Washington has someone new to blame for America’s economic ills: Activist investors.
The “new” crisis for Democratic legislators is “quarterly capitalism,” an emphasis by investors – in this case hedge funds — on the next earnings report. According to the argument, the push for higher short-term earnings places a greater emphasis on stock buybacks, dividend hikes and compensation cuts over capital investment, research, long-term growth and hiring workers.
Recently, Sen. Tammy Baldwin (D-WI) and Sen. Jeff Merkley (D-OR) introduced a bill they claim will boost investment in research and development, American wages and domestic facilities while deterring the “evils” of activist investing. The ever-outspoken Sen. Elizabeth Warren (D-MA) and presidential candidate Sen. Bernie Sanders (D-VT) naturally piled on as co-sponsors.
Now, the four Senators could push to make their three goals less expensive by simply revising the U.S. tax code; however, simple is not what Congress does.
Instead, they have proposed the Brokaw Act as the solution to America’s current economic troubles and any future financial challenges faced in U.S. companies.
At its core, the bill targets activist hedge funds and reduces the window that a firm has to file a 13D with the Securities and Exchange Commission (SEC). (A 13D filing is submitted to the SEC by anyone who purchases a stake of 5% or more of any class of publicly traded securities in a public company.)
The time to report a 5% stake would decline from 10 days to two days — and that’s not all. This bill accomplishes so much less.
Like a Springsteen song
The Brokaw Act takes its name from a small town – Brokaw, Wisconsin — which went belly up after a paper mill owned by Wausau Paper closed. The mill accounted for a significant stake of the town’s jobs. It reads like a Bruce Springsteen song.
Former Wausau CEO Hank Newell argues that activist Jeffrey Smith and his hedge fund Starboard Value were at fault. Newell claims the hedge fund pushed for radical short-term changes, stock buybacks and higher dividends – at the expense of the firm’s workers and long-term health.
Senator Baldwin took that charge and ran with it, attacking activism as a blanket ill on America.
“Activist hedge funds are leading the short-termism charge in our economy,” write Senators Baldwin and Merkley. The authors say that Wausau “went bankrupt after an out-of-state hedge fund closed a paper mill that had provided good jobs to the town for over 100 years.”
Their solution? Another law, of course.
Anatomy of a bad law
The bill has three parts: It reduces the 13D window from 10 days to two days. Second, it aims to reduce efforts of “Wolfpack” activist groups who may purchase stakes individually, but exceed that 5% figure as a group and are coordinating to engage in such nefarious practices. Finally, it revises timelines for hedge funds to report their “net short positions” to the federal agency.
Even on the surface, the bill has nothing to do with Starboard’s engagement of Wausau Paper.
Starboard was never a short-term investor in the paper company, as it began investing in Wausau in 2011. At its peak, it was Wausau’s largest shareholder for several years and reported its 15.2% stake as required.
Next, Starboard was pushing for changes at the board level and on strategy on their own for a long time. There was no “Wolfpack” attacking Wausau paper. This was a multi-year effort by Starboard to gain board seats and to make strategic changes at the corporate level — particularly on the strategy side. Altai Capital Management did join the battle over concerns of “continued underperformance,” but not until January 2014. However, it’s hard to prove any allegation that Altai’s emergence was coordinated.
Finally, Starboard never “shorted” or secretly bet against the company to fail. Antoine Gara, a staff writer at Forbes explains this was a case of shareholder dissatisfaction about the company’s corporate strategy. As Wausau’s largest shareholder, Starboard was pushing the company to sell or reduce its declining operations in free-sheet printing paper.
It also wanted to focus on the firm’s successful tissue paper business and to reduce bloated overhead, which included high executive compensation.
Calling an activist
The bill is based on the argument that activists are short-term, corporate raiders. Or as the Senators call them, “hijackers.”
The data suggests otherwise.
Hillary Clinton has called activists “hit-and-run” investors, a charge that is easy to disprove if one simply owns a computer. Ken Squire at Financial Advisor dug into the data in 2014, and found the average activist holding was “significantly above two years.” Compared to average investors in 2014, that’s in line. Global investment manager MFS says the average stock was bought and sold in 1.92 years that same year, according to DealBook.
In fact, Starboard’s efforts with Wausau were hardly hit-and-run. As Gara explains, the hedge fund maintained its stake in the firm until Wausau sold itself this year to SCA. That put Starboard’s stock-holding period at more than four years.
And, of course, the activist benefits are contrary to what the Senators argue. A 2015 study by Lucian Bebchuk, Alon Brav and Wei Jiang finds “no evidence that activist interventions, including the investment-limiting and adversarial interventions that are most resisted and criticized, are followed by short-term gains in performance that come at the expense of long-term performance.”
Furthermore, many activists have shown remarkable abilities to turn around companies and boost long-term value for shareholders. Starboard’s recent turnaround of Darden Restaurants (which included a major overhaul of an unpopular board of directors) was one of the best success stories of activism in recent memory. Carl Icahn saved Navistar from certain bankruptcy, and ValueAct has benefitted shareholders when joining the boardrooms of numerous firms.
Focus on the real problem
The primary provision centers on removing “the opportunity for riskless gains that activists achieve by shortening the 10-day disclosure window to two days.”
This idea is how and why Washington is so regularly shortsighted and why intentions always trump results on Capitol Hill. Like so many other laws passed in Washington, it’s a workaround, and it usually leads to a far worse situation than the one they meant to address in the first place.
Anyone who is building toward 5% would now have a shorter two-day window. Who cares?
The activist can just build up a stake to 4.9%, call all his or her friends, and then buy those last shares when they’re good and ready to make a proxy push. From there, Washington will have to chase the disclosure level down to 4%, to 3%, to 2%.
The Band-Aid approach doesn’t address the most important figure from the Senators’ public statement on the proposed law. As the proponents explain in their press release, activism is on the rise. “The number of activist campaigns has risen annually by 60% since 2010,” they write, “and there were 348 activist campaigns in 2014.”
Activist assets have also surged immensely in recent years.
But not one of the Senators asks why or how activism is so popular.
Naturally, “greed” is the buzzword preferred by Sanders.
But buybacks, mergers and dividends are driving stocks, especially in the era of cheap money.
On a broad scale, organic growth is dying, and there isn’t enough of it to offset the end of quantitative easing. The “buy” model is far preferred to the “build” model in today’s economy.
Much of that centers on Washington’s inability to get anything done: Fixing tax codes, entitlement reforms, educational reforms, eliminating burdensome regulations or reforming immigration.
D.C. has failed to increase positive incentives and eliminate negative ones for business.
Structural reforms are still needed in this economy. If the economy grows and businesses expand at reasonable, historical rates, activists won’t be incentivized to continue to push for these strategies to boost shareholder value.
But wait, there’s more. The Brokaw Act would also eliminate “secret net shorts” that allow a hedge fund manager “to profit by secretly voting against the company’s interests.”
If an activist builds a 5% net position, they will only have two days — not 10 days — to report it. Perhaps the Senators should watch more CNBC.
When an activist shareholder takes a net position, he or she lets investors know pretty fast. If Bill Ackman shorts anything, CNBC probably has a red phone for him to call in on.
Remember, short selling is an important component of the market. These investors help alert the markets about overvaluation, potential fraud, accounting problems and broader concerns about a firm. No, they aren’t always right, but multiple cases exist where Washington would have been better off listening to them.
David Einhorn warned about Lehman Brothers. Jim Chanos was right about Enron and the thousands of jobs and tens of billions of retirement savings that disappeared in the wake of Enron’s collapse were not the fault of short-seller Chanos; they were the fault of Enron’s fraudulent board over many years.
Had Lehman Brothers’ board listened to David Einhorn in July 2007 instead of buying back stock (without pressure from an activist), perhaps America’s financial system would be in a very different place today. Perhaps the unintelligible law that is Dodd-Frank wouldn’t exist.
At its core, the Brokaw Act is an indictment against hedge funds. Of course, it ignores the good these funds have done for markets over the years: From providing a lifeline and saving companies when no one else would to taking a stand for shareholders against hard-headed management teams. From reining in irrational corporate compensation — something one would think Sanders would support — to alerting the markets about illicit activities that could sink a company, sector or even the broader economy.
In the end, the real unintended consequence could be reduced accountability at the board level.
Congress — like the markets — should want outside investors to challenge companies, particularly when we look at overall performance based on how companies are structured.
Ertan Enginalev of WSD Capital Management offers unique insight on the Carried Interest website.
“Most controlled companies underperform non-controlled firms in terms of revenue growth, return on equity and total shareholder returns,” writes Enginalev. This performance lags “even though average CEO compensation is three times higher at controlled companies with multi-class stock structures than at single-class stock controlled firms and more than 40% higher than average CEO pay at non-controlled firms.”
With numbers like that, it’s good to have an activist challenging compensation and the composition of a company’s board of directors. In hindsight, an activist manager might have done Lehman Brothers a lot of good to challenge for a board seat last decade since its board awarded $700 million to its highest-paid employees a year before its collapse.
Another waste of paper
Traders and investors operate in the sand box fashioned by Washington policy. In liberalized markets, bad actors will always exist, and politicians will always chase them. But every reactive policy like the Brokaw Act creates new loopholes, new consequences and picks new winners and new losers.
“Quarterly capitalism” is actually older than Sanders.
The 1934 Banking Act laid the foundation for the very “short-term” quarterly earnings seasons that the proponents of the Act complain about (while they always seem to praise the New Deal legislative era). Is it not insane that the foundation of our financial markets still operates on 80-year old, pre-World War II legislation?
It is until you see the results of recent policy efforts. Sarbanes-Oxley was a hasty, toothless response to the Enron Era and still failed to address ineffective corporate leadership at the board level. Dodd-Frank failed to provide structural reforms needed in the post-crisis era and knee-capped community banks and the capital needed for new businesses in small towns like Brokaw, Wisconsin.
All this, while scatter-brained monetary policy helped fuel the housing bubble and has done little to create a sustainable economic recovery or growth in the post-crisis years.
The Brokaw Act is more of the same. Lazy talking points copied and pasted into a Washington bill with little tonic to solve the root problems. Even if this bill never makes it to the Senate floor, its sponsors may pressure the SEC to use its power granted under Dodd-Frank to accomplish these goals. That just stifles a much needed debate about broader public policy.
Handicap activist hedge funds all you want, Senators, but keep your pens handy. Another strategy will emerge to capitalize on the uncertainty and poor policy decisions made in Washington very soon.