Tax Cuts and Shareholder Activism

Spencer D. Klein is a partner and Joseph Sulzbach is an associate at Morrison & Foerster LLP. This post is based on a Morrison & Foerster publication by Mr. Klein and Mr. Sulzbach. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); and Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here).

The Tax Cuts and Jobs Act (the “Act”) was intended principally to simplify the tax code, reduce individual and corporate tax rates, and allow for the repatriation of cash held overseas at a discounted tax rate. But, as with any sweeping legislation, the Act will have numerous unintended consequences as well. Though all the effects of the Act will not be known for years, it is clear that the amount of cash on company balance sheets will substantially increase. Numerous companies have announced employee bonuses, 401(k) contributions, and other compensation increases. Others have announced significant growth initiatives. Even with these announcements, U.S. companies will face a high-class problem: What should they do with the extra cash?

Capital allocation—specifically the use of “surplus” cash—has always been a focus of activist investors, who typically encourage its return to shareholders. Indeed, capital allocation has been a campaign target of many activist campaigns. We therefore anticipate activist investor campaigns based on capital allocation to increase in the coming year.

To address these campaigns and retain the flexibility to use the extra cash to support long-term corporate strategy, we believe it is important for companies to better align themselves with their large, long-term institutional investors. Large institutional investors determine the outcome of most proxy contests. Furthermore, the growing size of index funds and index-based exchange-traded funds (ETFs) [1] managed by these investors has shifted their focus toward a longer-term perspective. This shift should be viewed as an opportunity to resist activist pressure to initiate short-term capital allocation strategies. Companies should proactively engage with their large institutional investors—before an activist surfaces—regarding their plans for the use of cash in furtherance of the company’s long-term strategy for growth.

Increased Activism Based on Capital Allocation

The Act, which went into effect on January 1, 2018, dramatically reduced the corporate tax rate from a maximum graduated rate of 35% to a flat rate of 21%. The Act also imposes a one-time “deemed repatriation” tax at a rate of 15.5% on previously untaxed foreign earnings held as cash or cash equivalents, and provides for the ability to repatriate these earnings in cash without additional U.S. tax. It is expected that the new corporate tax rate will result in increased after-tax cash flow at most companies, and that the “deemed repatriation” tax will lead to the return of substantial cash that had been held overseas. [2] In fact, since the Act’s adoption, numerous companies have announced plans to repatriate cash, including Goldman Sachs, Bank of America, JP Morgan Chase, American Express, and Honeywell.

Historically, activist investors have often targeted companies with perceived excess cash on their balance sheets. An activist investor will typically take a stake in a company and pressure the board to deploy excess cash according to the capital allocation strategy promoted by the activist. In light of this, we expect to see activist campaigns focusing on how companies deploy excess cash, attacking current corporate strategy (or lack thereof). In particular, we expect to see a surge in calls for share buybacks and special dividends.

Companies should assume that any activist campaign will be well run, as many activist investors have gained substantial experience executing numerous campaigns. Activist investors retain first-class advisors and do not shy away from confrontation or resistance. And they have the resources to invest heavily in their campaigns, often producing detailed white papers that convincingly describe how they can improve upon present management.

Growing Influence of Long-Term Institutional Investors

Today, the three largest institutional investors constitute the largest shareholder in approximately 40% of U.S. listed companies and 88% of the S&P 500. [3] A significant portion of their assets under management are held in index funds and ETFs managed by these institutions. Index funds and index-based ETFs are passive investment vehicles that seek returns correlated to the performance of a stated index—for example, the S&P 500. To do this, index funds and ETFs are required to invest in the companies that make up the underlying index. [4]

According to Moody’s Investors Service, by 2024 half of all assets under management in the U.S. will be held in index funds or ETFs. This estimate is in line with the immense shift in investment from actively managed funds to index funds and ETFs that has already taken place. Over the past decade, index funds and ETFs received approximately $1.4 trillion in net new cash and reinvested dividends, whereas actively managed funds experienced a net outflow of approximately $1.1 trillion, including reinvested dividends. [5] Accordingly, large institutional investors are expected to see significant amounts of new money flow into their index funds and ETFs.

Unlike actively managed funds, which can sell their holdings in poor performing companies in the discretion of the manager, index funds and ETFs generally cannot exit their investment in a poor performing company as long as that company remains in the relevant index. In order for index funds or ETFs to properly track the performance of an index, they must hold stock in all of the companies in the index. [6] It is also important to note that other large institutional investors (like CalPERS), although not tied to certain companies like index funds and ETFs, are inherently long-term holders and may not have the outright freedom to sell poor performing companies. Because of the sheer amount of assets they have to invest, they are effectively forced to invest in and hold stock of certain large companies.

Long-Term Perspective, Investment Stewardship, and Engagement

Because institutional investors are limited in their ability to sell the companies they hold through their index funds and ETFs, they effectively hold their investments in these companies indefinitely. This gives them a long-term perspective. Indeed, Vanguard has stated that its “emphasis on investment outcomes over the long-term is unwavering,” and BlackRock has made clear that it has a “long-term value mindset.” As a result, the typical short-term capital allocation strategies promoted by activists are often not compelling.

The need to hold stock indefinitely has led institutional investors to focus on investment stewardship. Many have created investment stewardship groups that promote defined principles of corporate governance at their portfolio companies. Notably, we understand that the number of employees in Vanguard’s investment stewardship group almost doubled last year, and other institutional investors are similarly expanding the size of their investment stewardship groups.

Increasingly, these groups have become the decision-makers on how proxies are voted, with such decisions being based on their own internal research and analysis. [7] This decision-making shift to investment stewardship groups has led many institutional investors to rely less on the guidance of shareholder proxy firms like ISS and Glass Lewis, whom many other investors still primarily rely on for proxy voting guidance.

Investment stewardship groups also strive to undertake meaningful and ongoing engagement with their portfolio companies in order to understand their strategy for long-term growth. And they are not just focused on engaging with large-cap companies: In the 2017 proxy season, for instance, 63% of Vanguard’s engagements were with companies under $10 billion, with 19% under $1 billion. [8]

Combatting an Activist Campaign

In order for a company to effectively position itself to address an activist campaign focused on capital allocation, we believe it is essential that a company’s board and management engage with their institutional investors on how extra cash fits into their long-term strategy.

Long-term strategy. The company must have in place a well-crafted and thoughtful long-term strategy with a goal of producing long-term shareholder value. This strategy must highlight how the additional cash from the tax cut will be used in furtherance of that goal. If it does not, institutional investors could support an activist investor’s demand for returning the cash to shareholders. Boilerplate policies lacking substance will not suffice. If an activist launches a campaign with its own in-depth strategy for how the company should use the cash, to the extent the company failed to present its shareholders with a meaningful alternative strategy, the odds that the company will lose a proxy contest are significant.

Engagement. The company must proactively engage with its institutional investors on its long-term strategy, corporate governance, and other areas institutional investors find compelling. This engagement should not be viewed as one call or meeting. It should be seen as building an on going relationship with the company’s permanent owners, in the hope that management builds credibility as well as support for its long-term strategy. It is important for the company to go into this engagement with an open mind and do as much listening as speaking. [9] The company should recognize that each institutional investor has different practices with respect to engagement.

Engage before a campaign is launched. It is imperative that management begin engaging with its institutional investors during a period of relative quiet. Building a meaningful relationship is much easier when there is no pressure or agenda. However, if the company waits until an activist investor launches a campaign to engage with its institutional investors, not only will the company have built neither a relationship nor credibility, but the outreach will also be viewed with uncertainty. As Vanguard’s former CEO and current Chairman quoted in his 2017 open letter to directors: “You can’t wait to build a relationship until you need it.” In addition, an activist campaign typically lasts three to four months from start to finish. This period of time is simply too short to develop a meaningful long-term strategy and communicate it to investors. Finally, if an activist emerges, it’s safe to assume that the activist has already visited with the company’s largest institutional investors and, at a minimum, did not receive a negative response. Convincing institutional investors of the merits of the company’s strategy becomes quite difficult at this point.

To conclude, we believe the increased cash on corporate balance sheets resulting from the Act will lead to more activist investor campaigns focused on capital allocation. To prepare for a potential activist campaign, companies should proactively engage with their institutional investors on how the excess cash will be used in furtherance of the company’s long-term strategy.


1For purposes of this post, the term “ETFs” refers to exchange-traded funds that seek returns correlated to the returns of an identified securities index and excludes actively managed exchange-traded funds.
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2We note that there are potential impediments to the immediate repatriation of all offshore cash, including the potential to trigger a foreign withholding tax and liabilities due to a lack of distributable reserves or a similar local law impediment.(go back)

3Jan Fichtner, Eelke M. Heemskerk & Javier Garcia-Bernardo, Hidden Power of the Big Three? Passive Index Funds, Re-Concentration of Corporate Ownership, and New Financial Risk.(go back)

4Although index funds (which are operated as open-end mutual funds) and ETFs distribute their shares differently, in terms of shareholder voting, they are alike in that the manager of an ETF or an index fund usually has the authority to vote the shares held in the fund’s portfolio.(go back)

5Investment Company Institute 2017 Investment Company Fact Book.(go back)

6Certain ETFs may invest in a representative sample of the constituents of an underlying index, rather than all constituents in such index. This is common with less liquid international markets. Nonetheless, the ability to exit their holdings is limited as long as the portfolio holdings remain part of the underlying index.(go back)

7For example, see Vanguard Policies and Guidelines for Investment Stewardship, and State Street Global Advisors 2016 Year End Annual Stewardship Report.(go back)

8Vanguard Investment Stewardship 2017 Annual Report.(go back)

9It should be noted that any one-on-one discussions with shareholders must comply with relevant disclosure regulations, including Regulation FD.(go back)

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