- Bozidar Bogosavljev
Business Decision-Making and Institutional Investors: Short-Term and Long-Term Considerations
Short-termism – the focus on creating visible financial results within a fairly short time-period, typically 12 to 24 months – has become a driving force for many public companies. Although short-termism can prove financially lucrative for skilled day traders, it can also lead to careless decision-making which contributes to financial crises. A study by McKinsey, for example, found that 86% of C-suite executives think a greater long-term focus would reduce reckless risk-taking, boost innovation, and improve financial returns, so it is worrying indeed that the same study also states that 79% of C-suite executives feel pressured (usually by hedge and mutual funds, which collectively own one-third of US corporate stocks) to produce financial gains within 2 years or less. This paper examines the responses – both regulatory and private – that can be adopted to counter short-termism, as well as some of the controversies that arise alongside them, most notably regarding institutional investors.
On the regulatory side, long-termism could, as many legal scholars point out, be promoted through a reevaluation of capital gains tax by offering a “sliding scale” of taxability based on the length of a stock-holding; the longer the holding, the smaller the tax scale would be. Coupled with an excise tax for otherwise exempt parties, such a reform could effectively discourage frequent share trading and promote long-term corporate strategies. Additionally, to stop complex, non-traditional structured and derivative arrangements which allow investors to influence board decisions without revealing their (potentially adverse) financial positions, a more robust response is needed to close such legal loopholes. This could, for instance, be achieved by establishing a formal stewardship code – indicating where investors’ duties ought to lie – such as the ones in the UK or Japan. Somewhat more directly, the legislatures around the globe could also emulate their French counterparts, who, in 2014, passed the Florange Act, which automatically gives double votes to any shareholder of over 2 years unless opted out of. Other suggestions include an expansion of fiduciary duties to encompass broader disclosure requirements for compensation, proxy voting, and trading policies, as well as a minimal mandatory shareholding period. While such suggestions would, no doubt, be very effective – investors will hardly focus on the capital gain from their shares in the next 6 months if they cannot be traded in the next 24 – such a hands-on solution would, arguably, not be received well by the US corporate community in particular. Even in the EU – which has historically endorsed much stronger government intervention – the philosophy has been one of incentivizing, not forcing, so it seems logical that in the US, too, the focus should rest more on proposals such as tax benefits for long-term strategies and investor stewardship codes, rather than mandatory shareholding periods, to stem the growing popularity of short-termism in corporate practice.
On the flipside, corporate actors themselves could adopt a variety of strategies to mitigates short-termism. For one, many institutional investors could follow in the footsteps of BlackRock’s CEO, Laurence Fink, who regularly reaches out to his investment companies and encourages mutual involvement in long-term-focused policy creation. Moreover, setting corporate milestones can offer a great incentive to switch to more long-term operations. For instance, Berkshire actively sets 5-year performance benchmarks to measure its long-term impact, while Norges Bank Investment Management made it a goal to significantly raise its funds’ equity stake in order to reduce unnecessary leverage – a policy which they stuck to even during 2008, despite significant political and economic pressures to sell off falling stocks, which ultimately resulted in a net return as soon as the market picked up again. Additionally, emphasizing stock option plans and longer vesting periods in management compensation can nudge executives to prioritize long-term success, and create a culture, starting at the very top, of corporate responsibility. This approach would also promote greater corporate involvement in public discourse surrounding environmental, social, and governance matters (which typically get sidelined when short-term economic gains are discussed), and would allow for the inclusion of issues such as pollution and social mobility in companies’ long-term plans, ultimately benefiting not only the companies themselves but also their clients, employees, partners, and communities.
Another avenue to promote long-termism would be via advisory corporate codes, such as those set by the Investor Stewardship Group that emphasize the importance of long-termism. Such codes are supported by some of the most influential financial actors in the world – such as Vanguard and BlackRock – and, in fact, the ISG’s codes could be said to largely mimic Vanguard’s own 4 pillars of responsible governance, which is hardly surprising given that Vanguard was one of the ISG’s founding members in 2017. It is important, however, to approach these matters with a critical eye. Although it may seem like the epitome of business long-termism – a large institutional investor going out of its way to ensure that long-term, not-strictly-financial goals are on the agenda – there is, in truth, a deeper layer to be mindful of here. If groups such as Vanguard were, as they claim to be, entirely committed to curbing the popularity of short-termism in business, they would, no doubt, at the very least be considerate (if not altogether supportive) of dual-class voting structures, which enable small groups of corporate actors to effectively control company decision-making via high-vote stock. Such structures allow boards to gain the financial benefits of public investment while at the same time resisting activist influences, providing some “elbow room” for the company to pursue its long-term strategies. So, why, then, do both the ISG and Vanguard so strongly reprimand the use of dual-class structures? The answer, arguably, is simple: powerful institutional investors have a massive stake in the market – the Big 3 (Vanguard, BlackRock, and State Street) collectively represent the biggest shareholder in 88% of S&P 500 companies – and dual-class shares would deprive them of their ability to influence corporate decision-making on a large scale. Although real concerns exist about the abuse of dual-class shares (such as allowing boards to entrench themselves and ensconce the lack of diversity at the very top of the corporate ladder), it is doubtful whether this is the real reason behind the Big 3’s criticism. The Big 3 are the world’s largest providers of ETFs – passive index funds which have massively grown in popularity in the last decade – which, by their very nature, have long-term outlooks due to their unlimited stockholding durations. The Big 3, therefore, currently have a strong business incentive to promote long-termism. But what if popular demand starts to shift again, and ETFs fall out of favor; will the Big 3 reduce, or altogether abandon, their commitment to long-termism, shifting to whatever is in demand at the time? We have already seen institutional investors take a fairly aggressive stance towards actors who did not conform to their standards (such as the Council of Institutional Investors’ campaign to exclude Snap, a dual-class company, from the S&P Dow Jones). Is it only a matter of time before a similar campaign is launched against a company whose corporate vision is considered too long-term, especially if the Big 3’s opinions on long-termism change?
It is entirely possible that this will not happen anytime soon. Nevertheless, if we want to safely promote long-termism in corporate practice – a commendable objective, to be sure – we should urge companies to consider not only strategies such as stock option plans and down-the-road milestones, but also dual-class structures to ward off unsolicited shareholder activism (notwithstanding opposition from groups such as Vanguard), though staying mindful, of course, of their potential for abuse and unjustifiable board entrenchment.