Engagement: The Missing Middle Approach in the Bebchuk–Strine Debate

Jasmin Sethi is Vice President and Matthew Mallow is Senior Managing Director and Chief Legal Officer at BlackRock, Inc. This post is based on a recent article by Ms. Sethi and Mr. Mallow. This paper comments on two papers issued by the program, The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here), and Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here). Additional related research issued by the program includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and Securing Our Nation’s Economic Future by Leo E. Strine (discussed on the Forum here).

In our article entitled Engagement: The Missing Middle Approach in the Bebchuk–Strine Debate, recently published in the NYU Journal of Law & Business, we contend that in the debate over whether more director or shareholder control would maximize firm value, a critical approach for influencing firm management effectively is missing. This approach is shareholder engagement, and it is growing in importance for asset managers and institutional investors in influencing the actions of directors and firm management.

The board versus shareholder debate has long been about whether more director or shareholder control would maximize firm value. On one side are those who argue for giving shareholders as much power as possible to revamp firms and reorganize boards and the executive suite in ways to make firms more efficient. Under this view, firm executives are agents that need to be monitored and potentially sanctioned, generally through shareholder voting. Those advocating for this view contend that boards must not become entrenched because then they become close to executives and resistant to helpful change. Instead, executives need to be managed as effective agents through active principals. This view is compatible with advocating for corporate structures that incentivize better oversight of boards by shareholders. Recommendations consistent with this view include opposition to staggered boards, more frequent voting by shareholders, and more power for shareholders, including the ability to adopt provisions that would allow them to change the company’s charter or state of incorporation.

On the other side are those who believe that firm management and boards are already incentivized to fulfill their fiduciary duties towards shareholders and that boards need to be insulated from shareholder activism. Under this view, boards can be trusted to act consistently with shareholder interests without shareholder intervention. Advocates of this view contend that activist shareholders influencing boards can harm longer-term firm value by trying to make short-term gains that simply increase risk at the expense of long term benefits. Hence, boards should be more closely aligned with executive management. Protection of boards leads to long-term considerations, and incentives should be designed to keep activist shareholders from undermining the efforts of the expert fiduciaries. Recommendations in this area include having staggered boards, less frequent voting by shareholders, and maintaining a corporate republic that defers to the elected directors.

By contrast, engagement is a middle approach that has been described by a number of market participants, and even regulators. Engagement has been defined as “direct communication between investors and companies,” [1] and “direct contact between a shareowner and an issuer (including a board member).” [2] Other commentators have provided more nuanced definitions of engagement. Investors can view engagement in differing ways depending on factors influencing their investment. For example, investors may define engagement as any communication with a company that enhances mutual understanding, or as a process intended to bring about a change of approach or behavior at a company, or even as a continuum covering all this and more, including full-blown activism.

Engagement should be of interest to shareholders because it has been effective in certain situations and has the potential to be even more effective going forward. This is because engagement builds relationships over time that engender trust and facilitate effective communication through “informed dialogue … rather than public confrontation, [which is more likely to build trust] and lead to a mutually productive outcome.” [3] Regardless of the definition being utilized, engagement is a more collaborative approach to effecting change than the view of activism assumed by Professor Bebchuk and Justice Strine. Engagement also allows for a more dynamic relationship between management and those entities, often asset managers, representing shareholders than the relationship between firm management and shareholders that has typically been assumed in the academic commentary. The academic literature tends to focus on whether shareholder votes are for or against management, and it often uses shareholder proposals as a signal of shareholders being active and responsible. Indeed, by many commentators, voting is seen as synonymous with shareholder engagement. Conversely, engagement, by our definition, is more effective for accountability and influencing change in companies that are responsive to shareholders, particularly on issues that are nuanced—as many business-relevant governance (including environmental and social) factors are.

In our article, we draw from work conducted on and by institutional investors and asset managers to describe the use and significance of engagement and to advocate for its greater use. Although not specifically about engagement, other recent work is beginning to examine the influence of asset managers on the corporate governance of firms. Some preliminary studies discussed in our article, though not systematic in their nature, indicate that examining the efficacy of engagement would be worthwhile. Understanding the efficacy of engagement is important because certain trends point towards its increased relevance. Many investors are long-term, buy-and-hold investors via retirement savings and through the use of index funds, which require long-term relationships between investors and the companies in which they invest. Furthermore, companies themselves have been recognizing the need for engagement and are voluntarily choosing to commit to it as an approach through actions such as becoming signatories to the Principles for Responsible Investment and utilizing the Shareholder–Director Exchange Protocol.

We believe that shareholders need not face a choice between activism that involves aggressive tactics and power through adversarial voting versus deference towards long-term management. A third, middle-of-the-road approach exists. This approach involves ongoing communication and discussions on a long-term basis; its efficacy is more difficult to quantify and measure. These limitations, however, do not make it less worthy of study. Rather, academics and policy makers should look for more ways to understand and promote engagement in order to fully reap its benefits.

The full article is available here.

Endnotes:

[1] Michelle Edkins, The Significance of ESG Engagement, in 21st Century Engagement: Investor Strategies for Incorporating ESG Considerations into Corporate Interactions, 4 (2015), https://www.blackrock.com/corporate/en-us/literature/publication/blk-ceres-engagementguide2015.pdf.
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[2] Marc Goldstein, Defining Engagement: An Update on the Evolving Relationship Between Shareholders, Directors and Executives, 7 (2014), http://irrcinstitute.org/wp-content/uploads/2015/09/engagement-between-corporations-and-investors-at-all-time-high1.pdf.
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[3] Teachers Ins. & Annuity Ass’n–Coll. Retirement Equities Fund, Policy Statement on Corporate Governance, 3 (6th ed. 2011), https://www.tiaa.org/public/pdf/pubs/pdf/governance_policy.pdf.
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