Promoting Long-Term Value Creation – The Launch of the Investor Stewardship Group (ISG) and ISG’s Framework for U.S. Stewardship and Governance
A long-running, two-year effort by the senior corporate governance heads of major U.S. investors to develop the first stewardship code for the U.S. market culminated today in the launch of the Investor Stewardship Group (ISG) and ISG’s associated Framework for U.S. Stewardship and Governance. Investor co-founders and signatories include U.S. Asset Managers (BlackRock; MFS; State Street Global Advisors; TIAA Investments; T. Rowe Price; Vanguard; ValueAct Capital; Wellington Management); U.S. Asset Owners (CalSTRS; Florida State Board of Administration (SBA); Washington State Investment Board); and non-U.S. Asset Owners/Managers (GIC Private Limited (Singapore’s Sovereign Wealth Fund); Legal and General Investment Management; MN Netherlands; PGGM; Royal Bank of Canada (Asset Management)).
Focused explicitly on combating short-termism, providing a “framework for promoting long-term value creation for U.S. companies and the broader U.S. economy” and promoting “responsible” engagement, the principles are designed to be independent of proxy advisory firm guidelines and may help disintermediate the proxy advisory firms, traditional activist hedge funds and short-term pressures from dictating corporate governance and corporate strategy.
Importantly, the ISG Framework would operate to hold investors, and not just public companies, to a higher standard, rejecting the scorched-earth activist pressure tactics to which public companies have often been subject, and instead requiring investors to “address and attempt to resolve differences with companies in a constructive and pragmatic manner.” In addition, the ISG Framework emphasizes that asset managers and owners are responsible to their ultimate long-term beneficiaries, especially the millions of individual investors whose retirement and long-term savings are held by these funds, and that proxy voting and engagement guidelines of investors should be designed to protect the interests of these long-term clients and beneficiaries. While the ISG Framework is not intended to be prescriptive or comprehensive in nature, with companies and investors being free to apply it in a manner they deem appropriate, it is intended to provide guidance and clarity as to the expectations that an increasingly large number of investors will have not only of public companies, but also of each other.
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The new Dutch Corporate Governance Code, issued December 8, 2016, provides an interesting analog to The New Paradigm, A Roadmap for an Implicit Corporate Governance Partnership Between Corporations and Investors to Achieve Sustainable Long-Term Investment and Growth, issued September 2, 2016, by the International Business Council of the World Economic Forum. The new Dutch Code is applicable to the typical two-tier Dutch company with a management board and a supervisory board. The similarities between the Dutch Code and the New Paradigm demonstrate that the principles of The New Paradigm, which are to a large extent based on the U.S. and U.K. corporate governance structure with single-tier boards, are relevant and readily adaptable to the European two-tier board structure.
Both the New Paradigm and the Dutch Code fundamentally envision a company as a long-term alliance between its shareholders and other stakeholders. They are both based on the notions that a company should and will be effectively managed for long-term growth and increased value, pursue thoughtful ESG and CSR policies, be transparent, be appropriately responsive to shareholder interests and engage with shareholders and other stakeholders.
Like The New Paradigm, the Dutch Code is fundamentally designed to promote long-term growth and value creation. The management board is tasked with achieving this goal and the supervisory board is tasked with monitoring the management board’s efforts to achieve it.
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The evolution of corporate governance over the last three decades has produced meaningful changes in the expectations of shareholders and the business policies adopted to meet those expectations. Decision-making power has shifted away from industrialists, entrepreneurs and builders of businesses, toward greater empowerment of institutional investors, hedge funds and other financial managers. As part of this shift, there has been an overriding emphasis on measures of shareholder value, with the success or failure of businesses judged based on earnings per share, total shareholder return and similar financial metrics. Only secondary importance is given to factors such as customer satisfaction, technological innovations and whether the business has cultivated a skilled and loyal workforce. In this environment, actions that boost short-term shareholder value—such as dividends, stock buybacks and reductions in employee headcount, capital expenditures and R&D—are rewarded. On the other hand, actions that are essential for strengthening the business in the long-term, but that may have a more attenuated impact on short-term shareholder value, are de-prioritized or even penalized.
This pervasive short-termism is eroding the overall economy and putting our nation at a major competitive disadvantage to countries, like China, that are not infected with short-termism. It is critical that corporations continuously adapt to developments in information technology, digitalization, artificial intelligence and other disruptive innovations that are creating new markets and transforming the business landscape. Dealing with these disruptions requires significant investments in research and development, capital assets and employee training, in addition to the normal investments required to maintain the business. All of these investments weigh on short-term earnings and are capable of being second-guessed by hedge fund activists and other investors who have a primarily financial rather than business perspective. Yet such investments are essential to the long-term viability of the business, and bending to pressure for short-term performance at the expense of such investments will doom the business to decline. We have already suffered this effect in a number of industries.
In this environment, a critical task for boards of directors in 2017 and beyond is to assist management in developing and implementing strategies to balance short-term and long-term objectives. It is clear that short-termism and its impact on economic growth is not only a broad-based economic issue, but also a governance issue that is becoming a key priority for boards and, increasingly, for large institutional investors. Much as risk management morphed after the financial crisis from being not just an operational issue but also a governance issue, so too are short-termism and related socioeconomic and sustainability issues becoming increasingly core challenges for boards of directors.
At the same time, however, the ability of boards by themselves to combat short-termism and a myopic focus on “maximizing” shareholder value is subject to limitations. While boards have a critical role to play in this effort, there is a growing recognition that a larger, systemic recalibration is also needed to turn the tide against short-termism and reinvigorate the willingness and ability of corporations to make long-term capital investments that benefit shareholders as well as other constituencies. It is beyond dispute that the surge in activism over the last several years has greatly exacerbated the challenges boards face in resisting short-termist pressures. The past decade has seen a remarkable increase in the amount of funds managed by activist hedge funds and a concomitant uptick in the prevalence and sophistication of their attacks on corporations. Today, even companies with credible strategies, innovative businesses and engaged boards face an uphill battle in defending against an activist attack and are under constant pressure to deliver short-term results. A recent McKinsey Quarterly survey of over a thousand C-level executives and board members indicates most believe short-term pressures are continuing to grow, with 87% feeling pressured to demonstrate financial results within two years or less, and 29% feeling pressured over a period of less than six months.
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UK UPDATE – Understanding and Dealing with Hedge Funds and Shareholder Activism Across Europe: The Impact of the Financial Crisis
The attached guide takes a pan-European look at trends and developments through the 2008 financial crisis and in the period since, focusing on:
- the position of hedge funds: their behaviour, performance and strategies in that period, as well as the changed regulatory landscape they now face, and
- activist behaviour by both hedge funds and other investors during that period.
ITALIAN UPDATE – Formation of New Italian Fund to Protect Italian National Champions, in Reaction to the Takeover of Italy’s Parmalat by France’s Lactalis
The recent acquisition of Parmalat — one of the biggest Italian listed companies — by the French dairy group Lactalis, caused a huge debate in the financial and political communities in Italy.
Lactalis’ bid was initially met with stiff Italian resistance, including encouragement of potential local “white knights,” issuance of an emergency decree to allow Parmalat to postpone its General Meeting, and debate about possibly issuing a decree granting the government new powers to block foreign bids for companies deemed strategic. But in the end, Italy decided to abandon the fight, and Lactalis managed to complete its takeover bid.
After the “thunderstorm,” the Italian government’s emphasis shifted from introducing protectionist measures to a more far-reaching goal of stimulating the Italian market for domestic mergers and acquisitions, so as to counter foreign competition. As a first step, the Ministry of Economy promoted the establishment of a new fund to invest in companies of “significant national interest”, which has been broadly defined. The initial investor in the fund is the Italian government’s Cassa Depositi e Prestiti, but the fund is also open to banks, insurance companies, and other institutional investors. It is expected that, in the near future, participation in the fund will be opened to foreign private investors as well.
The political fear of losing “national champions” to the advantage of “foreigners” is commonplace almost everywhere in the world, however, in Italy it has its own peculiar origins and reasons.
Italy’s economic base consists primarily of small and medium sized enterprises which contribute to most of the country’s national exports and GDP. Traditionally, Italy has fewer large industrial or financial groups, most of which are family owned or controlled, in comparison to other developed economies such as France, Germany, and the UK. Over the years, this peculiar structure of the Italian economy has contributed to making Italian industrial and financial groups comparatively less dynamic than their foreign counterparts when pursuing mergers and acquisitions. In general, in the Italian business environment, “friendly” transactions tend to be more common than competitive bids where several potential buyers compete for the same target. This is partially due to the fact that, traditionally, only a few Italian companies listed on the stock exchange are actually “public companies”. Also, Italian entrepreneurs often see few incentives in embarking on M&As, as family-run businesses — even when they grow to a meaningful size — can encounter significant difficulties in managing the challenges of external acquisitions.
While our purpose here is not to discuss the effect of the peculiarities of Italian capitalism on the economy as a whole, it is fair to say that, as the Italian M&A market has increasingly opened up to foreign investors over the last couple of decades, Italian companies have been faced with the challenge of foreign competitors which, overall, have been more aggressive and dynamic.
The recent acquisition by the French dairy group Lactalis of Parmalat — one of the biggest Italian listed companies in terms of market capitalization — caused a huge debate in the financial and political communities. Parmalat was turned around after going bankrupt in 2003, thanks to the efforts of a management team that was particularly effective in restructuring the company and making it profitable again. However, that same management was considered too conservative by many, in pursuing a strategy of growth. In fact, when Lactalis moved to acquire a large stake in the company, Parmalat was sitting on a significant amount of cash, while evaluating a few possible business combinations.
Soon after Lactalis increased its stake to around 29%, a group of Italian investors, mainly led by domestic banks, tried to find a “white knight” to launch a bid to prevent Lactalis from controlling the company. Despite significant initial political support, the Italian “white knight” never materialized, mainly because of difficulties in finding a strong industrial partner interested in joining the group. Eventually, Lactalis decided to launch a tender offer, and acquired full control of Parmalat. Notwithstanding the fact that Parmalat’s Board of Directors considered the offer price insufficient, the offer succeeded owing to a lack of concrete alternatives. Lactalis’ bid spurred a significant debate in the media and in the Italian political arena as it revitalized the numerous and vociferous advocates calling for stronger protection for Italian “national champions” from foreign takeovers.
Initially, the Italian government tried to place certain hurdles for the French takeover, and actually adopted an emergency decree to allow the postponement of Parmalat’s General Meeting for a couple of months, in an attempt to gain time to allow a group of Italian companies to launch a bid before Lactalis could appoint a new Board. As any prospect of an Italian “white knight” faded away, the government also considered the possibility of issuing a decree granting it new powers to block foreign bids on companies deemed strategic. This may well have halted the French bid. The new decree was supposed to be modelled on French law No. 2005-1739 of 30 December 2005, which created an authorisation procedure for foreign investments in certain sectors of activities that could have affected public policy, public security, or national defence. This attempt was, however, soon abandoned by the Italian government, fearing the risk that these new rules could have proved to be inconsistent with EU rules on free movement of capital. Thus, after a summit between Berlusconi and Sarkozy, the Italian government decided to drop the fight against the French “invader”, at least this time.
As the thunderstorm on Parmalat ended, with the French group finally taking over Parmalat, from a political standpoint, the problem of protecting Italian “national champions” from foreign attacks remained far from resolved. However, the government policy to curb this political pressure seems to have shifted from introducing restrictive measures aimed at deterring foreigners from taking over Italian companies, to the more far-reaching goal of stimulating the market for domestic mergers and acquisitions, so as to counter foreign competition.
The latter goal is clearly more far reaching and harder to achieve in the short term. In theory, this policy is obviously more desirable and consistent with Italian obligations under European law, however, it carries two significant risks. On one hand, it may not be considered sufficient to satisfy the immediate requests of those factions within the government that believe that the country is undergoing a “looting” of its strategic assets. On the other, its implementation requires strong government commitment to pursue significant changes to the structure of Italian capitalism and, at least, a bit of time.
For the time being, however, the government seems to have chosen an intermediate solution, which should be able to deliver some immediate results and represents a step forward in fostering the domestic M&A market. The idea was borrowed from France, as this next-door neighbour is not only perceived as the most significant “threat” to domestic ownership of Italian companies, but is also considered to be a front runner when it comes to protecting its own national strategic interests from “foreign attack”. The core of this approach is the creation of a fund focused on investing in companies of “significant national interest”, which have been broadly defined by the Ministry of Economy to include companies operating in strategic sectors, such as defense, security, infrastructure, public services, transportation, energy, telecommunications, finance, and high tech, as well as companies that, regardless of their business, exceed certain thresholds in terms of revenue and number of employees. While the broadness of the above definition will not limit a fund’s target choice very much, there is the more significant limitation that will come from the fact that only the buying of minority stakes in companies that are economically and financially sound will be allowed, as European rules on state aid limit the State’s ability to invest in distressed companies.
Similarly to its French predecessor, the Italian fund has been established by enlarging the scope of activity of an entity known as “Cassa Depositi e Prestiti”, a special entity controlled by the Ministry of Economy which lends savings collected through the postal services to public entities and finance infrastructures.
Therefore, as the initial investor of the fund is the Cassa Depositi e Prestiti, which is expected to inject approximately 1 billion euro (and in the aggregate up to 4 billion euro), the fund will be off the state’s balance sheets, as its funding does not actually come from public debt. Also, it is expected that, in the near future, participation in the fund will be opened to foreign private investors as well, in an effort to encourage foreign investment in Italian companies, while keeping them in domestic hands.
Critics argue that the fund may turn out to be an instrument for politicians to exert influence on Italian businesses, somehow recreating under the cover of a new and more acceptable form, the old system of state intervention in the economy — a sort of new IRI — the Istituto per la Ricostruzione Industriale — that over the years represented the State’s long hand in business sectors ranging from the transportation to the confectionery industry.
Even though the fund has yet to start operating, the significant background circumstances relating to the newly appointed Managing Director, Mr. Maurizio Tamagnini, are noteworthy. Mr. Tamagnini headed one of the largest international investment banks in Italy, and his appointment may be regarded as a significant step towards insulating the fund from political pressure, and may even give an indication of the fund’s investment style and strategy for the very near future.