Agreement in principle: a compromise for activist shareholders from the UK Stewardship Code.

Abstract

Equity ownership in the United States and Europe is now highly concentrated in the hands of institutional investors, which gives rise to new problems of agency and corporate governance. These large investment intermediaries, such as mutual funds, specialize in maximizing beneficial owner value based on short-term performance benchmarks but lack the expertise and incentive to actively engage corporate boards on business strategy and governance matters. Instead, institutional investors are "rationally reticent," meaning that they are willing to respond to governance proposals but not to propose them. Activist shareholders may offer an endogenous solution to address "latent activism" in institutional intermediaries and, ultimately, spur the effective monitoring of corporate boards. Activist shareholders, such as hedge funds, often achieve their business strategy and governance objectives by obtaining toehold positions in a corporation and soliciting support from institutional investors for their governance proposals. However, this solution is in jeopardy. Recently proposed regulatory changes in the United States track adopted legislation in the United Kingdom and Europe, and pose a threat to domestic activist shareholder success. This Note argues that incorporation of the UK Stewardship Code's Principle 5 into the U.S. regulatory scheme may help alleviate the potentially chilling effects of the proposed rule-making on shareholder activists.

TABLE OF CONTENTS I. INTRODUCTION II. THE EVOLVING ROLE OF INSTITUTIONAL OWNERS IN UK AND U.S. CAPITAL MARKETS A. The UK Stewardship Code 1. Historical Background 2. Policies 3. Principles B. Rational Reticence: The Nature of Institutional Investors C. The Emergence of Activist Shareholders D. Rational Reticence and Activism III. THE CURRENT DEBATE A. Activist Shareholders As Governance Intermediaries B. The Nature of Hedge Fund Activism C. The Williams Act IV. THE PRINCIPLE 5 COMPROMISE A. The UK Stewardship Code's Principle 5 as a Compromise for Activist Hedge Funds B. Changed Circumstances: Activist Hedge Funds Are the Superior Corporate Monitor V. CONCLUSION I. INTRODUCTION

Institutional investors in the United States and the United Kingdom now hold more than 70 percent of the outstanding equity issued by each respective nation's largest public firms. (1) The agency problems posed by the classical Berle-Means theory of dispersed share ownership are today a moot point. (2) With the vast majority of equity interests held by intermediary institutions, like mutual funds and pension funds, individual investors now find themselves grappling with two sets of unwieldy agency relationships: (1) between themselves and corporate directors and (2) between themselves and intermediary institutions. (3) The result has been further displacement of ownership from control and further devaluation of governance rights. (4)

Beginning in the early 1990s, many commentators argued that institutional investors ought to bridge this widening gap by "monitoring" and "engaging" portfolio companies on behalf of their beneficial owners and the public generally. (5) In response to the global financial crisis in 2008-2009, some jurisdictions, including both the United Kingdom (6) and the European Union, (7) agitated for best practice codes (8) urging governance obligations of "stewardship" and "sustainable shareholder engagement" upon institutional investors. (9) The push for these governance obligations stemmed from a belief that institutional investor stewardship will foster the long term success of companies "in such a way that the ultimate providers of capital also prosper." (10)

Institutional intermediaries, however, have proven to be ineffective as proactive corporate monitors because they lack the incentive and expertise for corporate stewardship. (11) As a result, the immense governance rights possessed by institutional owners have become significantly undervalued. (12)

Just because institutional investors are unwilling to actively engage corporate boards and propose changes in governance does not mean that they are unwilling to respond to such proposals. (13) Empirical evidence indicates that mutual funds often act on proposals presented to them, and oppose management, on core governance issues. (14) The theory underlying this behavior is known as rational reticence. While mutual funds are reluctant to proactively engage portfolio companies, mutual funds are not passive when faced with the opportunity to respond to proposals. (15)

In the United States, it has been argued that activist shareholders, such as activist hedge funds, are the capital market's evolutionary response to the agency gap that results from ownership concentration in institutional intermediaries. (16) Activist shareholders typically acquire noncontrolling toehold positions in corporations and then subsequently attempt to influence those corporations' business strategies. (17) Within this framework, activist shareholders play a specialized corporate monitoring role, breathing life into the substantial governance rights that lay dormant in the hands of institutional investors. (18) Activists derive the support they need for successful proposals by convincing institutional owners that their plan will enhance shareholder value. (19) In this way, activist shareholders bring about a form of "market-based stewardship." (20)

Assuming that activists are integral to market-based stewardship in the United States, the current debate over the terms of the stock accumulation disclosure requirement under the Williams Act (21) threatens to negatively impact the incentives of would-be governance activists. The Securities and Exchange Commission (SEC) has recently indicated possible regulatory changes that are in line with changes that have been enacted in the UK Stewardship Code and the European Union. These changes would lower the threshold for activist reporting, shorten the disclosure window, and broaden the scope of derivatives that must be disclosed. (22)

Although institutional owner rational reticence makes the UK Stewardship Code overall a poor fit for the United States, the Code's Principle 5 offers a compromise to activist shareholders. Principle 5 suggests that UK institutional investors should be willing to act collectively with other investors as well as disclose policies on collective engagement. (23) If U.S. institutional owners develop and disclose their policies for collective action, activist shareholders will have a significantly clearer idea of how successful they will be in gaining institutional owner support for their proposals at the outset, which may help alleviate the new challenges posed by a shorter disclosure window or broader derivative disclosure requirement. In turn, activist investors will continue to serve their role as governance intermediaries and corporate monitors.

Part II of this Note provides an overview of the historical development, policies, and Principles of the UK Stewardship Code. It then frames the effectiveness of the Code and its underlying policies within the context of institutional investor rational reticence. Further discussion describes the evolution of U.S. capital markets and the role activist investors have come to play as governance intermediaries. Following this discussion, this Note briefly addresses the current domestic debate involving regulatory changes that would emulate those enacted in the United Kingdom and Europe.

Part III analyzes the incompatibility of the UK Stewardship Code as a whole with U.S. equity markets. Part III then discusses how activist shareholders serve as governance intermediaries and give voice to institutional investor governance rights. After this discussion, Part III analyzes current regulatory proposals under consideration by the Securities and Exchange Commission, their similarities to European regimes, and the chilling effects they may have on the role of activist shareholders.

Part IV begins by discussing the way Principle 5 of the UK Stewardship Code already aligns with current U.S. equity ownership patterns. This Note concludes that Principle 5 offers a potential compromise to both activist shareholders and those arguing for regulatory reform in the United States similar to that in the United Kingdom. This Note recommends that the United States adopt Principle 5 of the Stewardship Code in conjunction with shortening the ten-day disclosure window. By requiring institutional investors to maintain and disclose a collective action policy, activist investors will have the opportunity to gain a clear sense of the support they are likely to receive from institutional intermediaries when pursuing certain governance actions. As a result, the broadened derivative disclosure requirements will be less likely to stymie the role activist shareholders play in monitoring corporate boards and leveraging governance rights. By adopting Principle 5, the United States would incorporate a helpful aspect of the UK Stewardship Code, and continue to foster efficiency in evolving U.S. capital markets.

2. THE EVOLVING ROLE OF INSTITUTIONAL OWNERS IN UK AND U.S. CAPITAL MARKETS

   The increasing concentration of equity ownership in the hands of institutional investors has been accompanied by a corresponding debate regarding the role that institutional investors should assume in monitoring portfolio companies. (24) As the agency gap between individual investors and company leadership widens, many argue that the institutions responsible for the widening should bridge the gap. (25) At first blush, this seems a reasonable solution given the size and sophistication of institutional investors and their proximity and access to the companies in which they invest. (26) On the other hand, many commentators express concern that institutional investors may be ill-suited to assume such a role in view of their predominantly short-term business models. (27)

   In truth, much...