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E-MailMark J. Roe is David Berg Professor of Business Law at Harvard Law School, and Federico Cenzi Venezze is an associate at Cleary Gottlieb Steen & Hamilton LLP. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); Don’t Let the Short-Termism Bogeyman Scare You, by Lucian Bebchuk (discussed on the Forum here); Corporate Short-Termism—In the Boardroom and in the Courtroom by Mark Roe (discussed on the Forum here); and Stock Market Short-Termism’s Impact by Mark Roe, (discussed on the Forum here).
Stock-market short-termism—stemming from rapid trading and activists looking for quick cash—is, a widespread view has it, hurting the American economy. Because stock markets will not support corporate long-term planning, the thinking goes, companies fail to invest enough, do not do enough research and development, and buy back so much of their stock that their coffers are depleted of cash for their future.
This widespread view has induced proposals for remedy. One proposal is for corporate “loyalty shares,” whereby stockholders who own their stock for longer periods would get more voting power than those who trade their stock quickly. In the proponents’ vision, executives would appeal to loyal, longer-term, stockholders for votes against activists and traders and, by investing for the long run, would obtain the loyalty share votes. The longer-run stockholders, with extra votes, would elect like-minded boards and support longer-term corporate business policies. The affected companies would profit more and the American economy would prosper.
The idea that more votes for long-term shareholders would promote more long-term corporations has a strong intuitive appeal. But, in our paper, we show why loyalty shares promoters’ thinking is optimistic.
First, we describe loyalty shares in theory and in practice. We analyse the types of shareholders that would gain and lose voting power in the United States to show that loyalty shares do not inexorably induce better long-term outcomes. Insider-managers would get more votes, as would—in an evenhanded set-up—the increasingly important index funds, which hold stock for the long term weighted by a standard stock market index, like the Standard & Poor’s 500. The three major index funds (BlackRock, Vanguard, and State Street) already own about one-quarter of the stock in a wide array of large public companies in the United States. In any evenhanded setup, the index funds would be big winners of extra votes. Traders, shareholder activists, and newly formed blockholders with long-term intentions would all lose voting power. We show how the likely voting shift, if even-handedly implemented, would not assuredly promote the long term; the dominant variable is the extent to which shifting voting power from activists to indexers promotes or degrades the long run. The impact of this shift on corporate time horizons is, we show, uncertain.
Second, we analyze the loyalty shares’ incentive structure to show that more votes for long-term owners does not translate into more long-term corporate behavior.
The most prominent means touted for why the stock market promotes short-term behavior is that excessively rapid trading pulls executives’ time horizons to match the traders’ short horizons. Often the channel for alignment is thought to be executive compensation. Loyalty shares could reduce trading, but will not stop stock prices from rising and falling, nor will they affect how traders price their shares. If quarterly results overly influence stock price now, they will overly influence stock price of companies with loyalty shares.
Further, we show that the longstanding, well-understood free-rider problem of having many shareholders who are passive would persist unameliorated, even if the smaller shareholders had more votes. The growing centers of stock ownership in the United States—the indexers—are generally passive. There is little reason to think that more votes would make them more active. The case for improving time horizons then rests with loyalty shares’ potential to weaken presumably short-term active shareholders and activist funds and its potential to strengthen the presumably long-term-focused insiders and controlling shareholders.
Third, we look at how loyalty shares have played out around the world. Dominant, controlling shareholders have been the primary users of loyalty shares. Although the loyalty voting boost is formally available to all shareholders in Europe, the real-world implementation mechanisms impede outsiders, such as most institutional investors—even long-term institutional investors and index funds—from acquiring the loyalty voting boost and the real-world structures facilitate insider-controllers getting the voting boost. We explain (1) the technical disruptions to their getting the voting boost and (2) how this limit to the institutions’ voting power was originally an intended one.
Fourth, we set out the current governing structure for loyalty shares in the United States and the current proposals for change. The experience in foreign jurisdictions could well be replicated in the United States. Insiders and controlling shareholders (although less prevalent in the United States than abroad) will disproportionately affect the design structure for loyalty shares. They will favor mechanisms that favor their own interests. It’s plausible that the eventual on-the-ground rules and company-by-company implementation will be heavily influenced, and sometimes controlled, by those with an interest in getting more votes for themselves and fewer for outsiders.
For these companies, controller-insider self-interest will dominate their motivation, not fighting short-termism. Controllers and insiders often have self-interested reasons to lock in control and shut down outsiders, even if doing so fails to improve corporate time horizons. Long-termism may be foremost in the headline rhetoric but less powerful in the on-the-ground results.
Fifth, we show that other reasons—as yet undiscussed as far as we can tell—may well justify opening corporate law to loyalty-share programs. We introduce to the loyalty-share analysis the ex ante value to the entrepreneur of retaining control—i.e., loyalty shares can help motivate founders and thereby induce new entry, new start-ups, and new, original entrepreneurial activity. Weighing the value of continued control in fostering start-ups and original entrepreneurial activity against its later costs if the controller persists running the company past his or her time is not easy. It is not obvious which weighs more overall and it is not obvious how to design the overall loyalty share structure to facilitate the first and minimize the second. But if there is economy-wide value to loyalty shares, motivating entrepreneurial start-up action is where it is likely to reside. Conversely, policymakers should be skeptical that promoting sound corporate long-termism will be a major result of facilitating loyalty shares in the American corporation.
The full paper is available for download here.
