Saturday, March 9, 2019

Investors Should Be Seen and Not Heard

I am fascinated by the eyebrow-raising speech SEC Commissioner Hester Peirce delivered to the Council of Institutional Investors (CII) earlier this week.  In it, she said:

I have concerns about CII’s position with respect to the Johnson & Johnson shareholder proposal. As you know, a Johnson & Johnson shareholder submitted a proposal that, if approved, would have started the process to shift shareholder disputes with the company to mandatory arbitration…. CII also submitted a letter stating that “shareholder arbitration clauses in public company governing documents reflect a potential threat to principles of sound governance.”…

CII argues that “shareowner arbitration clauses in public company governing documents represent a potential threat to principles of sound corporate governance that balance the rights of shareowners against the responsibility of corporate managers to run the business.” Among your worries is the non-public nature of arbitration and thus the absence of a “deterrent effect.”…

The problem is that these class actions are rarely decided on the merits. Instead, the cost of litigating is so great that companies often settle to be free of the cost and hassle of the lawsuit.  Settlements are rarely public and certainly involve no publication of broadly applicable legal findings. Additionally, such suits can depress shareholder value since they often result in costly payouts to make the suit go away that do not inure to the benefit of shareholders.  Indeed, the cost of defending and settling these suits is a substantial cost of being a public company. The result is that the company’s shareholders are ultimately harmed by the very option intended to protect them: first by the company’s diversion of resources to defend often meritless litigation, and second by the resulting decline in the value of their shares. Case law remains untouched, and the shareholders not involved in the process have no idea what happened. A big chunk of shareholder money typically goes to nice payouts for the lawyers involved.

As I understand it, in her view, institutional investors are not capable of judging the value of securities litigation relative to arbitration, may not be aware that securities lawsuits often settle without definitive factual findings, and also may have never head the criticism that such lawsuits are expensive for companies and enriching for attorneys. 

She also appears to believe that institutional investors are unable to identify the types of corporate information that contribute to their understanding of firm value.  As she put it:

My concerns are mainly ones of focus.  I recently had a conversation with a boy who shares an obsession with many other children his age—the video game Fortnite.  He described to me how much he enjoyed long stretches of playing the game ... How is it that this simulated environment can drown out the real distractions around him? Clearly, the designers of that game and others like it have figured out how to concentrate the mind on objects of their own making....

I see a parallel in today’s investment world.  Many investors these days seem focused on non-investment matters at the expense of concentration on a sound allocation of resources to their highest and best use. Real dollars are being poured into adhering to an amorphous and shifting set of virtue markers. I do not want the SEC to become an enabler of this shift in focus. … We are being asked more and more to shift securities disclosure to focus more on matters that do not go to an assessment of how effectively companies are putting investor money to work….

Institutional investors [] have been a strong voice in favor of regulation that supports the incorporation of environmental, social, and governance (“ESG”) in investing. The International Organization of Securities Commissions, or “IOSCO,” issued a statement on ESG investing in January.  The statement directed issuers to consider whether ESG factors—which are not defined—should be included in their disclosures, …

I found the statement to be an objectionable attempt to focus issuers’ on a favored subset of matters, as defined by private creators of ESG metrics, rather than more generally on material matters. The U.S. securities laws already provide for material disclosures. Explicit consideration of ESG factors must therefore require something more than what is already contemplated by our laws …

When the SEC is asked to concentrate on issues other than protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets, our focus shifts away from our mission. …

Yet despite this apparently low opinion of institutional investors’ ability to identify and advocate for their own interests, she also made the claim that:

If shareholders value the ability to bring class actions, they can divert their investments to companies that offer such options. I am sure that CII’s preferences will be well-attended by issuers seeking your investment money. I trust that shareholders like you are more than capable of handling the matter without our intervention.

I have to say, if institutional investors are distracted by nonmaterial ESG factors like a child playing Fortnite, I’m not sure how they’re supposed to go about pricing arbitration provisions in a publicly traded company. 

In fact, we may want to begin rolling back all of those exemptions from registration for institutional and accredited investors.  The premise of Regulation D, and Rule 144A, the “testing the waters” provision, and Section 4(a)(7) is that institutions are capable of bargaining for the information they need to make intelligent investment decisions, and they do not need the paternalistic protections of mandatory securities disclosure.  But if it’s true that they are ignorant even of the phenomenon of the securities nuisance settlement, I don’t have much faith in their ability to engage in the more complex task of valuing an illiquid limited partnership interest in a 10-year private equity fund. (To be fair, that’s also how institutional investors themselves see it; they’ve just asked the SEC for greater oversight of the private equity industry.)

Okay, I’m snarking, of course, but this highlights a greater tension in the law that we see both at the federal and state level: regulators like to say they’re relying on institutional investors’ own judgments and wisdom (Regulation D, Corwin, etc) right up until the moment that these investors start to advocate for things the regulator doesn’t like (ESG disclosure, hedge fund activism, reliance on proxy advisors), at which point, investors are like children: better seen and not heard.  It’s a way of making substantive regulatory choices while maintaining a pretense of deference to private ordering.  The greater truth, in my view, is that institutional investors themselves are a product of regulation; they couldn’t exist without it, it’s written into their bones.  They are so entangled with the regulatory state that the concept of private ordering becomes meaningless; there is simply one set of regulatory choices over another.

Ann Lipton | Permalink


"Settlements are rarely public"? Does she mean settlements in shareholder class action lawsuits are rarely public? Settlements in all class action lawsuits are legally required to be public, from the settlement agreement themselves to the pros and cons of the settlement in the supporting motion to the lodestar and fee awards. On my computer, I have the settlement documents for every securities class action settlement over the past 14 years. And nearly all of these settlements happened after a decision on the motion to dismiss, which typically involves a very lengthy and public briefing battle and published decision. I can be critical of shareholder litigation myself, but these objections just seem way off base.

Posted by: Jessica Erickson | Mar 11, 2019 7:00:17 AM

Oh good point - I wasn't even focusing on that.

Posted by: Ann Lipton | Mar 11, 2019 7:04:26 AM

I have called - with Jeff Madrick - for the closing of the Rule 144A exemption, albeit on other grounds here:
and we weren’t being snarky!

Posted by: Steve Diamond | Mar 11, 2019 3:43:58 PM

Ah, I hadn't seen that! Though I don't think it's precisely a modest proposal at all. I do agree with the broader point that there's a real question whether institutional investors have the sophistication (usually) legally attributed to them.

Posted by: Ann Lipton | Mar 11, 2019 3:50:30 PM

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