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E-MailThe following post comes to us from Paul Rose, Professor of Law at Moritz College of Law, Ohio State University.
As the number of—and assets controlled by—sovereign wealth funds (SWFs) has increased dramatically in recent years, so too has scrutiny about how SWFs are making use of these assets. With respect to equity investments in publicly traded firms, one facet of this concern is that SWFs will become activist shareholders. This concern arises in part because of an equivocation of the term “activist” and a misunderstanding of the regulatory consequences of certain kinds of activism by SWFs.
The types of shareholder activism engaged in by activist hedge funds differs from the activism typically engaged in by most other investors, including public pension funds. As Cheffins and Armour have noted, hedge funds tend to engage in what they term “offensive” shareholder activism. [1] Offensive activism is typically event-driven: the offensive activist agitates for change at the company, seeking to squeeze out value that, in the view of the activist, may be locked up in a subsidiary or in cash reserves.
In contrast to the offensive activism of hedge funds, some large institutional investors are engaged in “defensive” activism. The defensive activist monitors the firm not to seek ways to force value-creating changes, but to prevent losses from mismanagement. In other words, whereas offensive activism is designed to produce wealth in the short to medium term, defensive activism is designed to protect wealth in the long term. It is this type of defensive, “accountability” activism that is most commonly associated with large public pension funds and even some sovereign wealth funds. Norway’s Norges Bank Investment Management, which manages the Government Pension Fund—Global, is the most prominent example among SWFs. In 2013, for instance, NBIM submitted three shareholder proposals requesting access to the corporate proxy, which would enable a shareholder that has held 1% of the company’s outstanding common stock for one year to nominate one director for the company’s board of directors.
Unlike these two types of activist shareholders, most shareholders are largely passive. They may choose not to exercise their shareholder rights at all, or will simply follow any management proposal. Most SWFs fit in this category, and will probably never become “activist” shareholders. This passivity is attributable to the fact that SWFs tend to be what Bortolotti et al. have termed “Constrained Foreign State Investors” that “will refrain from taking an active corporate governance role in target companies in order not to generate political opposition or a regulatory backlash.” [2] In the U.S., even some defensive activism tactics that attempt to influence (as opposed to directly control) companies may result in serious regulatory scrutiny, particularly if (unlike Norway) the SWF is controlled by a government with which the U.S. has poor political relations.
And yet, a consensus appears to be developing that large institutional investors, including SWFs, should be aware of corporate governance issues at their portfolio companies, even if they choose not to actively attempt to influence management. Because they are long-term investors and often under political and regulatory scrutiny that makes them less likely to sell, SWF capital tends to be captive capital. Thus, protecting long-term returns by monitoring governance is a priority for many sovereign investors. However, some may not feel they are able to engage in defensive activism as Norway does. The difficulty for most SWFs, then, is how to hold mangers accountable without selling or directly engaging in ways that would concern regulators.
Fortunately for SWFs, the market for corporate influence in many countries has become sufficiently robust that portfolio companies with poor governance tend to be targeted early by activist investors; in other words, SWFs typically need not worry about initiating governance engagement, at least with firms that have significant institutional investor ownership. Hedge funds and, not infrequently, pension funds may be already pressuring a poorly-performing corporate management. Because SWFs are often large but passive blockholders, they can exert significant influence simply through the exercise of their voting rights. While this kind of corporate governance engagement may seem like governance free-riding, it is more accurate to think of it as riding on a reduced fare; the SWF will incur some costs in developing robust policies and procedures for the exercise of voting rights. The effort is essential, however, because if SWFs fail to exercise their rights as shareholders they risk creating a monitoring deficit that has the perverse effect of entrenching poor managers. This risk is increasingly relevant as SWFs take larger minority positions.
SWFs should be as transparent as possible about how they intend to use corporate governance rights. Publishing governance and voting policies, on the Internet and in annual reports, provides an important signaling effect to companies and other shareholders. It also provides a strong signal to the sponsor sovereign and its citizens of the quality of governance at the SWF itself. Moreover, so long as the SWF merely exercises its voting rights and does not try to directly control or influence the management of a company, it is unlikely to run afoul of host country regulations.
The full paper, prepared for the Università Bocconi BAFFI Center on International Markets, Money and Regulation’s 2013 Annual SWF Report, is available for download here.
Endnotes:
[1] Brian R. Cheffins & John Armour, The Past, Present and Future of Shareholder Activism by Hedge Funds, 37 J. Corp. L. 51, 58 (2011).
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[2] Bortolotti, Fotak, Megginson and Miracky, Quiet Leviathans: Sovereign Wealth Fund Investment, Passivity, and the Value of the Firm, FEEM Note di Lavoro 22.2009. Available at http://www.baffi.unibocconi.it/wps/allegatiCTP/SWF-paper-RFS-Final-oct25_2010.pdf.
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