, the FSA also discusses other participants’ understanding of the activists’ strategy. There must be no suggestion of concert parties or other people knowing what the major activist is going to do. Again, it’s not clear what that knowledge would entail.

HH (Eclectica Asset Management) Markets are falling. We’re in jeopardy. I’ve got redemptions. And do you know what? I’m not an activist investor. I’m an opportunist contrarian investor. I can see brass where others can see muck.

The contrarian in me has been feeding the turmoil that may be undermining the hedge funds and may be calling for these stiffer regulations.

I’ve found myself buying a large shareholding in EMI. It was a curious case. EMI was bidding for Warner Music Group, and Warner was bidding for EMI, and they were identical businesses. It was trading at the same price as 26 years ago, at the beginning of the bull market, when the Dow Jones was only 1,000 points rather than 14,000.

But there were two problems: what the internet has done to the profit stream of music royalties and recording music profitability, and secondly, it had been very poorly managed. I built a position, we had 2.2% of the shares. There was a debate and it’s good to talk.

I wrote a letter to the Financial Times, telling them the exact number of shares, and that part of our shareholding was in the form of CFDs.

We even told them that the 2% represented almost 20% of our fund. No secrets. As they seemed to be identical businesses, I said the only way to differentiate was in the actions of the management teams. Warner seemed to have a sizeable proportion of their wealth invested in their shares. EMI had a lamentable investment in the underlying business. This seemed to explain the poor decision set taken by the British counterparty, and I supported Warner Music.

I don’t think I’d done anything wrong and there wasn’t any need for regulation. The Financial Times published an article taking exception to my letter, saying: ‘I’m not sure a hedge fund manager is the best person to decide who runs a global music empire.’

The nagging question is whether portfolio managers are qualified by experience or temperament to take operational decisions. I wasn’t advocating any operational decisions, I was using the rhetoric of Warren Buffett, who wrote the activist rulebook. He likes management that has a taste of its own cooking.

Two further points. Activism is correlated with hem lengths. Short skirts tend to be at the top of bull markets when there’s more confidence and more risk-taking. Activism, corporate takeovers, hem lengths, music; they are all linked.

Beatlemania was the first time we had people throwing themselves at mere mortals. It was the triumph of celebrity over grim reality. It was 1966, and the Dow Jones took 16 years to get back to those levels (25 years if you measure inflation properly).

We’re in an environment where we have reality TV, where everyone thinks they should be a star. Again it’s trying to disconnect from the grim reality. The reality is with us in financial markets: they are no higher today than eight years ago, and that’s a dramatic break with the past.

We have seen some big deals and everyone has benefited from the Deutsche Börse intervention. I can’t find one example of abuse where people lost out on activism.

My second point is that regulation is always displaced by time and intention. The US banned banks from owning investment banks. They had to be a separate business line, so that problems experienced today could not impact on the high street, mortgage lending or your car loan. This was regulation that followed the 1930s’ crash. We had that regulation for 70 years, and they took it away three years ago. Now we wish they hadn’t taken it away and they’ll bring it back in 10 years’ time.

Another rule says stock has to tick upwards before you can short it in the US. We had that rule for 77 years. They suspended it in July 2007 when the Dow Jones hit 14,000.41. It would be ironic if that were the high, that again they managed to suspend the regulation.

Judging by skirt lengths, the ABN Amro deal will be the last great activist adventure for a while. It marks the introduction of a more sober system of capital markets, because today we have a massive proposed banking takeover at a time when banks are unwilling to lend to each other.

It is a preposterous proposition reflected in the collapsing share prices of all the banks associated with it, and I fear September will see a suspension of that deal.

ABN estimates that $35 billion of hedge fund money is invested in it. If that deal gets called out, it will wipe out a lot of capital from the hedge fund community and will do more than any hapless German politician to regulate a sector that does not require regulation.

WC-S (Insight Investment) The chairman said that the default position of institutions such as the one I represent has been to support management. But there are many examples where we haven’t.

There was a famous case in the 1950s where Prudential’s largest shareholder in BSA unseated the company’s flamboyant chairman, Sir Bernard Docker, who had run it as if it were a private company.

When I joined Clerical Medical in 1978, we led a campaign to stop the then S Pearson buying out the minority shareholders in Pearson Longman at what we felt was an inappropriately low price. So there is actually a long history of shareholders becoming activists if they need to be.

In the UK we have the huge advantage that company law works for us. It amazes me that in many jurisdictions people still invest in non-voting shares. Shareholders in the UK have a vote that matters.

At AGMs or EGMs mandatory resolutions are passed rather than resolutions that have no binding powers. In extreme cases we have a shareholder’s right to call an EGM if 10% of us get together. Shareholders have benefited from the structure of the UK market where a small number of large institutions represented a large part of that market. If we had an issue, we could pick up the phone to other investors who owned 20% or even 50% of the shares, and with a loose agreement it was fairly easy to go along to the management and say: ‘Your investors think there’s an issue here that needs to be addressed.’ In the US, until recently the SEC used to disbar shareholders from talking to each other.

The UK has other routes of influence too. The press is one. But all listed companies in the UK have a sponsoring broker as a way of communicating concerns to the company’s executives or non-executives. Historically the investment banking, corporate broking community has had a much greater influence in the boardrooms of UK companies than investors. But we are, as long-term engaged investors, constantly talking with companies that we’re investing our clients’ money in on the right track.

There is a role for the specialist investor that acquires a holding to influence a company but only if the engagement route has failed. Activist shareholders need to get others on side, and they will only be able to do that if a company either hasn’t been told that there is an issue, which is a failure of the investment community, or because entrenched boards haven’t listened to investors. I suspect this is more common outside the UK, but on balance shareholder activism is a good thing. Although there are corporate insiders who abuse their position, you need people to champion shareholder rights.

Fay Sanders, international editor, IR Magazine: Hugh, what do you make of Andrew’s idea for a code of conduct for activism?

HH It doesn’t make sense in my world. You’ve intervened and said, ‘We believe this business is undervalued.’ And you’ve been proven right. So you find another business and you apply your intellect and your resources and you come to the same conclusion.

The notion that you should be penalized because of your intellect, graft and resources, but you should hang around so that someone else can catch up, really upsets me. You can’t be inside your own inside information. If I could see some travesty that needed righting, I could understand a code of conduct, but I can’t.

My code of conduct with activist investing is the same for all investing. Make sure you’ve got a good idea and you’d better not lose money with it.

AS What about managers who sell the shares to an activist just before they issue the letter and the share price goes up 15% to 20%? Some of them would be aggrieved and some of them wouldn’t, but there needs to be some clarity. Maybe an activist should be perfectly free to buy 5% in a business, publish the letter the next day and benefit from their intellect and analysis. At the moment it’s not clear what action the FSA would take if the person who sold the stake to that activist complained.

HH This is like trying to introduce socialism into the stock market. The less bright managers, through their failings, sell the stock, while someone else, using his intellect, buys. He’s not using information that the others don’t have. You’re trying to rob him of the rewards for his intellect. I don’t need the FSA to tell me something that is crystal clear.

Iain Richard, Morley Fund Management The FSA is focused on procedure and process. Does it have the skills and resources to intervene and micro-manage the market?

WC-S No. That’s the simple answer, and there is already plenty of regulation in this area. The Market Abuse Directive and the concert party rules of the Takeover Code should prevent abuse. If there is abuse, let’s see enforcement through these routes. There are a lot bigger abuses of inside information than that somebody writes a letter setting out their view on the valuation of a stock in a not significantly different way from a broker’s circular setting out his view.

AS I’d agree. The idea of principles-based regulation is that the FSA doesn’t have the skills and the knowledge to micro-manage markets and that’s why it looks to the industry to come forward with codes rather than writing detailed regulation.

You must look at the political reality as well. The FSA tends to have a liberal view of markets and shareholder activism, and doesn’t want to discourage it. The view elsewhere is different. People in the political establishment in Europe talk about reintroducing different classes of shares. We had voting and non-voting shares in emerging markets 15 years ago, and a sign that you were moving from an emerging market to a developed market was that you got rid of these. I don’t think you should see this as the FSA wanting to micro-manage markets, it’s more a judgement about the political realities in Europe and in the G8.

HH You’re making a bogeyman out of this political thing. Over the past 18 months the German locust quote has been repeatedly laughed out of court. It lacks credibility. Non-voting shares are not coming back.

At the depths of the retrenchment in the technology sector in 2002, when Ericsson needed to stiffen its balance sheet with a rights issue, it only got the money by getting rid of those voting shares, and that voting structure isn’t coming back. Everyone is trying to replicate the "success" of the American financial model, and I don’t see anyone trying to turn back the clock.

WC-S It’s because of the existence of differential control rights that there may continue to be more need for activists in Europe because shareholders don’t have the power we have in the UK. It is important that there are people pointing out problems, as was evident with Deutsche Börse or, to go back to one of Eric Knight’s successes, VNU, or ElectroBel, where it is clear that European companies haven’t been running shareholders’ interests in the way that we try to ensure they do in the UK and the US.

Alex Cain, Mergermarket Could Hugh Hendry expand on what he thinks about the ABN deal and the role of activism there?

HH I’m not an activist fund. I try to engage with many different variables. Some activist funds say: "To heck with the fact that Big Ben is stuck at 12 o’clock. That doesn’t matter in my world." Whereas I would say: "Mmm, Big Ben’s stuck at 12 o’clock. What does that mean to the world?"

Some banks are showing risk aversion and an unwillingness to lend. We know the opaque structure. We’ve got this new lexicon of conduits, SIVs, SIV-lites. You see the share-price performance of the banking community. The financial sector in the US peaked in July 2006 and has crashed.

Those are factors that, not being purely an activist investor, would make me wary of a deal such as ABN concluding. Some of the great turning points in stock market history, say 1987, revolved around the cancellation of deals which were caught up in a frothy environment, owing more to the previous six months than to the future.

Heaven help us if that does happen. But we’re talking about European banks trying to consummate one of the world’s largest-ever takeover deals in the same month that the ECB and the Bank of England had to intervene in those very same banks. I fear it’s not a done deal.

Alex Cain Is that because of the weakness of the ABN board?

HH I take no issue with ABN being subject to a takeover. Historians will look back on the debate about hedge funds pursuing this activist role, and say it owed more to the fact that they accumulated too many assets. They had to get involved, become like pension funds and long-only managers, taking positions where they couldn’t change their mind, and had to be committed.

This avenue tried to protect that interest. But the central issue was whether they were managing more money than the strategy could accommodate. If one of those deals were to fail, with $40 billion or $45 billion invested on it being completed, that would be proof that perhaps hedge funds are managing too much money.

WC-S Contrast the letter to ABN with the letter to Prudential. The letter to ABN from the shareholders got things going, because ABN hadn’t been listening to its shareholders. I was amazed that, when the story ran that an unnamed investor had written to Prudential, the share price rose 4% or 5%. This letter was just asking questions that many other investors had asked of the company and, in our case, received satisfactory explanations.

Sometimes you have to question whether activists have got anything to add to what mainstream investors have already done. The role of publicity appears important in trying to get a bit of action. While I’m not saying there is market abuse, trying to get stories into the press to get the share price up, to take short term profits is a potential area for market abuse investigation.

BC How should managers respond when they receive letters like this? If they’d been ignoring the shareholders previously, then they might panic. Assuming they believe they’re doing what they think conscientiously is in the best interests of the company, how should they respond?

WC-S Politely. It’s appropriate that management should have answers to all legitimate questions and that these can be asked in public at an AGM. If you get no response, there are other routes. It’s incumbent on management to respond to letters they receive in the way that they respond to questions that fund managers ask at routine meetings.

AS The shareholders own the company, so the management should respond to that challenge. There are corporate insiders who don’t run the firm in the best interests of shareholders, and it’s good to be challenged and to get different perspectives. They should consider the points made and answer them.

WC-S They must not selectively disclose information to either the letter-writer or the questioner, other than in an AGM where it’s public. Anything important which is communicated to one shareholder must be communicated to all. But in most cases, the response to an activist letter should be a reiteration of strategy that has already been spelled out to shareholders. However, sometimes there are good ideas and, as we said to HSBC: "If Eric Knight’s got anything sensible in his letter, I’m sure you’ll start doing it."

BC I noted that there had been an increase in offensive shareholder activism in the past five to 10 years. William pointed out that there has been shareholder activism previously but of a different nature. What’s changed? Is this a blip or a trend that will continue?

HH It’s related to stock market cycles. What we’ve experienced in the past five years mirrors the Michael Milken era from 1985 to 1987, which culminated in a hypermarket. It’s reflected in the Jim Slater activity in the early 1970s, which preceded the secondary banking crisis. It’s related to the conglomerate takeover boom that we saw in the brief window between 1966 and 1968.

I’d take you back to hemlines and exuberance within the society of human beings. Certain pockets of them make a lot of money, become masters of the universe and take more risks. This is offensive risk-taking strategy having periods of preponderance.

BC The conglomerates and Jim Slater were different, because they took over companies. This is a situation where you have investors owning tiny percentages of shares trying to shake up incumbent management. I take your point about deal-making activity being cyclical, but this isn’t deal making. It seems economically irrational that you do all the work for all the other investors, some holding below 1% of the shares. Why would activists continue to make money for other shareholders?

WC-S We’ve got a number of fund management organisations whose business model is based around being activist – Hermes for example – and it’s part of their marketing. They are making money for all of us, because in the UK it’s important that all shareholders are treated fairly. We don’t have the history of greenmail that activism has sometimes led to in the US. But they are also quite happy to make the press aware of what they’re doing, because it makes it easier for them to raise money for their next fund.

HH Let’s not forget private equity. Those periods in the market are defined when liquidity and the price of money gets skewed, and the price of money that’s been available to hedge funds in the private equity arena has been skewed in a favourable light.

Florence Lombard, chief executive, Alternative Investment Management Association Andrew, I presume you mean a code of conduct that is voluntary. When we’re seeing other voluntary codes ignored by market participants, such as for example in the commercial property sector, what’s the validity of the code of conduct in that context?

AS I mean a voluntary code of conduct that comes from the industry. The FSA will "confirm" codes of conduct that come forward, and for those that choose to abide by them, I think it will help them avoid enforcement action.

If people choose not to, then they open themselves to the danger of enforcement action if the FSA take a different view on a situation to the firm. I don’t know whether it would be done under the auspices of AIMA. I know there’s a group of 30 hedge funds that are working on some kind of code of conduct, with a number of working parties, one of which covers market abuse and shareholder activism.

Kate Walsh, City AM What are your views on Anthony Bolton’s comments on Nelson Peltz taking 3% of Cadbury and then apparently forcing the board to change its strategy?

HH It’s not that obvious. How do you differentiate from a coincidental factor? It may have been planning to do it.

WC-S Apparently what prompted Stelios to step down as chairman and chief executive of EasyJet was a letter from CIS, who owned next to no shares. In normal circumstances a larger shareholder is more likely to be listened to than the smaller shareholder, but a good idea is more likely to be listened to than a bad idea, regardless of the size of shareholding.

Kate Walsh Anthony Bolton said that Fidelity would take an activist stance, but would have substantially more than 3%. Do you think there should be a boundary?

WC-S No. It’s likely that other shareholders would be supportive of a good idea. The fact that Vincent Bollore has 29% of Aegis shares, as evidenced by the number of EGMs he’s fought on this issue, doesn’t entitle him to have two directors on the board if the other 71% don’t think it’s a good idea.

HH The other side of that is the hostile reaction in a lot of financial papers that met the AGM request regarding Vodafone. Vodafone, on my calculations, is undervalued and one catalyst for change would be removing the opaque ownership structure of their most important assets. Let’s have that debate. Yet the proposal was met with such venom. It seemed to me that venom was related to the size of the shareholding of the proponent of the idea, rather than the validity of the idea.

Tom Powdrill, Pensions Investment Research William, in the institutional market you’ve already got a voluntary framework for a code of practice for activism, drawn up by the Institutional Shareholders Committee. Has that worked?

WC-S The history of UK institutions is a cooperative one, and by working together we have managed to achieve much, principally behind closed doors, because often that is the best way. We are also subject to regulatory frameworks and the only time we have had any issues has been with the concert party rules of the Takeover Code. I don’t pull out the ISC code every day, because the appropriate behaviour expected from that code tends to happen anyway.

BC There’s been little empirical work on this issue. Work’s just beginning in the US, and there’s been one academic study in the UK, on the Hermes activist fund. While I endorse active shareholders keeping the management’s feet to the fire, the jury’s still out on proving any correlation between activism and creating shareholder value.

WC-S It’s not just within the companies that are subject to activist pressure that value is created. There are definite positive externalities. Companies behaving inappropriately may, without even needing to be approached, decide to act in the shareholders’ interests to avoid becoming subject to shareholder pressure.

HH Exactly. The riposte to being activist is: "If you don’t like it, sell the shares." If everyone does that, then the company will become vulnerable to takeover. Academic studies consistently find that takeovers rarely add value, because of the transaction costs involved and prices paid. So this might be a means of forcing change without the known negative of value-destroying takeovers.