Shareholder Activism or Terrorism? The Line is BLURRY

At least 20 years ago, I was a director of our local CFA society, in charge of corporate governance which of course was very early days in the evolution of increasing expectations concerning the accountability of senior management. I recall arranging a society luncheon with two guest speakers – one from a diversified public company that had a board of directors that was more of the country club variety, BUT the other was run by accountants devoted to transparency. The former company hasn’t changed much culturally in all these years but employs far more people and has expanded globally, while the latter company, whose management typically shunned investing in risky innovation, was ultimately bought and the assets split-up and then resold.

There’s no real message to convey by my reminiscing, except to say that I sometimes regret my microscopic contribution towards a higher standard of corporate governance. Not because it’s a bad thing – it is a GREAT thing; but because the original motives have morphed into something much less desireable – just like a virus mutates into something harder to cure.

The culprit as I see it is vaguely labelled ‘Shareholder Activism’.  Like so many viruses, there are many strains of activism. They differ depending upon motives of which there are many, but I’ll address just three.

  1. Address fraudulent activities by Senior Management & possibly the Board of Directors
  2. Deal with underperforming Senior Management & possibly the Board of Directors
  3. Identify and hope to correct corporate behaviour that is somehow harmful to the environment or society.

The trial of former senior executives of bankrupted Nortel Networks is underway. Here is a clip:

From the Ottawa Citizen, January 19, 2012

“He (the Crown prosecutor) queried decisions by the top three finance executives to book a series of late entries in January 2003, which turned a fourth-quarter 2002 profit into a loss. And he spent a lot of time examining the period in late June and early July 2003, when Nortel was closing the books on the critical second quarter. That financial period was pivotal because a loss would have brought to an end the Return to Profitability bonus, which required consecutive quarterly profits.”

There are many businesses that ‘manage’ earnings. A cushion is created (such as non-performing loans at a bank) and it can be increased (less earnings) or decreased (a boost to earnings) in order to smooth reported earnings. Nortel executives, like hundreds of others were using a liability account to do the same. Is this wrong? You’d think so at first blush, but there is tremendous pressure for management teams to deliver steady growth; from shareholders, analysts and the press. Wrong or not, massaging the accounts to manage reported earnings grew to be as commonplace as toothpaste. I might suggest that:

  • It’s okay if there’s nobody gaining or losing by it, and great if it creates less volatility in a gradually rising (or falling) shareprice – for the benefit of skittish shareholders.
  • It’s not okay if it is intended to fool shareholders into believing the results are better than they actually are by a wide margin, in order to bolster the bonuses to senior managers.

Nortel executives are accused of having less than pristine motives for managing the reported earnings. But WHY would they be tempted to do so in the first place? I think back and realize that it was in fact activism in the first place which inspired cultural and even regulatory change in the corporate world.  It was responsible for the creation of such bonuses (and stock option plans etc.) in order to more closely align the interests of company managers with shareholders. Was it wrong to incent executives to deliver what shareholders want (steady & increasing earnings and therefore stock price)? Once upon a time, senior managers were simply expected to do a good job, with little incentive to be anything other than diligent. I’m reminded of Mao Zedong’s “Great Leap Foward.” Local leaders were publicly ridiculed if they couldn’t provide production (grain, peanut oil, steel, manufactured goods) levels that exceeded government mandated targets. Not surprisingly, they just inflated the production numbers to make their superiors, and in turn even higher up superiors happy! Party honchos received hugely inflated data and truly believed there were food surpluses and heaped the most praise on the best liars, while crops were in fact shrinking and millions of people were starving. Probably the world’s worst famine was caused by cutthroat efforts to squeeze more out of an economy than it could possibly deliver.

Recently, Research in Motion has been under a great deal of pressure by activists to dispense with its unconventional co-CEO structure and adopt policies more in line with what other companies are doing. Never mind that the structure has helped a little business from Waterloo, Ontario in Canada revolutionize the world of mobile communications, employ thousands of people and do it profitably for the most part. Just like an armchair football fan criticizes his team and shouts “I can do it better!” shareholder activists insist players and team management should be replaced. The only difference? Somehow while striving for management accountability we’ve unintentionally allowed it to become possible for some shareholders and analysts to actually create havoc, while the sport fan is harmless.

Look at it another way: Would you really want the demonstrators that camped out on Wall Street (or Bay Street in Toronto) to be able to replace Chase bank’s executives, or oust the the Mayor or State Senator and replace him/her with someone of their choosing? If you say YES (after all, how much worse could it be?) let me point out that with the same incentive, governance and corporate culture still in place – Mr. Protestor would be behaving the same as his predecessor was in no time at all.

Canadian Pacific Railway Limited is in the throes of a skirmish with an activist shareholder. The Board of Directors, voted in by a majority of its shareholders, is being bullied into dismissing its preferred selection for CEO and appointing a candidate chosen by the activist shareholder. Instead of being 100% focussed on running the business for the benefit of all stakeholders (shareholders, employees, debt holders, customers etc.) senior management is now distracted for months on end by the threat of a heated proxy battle.

While hoping to inspire executives to act in the best interests of all (majority and minority) shareholders, have we not instead created more ways to allow any third party – anybody who can afford to buy enough shares – with no other motive but personal gain – to exploit both majority and minority shareholders in order to put themselves in a position to cajole management into working solely for them?

So when does shareholder activism become terrorism? Returning briefly to my 3 motives, I’ve watched us conscientious shareholders over the years put forth a worthy effort to persuade companies to behave responsibly (#3) when it comes to the environment or society; and since that worked we soon adopted ‘shareholder rights’ as a cause célèbre – intending to constuctively influence the behaviour of senior management (#2) ; and since mankind will never pass up an opportunity to corrupt a good thing, now we have shareholder activism (#3) which paves the way for many abuses that once might have been considered unethical if not exactly fraudulent.

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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