CORPORATE SHORT-TERMISM AND INTERTEMPORAL CHOICE.

• Author: Rhee, Robert J.

Abstract

This paper presents an intertemporal model of short-termism. Critics have portrayed short-termism in broad brushstrokes as the bane of corporate governance. But short-termism does not have a self-evident, efficiency-based normative value. A simple application of a well-accepted asset valuation theory shows that short-termism is not per se inefficient. If profitable enough, a short-term strategy would be better than a long-term strategy. This intuition is a mathematical and financial fact. The model presented here is tested in a case study of Air Products and Chemicals, Inc. v. Airgas, Inc., a prominent and legally significant Delaware hostile takeover battle. Short-termism was a key fact in the court's legal analysis of the target's poison pill defense. The case enables a counterfactual analysis of the financial returns based on the target's intertemporal strategic choices and the time horizons of shareholders. The choice of a short-term strategy is contextual; the outcomes therefrom can result in random errors or rational outcomes. It can also result in a systemic social problem, but only when two levels of market inefficiency coexist: the corporate market is systemically biased in intertemporal decisions, and the capital market is inefficient in failing to incorporate this bias into stock prices. These conditions are special, occurring only infrequently. They are intrinsic qualities of a market bubble.

TABLE OF CONTENTS INTRODUCTION I. THE PROBLEM OF SHORT-TERMISM A. Academic Debate B. Delaware Judges and Courts C. Forms of Short-Termism II. INTERTEMPORAL MODEL OF PROFIT TRADEOFF A. Primer on Asset Valuation B. Intertemporal Model of Tradeoff C. Numeric Examples III. AIRGAS CASE STUDY A. Background and Chancery Court's Analysis B. Counterfactual Analysis of Intertemporal Returns C. Financial Performance and Stock Price Analysis IV. SHORT-TERMISM AND THE ROLE OF HEDGE FUNDS A. Benign and Beneficial Short-Termism B. Harmful Short-Termism C. Liquidity of Concentrated Ownership CONCLUSION INTRODUCTION

The concern over corporate short-termism has been long expressed. (1) Short-termism is the idea that managers myopically focus on short-term results at the cost of long-term profitability and firm value. Recent debate over short-termism expresses the concern that, given the heterogeneity of shareholder investment time horizons, activist short-term shareholders--archetypically hedge funds--pressure managers to adopt strategies that increase short-term share price at some cost to the firm's long-term profit or prospect. (2) The debate is important on several levels. At the level of theory, it informs the fundamental allocation of power between managers and shareholders. (3) At the level of corporate governance, it informs directors and officers of the broad directive to create value. (4) At the level of policy, it informs whether corporation law or other laws should be used to remedy a perceived social problem or market inefficiency. (5)

If short-termism exists in the market and diminishes the value of firms, it undermines the idea that greater shareholder power and activism leads to wealth maximization. Some have argued that activist short-term shareholders do not create value, and they instead extract rent resulting in net social cost in the form of lower firm values over the long-term. (6) This argument strikes at the heart of a strong shareholder-centric paradigm and the legitimacy of increasing activism by shareholders with shorter investment horizons such as hedge funds. (7)

Academic attention on short-termism has been legion. (8) Engaging in theoretical and empirical analyses, commentators have sharply disagreed on the hypothesis of short-termism. (9) The perception that short-termism is a problem has influenced elite levels of the corporate community, business courts, and policymakers. (10) The academic debate has a direct connection to the levers of policy.

This paper contributes a theoretical model of short-termism. The thesis is simple: when a firm faces an intertemporal choice of profit tradeoff, the choice of the short-term profit is not per se inefficient. This idea is empirically testable against the facts of one of the most prominent hostile takeover cases in recent years. Based on this analysis of theory and case study, this paper presents a framework for understanding how short-termism can be benign, beneficial, or harmful. (11) These ideas are organized into four sections.

Section I briefly summarizes the academic and judicial literature on the hypothesis of short-termism. Commentators sharply disagree on theory and empirical evidence. They sometimes use or confuse subtle but different definitions and conceptions of short-termism. These differences are significant. Ambiguity in the conversation hinders understanding; precise definitions and concepts advance it. This paper proposes three distinct forms short-termism. Each form requires a specific analysis.

Section II constructs an intertemporal model of short-termism. The core scenario in the debate concerns managerial choice of intertemporal tradeoff of short-term profit and long-term cost. The model is based on a theory of asset valuation that is well-accepted by the financial community and Delaware courts. It confirms as a matter of mathematical and financial truth the intuition that, if profitable enough, a short-term strategy can be rational and maximize firm value. The model shows that short-term choices can frequently be the optimal strategy.

Section III applies the model in an empirical case study of Air Products & Chemicals, Inc. v. Airgas, Inc. (12) The case provides an ideal set of facts to test the model and its idea. Unique events permit a counterfactual analysis of the target's intertemporal choices in a legal context where the short-term time horizon of shareholders was the most important factor in the court's analysis of the target's poison pill. This case study confirms that, given a specific condition, the short-term strategy can be more profitable. It shows that the intertemporal model has explanatory power in understanding board decisions and judicial analyses.

Section IV analyzes the conditions in which short-termism is benign, beneficial, and harmful. The form of short-termism and its systematicity determine whether it can be a social problem. Short-term shareholders, such as hedge funds, can play a beneficial role. By providing a liquidity of concentrated ownership, they push the traditional, historical structure of diffuse ownership in United States (U.S.) public corporations toward the structure of concentrated ownership commonly seen in other parts of the world, though the U.S. form of such ownership is transient and transactional.

1. THE PROBLEM OF SHORT-TERMISM

   In the new century, U.S. companies have continued to experience three interrelated phenomena: increasing institutional ownership, (13) shortening hold periods, (14) and increasing shareholder activism. (15) The idea of short-termism connects these trends to hypothesize that some activist shareholders with short-term holding periods as an investment strategy--archetypically hedge funds (16)--pressure managers to select suboptimal corporate strategies and actions that increase short-term profit by sacrificing the firm's long-term prospects. Among other pressure tactics, they coerce management through publicity campaigns and proxy contests. (17) Strategies and actions advocated through such coercion include an array of financial decisions, strategic choices, and governance changes: for example, changes in policies on distributions such as dividends and stock buybacks, divestitures, mergers and acquisitions (M&A), asset allocation, capital expenditures, research and development (R&D), internal governance matters such as takeover defenses, and leadership changes in the board and senior management. (18)

   1. Academic Debate

      Scholars have vigorously disputed the hypothesis of short-termism. Proponents of the hypothesis have argued that short-termism exists, is a serious problem, and must be fixed through policy. (19) They are suspicious of short-term shareholders and question whether the abnormal returns reflect "value actually created" or value "merely appropriated from fellow stockholders with longer-term investment horizons." (20) Disunity of shareholders' interests is possible because markets are imperfect, resulting in increased short-term stock price even when long-term value has been diminished, and because shareholders have heterogeneous preferences in terms of risk and time horizon. (21) A myopic, short-term perspective has broad social implications because it has been a causal factor in past major crises in the corporate and financial markets. (22) Thus, short-termism not only adversely affects companies and long-term shareholders, but also the broader society.

      Opponents of the hypothesis have argued that short-termism is an incoherent idea. (23) One argument is that as a matter of finance theory, short-termism cannot exist in informationally rich, liquid capital markets. (24) Short term shareholders can profit at the expense of long-term shareholders only if the stock market has a systematic bias; the market must undervalue long-term profit relative to short-term profit. If information on profitability is correctly incorporated into stock price, all shareholders are in the same position. There is a unity of shareholders' interests because their profit, short-term or long-term, inures to the benefit of all shareholders. (25)

      Other skeptics have argued that short-termism is consistent with firm value maximization (26) or that no policy redress is needed in light of already existing corrective mechanisms in the market. (27) Some have also suggested that proponents of the hypothesis have a hidden agenda: that is, a belief that short-termism tends to increase shareholder profit at the cost of long-term stakeholder interest and an objection...