2.1 The Political Origin of Shareholder Democracy in the Early Twentieth Century

When the US public stock market took shape in the early twentieth century, those who came to own public shares sold by retiring founder-shareholders were mostly retail shareholders − that is, individual households. They were fundamentally passive investors. Each holding a minuscule percentage of a corporation’s shares outstanding, they had no ability or incentive to engage with corporate management. They were only concerned with monetary rights attached to the stocks they owned, such as entitlements to dividends and capital gains. Their general willingness to leave control to managers stemmed in part from the prior revenue-generating successes of those corporations and partly from the trust the shareholders had in financial intermediaries who had persuaded them to buy those corporate stocks. More fundamentally, being passive was a rational choice for these retail shareholders because the shares they held were liquid so that they could sell them on the stock market at any time, a maneuver that became known as “the Wall Street Walk.” They would not have purchased the shares in the beginning had they been obliged to be active and commit time and effort to oversee corporate management.Footnote ⁵

The movement for shareholder democracy progressed with the emergence of these retail shareholders. Promoters of shareholder democracy envisioned a more cohesive society where mass workers would turn into mass shareholders supporting corporations and capitalism. John Bates Clark, a neoclassical economist, expected at the turn of the century that the share ownership by workers would “blur, or perhaps disappear … the old line of demarcation between the capitalist class and the laboring class,” and argued that “[t]he socialist is not the only man who can have beatific visions.”Footnote ⁶ This vision continued into the 1920s. John Raskob, a financier and businessman who played a crucial role in the expansion of Du Pont and General Motors, for instance, famously stated, “Everybody ought to be rich,” when he laid out proposals for working- and middle-class wealth building in a 1929 article in Ladies Home Journal.Footnote ⁷

In the same context, Julia Ott (Reference Ott2011) states in When Wall Street Met Main Street: The Quest for Investors’ Democracy, the primary concern of “intellectual, political, corporate, and financial leaders who embarked on a quest for mass investment” was how to build a stable and prosperous political system in the face of not only public distrust of “corporate power and accountability” but also of political challenges of internal integration from “mounting economic inequality, surging immigration, ethnic diversity, Jim Crow segregation, and women’s demands for suffrage [that] sparked fundamental debates about citizenship.” They hoped that “[m]ass investment could shore up the propertied foundations of citizenship, preserve economic mobility and autonomy, enhance national prosperity, and make corporations accord with the will of the people” (p. 4).

While promoting shareholder democracy as a political project, they made it clear that they did not think of it as being related to raising capital. According to Ott, they “did not view mass investment as a particularly efficient or profitable means of raising capital,” and the “[c]orporate need for capital did not call forth popular demand for financial securities spontaneously.”Footnote ⁸ In other words, the promoters of shareholder democracy did not employ an economic rhetoric that would improve the economic efficiency of corporations or the economy. William Lazonick and Mary O’Sullivan point out in the same context: “The stock market [at the time] did not serve as a source of funds for long-term business investment. When an enterprise went public, the stock market was the instrument for the separation of stock ownership from strategic control over internally generated corporate revenues.”Footnote ⁹

Because the promotion of shareholder democracy was a political project, institutional shareholders were not included in the movement because they were fiduciaries, not citizens who had political rights of representation. Institutional shareholders, such as mutual funds, were only beginning to emerge and held only about 5 percent of the US equity market capitalization by 1929.Footnote ¹⁰ They were considered merely money managers who functioned to diversify investments, thereby raising yields on portfolio investments while managing risks, an option not available to most retail shareholders.

This diversifying function of institutional shareholders had been well established from the days of the first collective investment trusts that emerged in Scotland and the UK in the latter half of the nineteenth century. For instance, the stated goal of the Foreign and Colonial Government Investment Trust established in 1868 was “to give the investor of moderate means the same advantages as the large capitalist in diminishing the risk of investing in Foreign and Colonial Government Stocks, by spreading the investment over a number of different stocks.”Footnote ¹¹

2.2 New Deal Financial Regulations of Institutional Shareholders

In line with the overall spirit of shareholder democracy in those days, New Deal financial regulations established in the 1930s emphasized the passivity of public shareholders and specifically discouraged institutional activism. As a policy response to the turmoil of the 1929 New York Stock Exchange crash and the subsequent collapse of economic activity, the Securities Act of 1933 and the Securities Exchange Act of 1934 sought to regulate financial markets.Footnote ¹² A few years later, Congress passed the Investment Company Act of 1940, which regulated institutional shareholders.Footnote ¹³

These New Deal regulations embodied three enduring principles that would guide the relationship between shareholders and companies: (1) the prohibition of fraud and deceit, including profiting from insider information; (2) regulating any shareholders acting as a group and prohibiting the formation of investors’ cartels; and (3) encouraging institutional shareholders to diversify their portfolios and discouraging them from exerting influence over management.

Under the first principle, the regulations required public companies to make regular, accurate, and timely public disclosures of financial information to shareholdersFootnote ¹⁴ and barred shareholders and managers from misappropriating corporate resources and profiting from insider information.Footnote ¹⁵ They specifically prohibited “fraudulent … manipulative [and] deceptive conduct.”Footnote ¹⁶ To deter insider trading, they required those who were deemed insiders, whether manager-owners or investors, to disclose “all the information prior to trading.”Footnote ¹⁷ In addition, the regulations outlined that, should insiders profit by buying a company’s securities and selling them within six months or vice versa, they “are recoverable by the issuer [the company].”Footnote ¹⁸

Under the second principle, the formation of a voting group by investors was heavily regulated as establishing an investor cartel. If the combined shares of a group of investors exceeded 10 percent of the company’s stock, its members were subject to the same regulations as insiders.Footnote ¹⁹ Furthermore, communications between investors were subject to strict oversight to prevent the development of such a group. If a group is to be formed, its prospective members should communicate with each other. The regulations, therefore, judged the communication as a proxy solicitation and made it necessary to file it by providing the information specified in Schedule 14 A of the 1934 Act.Footnote ²⁰ Blair (Reference Blair1995), therefore, points out that the regulations made it “difficult for shareholders to communicate with each other at all … without the approval and support of management” (p. 71).

Under the third principle, institutional shareholders were encouraged to diversify their portfolios and discouraged from seeking to control management. The 1934 Pecora Report, the product of a Senate securities investigation, explicitly walled institutional shareholders off from management, making it clear that mutual funds were only allowed to engage in investment activities.Footnote ²¹ This principle was also embodied in the Tax Code of 1936: “another safeguard … is to prevent an investment trust or investment corporation [from] being set up to obtain control of some corporation and to manipulate its affairs.”Footnote ²² In testimony regarding the enactment of the Investment Company Act of 1940, a high-ranking SEC official asserted that “a mutual fund’s only positive function was to provide diversification; any extension risked thievery.”Footnote ²³

This regulation clearly separating management from institutional shareholders answered in part the need to remove the potential for conflicts of interest: If institutional shareholders were allowed to control corporations, they would tend to utilize their position for their own profit at the expense of other shareholders. More importantly, behind the regulation was a clear understanding that corporate managers and institutional shareholders serve different functions: While the former seeks to create value in corporations by producing high-quality and low-cost goods and services, the latter helps individuals extract value from corporations by leveraging size and diversification of corporate shareholding.Footnote ²⁴ The mutual fund industry did not oppose the government in imposing the regulations at the time because they legitimized the industry in the eyes of the public.Footnote ²⁵

These three principles had been well enough established and went unchallenged until the 1980s. As recently as 1974, Congress upheld the same principles when it introduced the Employee Retirement Income Security Act (ERISA), a policy response to the growing need to regulate pensions. First, ERISA’s rules prevented self-dealing behavior on the part of employers and fund managers.Footnote ²⁶ Second, they discouraged pension funds from taking excessive risks and encouraged them to diversify investment portfolios broadly.Footnote ²⁷ Third, they urged pension funds to refrain from exercising control over companies in their portfolio.Footnote ²⁸ In this context, Peter Drucker, one of the earliest thinkers who envisaged the coming of the Pension Fund Revolution, pointed out that pension funds “have no business trying to ‘manage’ … To sit on a board of directors … and accept the obligations of board membership, is incompatible with duties as ‘trustees’ … which have been sharply and strictly defined in the Pension Fund Reform Act of 1974 [ERISA].”Footnote ²⁹

3.1 The Growing Voting Power of Institutional Shareholders

The share ownership structure of US corporations is conventionally characterized as “dispersed ownership.” Since 1932, when Adolf Berle and Gardiner Means offered this classic characterization and pointed out the “separation of ownership and control” as its result, it has been the starting point of the debate on corporate governance and economic performance.Footnote ³⁴ Undoubtedly, the shareholding of major corporations in the United States is still dispersed compared with those in other countries. However, the characteristics of the dispersion have undergone qualitative changes. If the classic dispersion saw shares in the hands of retail investors who were the actual owners of the shares, the prominent feature of the current-day dispersion is that shares are in the hands of institutional shareholders, fiduciaries of the savers who are the shares’ ultimate owners.

This institutionalization of shareholding progressed through the latter half of the twentieth century and has continued in the twenty-first century. As shown in Figure 2, the institutional shareholding of US public stocks was at only 7.2 percent in 1950 but continued to increase to 40.0 percent in 1980 and 59.8 percent in 2020. In Figure 2, drawn from the Federal Reserve dataset, hedge funds and private-equity funds are classified as “households,” not as “institutional shareholders,” despite the fact that most of them function as institutions by pooling and managing other people’s money.Footnote ³⁵ If one includes hedge funds and private-equity funds in institutional shareholders, the actual institutional shareholding percentages would be substantially higher than what Figure 2 shows. For instance, Pensions & Investment estimated institutional holding as 80.3 percent of the market value of the S&P 500 index and 78.1 percent of the US broad-market Russell 3000 index in 2017, while the Fed data indicate the institutional share as 61.9 percent.Footnote ³⁶

Figure 2 The growth of institutional shareholding in the United States.

Source: Estimated from Z.1 Statistical Release of Federal Reserve Board (The Federal Reserve Board website, www.federalreserve.gov/datadownload/Download.aspx?rel=Z1&series=75cf7aa5c5495b9ba5194795df5ee426&from=01/01/1945&to=12/31/2023&lastObs=&filetype=spreadsheetml&label=include&layout=seriesrow (Accessed on July 30, 2023))

3.2 Imposing Compulsory Voting on Institutional Shareholders: Robert Monks and ISS

In transforming institutional shareholders into activists, Robert Monks, who described himself as “an entrepreneur of the idea of corporate governance,”Footnote ³⁷ was the principal ideologue, administrator, and businessman, almost single-handedly making proxy voting a fiduciary duty of institutional shareholders while profiting from establishing the Institutional Shareholder Service (ISS),Footnote ³⁸ the first of its kind and the most prominent proxy-advisory firm to date. A close consideration of his arguments and career illuminates the evolution and consequences of institutional activism.

3.3 Shareholder Activists Acting Together: The 1992 Proxy Rule Change and “Free Communication and Engagement”

While establishing proxy voting as a fiduciary duty of institutional shareholders, shareholder activists advocated for a proxy rule change that would make it easier for shareholders to aggregate their votes, allowing them to exert more influence on corporate management through freer communication between shareholders as well as freer engagement of shareholders with corporate management. Their concerted efforts resulted in the watershed SEC amendments to its proxy regulations in 1992.Footnote ⁶⁰ Public pension funds, especially led the California Public Employees’ Retirement System (CalPERS), and corporate raiders, through their umbrella organization, the United Shareholders Association (USA), collaborated closely to make the proxy rule change happen.

3.4 Allowing Unlimited “Alternative Investment” in Hedge Funds: The 1996 NSMIA

Hedge funds, classified as private funds, are notable (and definable) primarily by their strategy of organizing outside existing financial regulations applicable to larger institutional funds. Because of this, hedge funds can employ trading strategies considered too speculative and therefore not allowed to institutional shareholders, and they conventionally utilize the “2 and 20” performance-pay scheme: an annual management fee of 2 percent of assets under management and a performance fee over the life of a particular fund of 20 percent of the profits in excess of a predetermined hurdle rate. Hedge funds and other private funds are structured specifically to avoid actions that would trigger certain disclosure rules and other regulations. For example, under the Securities Act of 1933, a fund seeking to be a private (i.e., unregistered) fund cannot publicly solicit prospective clients, the rationale being that “private placement” attracts informed, experienced investors.Footnote ⁹⁴

The gap between rhetoric and reality is most evident in hedge funds. The term “hedge fund” refers to managing a financial portfolio by “hedging” risks, a trading strategy originally adopted by Alfred Winslow Jones when he set up the first-ever hedge fund, A.W. Jones & Co., in 1949. However, the term has now been appropriated by speculators and manipulators who ply global financial markets in pursuit of “absolute returns” for themselves.Footnote ⁹⁵

For nearly half a century after the launch of the first hedge fund, the hedge-fund industry grew anemically overall, experiencing periods of expansion and retraction.Footnote ⁹⁶ From the 1990s, however, hedge funds exploded in size and number. The number of funds grew from around 610 in 1990 to about 11,000 in 2015. Their assets under management (AUM) grew from about $39 billion in 1990 to over $3 trillion in 2016 (Figure 3).Footnote ⁹⁷

Figure 3 The growth of the hedge-hund industry, 1997–2023.

Source: Statista (www-statista-com.libproxy1.nus.edu.sg/statistics/271771/assets-of-the-hedge-funds-worldwide, accessed on July31, 2023)

There were pull factors in this growth of the hedge-fund industry. In the early 1990s, some spectacular hedge-fund success stories became known to the public. One sensational story was the estimated $1 billion gain George Soros reaped on Black Wednesday in 1992 by “breaking the Bank of England” by shorting the British pound. Not only that. Soros Fund was reported to have generated an average annual return of more than 30 percent since its inception.Footnote ⁹⁸ Hedge funds were beginning to be accepted as special investment vehicles that could create a persistent “alpha” – extra yield above the benchmark yield, although it is a matter of controversy whether they actually generate “alpha” for their clients.Footnote ⁹⁹

The explosive growth of the hedge-fund industry in the 1990s, however, had more to do with push factors that allowed the allocation of institutional shareholders’ portfolios to hedge-fund investing as an “alternative investment” in their search for higher yields. The 1996 National Securities Markets Improvement Act (NSMIA), part of the Clinton administration’s financial market deregulation, was crucial here. According to David Dayen, the regulatory change, “largely unnoticed at the time” and “advanced with broad Wall Street support and almost no resistance in Congress,” effectively allowed hedge funds to draw unlimited financial resources from institutional shareholders without regulations that would have required disclosure of the firms’ structure or prohibited overly speculative investments.Footnote ¹⁰⁰

Previously, to be exempt from regulation under the Investment Company Act of 1940, a hedge fund had to serve fewer than 100 “high-net-worth” investors, who were persons with a net worth of at least $1 million or who had generated an income of at least $200,000 annually for the previous two years. However, Section 209 of the NSMIA modified the Investment Company Act of 1940 to remove the long-existing regulation on the number of clients, creating an exemption for an unlimited number of “qualified purchasers,” which could include any individual investor with a net worth of $5 million or more or any institutional shareholder with financial assets of $25 million or more.Footnote ¹⁰¹ As such, NSMIA continued to treat hedge funds as private entities while granting them the ability to draw funds from a substantially larger pool of investors, most notably from institutional shareholders. As will be discussed in Section 5.5, the infusion of funds from institutional shareholders into hedge funds enabled their “co-investments” in target companies and inflated the power of activist hedge funds against them.

As Figure 3 shows, it took only seven years after the enactment of the NSMIA for hedge funds’ assets under management (AUM) to increase more than tenfold, from $118 billion in 1997 to over $1.2 trillion in 2004. Since then, they more than doubled to over $3 trillion in 2016 and again nearly doubled to $5.1 trillion in 2022. The main contributor to this explosive growth of hedge funds’ AUM was the alternative investment by institutional shareholders following the 1996 NSMIA. According to Preqin Global Hedge Fund Report, about 60 percent of hedge-fund assets in 2015 came from more than 5,000 institutional shareholders. Leading institutional funds were public and private pension funds and endowments, representing about 53 percent of hedge funds’ total assets.Footnote ¹⁰²

The rise of hedge-fund activism was a phenomenon that reflected the explosive growth of the overall hedge-fund industry. The combined AUM of activist hedge funds increased more than tenfold in six years, from $15 billion in 1997 to $117 billion in 2003, and then more than quadrupled in the next 11 years, to reach $507 billion in 2014, as Figure 4 shows.Footnote ¹⁰³

Figure 4 The expansion of hedge-fund activists, by type of fund, 1997–2016.

Source: Lazonick & Shin (2020, p. 131, Figure 6.2)

Both the incidence of activist campaigns and their success ratio increased sharply. Schedule 13D filings with the SEC are often used as a proxy for activist campaigns because a 13D must be filed when an investor accumulates a 5 percent-or-greater share of a corporation’s outstanding stock, which also triggers a requirement that the investor discloses the purpose of its accumulation.Footnote ¹⁰⁴ The incidence of 13D filings for activist purposes increased from 10 in 1994 to 212 in 1997.Footnote ¹⁰⁵ It then increased to 353 in 2008. After a sharp reduction during the Global Financial Crisis of 2008–2009, the incidence recovered to 355 in 2015. In 2003, 39 percent of proxy fights for board seats resulted in settlements or victories for activists; this success rate soared to 60 percent in 2013.Footnote ¹⁰⁶ The growth of hedge funds, the growth of activist hedge funds, and the increasing success rate of hedge-funds’ activist intervention were phenomena that happened in parallel since the introduction of the 1996 NSMIA.

3.5 Agency Theory and the Maximizing Shareholder Value View (AT-MSV)

Social movements progress with ideologies to legitimize them. For shareholder activism, the legitimization was provided by agency theory and its maximizing shareholder value view (AT-MSV henceforth),Footnote ¹⁰⁷ which emerged as a new branch of neoclassical economics in the middle of the 1970s when corporate raiders were beginning to make their marks. The AT-MSV argument runs in the following manner: (1) Corporate managers are agents of shareholders who are (ultimate) owners of the corporation, and they are responsible for maximizing the value of their principals, that is, shareholders; (2) If managers act entirely as agents of shareholders by focusing solely on maximizing shareholder value, corporate performance as well as the efficiency of the economy would improve. (3) Managers, however, try to maximize their own benefits as self-interested agents and tend to build their own fiefdoms (at the expense of their principals), resulting in agency costs. One way to reduce this “agency cost” is to increase stock-related compensation for corporate executives because it will align their incentives to shareholders.Footnote ¹⁰⁸

Although it had logical and empirical fragilities, as discussed in Section 5.1, AT-MSV provided shareholder activism with strong academic support. First, AT-MSV’s principal-agent relationship between public shareholders and corporate managers established the primacy of the latter and bolstered the confidence of shareholder activists. It elevated public shareholders to the status as if they could make an order to managers, “You should strive to maximize my value wholeheartedly. That is your mission!” Combined with Robert Monks’ push for portraying institutional shareholders as “owners” of corporations,Footnote ¹⁰⁹ AT-MSV helped the relationship between institutional shareholders and corporate managers increasingly be accepted as a vertical one where the latter is an agent of the formers. However, their legal relationship is horizontal in that institutional shareholders are “money-managing fiduciaries” serving their clients, whereas corporate managers are “business-managing fiduciaries” serving their corporations, as will be discussed in Section 5.1.

AT-MSV justified this principal-agent relationship with the “residual claimant” argument in that it is only shareholders who make risky investments in the corporation’s productive assets without guaranteed returns, and therefore, it is only shareholders who have a claim on the corporation’s profits, if and when they occur.Footnote ¹¹⁰ Although this argument is fraught with logical and empirical weaknesses, it offered justification for corporate raiders’ and later hedge-fund activists’ push for increasing dividend payouts and stock buybacks as their rightful claims.Footnote ¹¹¹

Combined with establishing the primacy of public shareholders through the principal-agent relationship, AT-MSV’s depiction of the relationship as a conflicting rather than a cooperating one offered strong support for shareholder activism to place managers under the control of shareholders. Jensen (Reference Jensen1986) emphasizes: “Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power … Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control” (p. 323). Fama’s (Reference Fama1980) model is also based on the manager’s tendency of “shirking” or appropriating “perquisites”: “ … a manager has an incentive to consume more on the job than is agreed in his contract. The manager perceives that … he can beat the game by shirking or consuming more perquisites than previously agreed” (p. 296).

AT-MSV, therefore, explained hostile takeovers led by corporate raiders, or what was more generally known as “the market for corporate control,” as one way to improve corporate performance by forcing managers to stop wasting corporate resources and by “disgorging” the corporation’s “free cash flow” to shareholders. Jensen (Reference Jensen1988) argues, “Increase in financial flexibility that gives managers control over free cash flow may actually cause the value of the firm to decline” and takeover activities accompanied with the increase in debts, that is, leveraged buyouts would “motivate managers to disgorge the cash rather than invest it at below the cost of capital or waste it through organizational inefficiencies” (p. 29).

At the same time, AT-MSV legitimized making stock-based pay an important proportion of executive compensation because it would supposedly align the incentives of corporate managers in allocating resources with those of public shareholders.Footnote ¹¹² Based on their assumption of the entirely egoistic CEO that “[he] compares only his private gain and cost from pursuing a particular activity,” Jensen and Murphy (Reference Jensen and Murphy1990) argue, “compensation policy that ties the CEO’s welfare to shareholder wealth helps align the private and social costs and benefits of alternative actions and thus provides incentives for CEOs to take appropriate actions” (p. 226).

Following AT-MSV’s advice and the insistence of shareholder activists, companies substantially increased executives’ stock-based pay. According to Frydman and Jenter (2010), the S&P 500 CEO’s average pay increased from $1.2 million in the 1970s to $1.8 million in the 1980s, $4.1 million in the 1990s, and $9.2 million in 2000–2005 in 2000 constant dollars.Footnote ¹¹³ A significant part of this steep pay increase was due to the increase in stock-based pay. The portion of stock-based pay to CEOs’ total compensation was 13 percent in the 1960s and 16 percent in the 1970s. It then increased sharply to 26 percent in the 1980s, 37 percent in the 1990s, and 60 percent in 2000–2005. This increase in stock-based pay opened a room to make executives susceptible to the pressure from hedge-fund activists to increase stock buybacks, as will be discussed in Sections 4.2 and 5.1.

4.1 The Recent Empirical Research on Institutional Activism and Hedge-Fund Activism

In ‘Thirty years of Shareholder Activism: Survey of Empirical Research,’ Denes et al. (Reference Denes, Karpoff and McWilliams2017) summarize the results of the empirical research as follows: (1) shareholder activism was in general effective in bringing about some organizational changes in target firms; (2) shareholder proposals and negotiations by institutional shareholders are ineffective in changing target firms’ stock prices and earnings; (3) but shareholder activism by hedge-funds was effective in changing target firms’ stock prices and earning in the short run, especially when it is combined with hedge funds’ purchase of relatively large block of shares; (4) following hedge-fund activism, target firms tended “to decrease their capital expenditures, increase their payouts, and increase their incidence of asset divestitures, restructurings, or employee layoffs,”Footnote ¹¹⁴ (5) studies that claim long-term effects of shareholder activism is mixed: The effects on stock returns are “statistically insignificant” while “hedge fund activism is associated with increases in operating performance.”Footnote ¹¹⁵

Findings (1) and (2) had been well established by the early 2010s. One of the authors of the paper above, Karpoff (Reference Karpoff2001), already reported a survey result that institutional activism had “negligible effects on target companies” in terms of “share values, earnings, or operations” while it prompted “small changes in target firms’ governance structures” (p. 1). Gillan and Starks (Reference Gillan and Starks2007) provided similar survey results on institutional activism. Brav et al. (Reference Brav, Jiang and Kim2010), who are supportive of hedge-fund activism, also made it clear that they concurred with Gillan and Starks (Reference Gillan and Starks2007) and said that was why they focused their empirical research on hedge-fund activism.

Findings (3) and (4) are also hardly disputed. Compared with activist institutional shareholders frequently exposed to a conflict of interests,Footnote ¹¹⁶ hedge-fund activists make single-minded interventions to increase their financial gains through stock-price manipulation, cost reductions, and other restructuring measures. Moreover, hedge-fund activists have substantially strengthened their power, and it has become increasingly difficult for corporate management to ignore their demands, as discussed in Sections 3.3 and 3.4. Therefore, finding (5) – the long-term effects of hedge-fund activism on share prices and operating profits – is the only remaining issue to be resolved.Footnote ¹¹⁷

In ‘Long-Term Economic Consequences of Hedge Fund Activist Interventions,’ deHaan et al. (Reference deHaan and McClure2019) delve into the issue (5). Their conclusions are identical to those of Denes et al. (Reference Denes, Karpoff and McWilliams2017) in rejecting the claim of positive effects on long-term stock returns. So, the change in long-term operational profits is the only controversial issue that needs to be resolved. They closely examine 11 papers that Denes et al. (Reference Denes, Karpoff and McWilliams2017) surveyed on operational performance, including Bebchuk et al. (Reference Bebchuk, Brav and Jiang2015), Brav et al. (Reference Brav, Jiang and Kim2010), and Brav et al. (Reference Bebchuk, Brav and Jiang2015).Footnote ¹¹⁸ They then reject the hypothesis that hedge-fund activism brought about long-term positive effects on operational performance.

First, deHaan et al. (Reference deHaan and McClure2019) point out that the previous studies claiming the positive effects only examined the post-activism performance without comparing it with the pre-activism performance. Considering the pre-activism trend is critical because the improvement in operational efficiency during the period after the activist intervention may simply reflect the trend of operational improvement already set before the intervention. deHaan et al. (Reference deHaan and McClure2019, pp. 541, 554) took the pre-activism performance into account and compared the performance of the initial year with the post-activism performance. They then find no evidence of abnormal post-activism performance improvement and reject the hypothesis.

Second, deHaan et al. (Reference deHaan and McClure2019) also raise questions about employing returns on assets (ROA) as a measurement of operational efficiency after activist interventions. All eleven studies cited in Denes et al. (Reference Denes, Karpoff and McWilliams2017) focus on ROA, and some of them supplement their findings with other measures such as Tobin Q, FSCORE, and ROE (returns of equities). deHaan et al. (Reference deHaan and McClure2019) mildly criticize this convention of the previous researchers by remarking, “ROA only provides a partial view of a firm’s operating efficiency. For example, a target’s ROA may be inflated because the denominator has shrunk due to cash payouts, even though its use of operating assets has not changed” (p. 544).

In my view, this is a more serious matter. I suspect that the predominance of relying on ROA may have to do with the relative ease of “proving” the supposed positive effects of hedge-fund activism. Take a look at Denes et al.’s (Reference Denes, Karpoff and McWilliams2017) summary of the previous studies on operational changes after activist interventions in finding (4) above: “Following such activism, target firms tended to decrease their capital expenditures, increase their payouts, and increase their incidence of asset divestitures, restructurings, or employee layoffs” (p. 413). It is then more likely that the increase in ROA was due to the decrease in the denominator (asset) through asset divestitures, decrease in capital expenditure, restructuring, and layoffs without the increase in the numerator (net profit). It is misleading to interpret the ROA increase itself as an operational improvement of a company.

Third, there is an even more severe problem of the empirical studies purporting long-term operational efficiency improvement, which deHaan et al. (Reference deHaan and McClure2019) do not point out. It has to do with flaws in their dataset. For instance, Bebchuk et al. (Reference Bebchuk, Brav and Jiang2015, pp.1099, 1090) claim to provide “the first systematic evidence on the long-term effects of hedge fund activism” by using a dataset consisting of “the full universe of approximately 2,000 interventions” and by examining the effects during the five years after the interventions. However, almost half of the firms disappeared from the Compustat database that they used to calculate changes in earnings. In the case of ROA, the number of firms that remained in Compustat declined from 1,584 in the year of the 13D filing to 815 five years later, and in the case of Tobin’s Q (the measure of the firm’s market value to book value), the decline was from 1,611 to 831.Footnote ¹¹⁹

Bebchuk et al. (Reference Bebchuk, Brav and Jiang2015, p. 1104) assert that “most of the disappearances from Compustat [were] due to acquisitions.” But they do not provide any evidence to support it. They only claim, “When we compare the target firms to peer companies matched by size and performance, we find that the matched firms also have a high attrition rate of 42% within five years; most disappearances from Compustat are again due to acquisitions.” As they do not tell us whether they documented acquisitions among the “peer companies,” which is unlikely, their claim is just their surmise. They only mention “the acquirer’s expectation” of the improvement to support their surmise in a footnote.Footnote ¹²⁰ Without documenting why nearly half of the firms in the dataset disappeared, asserting that they did so primarily by acquisitions is not a tenable academic proposition.

A company disappears from a dataset of listed companies for various reasons: It may go out of business, fail to maintain the minimum listing requirements of the stock market, or be acquired by another company. It will be more reasonable to suppose the average performance of surviving companies in the stock market after five years is generally better than that of all the companies listed in the first year. The initial average performance of bankrupt companies, or those failing to maintain the minimum listing requirement, is likely lower than that of surviving companies. This survival effect will be more substantial if the number of disappearing companies is high, such as Bebchuk et al.’s dataset, where nearly half of companies disappeared after five years. It is not reasonable to use the higher average performance of the surviving companies as evidence that the overall performance of the initial group has improved.

A re-examination of the empirical research discussed above does not support long-term performance improvement from shareholder activism, both institutional and hedge-fund activism. The result is not surprising if one looks at the contents of hedge funds’ demands on corporations. Their typical demands are to increase payouts to shareholders through stock buybacks and dividends, often accompanied by selling off assets and slashing costs. It is difficult to find a plausible reason why a company will achieve a long-run operational improvement and the consequent long-run stock price increase if its managers follow those demands. The only “theoretical” support for those demands comes from AT-MSV, as discussed in Section 3.5.

4.2 The Buyback Economy and Predatory Value Extraction

If we examine the flow of funds between corporations and shareholders, it will be more plausible to say that shareholder activism has resulted in “predatory value extraction” rather than simply not bringing about a long-run performance improvement. Two facts stand out from Figures 5 and 6, which show the flow of funds for 219 companies in the S&P 500 Index publicly listed from 1981 through 2019.

Figure 5 The trend of corporate income, stock buybacks, dividends, and total payout of S&P 500 companies (Value, US dollar).

Note: Data are for 216 companies in the S&P 500 Index in February 2020 that were publicly listed from 1981 through 2019. BB: Buyback; NI: Net income; DV: Dividend payout; (BB+DV): Total payout

Source: Standard and Poor’s Compustat database; calculations by Mustafa Erdem Sakinç and Emre Gomeç of the Academic-Industry-Research Network in July 2023.

Figure 6 The trend of corporate income, stock buybacks, dividends, and total payout of S&P 500 companies (payout ratios).

Source & Notes: Same as those in Figure 5

First, the total payout to shareholders (inclusive of dividends and stock buyback) has continued to increase, and currently, almost all the net income of S&P companies is paid to shareholders. It comprised 48.5 percent of their net income in 1981, and the total payout ratio rose to 114.4 percent in 2019. The rapid and steady growth of the payout ratio can be viewed better by examining the trend of the average payout ratio over decades. The ratio in the 1980s (1981–1989) was 69.7 percent. It then rose to 76.1 percent in the 1990s (1990–1999), 88.8 percent in the 2000s (2000–2009), and 95.7 percent in the 2010s (2010–2019). Many S&P companies “routinely distribute more than 100% of their net income to shareholders.”Footnote ¹²¹

Second, the increase in stock buybacks accounts for nearly all the payout ratio rise. At the beginning of the 1980s, buybacks were minimal, comprising only 2.2 percent of the net income of the S&P 500 companies, and the buyback portion of net income increased to 63.5 percent in 2019. Over the past three decades, the dividend increase was nearly proportional to the corporate profit increase. The dividend ratio was 49.9 percent on average in the 1980s, 47.5 percent in the 1990s, 42.1 percent in the 2000s, and 43.1 percent in the 2010s. But the buyback ratio, recording 19.9 percent on average in the 1980s, rose to 28.5 percent in the 1990s, 46.7 percent in the 2000s, and 52.5 percent in the 2010s.

We should pay particular attention to the sharp increase in stock buybacks to understand the extent and contents of predatory value extraction. Traditionally, companies used to justify stock buybacks for other reasons, for instance, to keep them as reserves to reward their employees and executives, use them as currencies for stock-swap M&As, and defend stock prices when market conditions are unfavorable. With the strengthening of shareholder activism, however, companies have increasingly justified buybacks as a “shareholder-friendly measure,” “returning excess cash to shareholders,” or even “returning capital to shareholders.” Hedge-fund activists’ demand for stock buybacks is also justified as a shareholder-friendly measure. Section 4.1. pointed out that there is no plausible economic theory that the contents of shareholder activists’ demands would improve the operational efficiency of companies in the medium and long run. The same can be said about stock buybacks, which is the main content of the activists’ demands.

Stock buybacks are simply a shift of corporate assets from one form to another because a company purchases its shares in the open market by paying its reserves. There is no intrinsic value difference between when it keeps money as reserves and converts the equivalent amount into its shares through buybacks. Stock buybacks can increase the corporate value only when they correctly time the repurchasing of shares at prices below their intrinsic value and keep them until the stock prices are recovered. However, major US companies tended to do buybacks in bull markets, for example, when share prices were high rather than low. Their buybacks, therefore, should not be understood as investments in their own undervalued shares.Footnote ¹²² Why do we then see the buyback spree?

It has to do with the fact that stock buybacks change two things: short-term demand for its shares and its earnings per share (EPS). First, they create extra demand for a company’s shares in the stock market. This effect is more substantial when the scale of buybacks is bigger. Second, buybacks increase a company’s earnings per share (EPS) without increasing overall earnings because they decrease the number of outstanding shares, the denominator of the EPS calculation. Market participants often accept the increase in EPS as an improvement in corporate efficiency without carefully examining whether the change has come from the numerator or the denominator.

After the announcement of stock buybacks by a company, the combination of the short-term demand increase for shares and the EPS increase tends to result in a short-term increase in share prices.Footnote ¹²³ The empirical research on the effect of stock buybacks mostly confirms short-term share price increases after the announcement of stock buybacks, although the effect is not conclusive on the long-term share price increase.Footnote ¹²⁴ This result is consistent with the empirical research on shareholder activism discussed in Section 4.1, as one of the most frequent requests by hedge-fund activists is stock buybacks.Footnote ¹²⁵

Lazonick (Reference Lazonick2014b) points out that this short-term movement of stock prices principally benefits sharesellers, not shareholders. Those who sell shares can safely realize capital gains when the share price increases as the company continues to repurchase them from the stock market for a given period. Those who hold shares beyond the repurchase period do not benefit from stock buybacks because the company’s intrinsic value does not change. It should be noted that those who can benefit from the window of selling opportunity are limited to those with access to information and the capability to time the trading. They include hedge-fund activists who instigated stock buybacks after buying shares with an expectation that companies would acquiesce to their demands and senior executives who are involved in making decisions on stock buybacks and can benefit from the timing of stock option exercises and the vesting of stock awards.

Corporate executives became susceptible to stock buybacks from the 1980s for two major reasons. First, the introduction of Rule 10b-18 of the Securities Exchange Act in 1982, a “safe harbor” clause, allowed management to buy a significant number of the company’s shares in the open market on any given business day without fear that the SEC would charge them with stock-price manipulation.Footnote ¹²⁶ Second, ever since the broad adoption of stock-based pay for corporate executives starting in the 1980s, they have been paid heavily through stock options and stock awards, which ranged between 60 percent and 86 percent of the total remuneration for the 500 highest-paid executives between 2006 and 2015.Footnote ¹²⁷ EPS also became an important metric to determine their salaries because stock options and stock awards can be exercised when EPS hits certain targets.Footnote ¹²⁸

Before the 1980s, the growth rate of real wages tracked that of labor productivity. From the 1980s, however, the gap between the two has continued to increase, with the former falling further behind the latter.Footnote ¹²⁹ The corporate reserves spent on buybacks could have been used to provide increased job stability and higher earnings to the broad base of employees who helped generate the company’s profits. Instead, by raising the gains of those privileged sharesellers, buybacks contributed to the widening income gap.Footnote ¹³⁰ This process of concentration of income in the hands of a small number of people has undergone over the last three decades and contributed to the decline of the American middle class and the emergence of the “1 percent versus 99 percent” framework in income distribution.

5.1 Confusion between Value Creation and Value Extraction

The problems that corporations are perceived to have are associated with one of two phenomena: value creation and value extraction. Value creation is a process of creating corporate value by improving operational performance. It is mainly a domain of corporate management: Managers try to achieve better operational performance by generating high-quality, low-cost goods and services, for which they combine strategic control, organizational integration, and financial commitment. This capability to innovate by overcoming uncertainties is called managerial capability.Footnote ¹³⁴

On the other hand, value extraction is a process of distributing value created by a corporation to its stakeholders, including shareholders, workers, managers, and banks. Institutional shareholders, one of those value extractors, have limited liabilities over the corporations and are legally protected from corporate failures, not more than the loss of their shareholding. They are, therefore, not directly involved in management and only voice their requests or concerns to management through directors or shareholder meetings.

5.1.3 Business-Managing Fiduciary vs. Money-Managing Fiduciary

AT-MSV’s claims that corporate managers are agents of shareholders because shareholders “own” corporations are also not justifiable from the legal perspective of incorporation. Once a firm is incorporated, all its assets are owned by the corporation, that is, the legal entity specifically set up to manage the assets and conduct businesses, founders turn into shareholders, owners of shares issued by the corporation, not owners of the corporation. Jean-Philippe Robé (Reference Robé2011), a legal scholar and practitioner, calls this “the first separation of ownership and control” in contrast to “the second separation of ownership and control” described by Berle and Means (Reference Berle and Means1932) about the emergence of large public corporations with dispersed shareholding in the US in the early twentieth century.

I would put Robé’s “first separation” as the “permanent separation of ownership and control.” The “permanent separation” or “first separation” occurs at the time of incorporation, and this process is well-established in the legal profession, with different names such as “capital lock-in,” “affirmative asset partitioning,” “asset separation from shareholders,” and “the absence of a repurchase condition.”Footnote ¹³⁸ There is hardly any dispute about this permanent separation when a company is incorporated. The ownership is separated from founders who, in return for transferring their assets to the corporation, become shareholders with controlling rights and monetary rights over the corporation. Even in a corporation with only one shareholder, the person does not own it. He or she has 100 percent control over the corporation.

Confusion arises with terms such as Berle and Means’ “separation of ownership and control” or Robé’s “second separation of ownership and control.” What these terms indicate is the “dispersion of control.” In US corporations set up in the nineteenth century, the separation between ownership and control already happened as soon as they were incorporated. Since then, corporations have owned themselves all the while, that is, there was no more separation of ownership and control. What happened later in the late nineteenth century and early twentieth century in some large US corporations was that the control passed from their founding shareholders to professional managers, as Figure 7 shows. When founding shareholders sold their shares in the market and retired from management, institutional shareholders hardly existed, and it was mainly individuals who purchased the shares. These retail shareholders were weak and dispersed. They were only interested in the monetary rights attached to their shares, that is, prospective dividends and capital gains. They had neither the will nor the collective power to exercise the controlling rights coming with the shares they owned. Hence, the control was passed to professional managers who had worked with the founders and stayed true to their founding spirits by continuing to invest for the long term. The US thus entered the era of “managerial capitalism” with this dispersion of control in large corporations.Footnote ¹³⁹ Robé’s “second separation” is also not correct because the ownership has already separated, and there was no ownership to be separated again.

Figure 7 Ownership and control at the birth of managerial capitalism in the US

Understanding the process of incorporation is important to understanding for whom managers work. AT-MSV insists that managers are agents of shareholders only by relying on the untenable “residual claimants” argument. As a result of the permanent separation, however, shareholders do not own the corporation or its assets. They have become owners of special securities, that is, shares, issued by the corporation and are entitled to controlling and monetary rights over the corporation. They can exert their controlling rights through the board of directors or shareholder meetings. Robé (Reference Robé2011) thus emphasizes, “The shareholders enjoy the privileges of the owner towards what they own: the shares. They don’t and can’t have these privileges towards the corporation having issued the shares” (p. 3).

Due to this permanent separation of ownership and control, shareholders do not enter employment contracts. As an independent legal person, a corporation makes employment contracts with its managers. Managers are, therefore, agents of the corporation, not shareholders. They serve the corporation for its survival and prosperity. In other words, corporate managers are “business-managing fiduciaries” entrusted by the corporation. Ignoring this fundamental relationship between the corporation and its shareholders and bypassing the existence of the corporation, AT-MSV connects shareholders and managers directly and places managers as agents of shareholders.

Monks and other shareholder activists even attempt to elevate institutional shareholders to the status of corporations’ “owners.” It is not frequent that institutional shareholders portray themselves as “owners.”Footnote ¹⁴⁰ However, they do not own shares of corporations with their own money. They are managing money that savers put in their custody. In other words, institutional shareholders are “money-managing fiduciaries” entrusted by savers. So, the relationship between corporate managers and institutional shareholders is not vertical, contrary to what institutional activists purport. It is a horizontal one between two different fiduciaries serving different customers. There should be constructive conversations between the two fiduciaries, not an order from one fiduciary to another.

5.2 Uninterested and Incapable, but Strong Institutional Shareholders

Shareholder activism also went astray because characteristics of institutional shareholding have evolved far away from the ideal of shareholder democracy. Shareholder activists maintained the outdated outlook of “dispersed ownership” and portrayed institutional shareholders as weak “minority shareholders” who did not have effective means of voicing their concerns to “all-powerful” corporate management. They then sought to strengthen the power of institutional shareholders against management by changing regulations so that they could easily aggregate their voting power by allowing de facto investor cartels with “free communication and engagement.”

However, institutional shareholding already surpassed 40 percent of all shares outstanding in 1980 and approached 52 percent in 1990, making institutional shareholders the most dominant corporate shareholders (Figure 1). Moreover, institutional shareholding has been extremely concentrated in the hands of relatively few large institutional shareholders. For example, in 2022, the ten largest institutional shareholders held stock valued at $22.3 trillion, nearly 60 percent of that held by the 100 largest institutional shareholders, as Table 1 shows. Even among these ten largest institutional shareholders, concentration is remarkable. The “Big Three,” (BlackRock, Vanguard, and State Street) held $13.3 trillion of stock, more than one-third (35.4 percent) of public shares held by the 100 largest institutional shareholders. They “collectively vote about 20% of the shares in all S&P 500 companies” in 2018.Footnote ¹⁴¹ The US stock market is dominated by a few institutional shareholders, the “King Kong of investment America,” as the Vanguard founder John Bogle pointed out.Footnote ¹⁴² Their power is greater and more concentrated than that of large corporations.

In the conventional characterization of “dispersed ownership,” public shareholders, including institutional shareholders, are described as powerless “minority shareholders” who have no means to influence the management. “King Kong” institutional shareholders, however, amassed unprecedented voting power over individual companies. For instance, As Table 2 shows, BlackRock held 5 percent or more of the outstanding shares in 3,157 companies in 2022. Vanguard and Fidelity held 5 percent or more of the shares in 2,234 companies and 992 companies, respectively. In an article entitled “The Giant of Shareholders, Quietly Stirring,” the New York Times reported in 2013 that BlackRock was “the single largest shareholder in one of every five U.S. companies including Exxon Mobil and Chevron; AT&T and Verizon; JPMorgan Chase and Citigroup; GE; and more than 800 others. It also holds 5% or more shares of 1,803 U.S.-listed companies, about 40% of U.S.-listed companies.”Footnote ¹⁴³

Their voting power over individual companies is more remarkable when we consider the fact that these largest institutional shareholders are the most diversified stock traders in world history. Leading mutual funds and pension funds rely heavily on holdings in index funds such as exchange-traded funds (ETFs), by which they effectively “own the market,” as the number of portfolio companies in a fund sometimes exceeds 10,000. Even though their portfolios are often criticized for “excessive diversification,” they are still the single largest shareholders in a great number of public companies.

A serious problem with the voting power of index funds lies in the fact that they are neither interested in nor capable of voting even if they have already become the most important and powerful shareholders of US public corporations. John C. Coates (Reference Coates2018), a professor at Harvard Law School and formally an acting director of the SEC’s division of corporation finance, estimated in 2018 that “indexed funds now own more than 20% and perhaps 30% or more of nearly all U.S. public companies.”Footnote ¹⁴⁴ The wide variation of his estimates is understandable. Firstly, official statistics on index funds released by Investment Company Institute only include “registered index fund assets.” Yet a large and increasing portion of assets held by pension funds, insurance companies and non-profits are managed in index fashion. Secondly, the statistics do not include foreign funds. Foreign funds hold about 20 percent of all US equities, and they are managed in index fashion much more than domestic funds.Footnote ¹⁴⁵ Thirdly, a large portion of “nominally active funds” are in fact managed in index fashion.Footnote ¹⁴⁶ Whether one chooses to use the lower bound or the higher bound of the estimates, the dominance of index funds in the shareholding of US public corporations is likely to be strengthened further for quite a long while. Coates projected: “If current growth rates continued …, the entire U.S. market would be held by such funds no later than 2030. But even if the trend flattens, the majority of most companies will soon be owned by indexed funds.”Footnote ¹⁴⁷

Index funds’ critical competitive edge lies in the extremely low fees they charge to customers. They do so by managing funds through tracking indexes rather than picking shares of individual companies. They track indexes mostly with computer models by compiling information on companies and markets that is publicly available. They also enjoy greater economies of scale than active funds because, once an indexation model is devised, it is easily replicable in other funds with only minimum revisions and extra costs. They do not need to spend money and time to research individual companies in an attempt to find additional information unique to those companies. Unlike active funds that enjoy a decisive competitive edge due to such information, being uninterested in individual companies and remaining incapable of knowing about their unique information is the raison d’être of index funds.

Related to the growth of index funds, the portion of assets managed by artificial intelligence (AI) has increased dramatically. On the New York Stock Exchange, high-frequency trading (HFT) accounted for over half of the total trading volume after peaking at over 60 percent in 2009 (Figure 8). As a result, the average stock holding period was shortened from 57.1 months in 1980 to 15.4 months in 2000, and 4.8 months in 2009.Footnote ¹⁴⁸ The financial market is flooded with reports such as “Algorithms Take Control of Wall Street,” “A.I. Controls the Stock Market,” “The U.S. Stock Market Belongs to Bots.”Footnote ¹⁴⁹ A JPMorgan Chase report estimated that discretionary equity trading accounts for only about 10 percent of the total trading after removing HFT and index fund trading.Footnote ¹⁵⁰ It is impossible to expect that these AIs would behave as responsible and capable “corporate citizens.”

Figure 8 HFT as a share of US equities daily volume.

Source: Meyer et al. (Reference Meyer, Bullock and Rennison2018)

This change in the shareholding and trading structure reveals the schizophrenia of shareholder activists. In their zeal for activism, they envisioned a new world where institutional shareholders become more active and capable of intervening in corporate management through “relational investing.” However, institutional shareholders have evolved toward being less interested and less capable in proxy voting and engagement. Ironically, the legitimacy of institutional shareholders’ proxy voting and engagement has eroded as their power over corporations has increased. In denial of this new reality and, at the same time, sensing and exploiting the growing power of institutional shareholders, shareholder activists have only pressed for strengthening activism by aggregating power of already powerful institutional shareholders.

5.3 Misguided Compulsory Voting: Power to Proxy Advisory Firms

Monks invoked the concept of “citizenship” from political democracy when he pushed for compulsory voting of institutional shareholders. Like him, advocates of shareholder democracy have tended to employ analogies taken from political democracy. But Monks critically erred in using this analogy because compulsory voting is not a norm of political elections in most countries. He did not examine why it is not so or what its implications are for shareholder democracy. More importantly, he avoided assessing what real effects imposing compulsory voting as a fiduciary duty would have on the behavior of institutional shareholders.

5.3.1 Incorrect and Arbitrary Analogy to Political Voting

In a political election, compulsory voting certainly has its pros and cons. It can have the positive effect of augmenting the power of representation by increasing the turnout of voters at the ballot box. However, it can have negative effects on an election outcome because it increases blank, randomly marked, and spoilt ballots from voters who are not interested in the election and do not know about the candidates. These uninterested voters are also more prone to cast their votes in response to hot-button issues of the day or political scandals, rather than trying to align their voting with ideological or policy preferences.Footnote ¹⁵¹

The political reality around the world is that, whatever the theoretical balance of pros and cons, only a small number of countries adopt a compulsory voting system. There were 22 out of about 200 countries in 2019, including Australia, Brazil, and Singapore, where compulsory national voting was in effect and two local governments that had made voting compulsory.Footnote ¹⁵² Most countries consider voting as a right, not as a duty that they should enforce on their citizens. Many countries also take the position that abstaining from voting is also an expression of political preference that should be allowed in accordance with the constitutional right of freedom of speech. The fact that most countries do not adopt compulsory voting in political elections tells us that they are much more concerned with its cons than with its pros.

Yet advocates of compulsory voting for institutional shareholders presented only its potential pros, without considering or presenting either its cons or what the net effect of those pros and cons would be. If one looks into the nature and process of proxy voting by institutional shareholders, it is not hard to find that the cons of compulsory proxy voting are a lot more pronounced than those of compulsory political voting. In a political election, the secret ballot is the norm: Voters are guaranteed the secrecy of their ballots and not compelled to explain their voting decisions. In this situation, the negative effects of voting at random can be mitigated by the law of large numbers. In proxy voting, however, institutional shareholders are required not only to declare how they voted but also to provide justification for their voting decisions.Footnote ¹⁵³ Therefore, uninterested institutional shareholders are compelled to create or purchase justifications for their voting decisions. Even those who are interested in voting may decide to vote against their own preferences if strong public backlash against their voting decisions appears likely when they reveal their voting decisions.

Moreover, proxy voting is wide open to conflicts of interest whereas there is no room for conflict of interests in political voting (unless one can divide a person). In fact, the phenomenal growth of both the stock market and institutional investment has greatly lengthened and complicated the chain of intermediaries involved in institutional shareholding. In pension-fund investments, for instance, the chain extends from pensioners to pension administrators, pension investment advisers, funds of funds, external asset managers, and others. The relation among those intermediaries has also become very complex because, even within one mutual fund, there are numerous sub-funds (Figure 9). Considering the length and complexity of this chain, it is questionable whether those at the end of the chain would really exercise voting rights over corporations on behalf of the customers who had put money into their custody. Far detached from the original customers, institutional shareholders may cast their votes in their own interest rather than in the interest of those whose proxies they hold.

Figure 9 The lengthening of control chains within and among institutional shareholders

Source: Wong (Reference Wong2010)

This possibility of conflicts of interest becomes greater if the original customers have little power to replace their intermediaries, as typically is the case with public pension funds. Putting it in the terminology of agency theorists, institutional shareholders are prone to their own agency problems when they cast their votes ostensibly in attempts to resolve agency problems of corporate managers. These conflicts of interest were already evident as the empirical research on institutional activism detailed in Section 4.1 shows.

Nonetheless, the SEC expressed naïve expectations about the benefits of compulsory proxy voting in the “Final rule” in 2003, and this stance has not changed so far:

“Although we recognize that compliance programs, including proxy voting programs, may require advisers to expend resources that they could otherwise use in their primary business, we expect that the rules and rule amendments may indirectly increase efficiency in a number of ways. Advisers would be required to carry out their proxy voting in an organized and systematic manner, which may be more efficient than their current approach. Requiring all advisers with voting authority to adopt proxy voting policies and procedures, and meet recordkeeping requirements, may enhance efficiency further by encouraging third parties to create new resources and guidance to which industry participants can refer in establishing, improving, and implementing their proxy voting procedures.”Footnote ¹⁵⁴

The SEC’s position is based on the optimistic expectation that institutional shareholders would develop analytic capabilities to make voting decisions “in an organized and systematic manner,” and that “third parties” would be competent and objective in providing advice. Reality has shown this optimism to have been unfounded. Far from taking compliance seriously, the largest institutional shareholders, especially index funds, have limited their efforts to setting up skeletal research units that barely paid lip service to the new rule. Nor have the “third parties,” the proxy-advisory firms, equipped themselves adequately for their task; still, they exert undue power over the voting decisions of institutional shareholders and, thereby over corporations. In addition, they also have a serious potential for conflict of interest, as will be detailed below.

5.4 Consequences of “Free Communication and Engagement”

In bringing about the 1992 proxy-rule amendments, shareholder activists employed an analogy from political democracy. They portrayed corporate management as autocrats who ignored popular demands for freedom of speech and freedom of assembly while installing strict censorship in the form of proxy-filing procedures that, they charged, unfairly favored management. In contrast, they portrayed themselves as endeavoring to realize a true shareholder democracy by abolishing the censorship and thus obtaining the right of free communication and engagement. They then justified the proxy-rule changes by arguing that they would correct the imbalance between shareholders and management and bring about a more efficient market outcome.

However, such expectations are based on the critical assumption that freer and easier exchange of information has an efficiency-enhancing effect in the market, an assumption that follows from conventional economic models of competitive markets, which are in turn based on the assumption that interaction among players who have equal capability and equal access to information is the key to ensuring an efficient outcome. But markets in general, and the stock market in particular, do not function according to this neoclassical model. Markets may be unduly influenced by strong movers and shakers, and the stock market in particular is prone to manipulation. As it turned out, the very practices that the traditional regulations were meant to deter by preventing free communication and engagement, “fraud or deceit” and “manipulative or deceptive devices or contrivances”, became more widespread because of the proxy-rule changes and compulsory proxy voting.Footnote ¹⁷¹

The “wolf-pack phenomenon” – sudden concerted campaigns of hedge funds against their target companies – has become a new normal since the 1992 proxy-rule changes.Footnote ¹⁷² Wolf packs can only be seen as de facto investor cartels. In conventional economics, cartels are considered prime obstacles to realizing the efficient allocation of resources, and they are therefore regulated heavily in most countries with capitalist economies. The existence of unregulated wolf packs is testament to the fact that, with the proxy-rule changes the SEC effectively gave up its duty as a market regulator, employing the rhetoric of promoting “market efficiency” to hide this failure.

The SEC might have naively thought that freely allowing investor cartels made up of shareholders, none of which held less than 5 percent of the target company’s stock, would not undermine “market efficiency”. However, in light of the broad dispersion of shareholding in big public companies, those with a 5 percent stake can easily exert a strong influence on management. For instance, Third Point Management and Trian Fund Management, holding only 2 percent of outstanding stock of Dow Chemical and Du Pont respectively, engineered a merger-and-split of America’s top two chemical giants, as mentioned in Section 1.

Moreover, activist shareholders can easily circumvent the 5 percent rule by forming wolf packs. It is now a common practice for hedge funds to collaborate among themselves or with other institutional shareholders around a target company and coordinate their strategies and tactics. Even if each of those collaborating holds less than 5 percent of the target company’s outstanding shares, their combined stake can easily elevate them to the status of controlling shareholders. It is also possible for one lead wolf to take a share exceeding 5 percent, make public its intention of campaign, and then recruit other unidentified wolves, each holding less than 5 percent shares, to support the lead wolf’s attack. In the fight over control of Barnes and Noble, for example, the lead activist held an 18.7 percent stake in the company, but it turned out that the actual wolf pack controlled a 36.14 percent stake.Footnote ¹⁷³ In the campaign that forced the sale of Knight Ridder, “[w]hat started out as a 19% stake effectively grew to 37% in just 48 hours. The campaign succeeded almost instantly.”Footnote ¹⁷⁴

Moreover, the easier formation of wolf packs, in turn, made it easier for hedge-fund activists to manipulate the market through the “wolf-pack effect”. Upon the announcement or leaking of information about the formation of a wolf pack, the stock market generally reacts positively. For instance, an international study on the wolf-pack effect reports “abnormal announcement returns of 7% for the United States during a (-20, 20) day window” and of “6.4% and 4.8%, respectively”, for Europe and Asia.Footnote ¹⁷⁵ Those in the pack can easily develop trading strategies in advance because they exclusively know when they will trigger the wolf-pack effect. The market will also react to the way in which the wolves are moving together after the formation of the pack becomes public knowledge. Those in the pack again have advance knowledge of how they will act and can profit from front-running the market movements they create. The development of the derivatives market made it a lot easier for them to profit from front-running without being detected by regulators for market manipulation.

If both the anti-cartel spirit of the 5 percent rule and the anti-manipulation spirit are so easily compromised, the SEC should have tightened up the proxy rule to make it difficult for wolf packs to form and to profit from wolf pact effects. But the SEC has so far neither admitted the failure of the proxy rule change nor done anything to reverse the rule. This inaction only strengthens suspicion that the SEC, “self-regulating body”, is in effect functioning as a promoter of financial interests captured by shareholder activists who simply clamor for more power and freedom for themselves.

Allowing free communication and engagement with management has similarly failed to bring about market-efficient outcomes mainly because shareholders do not have equal access to management. While corporate executives can ill afford not to be serious in communicating and engaging with big institutional shareholders, they can simply ignore or offer perfunctory replies to the demands of small shareholders, who lack the larger players’ resources. A critical question here is whether big institutional shareholders and other influential activists engage with management as impartial representatives of the general interests of shareholders or exploit their access to management mainly for their own gain. Common sense, as well as broad anecdotal evidence of institutions’ self-serving utilization of communication and engagement with management, favors the latter answer.Footnote ¹⁷⁶

Calio and Zahralddin (Reference Joseph Evan and Xavier Zahralddin1994) pointed out that free communication and engagement with management provides institutional shareholders with a “tactical edge over the management and small shareholders because it occurs behind-the-scenes without media scrutiny or individual investor awareness” (pp. 522–523). Cioffi (Reference Cioffi2006) similarly concluded:

In addition, the free communication rule, far from evening the aforementioned imbalance between shareholders and management, intensified the imbalance skewed to shareholders. Activist shareholders are now free to criticize the company’s management “as long as the statements [they make] are not fraudulent.”Footnote ¹⁷⁷ In contentious issues, management makes its decisions by weighing their advantages and disadvantages. But activists can just focus on their perceived disadvantages and find whatever faults with management within the boundary of “not being fraudulent.” It is even possible to criticize management for not achieving better performance in the name of maximizing shareholder value when the company concerned has been performing well. On the other hand, it is not often easy for management to criticize the company’s activist shareholders unless it finds something seriously wrong with their statements or their behavior.

Owing to the free-communication rule, it has now become a convention among hedge-fund activists to criticize management, not only by sending letters but also by publishing “white papers” and even convening press conferences. This kind of public criticism puts enormous pressure on management and, rather than considering the public warfare, company executives tend to prefer making compromises with activists by yielding to some of their demands. Daniel Loeb’s (Third Point) attack on Dow Chemical is a case in point. Loeb opened a website specifically designed to criticize Dow management and their alleged “broken promises”. Dow management gave in and accepted two directors nominated by Loeb in return for a one-year truce including the closure of the website. These two directors were under Loeb’s “golden leashes” and soon played a central role in pushing Dow Chemical to conclude the merge-and-split deal with DuPont in December 2015.Footnote ¹⁷⁸

5.5 “Co-Investments” between Hedge-Fund Activists and Institutional Shareholders

Hedge-fund activists exert influence over corporations far beyond their shareholding because they often receive support from institutional shareholders implicitly or explicitly. The close ties between hedge-fund activists are multi-faceted. As financial investors, they share a similar world outlook that is focused on value extraction, which is different from corporate managers whose main responsibility is to create corporate value by producing high-quality, low-cost goods and services. Fund managers in institutional shareholders are also evaluated by their short-term performance even if they claim to pursue long-term gains. In this incentive structure, they tend to ally with hedge-fund activists. A Fortune report following the release of a letter to CEOs from BlackRock head Laurence Fink in 2014 that urged a long-term approach offers a vivid illustration:

The 1996 NSMIA provided a strong impetus to convert the potential ties between hedge-fund activists and institutional shareholders into “co-investments,” taking shares in the same company and coordinating their actions. Institutional shareholders already share commercial interests with hedge-fund activists because they supply about 60 percent of hedge funds’ AUM. Institutional shareholders apparently maintain the practice of voting independently of hedge-fund activists, which is legally required of them. However, if an institutional shareholder holds shares in both the hedge fund and the targeted company, it is highly likely to side with the hedge fund to raise the overall yield of its holding in the company and its alternative investment in the hedge fund. Anecdotal evidence of co-investment abounds.

For instance, it was revealed during the proxy battle between DuPont and Trian Partners that the California Teachers Retirement System (CaLSTRS) had cooperated with Trian’s campaign from the beginning. According to a Fortune report, DuPont’s management had never thought of this possibility because CalSTRS was a long-term shareholder and the company “generally had a congenial working relationship with the pension fund”. But CalSTRS co-signed an early letter supporting Trian when the latter attacked DuPont in 2015 and turned out later to be one of the hedge fund’s major investors. In detailing how DuPont went to war with Trian, the report stated that “[t]ies like that have made it harder for companies like DuPont to argue that siding with activists isn’t in the interest of shareholders.”Footnote ¹⁸⁰

The most detailed account of co-investment revealed in public so far has probably been that between CalSTRS and Relational Investors, an activist hedge fund set up by Ralph V. Whitworth and David H. Batchelder, who used to work with T. Boone Pickens as fellow corporate raiders.Footnote ¹⁸¹ CalSTRS committed $1 billion to Relational, $300 million to Trian, and $100 million to Starboard in 2013. Working in tandem from the beginning, Relational and CalSTRS increased their participation in Timken, a fifth-generation family business producing high-quality steel and bearings, until the holding of each reached the 5% threshold for a 13D filing. As part of their attempt to push the Timken family into breaking the company into two separate entities and increasing stock buybacks, Relational and CalSTRS set up a website, “unlocktimken.com”, that criticized Timken management publicly. An investment officer from CalSTRS joined a roadshow organized by Relational, flying to New York to meet fellow pension-fund managers. A seat on the Timken board was filled by a CalSTRS representative, and “the pension fund, long a champion of better corporate governance, made the case that Timken’s board was dominated by family members who paid themselves liberally and put their own interests ahead of shareholders’ interests.”Footnote ¹⁸² In April 2012, three weeks before the proxy vote, Relational and CalSTRS put out a news release calling Tim Timken’s $9 million pay package in 2011 “grossly out-of-line with other executive chairmen in Timken’s peer group.”Footnote ¹⁸³ Their proposal to split the company into Timken and TimkenSteel eventually garnered 53 percent of shareholder votes.