Corporate Governance versus Hedge Fund Activism

A typically Canadian storyline has become conventional wisdom to explain the Canadian Pacific saga

Clubby Canadian board members, comfortable with the status quo and reluctant to rock the boat, lest they diminish their attractiveness as corporate directors, watch passively as shareholder value is destroyed by incompetent management. Institutional investors, pension funds in particular, hide their dissatisfaction behind a facade of “good” governance with ever more finicky demands for marginal improvements of the “say-on-pay” sort.

Fortunately, at last, comes the swashbuckling American in shining armor to right the wrongs inflicted on the long-suffering Canadian shareholders.

While there may be some kernels of truth in this description, it draws misinformed distinctions between the American and the Canadian financial systems. Indeed, corporate governance suffers from a surfeit of rules, guidelines, and principles, often pushed or imposed on boardsof directors by “proxy advisor” outfits. But that is not a Canadian phenomenon as these outfits have been created first and foremost for the American market.

But it may surprise Canadians that, in spite of the persistent demands of investors in the USA, American corporations and their boards still enjoy a lot more protection from activist investors and takeover artists that Canadian companies do.

A third of the S&P 500 companies still have staggered boards (that is,only a third of board members are up for election each year). Staggered boards are practically non-existent in Canada. If CP had a staggered board, they could have basically sent Pershing Square up the proverbial creek. Only five board members would have been up for election this year and perhaps none of those targeted in the proxy fight!

Only 41% of S&P 500 companies have separate Chair and CEO position and in many cases that chair person is not an independent member but the former CEO; fully 85% of Canadian companies have adopted this principle, an important one in situations of conflicts with shareholders.

Legislative actions in some 30 U.S states in the Land of Free Markets have enhanced the power of the board to resist unwanted takeovers, and assorted hostile manoeuvres against the company. These legislations vary from state to state but they all aim at shifting the balance of power to the board of directors.

There is no equivalent in Canada. Once a company is put in play,protective measures are few and of short duration; they are basically designed to give the board the time to shop around for a better offer.

The only distinctive measure of protection for significant companies in Canada is provided by their adoption of dual-class structures of shareholding, a model that is finding a good many adepts in the United States among the founders of high-tech companies, such as Google, Facebook and others.

The claim that hedge funds may be playing a benign, beneficial role by prodding complacent companies to perform better in the long run is not supported by empirical research. For instance, a study of 130 cases of hedge fund interventions (Bratton, 2006) found that these funds usually requested that companies implement one or the other of four types of actions:

Selling the company.

Simply put, these hedge funds took an equity position and then agitated for the firm to be sold, so they could pocket the usual control premium, ranging between 30% and 50% when a sale transaction is completed.

Unbundling.

Here the funds push the company to get rid of specific “underperforming” or unrelated subsidiaries or divisions by selling them or spinning them off to the market; not only will that produce immediate cash but it should result in a better performance for the residual company, and hence for the company’s stock price, providing a profitable exit for the hedge fund.

Disgorging cash.

Here the game plan is to force the company to use any “excess” cash, or to leverage the company’s balance sheet, to buy back shares or increase dividend payments, both measures likely to increase share value in the short term but resulting in a more fragile company with fewer resources for longer term investments.

Changing strategy and governance.

Hedge funds, in these cases, become expert at running companies; they will offer specific criticisms of the current management and strategy, and argue for a change in direction and game plan; they will ask for board representation to influence the management and strategy of the company; of course, these hedge funds often end up creating turmoil, uncertainty and conflict within the company; by a savvy management of financial markets, the fund may be able to bail out at a profit before the damage is apparent to supportive institutional investors.

It is highly doubtful that Canada would be well served by the large-scale importation of these short-term stratagems and “greed-is-good” artists. But, strange as it may seem and for the reasons described earlier,Canadian companies, other than those with a dual class of shares, are more vulnerable to these “activists” than American companies.

By the way, given that the American financial system is replete with these “activist” hedge funds and all other sorts of brilliant, no-nonsense fund managers, one is at a loss to explain:

• The dismal arrangements that brought their financial system, andthe global one, within a hair’s breadth of total collapse in 2008;
• The fact that over the last ten years, sedate, complacent Canadian companies have produced a shareholder return of some 54.8%(TSX 60 index) while the dynamic American companies, watched and prodded by activist funds, managed to deliver only 28.3% during the same period (S&P 500).

Go figure!

(Opinions expressed herein are those of the author only)