September 13, 2006
Hedge Fund Returns
Gregory Zuckerman writes today in the Wall Street Journal ("Hedge Funds Miss Their Target") on hedge fund returns. As I have come to expect, he does a great job with the piece. Behind his analysis on raw returns however is an undiscussed elephant in the room. Hedge Fund reports to their investors (existing and potential) show tremendous variety whenever the funds hold non-publicly traded assets. Valuation problems of privately traded assets invite hedge funds to use very, very optimistic valuations of assets, particularly the stock of privately held portfolio companies that may have fallen on hard times. The funds are very reluctant to write their values down. There are many other such examples and there is no standardization on many difficult asset valuation issues in these funds. Given the valuation problems of many hedge funds, the data on their returns is hard to trust. In any event, a hedge fund that reports low returns, given the leeway hedge funds have on valuation, may have really had a bad year. I have tried to get information on hedge fund reporting many times, only to be rebuffed by those in the industry -- don't ask, we won't tell.
Panel on Competitiveness
A group, called the Committee on Capital Markets Regulation, has been formed by a Harvard Law professor, Hal S. Scott, the Dean of the Columbia Business School, Glenn Hubbard, and the Board Chairman of the Brookings Institute, John L. Thornton. The sterling credentials of the committee promoters continued with their selection of a group of well-known business leaders and academics and their selection of a group of academic presenters who will prepare papers for comment. There is speculation that behind the Committee is the fine hand of the current Treasury Secretary, Henry M. Paulson, Jr. The intent of the Committee is to provide a persuasive, nonpartisan basis for reform of Sarbanes-Oxley and other government regulations that, at the moment, are too heavy handed and adversely affect the international competitiveness of American business. There findings will not be controversial (most professionals understand that we overreacted to the scandals of 2002) but the implementation will be. It is very hard to find political cover for politic ans who go along with reducing the impact of government regulation on corporations. It is all too easy (and too effective) for political opponents to yell that such politicians they "favor the rich and powerful...have sold out to corporate welfare..." and so on. Whether the Committee can prove the necessary politcal cover for new legislation is highly doubtful.
More on the AIG Case
A few weeks ago a federal circuit court in New York City, known for its expertise on corporate law matters, decided a case that is a watershed moment in corporate governance.
The Second Circuit held that American International Group Inc. (AIG) has to submit a new bylaw to its shareholders for a vote at the next annual meeting. The bylaw enables any AIG shareholder holding over three percent of the voting stock of the company to nominate candidates for election to the AIG board of directors. The company must include the nominations on the company’s proxy card.
The bylaw, if passed, will facilitate election contests. In the past the board of directors nominates its own candidates for the board and includes only these nominations on the firm’s proxy card. Shareholders wishing to nominate other candidates must create and mail their own proxy card, which can cost a half million dollars or more. As a consequence, contested elections are very, very rare.
With the AIG bylaw, contested elections would be common. This is a huge change.
This case began when a major shareholder, a public pension fund (The American Federal of State, County and Municipal Employees) requested that AIG include the bylaw in its proxy materials. The shareholder claim authority under a Rule of Securities and Exchange Commission (SEC), Rule 14a-8, on shareholder proposals.
The company asked the SEC for permission to refuse. In February of 2005, the Securities and Exchange Commission sided with AIG. The agency relied on an exception to the Rule for any proposal that “relates to an election.” The District Court agreed, holding that the bylaw deals with nothing but a board election.
The Second Circuit focused on the article “an” in the language of the exception and reversed the District Court. The Second Circuit held that general election procedures were not exempted. Election procedures, the court held, affect many elections not just a single election.
Management control of a firm’s proxy card and, through that control, control over who is nominated to be a director has been a defining feature of American corporate governance for over one hundred years. The AIG bylaw creates an easy opportunity for a single shareholder to create a contested election. Management that has not performed well for its shareholders may find its candidates rejected.
The Second Circuit ruling stunned the management community and their lawyers. They have put immediate and heavy pressure on the SEC to revise its rules to put the older system back in place. It appears that the SEC will respond to the pressure and act to overturn the Second Circuit decision with a rule change. Pity.
We will soon know as a public hearing on the rule revisions is scheduled for October 18th.
An SEC rule change back to the old system will not be the end of the matter, however. The rule change must stand up to a court challenge on rule adoption procedures and the SEC has not done well recently in such challenges. Moreover, Congress may put opposite pressure on the SEC to be more sympathetic to shareholders. If unsatisfied, Congress can overrule any SEC rule change with legislation.
A decade ago this change would have been unthinkable. Suggestions for contested board elections have been around for a long time and have never been taken seriously. But a decade of managerial misbehavior, accounting and stock backdating scandals and compensation excesses, have given calls for more shareholder power over board elections a new strength and vitality.
There is real depth to the public’s discontent with management compensation levels, for example, and the AIG taps directly into that discontent. Managers will come to realize that their over-reaching on salary has generated a sea change in public confidence in their prerogatives.
And it may play out in the AIG bylaw controversy. The Second Circuit decision may be the event that dislodges the massive boulder of management control and begins its roll down the hill.