Tag: Shareholder Value

Investors as Stewards of the Commons?

Investors as Stewards of the Commons?

In our first article from the (JACF Spring/Summer issue) George Serafeim makes the case that business generally, not just government, should assume responsibility for social and environmental problems. The Sustainable Development Goals (SDGs) formally recognize the role of the private sector in addressing some of the world’s most pressing environmental and social challenges. What started as a corporate social responsibility movement now a focuses on integrating positive social impact into the core mission of the organization.

Encouragingly, studies document that improving firm performance on business-relevant ESG issues has a positive association with future financial performance. Investors can enable better societal outcomes by exercising ‘voice’ and voting rights in corporate governance.

He acknowledges that competitive businesses face a “commons” or “free-rider” problem where a defector avoids the full cost of his actions. Overcoming this problem requires legally sanctioned collaboration between business enterprises and large institutional shareholders, particularly pension funds. He also acknowledges that the corporate level free-rider problem has a counterpart that at the investor level. Investor engagement with companies involves resources, money and time. It is no simple matter to justify increased costs in the context of asset managers that compete on the basis of low management fees, such as index funds.

Collaboration between companies can mitigate some of these free riding problems. Large institutional investors with long time horizons and significant common ownership across different companies may have the best opportunities for collaboration. But, smaller activist funds and retail investors also have an important role in pushing large institutional investors to engage. While it is unlikely that investors will be able to solve all of the pressing societal problems, progress can be made.

Authored by George Serafeim, Harvard Business School

What Really Drives “Short-Termism”?


What Really Drives “Short-Termism”?

Earlier this month, the CEO of Pepsi Co. suggested to President Trump that eliminating quarterly reporting (and shifting to biannual reporting) would reduce the pressure on managers to focus on the short-term. As impulsive as Elon Musk, the president bought this view hook, line, and sinker and tweeted his proposed shift to the world (and a probably startled SEC).

But what will be the actual impact? Those who have a law and economics orientation will predictably respond that widening reporting frames will present investors with greater uncertainty and risk, with the result that stock prices should decline (and the cost of capital should increase). Some corporate managers will point to offsetting cost savings from reduced reporting, but cost savings are trivial in comparison with even a small stock price decline. Nonetheless, the argument that moves more managers is that, under six-month reporting, they can focus more on the long-run. Yet, this argument may be precisely backwards; that is, the shift to six-month reporting is more likely to exacerbate than alleviate this problem.

The empirical research in this area (while limited) tends to show that financial managers will indeed sacrifice long-term shareholder value in order to meet a quarterly earnings forecast. In a well-known study, three respected financial economists surveyed 401 senior financial executives and posed a hypothetical problem to these executives: If they saw they were likely to fall short of a quarterly earnings target, would they cancel or delay an investment or project with a positive net present value (“NPV”)?(1) The majority conceded that they would. In addition, more than three-quarters of the surveyed executives agreed that they would sacrifice shareholder value (by deferring NPV investments) to smooth earnings—apparently because they believe that missing the earnings target (or experiencing earnings volatility) will cause a stock price drop.

So, there is a problem (which my neoclassical friends in the law and economics field tend to ignore). But does a shift to less frequent reporting help or hinder? If we shift to six-month reporting, financial managers may face even greater pressure to meet their earnings target (or the consensus forecast). After all, impatient investors will have waited longer and faced greater uncertainty. The failure to “meet your forecast” would cast even a greater cloud on management’s reputation and competence.

Consider the problem this way: If it were possible to report earnings on a monthly basis (or—and this is sheer fantasy—a weekly basis), missing the monthly or weekly target would not mean that much. A short fall in one week could be offset by a compensating gain in the next week. But a failure to meet a six-month forecast could not be corrected until the annual audited results were posted some eight or nine months later (when the issuer filed its Form 10-K). Thus, self-interested managers will be even more incentivized to sacrifice NPV projects to meet the earnings target.

Ironically, logic thus suggests that the narrower the reporting frame, the less that the long-run will be subordinated to the short-run. To be sure, nothing here is certain. The UK moved from six-month reporting to quarterly reporting in 2003, and then moved back to six-month reporting in 2013. No one has detected any measurable change in capital investments on either of these shifts. Still, cultures and pressures may be different on opposite sides of the Atlantic, and there is both much greater use of incentive compensation in the United States and much greater pressure from activist hedge funds focused on the short-run. These factors may incline managers in the U.S. to focus more on the short-run to please the market.

Some other impacts do seem more certain. Under a six-month reporting cycle, information asymmetries will increase, and this will make insider trading even more profitable (and probably even more predictable). Stock volatility seems also likely to increase in the face of greater uncertainty.

So what should be done? Probably the simplest and best answer would be for financial managers to give less guidance about future earnings. Once a financial manager makes a forecast, he has effectively pledged his reputation and needs to protect it by manipulating earnings. Hence, less in the way of earnings forecasts implies less pressure on managers. The SEC and the stock exchange could discourage forecasting in a variety of incremental ways, but, of course, they cannot prohibit forecasts.

Can the SEC simply shift from quarterly to six-month reporting? This is a legal question that may cause the SEC to assert its powers under Section 36 of the Securities Exchange Act of 1934. Section 36 (“General Exemptive Authority”) authorizes the SEC to “exempt any person, security, or transaction, or any class or classes of persons, securities or transactions, from any provision or provisions of this title or of any rule or regulation thereunder…” But exercise of this authority requires the SEC to find “that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” To date, the SEC has used this provision only sparingly. Suppose then that such an exemption is granted by the SEC, based on cost savings justifications and the claim that it will protect investors from short-termism. Suppose next that a large group of institutional investors (including the Council of Institutional Investors) sues, claiming that the SEC’s exemption is very inconsistent with the “protection of investors.” How much deference should the SEC get?(2) Indeed, does this exemption even qualify for Chevron deference? This is a short column that will not attempt to resolve the current status of Chevron deference, but my bet would be that a conservative Supreme Court would back a conservative SEC.

But maybe I am just a pessimist.

John C. Coffee, Jr., is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

(1) See John R. Graham, Campbell R. Harvey and Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, (available at https://ssrn.com/abstract=647705 (2005). This study later appeared in the Journal of Accounting and Economics in 2005).

(2) If one wishes to read more on this topic, see Daniel T. Deacon, Administrative Forbearance, 125 Yale L.J. 1548 (2016); Lesley Chen, The SEC’s Forgotten Power of Exemption: How the SEC Can Receive Deference in Favor of Internal Whistleblowers Even When the Text is Clear, 67 Emery L. J. 1043 (2018).

Corporate Finance and Sustainability

The Case of the Electric Utility Industry

In our last article from the (JACF Winter issue) we discuss how although the electric utility industry is in transition, it still needs to move faster for the country to meet its emissions goals. The industry has historically moved cautiously, but policies and regulatory approaches must avoid unintentionally reinforcing the status quo. Incentive-oriented policies and redesigned regulations must balance environmental sustainability with economic sustainability. The authors draw on well-established corporate finance principles to guide more effective policies. Shareholder-focused utility executives must make investments conditioned by three elements: (1) the return on equity the utility can expect to make on each project; (2) the investors’ required return on equity capital for each project; and (3) the size of the investment.

The well-established economic value added (EVA) model can assist policy analysis: V=(r-k)I; where V is the shareholder value created, r is the return on equity, k is the return investors require if they are to invest in the stock, and I is the scale of the project. Any new incremental V translates into higher stock prices.

All three elements of their model (i.e., risk, return, and scale) require attention by regulators and policymakers to create value for shareholders. The authors show how the right state policies could create powerful incentives for shareholder focused utility executives to support such transitions.

Authored by Steven Kihm, Seventhwave; Peter Cappers, Lawrence Berkeley National Laboratory; Andrew Satchwell, Lawrence Berkeley National Laboratory; and Elisabeth Graffy, Arizona State University

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

In our third article of the Winter 30.1 issue we look at whether logically, the practice of corporate finance and corporate strategy should be closely coordinated, but in reality there remains a massive gap between the two. This can lead strategically oriented firms to de-emphasize or even discard NPV. Neither financial theory nor competitive strategy has been very open to the economic value of investment opportunity capture. Strategy must recognize that financial flexibility provides powerful advantages and financial theory must evaluate entire strategic programs rather than discrete, stand-alone projects.

Necessarily, the financial discussion of cost of capital and capital structure has to change. The authors offer two specific concepts to bridge the Gap between Finance and Strategy:

1) Reserve Financial Capacity is the annual sum of Free Cash Flow, Financing Flexibility and Cash Reserves over the period envisioned for strategy execution. Individual projects must belong to strategic programs in the sense that they either: 1) keep the base business running; 2) preserve an existing competitive position; or 3) form part of a program to enhance advantage or fashion a strategic breakout.

2) Strategically Sustainable Cost of Capital is the true, blended cost of capital required to complete an entire capital program.

These concepts provide financial rigor to firms with well-defined strategies and allow managements to wield Financial Flexibility as a strategic weapon, creating options on unique buying opportunities, such as at the bottom of industry cycles. The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.

Authored by Stephen V. Arbogast, Kenan-Flagler Business School, University of North Carolina at Chapel Hill and Dr. Praveen Kumar, C.T. Bauer College of Business, University of Houston.