Thursday, January 2, 2014
Can loyalty-driven securities solve the problem of short-termism? Probably not, according to a study.
The Generation Foundation (the “Foundation”), which focuses on sustainable capitalism, commissioned Mercer and Canadian law firm Stikeman Elliott LLP to study ways to foster more long-term thinking in the capital markets. In a prior report the Foundation proposed five actions to counteract the effects of short-termism including: (1) identifying and incorporating risks from stranded assets; (2) mandating integrated reporting; (3) ending the default practice of issuing quarterly earnings guidance; (4) aligning compensation structures with long-term sustainable performance; and (5) encouraging long-term investing with loyalty-driven securities.
Loyalty-driven securities provide differentiated rights or rewards to shareholders based on their tenure of shareholding. These rewards could include extra dividends, warrants or additional voting rights for owners who held shares for three years (or some other time period), limiting proxy access to shareholders of a specified minimum duration, or inferior voting rights for short-term shareholders. The idea is not far-fetched. Apparently, the European Commission is considering proposals to reward certain shareholders with additional voting rights.
In a report issued in December 2013 the Foundation, Mercer and the law firm outline the results of their legal review of almost a dozen countries and the interviews of over 120 experts. Interviewees included academics, pension funds, investors, and stakeholders such as GMI, Blackrock, UBS Global Asset Management, Ceres, the Conference Board, the Office of NYC Comptroller, Johnson & Johnson, Fidelity, Ira Millstein, CalSTRS, Aviva Investors and academics from Columbia and the London School of Economics.
The report starts with the premise that “heightened interest in ‘short-termism’ also reflects the belief that causes of short-termism… are products of poorly designed organizational incentives and failures of corporate governance systems rather than simply a result of information asymmetry, technological innovation, or the cognitive limits of decision-makers.”
The study revealed that proposals to consider loyalty-driven securities --which are already allowed by law and in use in France -- met with considerable resistance. Those who opposed them mentioned potential discrimination between shareholders; the risk of unintended consequences because it would favor certain types of investors such as passive investors; administrative complexities around share transfers, tracking of tenure and custody; the weakness of the incentive because the nature of the reward would not be enough to forego revenue; and finally a concern that loyalty-driven securities would not address the root causes of short-termism.
Three themes emerged from the interviews for continued study. First, the authors suggest longer time horizons for investment analysis and a review of different forms of capital including financial, physical and human. Second, they recommend realigning frameworks for performance measurement and reward so that individuals will not be penalized for their longer-term decision-making. Third, they believe that investors may need more information and stronger relationships with companies so that they can have faith in long-term value creation and strategies and the executives in charge of implementation.
To effectuate this kind of change they recommend: better-informed fiduciary oversight; board and investment committee education programs; a database of sustainable financial market-certified candidates for board, trustee and investment committees; focus by policymakers and regulators on shaping laws conducive to long-term thinking; a live shadow-monitoring pilot to establish a set of metrics against which to monitor and report fund manager performance to clients; alignment of incentives related to executive compensation; a formal investor-issuer council for systemic risk; and a campaign to educate and encourage analysts and investors to question companies about their long-term strategy during quarterly earnings calls.
Given my focus on corporate governance and sustainability, I read the report with great interest. Whether or not you favor loyalty-driven securities, the full report and appendices are worth a read.