Directors, ignore long-termism at your peril

Tom Morgan considers the continued call for increased long-term corporate governance strategies and the benefits that adopting this approach will bring to business and the wider economy.

While the debate over short-term versus long-term corporate governance and investment strategies by companies is by no means new, in recent times there has been increasingly active and vocal movement by some of the world’s largest institutional investors to support and encourage companies and boards that focus on long-term strategies.

Given the large presence of institutional investors in Australia, the increased pressure placed on companies and boards to focus on long-term investment strategies is likely to have a significant impact on corporate governance practices for Australian companies.

Impact of short-termism

Short-termism, as the name suggests, is when the performance of a company is measured over a short time span.

Critics of short-termism say that it is damaging, not just to companies and other investors, but to the wider economy. Companies that focus on maximising short-term gains ultimately need to forego long-term investment opportunities and projects, such as product development, scientific research and education.

The Roosevelt Institute published a recent report that examined the prevalence of short-termism amongst US S&P 500 corporations:

• These companies spent approximately $3.26 trillion (54 per cent of their earnings) on share buybacks between 2003 and 2012.
• Corporate investments increased by approximately $540 billion between 2009 and 2013.
• During the same period, distributions to shareholders increased by approximately $1 trillion and borrowings increased by $1.2 trillion.

The Roosevelt Institute’s report concluded that short-termism is a significant drag on investment, which ultimately leads to weakened productivity, growth and innovation, damaging the long-term prospects of gross domestic product and the economy as a whole.

Inflated earnings

A separate study in the US by Cremers, Pareek and Sautner, concluded that when there is a large influx of short-term investors into a particular company, it places pressure on that company to reduce long-term investment in areas such as research and development expenditure to generate inflated earnings and increase the share price. These increased earnings are generally short-lived and can be misinterpreted by a wider group of investors who decide to follow the short-term investors into the company based on these figures. When the short-term investors cash in, the inflated earnings and valuations dissipate. Long-term investors and those who followed the short-term institutional investors in, ultimately lose out.

Moving away

A number of leading UK fund managers, through the Investment Association, recently published a paper entitled Supporting UK Productivity with Long-Term Investment. This paper represents the growing movement by institutional investment managers towards supporting and actively encouraging corporate governance practices and investment strategies by companies that focus on long-term objectives.

Through its paper, the Investment Association hopes to promote a series of actions amongst investment managers with a view to improving long-term investment strategies by public companies.

This paper follows a number of articles, media reports and direct communications from the US that have a common theme – institutional investment managers are increasingly focusing on, and are actively encouraging, boards that place a greater emphasis on long-term strategies.

In February 2016, Laurence D. Fink, chairman and CEO of the world’s largest investment manager, BlackRock, sent a letter to the CEO of each S&P Fortune 500 company, asking that they lay out for shareholders each year a strategic framework for value creation. Fink made it clear that BlackRock’s corporate governance team, in their engagement with companies, will be looking for such a framework and board review.

The letter from Fink coincided with media reports of a “secret summit” attended by the world’s largest asset managers. According to reports, this summit was attended by Warren Buffett and the heads of various banks and fund managers including JP Morgan Chase, BlackRock, Fidelity, Vanguard and Capital Group. The purpose of the summit was to discuss ways for investment managers to encourage longer-term investment and reduce friction with shareholders by improving corporate governance of public companies.

Implications for companies

The increasing pressure being placed on companies to implement long-term investment and corporate governance strategies by institutional investors is not something that can be ignored by CEOs and directors. To put some perspective around the importance of these organisations to global capital markets, the total current market value for equities listed on ASX is approximately $1.62 trillion. Compare this to BlackRock, which has approximately $6.45 trillion in assets under management alone and the Investment Association, which represents UK investment managers who have more than $10.84 trillion under management around the globe.

While ultimately it is up to directors to take a long-term approach to governance and investment strategies, there are a number of possible areas of reform that may give further incentive to directors in this regard:

• Introduce legislative amendments to directors’ fiduciary obligations – Directors in Australia have a general fiduciary duty at law to act in good faith in the best interests of the company and for a proper purpose. Under legislation in the UK, directors are required to have regard, among other matters, to the likely consequences of any decision in the long term in fulfilling their fiduciary obligations to the company. Legislative reform in Australia could be introduced to reflect the position in the UK.
• Reducing red tape to allow directors to focus on long-term strategy – Many directors feel that red tape and regulations are stifling the ability of boards to dedicate sufficient time and attention to stewardship and long-term strategy. A reduction in overly burdensome and unnecessary red tape would allow directors to dedicate more time to considering and formulating long-term investment strategies.
• Requiring directors to create and disclose a long-term strategic plan – As a trade-off for a reduction in red tape and regulations, boards should be required to make open and transparent disclosure about their long-term growth plans to investors, as well as progress in executing those plans. BlackRock in particular has announced that its corporate governance team will be engaging with, and looking for, companies that can demonstrate a strategic framework aimed at creating long-term value for investors. BlackRock is also proposing that boards explicitly affirm that they have rigorously reviewed, discussed and challenged their strategic plan.

• Increasing long-term remuneration for directors – Directors have received significant criticism since the GFC in relation to what the public perceive as excessive remuneration. In order to incentivise directors to place an increased emphasis on long-term investments and strategy, directors’ remuneration should be increased and structured in such a way that more closely aligns their interests with those of long-term investors. This could be in the form of an increased number of long-term incentive shares that vest at some point after they cease to be a director. Further, new directors could be required to purchase shares out of their own pockets – which is a model traditionally adopted by longer-term investors such as private equity.

Ultimately, it is a matter for each board to take steps to implement well-planned, long-term corporate governance and investment strategies, for the good of the companies that they are charged to oversee and for the good of the wider economy. Boards that ignore the increasing pressure by large institutional investors to focus on long-term governance and investment strategies will do so at their peril.