Opening Remarks to SEC-NYU Dialogue on Securities Markets #4: Shareholder Engagement

Jay Clayton

New York, N.Y.

Jan. 19, 2018

Good morning, and thank you, Dean Morrison, for that kind introduction.  It is a pleasure to be back at NYU and to be in the company of so many who care deeply about our markets and our investors.

Special thanks also goes to Alexander Ljungqvist, Anthony Lynch, Ed Rock, and others from the Salomon Center for the Study of Financial Institutions and the Stern School of Business at New York University.  Thank you also to the staff in the Division of Economic and Risk Analysis, for all of the preparation required to make an event like this happen.

This is now the fourth in the series of SEC-NYU dialogues, and I am pleased with the four topics that have been covered, as well as the quality of the discussions thus far.  It is important that the SEC be able to take a forward-looking approach with respect to our securities markets — to keep up to date with key developments, and be alert to issues where regulation may be appropriate in the future.  Hearing about new developments or theories — whether they require us to take specific action or not — is an important part of that process.  At the end of the day, our ability to spot growing issues and head them off with thoughtful, informed, incremental regulation, or deregulation, will always be preferable to addressing problems retrospectively, including through enforcement.

I also appreciate these SEC-NYU dialogues for their cross-disciplinary focus.  Bringing together practitioners, stakeholders, regulators, and academics of various stripes to exchange ideas means that our views can be subject to debate and analysis by those with a perspective different from our own.  Iron sharpens iron; we are all the better for it.

Today’s SEC-NYU dialogue will focus on the current state of shareholder engagement, including the roles of institutional and activist investors — and how those roles have changed over time.  I’ll try to set the table.

The governance structure of public companies reflects the reality of capital allocation in a well-functioning free market economy:  capital is allocated predominantly on a collective but widely distributed basis; in practice, companies have many shareholders who have no connection to one another.  Various factors drive this approach to collective capital allocation, including that, first, in a global economy, firms have necessarily become large (and therefore very few can be funded by a single investor or small group of investors).  Second, from an investor’s perspective, diversification across investment opportunities has proven to be a prudent and attractive strategy.  As a result, firm ownership is diffused and ever-changing.  This is fertile ground for the age old problems of collective action.  How do we address collective action problems?  There are several proven approaches but, for companies, we have long settled on the approach of selecting dedicated individuals to oversee the company’s affairs and imposing on them a fiduciary duty.  These fiduciaries generally own no more than a small portion of the company.

While the U.S. approach to capital allocation and firm governance is a proven approach — and I firmly believe the best approach — it is not a perfect one.  The separation of ownership and control raises alignment of interests questions — or as my fellow economists say (I’m upgrading my status here), principal-agent problems.  How can the principals (the stockholders) be sure their agents (the managers) are acting in the best interests of the stockholders?  These are not new issues.  I studied them in earnest 30 years ago and my professors at the time had been studying them for 30 years before that.  We have, however, in practice made significant strides in the past 30 years.  These strides have been driven by many factors, including our experiences — both good and (unfortunately) bad — new or changing regulation, and, importantly, as a result of substantial reductions in the costs of monitoring and shareholder communications.  The information asymmetries and absences that plague principal-agent relationships have been narrowed.  As regulators, we have mandated or suggested rule sets — including disclosure requirements and incentive driving requirements and prohibitions — that have reduced the opportunities for misalignment between shareholders and managers.  Based on my observations and, more significantly, my interactions with various market participants, I believe it is clear that governance has improved as a result.

Our work is far from over.  Why?  Not because more rules are better, but because our work has not been perfect, and because markets are ever-changing.  We need to ask if our rule set has kept pace.  For example, increasingly, a second layer of separation between ownership and control has opened between the ultimate owners of capital and corporate management.  Shareholders invest in investment vehicles — mutual funds, ETFs, etc. — which in turn own the shares of operating companies.  In theory, a daisy chain of fiduciary duties keeps these interactions focused on the interests of the ultimate beneficial owner, but it also means that the principal-agent issues are multi-layered.

In addition to principal-agent alignment issues, there also are shareholder alignment issues within the body of shareholders of the same firm.  The key issue to understand how best to serve the interests of the ultimate owners of capital is to understand what they want.  This issue, while facially straightforward, also is vexing — particularly when you dip below the level of broad principles.  Shareholders often have different and sometimes divergent views on objectives and how best to achieve the selected objectives.  This is not a surprise.  Shareholders can have vastly different investment time horizons.  As a well-known specific example, we have seen many cases where some shareholders believe capital should be reinvested while others believe it should be returned to shareholders through buy backs or dividends.

To take a slightly more complex example, let’s assume an index fund that owns, as a part of that index, a company that may be poorly managed.  What might an investor in that index fund expect the fund’s investment manager to do?  Perhaps the fund should do absolutely nothing:  investors may simply want the lowest-cost exposure to the market, warts and all.  Perhaps the fund should do nothing affirmative, but if an activist engages with the mismanaged company, the fund could support the activist — which would ideally drive up the stock price with the index fund along for the ride.  Perhaps the fund should intervene directly — if the index fund can’t exit the investment, then being an activist passive fund may be the best path toward increasing the value of the fund.  How should an index fund select from among these options?  Should index funds seek guidance from investors in the fund, or clearly disclose their engagement policies such that potential investors could self-select into their desired category?

And what if the company is not being actively mismanaged, but simply lacks some of the governance features that governance professionals have deemed to be “best practice”?  Should the passive index fund actively pre-empt?  Should the index criteria themselves take on this issue?  Recently, particularly at larger public companies, active shareholders have sought to establish or modify specific aspects of governance rule sets, as well as company policies on an array of environmental and social topics.  How should companies respond to those overtures?  How should other investment funds react?

These are all complicated issues, with no easy answers, in large part because engagement, while it is valuable in many cases, is not free.  It costs shareholders time and money to engage and, for some shareholders — or in some cases, a substantial majority of shareholders — the marginal benefit of engaging on a particular topic may not be worth the effort.  Let’s not forget that the director-officer fiduciary duty model itself was designed to, and does effectively, if not perfectly, address the fundamental problem of fair and efficient collective action.

One more point on structure.  Even proxy voting is costly to shareholders:  analyzing the issue up for a vote, the potentially varying points of view on that issue, formulating an opinion, and casting the ballot is a series of actions that requires nuanced determinations that may be beyond individual shareholders.  Even investment companies struggle.  Because they frequently compete on fees, are funds tempted to understaff proxy voting, or to outsource it to a proxy advisory firm?  Have we added a third layer of principal-agent issues?  Has it helped?

These are all questions that we need to be examining, and I hope today’s discussion can shed some light on at least some of them.

Turning from structure to market realities of the day:  Few companies are immune to activist pressures — as two of our distinguished panelists here today will no doubt discuss, activist owners can substantively influence the governance of the largest of companies.  And, increasingly, they are doing so.  Activism may be evolving, but it is not going away.  So it is more important than ever for shareholders to understand and evaluate activists’ long-term impact on companies and shareholder value.  In particular, to what extent do shareholder campaigns launched by activist investors create value for all shareholders?  What is the effect of these campaigns on long-term value?  To what extent does passive institutional ownership – and the involvement of proxy advisors – facilitate the growth in activist campaigns?  And activists themselves are not monolithic; they may themselves have different tactics or different time horizons that may lead to differential outcomes with respect to this range of questions.  Do activists take advantage of the imperfections in our system or do they smooth them?  I’ll give an answer — it’s probably both.

As we explore these issues, I want us to keep in mind a group of shareholders whose voices rarely have a place at the table: the Main Street Investor.  The engine of economic growth in this country depends significantly on the willingness of Main Street investors to put their hard-earned capital at risk in our markets over the long term.  If our system of corporate governance is not ensuring that the views and fundamental interests of these long-term retail investors are being protected, then we have a lot of work to do to make it so.

I look forward to hearing the discussions, analyses, and recommendations that will come out of today’s event.  Thank you all for agreeing to spend your time with us so that we can benefit from your insights. I wish you a day full of enjoyable and fruitful discussions.