(Ep.105) The Acquirers Podcast: Lawrence Cunningham – Quality Shareholder: How To Attract Quality Shareholders And How Being A Quality Shareholder Improves Returns

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In this episode of The Acquirers Podcast Tobias chats with Lawrence Cunningham, author of several books including The Essays of Warren Buffett, Dear Shareholder, and Quality Shareholders. He is also the key driver behind The Quality Shareholders Initiative. During the interview Lawrence provided some great insights into:

  • Quality Shareholders
  • Validation Capital – When Activists Try To Seize Control, These Shareholders Come To The Rescue
  • A Solution To Improve Proxy Plumbing
  • The Impact Of Corporate Governance On Business Judgment
  • The Quality Shareholders Initiative
  • Quality Shareholders Improve Returns
  • Berkshire’s Success Is Built On Quality Shareholders
  • The Correlation Between High Director Ownership And Quality Shareholders
  • Activists Can Be Engaging Shareholders
  • Berkshire’s Moat For Fending Off Activists

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Lawrence Cunningham. He’s been a longtime observer and student of Warren Buffett and Berkshire Hathaway. We’ll be talking about his brand new book, Quality Shareholders, and his Quality Shareholder Initiative. It’s an absolutely fascinating discussion. I learned a lot. It’s coming up right after this.


Tobias: Well, I just wanted to say what an absolute pleasure it is to be speaking to you, first of all. I’ve been a longtime fan of yours, because I’ve got the original book that you wrote. The collation of Buffett’s essays, this one is from 1997. You’ve had a very long-term interest in Buffett, and now you’ve got a new book called Quality Shareholders. Just for folks who are not familiar with that term, how do you define a quality shareholder and what’s the relationship to Buffett?

Quality Shareholders

Lawrence: Well, it’s a close relationship, because I got the term from Buffett. He wrote in his 1978 letter that his goal at Berkshire Hathaway was to attract the highest density of quality shareholders. He called them high-quality shareholders. I dropped the word “high.” Then, he defined them as long term and concentrated. He wanted people who were going to hold forever, and who were interested in the business, and who would focus on the economics of the investments and acquisitions and the analytics of his own philosophy. He didn’t want short-term people. He didn’t want people who bought everything indiscriminately. That’s where the phrase comes from.

The connection is– thanks for saying, I’ve been studying Warren and Berkshire for a long time, 25 years or so. I’ve written a lot. I discover more and more things every year. The most important discovery of the past five was that Warren’s success in attracting that quality shareholder base was an important reason for Berkshire’s prosperity. There are a lot of factors that go into Warren and Berkshire, his intelligence, his patience, his discipline, and we’ll get into all those. One indispensable factor was his recruitment of that high-quality shareholder base. People who were patient, they’ve held for that whole time and who were focused on Berkshire. That’s my most recent discovery. I think, maybe the most important one.

Berkshire’s Success Is Built On Quality Shareholders

Tobias: Yeah, I love the idea. Berkshire is two things. Berkshire, I think, tries to be a quality shareholder. Berkshire also tries to attract quality shareholders. Let’s deal with the second part first. What advantage does it bring to a company to have quality shareholders on the register?

Lawrence: There are quite a number of them. The most obvious is the horizon. It gives managers a runway to execute on strategy. If they don’t need to deliver every quarter, or every year, they do have to eventually deliver. This in the license for lethargy forever, but they have some runway to develop that product, search for that market, find that acquisition execute on the strategy and that’s not a luxury many CEOs have, but most would welcome. The second thing is it promotes a degree of rationality in the stock price. Volatility is usually a product of short-term transient traders doing arbitrage things, making trades that really are about value that has already been created, rather than investments in the future of value creation. Then, when that volatility spreads, even the indexers need to buy and sell. So, you get wider swoons and swings, there’s greater departures or wedges between the business value and the stock price at any given time.

The more quality shareholders a company has at its base, the greater the leavening effect they have. There’s less volatility, there’s less trading for exploiting past value and more investment in patient value creation. That’s useful in a couple– I mean, what I’ve said so far might sound theoretical, it’s practically relevant for the CEO who wants to use stock to make an acquisition. That currency is worth most when it’s most closely priced at value. If it’s highly inflated, paying– especially if the seller is going to join you, or the sellers, owners, or employees are going to join you, there will be recriminations later if you paid an inflated stock, and obviously, if you’re paying for an acquisition with undervalued stock, you’re destroying capital for your shareholders. So, having a fairly valued stock is extremely advantageous for acquisitions.

Likewise, it’s advantageous for paying employees if stock compensation is any important part of your pay package or indeed, if you’re trying to develop an owner culture, so employees buy stock, either just by encouragement or through some bonus mechanisms. The best stock is the one that’s fairly priced. You’re not being paid an inflated or deflated currency. I can go on. Those are two big advantages. I’ll mention a third just since managers might be listening.

These are constructive engaged shareholders. These are not sycophants or toadies or, they listen, they pay attention and if you need them, they’ll talk to you and be constructive about it. It’s nice to have, I call it a brain trust, a CEO will very often like to know what his or her most intelligent shareholders think. If you’ve got a steady base, a significant number of meaningful long-term holders, there you go to people, you can talk to them. Heck, you can put them on your board of directors. Some of the best quality companies have done that, including Berkshire Hathaway, Sandy Gottesman is the most obvious, Tom Murphy is another.

Validation Capital – When Activists Try To Seize Control, These Shareholders Come To The Rescue

Lawrence: The related point, then, is that when a short-term activist argues for a new strategic direction, sometimes they’re right. When the activist overzealous and unduly short term, the CEO with a base of long-term focus shareholders can go to them and say, “Do you agree what they’re trying to do here? Tell me if you do, we’ll change course. But if you don’t, will you help me persuade them that this is not the target they should hit?” That has been a– I’ve got an article coming out, or it just came out? I’ve got an article recently out in MarketWatch, explaining that use of quality shareholders. Those are three big reasons, and the book identifies another half dozen, there’s almost no downside. [laughs]

Tobias: What was the MarketWatch article? What was the example that you gave in that?

Lawrence: I gave quite a few different examples. The inspiration was, there’s a new research article by some professors I know called Validation Capital. They observed in the past bunch of years, companies have identified block holders who have validated manager’s strategic direction in a way that warded off activist holders. I thought, “Oh, that’s interesting–” so this came out two weeks ago when this will air, but I would say around February 20th or 15th, the article came out and it’s called Validation Capital.

That inspired me to look back and think, in the 1980s, Warren Buffett was famous for among other things, being a White Squire. That was a phrase during the battle, the takeover battles of that era. When a company would secure a large block holder, who would be faithful, supportive, not a sycophant, but just who would listen and ideally understand management’s view and deter hostile bids. Warren bought large stakes in convertible preferred stock of five or six different companies. Gillette, Solomon, Champion, US Air, where he was aligned with the prevailing strategic direction, and they were aware that there were hostile bidders prowling and so he served a defensive purpose.

What I took from this validation capital, you know what? There are a lot of quality shareholders today who provide a similar validation. The best example I had, or I’ve got a bunch of them in that column and they’re in the book too, was where about three years ago, a chemical company, Ashland Global, was targeted by a relatively small activist, but they can be fierce [chuckles] small, I think it was called Cruiser Capital. I think that was the one. The board got the letter, the proposal. They didn’t think it sounded right. They called their long-term, concentrated shareholders and they had a bunch of them. The largest, I guess, and longest was Neuberger Berman, which is widely known to be a stock picker and a buy and hold type of firm, and ran the proposal by them. Neuberger said, “No, we agree with you.” They contacted a few other long-term focused shareholders and asked them the same question and they all agreed, “This is not a good strategy.” The board was able to tell the bidder, the insurgent, “Good luck, because our shareholder base is not interested.” The fellow went quietly away.

I’ll give a couple another good examples. RenRe, Renaissance Reinsurance, which is a Bermuda based insurance company listed, I think, in New York Stock Exchange, received an overture and it happened that at the time, it was negotiating for an additional issuance of common stock to State Farm Insurance, also a revered quality shareholder, most of its portfolio is long term and concentrated. They had a 5% stake in RenRe and they were negotiating for more. They upped their stake, they doubled their stake. All of a sudden State Farm owns 10% and they were quite supportive of the existing strategy. RenRe was also in the middle of negotiating the acquisition of a Japanese insurance company called Tokio Marine, they had been planning to pay in cash, but when this insurgent hit, they said, “Well, why don’t we pay in stock? You’ll become a five percenter, forget the figure, meaningful holder.” They had a long-term relationship with Tokio Marine, they knew they would be the long-term focus shareholder that State Farm had been and so on. All of a sudden, they had 15% in two holders, and then had a few others like that, and they were able to go back to the bidder and say, “We don’t share your view, and moreover, lots of the shareholders don’t either.”

It gives managers leverage, I guess the advantage to a company and to an incumbent board that, especially in today’s environment, where activists have very loud megaphones, amplified voice. They’ve got a well-developed professional ecosystem of advisors, lawyers, bankers, and funders, and proxy advisors, and their own shops have very talented repeat players in this game. So, if you are targeted, it helps to have shareholders who you can talk to, who will listen to you. Many indexers are unavailable a lot of the time. Again, they’re not sycophants. Neuberger Berman isn’t going to just jump because some board says so, but they will at least be a sympathetic ear and maybe a strong partner in supporting the board and management’s case.

Berkshire’s Moat For Fending Off Activists

Tobias: Berkshire has had a run over the last 10 or 15 years where the stock price has underperformed a little bit, and it’s attracted some criticism, and it has had several activists appeared meetings and try and ask various questions. I don’t think there was ever any suggestion that they were going to be able to achieve anything because Buffett controls it and there are lots of other shareholders, quality shareholders who’ve been there for a very long time. You only need to go to a shareholder meeting and everybody, the first thing they’ll tell you is how long they’ve held their shares. Certainly, people aren’t trading it. But doesn’t that sort of seem to indicate that even with that kind of shareholder base, you can see compression in the price to the underlying value. It doesn’t seem to insulate you from criticism, you still seem to face activists. How do you square those two ideas?

Lawrence: Yeah, there’s no guarantee and certainly, a persistently underperforming company may need to be shaken up. I think there’s a role for activism. I think a lot of the activists, Loeb, Ackman, even Carl Icahn, some of the tougher fighters in there, they have added value and helped change direction at a lot of companies. Indeed, activist investors can be quality shareholders. Bill Ackman and Loeb, they very often have very long holding periods and quite concentrated portfolios. These are the opposite of indexers and transients. There is a different category or some of those guys can sometimes occupy what looks to me like a much more short-term strategy or just get overzealous and something where they cling to a strategy idea that actually doesn’t make sense and they just suffer from ordinary behavioral biases. It’s that overzealous cohort that I worry about, and for whom I think it cohort equality shareholders can be particularly helpful but A persistently underperforming company has a problem and needs to change.

In the case of Berkshire and Buffett, I think their run is spectacular, so spectacular for decade upon decade, that when you look at the past 10, you say, “Well, that’s not so spectacular anymore.” Or, even the prior 10 is nothing like what it was in the 70s or 80s. There’s a couple of reasons. One is, obviously, they get bigger and bigger, it’s harder to outperform, it’s harder to find opportunities to allocate $30 or $40, $50 billion at a time. They’ve only found a couple. That’s a big problem. Then, you also end up needing to invest in businesses that require capital, so you’re against the contemporary curve a little bit buying a railway, buying energy businesses, when most operations are moving to intangible assets, you’re bulking up. I think it’s a victim of its own success in some ways. That said, it’s not as if it is hemorrhaging cash. It’s accumulated abundant amounts of it and managing to perform at least as well as the index.

On the agitators, there have always been agitators at Berkshire for 30, 40 years. One cohort argued that the company must pay a dividend. It hasn’t paid one since 1968 or 1972, whenever it was. Warren’s joking on that one, he said, “During that board meeting, I must have gone up to the bathroom when they passed the resolution.” We’re talking Incidentally the Friday before the Saturday when the letter comes out, there is some rumor and mumbling and so on about, “Well, maybe he’s going to finally announce the dividend.” We will see. The record that suggests he’s not, and he’s got 130 or 40 or 50 billion, I don’t know what it is. but for 30 years, a cohort is agitated to pay a dividend. They don’t like that strategy. What he’s done on two occasions, is take a poll of the shareholders, the non-Buffett shareholders, and the overwhelming majority of that cohort said, “No, please keep the funds, please reinvest them.” They seem still to be happy with that, even though they’re reinvesting them in treasuries at the moment.

The more recent agitation in the past dozen years has been the bandwagon against conglomerates. The argument that you’ve got 80 different businesses in every artery of commerce, manufacturing, you can’t possibly understand all those things. They can’t possibly be adding value synergies, you really should start busting up, selling them off. The answer is manifold, but the first answer is, there are extraordinary gains, synergistic gains from being inside the Berkshire umbrella. Vendors pitch their products to Berkshire subsidiaries at a huge discount. IBM has cultivated their data processing, their financial accounting systems, and data analytics, and they give individual subs a discount. There are lots of other vendors who do that.

Moreover, the commitment to permanence that Berkshire has always made that is we don’t bust up the company. We don’t sell off divisions, so long as they’re generating some cash and don’t have any labor unrest. We’ve had a couple of sales. We sold off the newspaper businesses because they’re hemorrhaging cash, sold a small insurance company because it was cannibalistic. Two Berkshire subsidiaries in the same business, didn’t make sense, owning both and there was no way to combine them. He sold a couple, but the main idea is that when you sell to Berkshire, you got a permanent home. So long as you’re doing okay, we’re not going to sell you that has appeal to a lot of businesses seeking that kind of commitment, that kind of permanence. Family businesses that want to maintain that legacy, entrepreneurs who want the runway and the ability, the agility to do their thing, and that has added significant value to Berkshire.

I think that the policy remains important. Even though we haven’t made a lot of acquisitions in the last five or eight years, the ones that we made have been helped by that commitment. When I did research for an earlier book, I interviewed a lot of the selling families. Many of them said, “We took a lower price from Berkshire compared to rival bids or market fair value because we put up a price, we put a quantity on that intangible commitment.” It’s saved Berkshire, it’s been an important part of the value proposition of Berkshire. If you said, “Hey, you know what? Let’s just start selling things off, it would be the end of the road. Maybe someday you’ll be at the end of the road, but I don’t think we’re near there yet.

Activists Can Be Engaging Shareholders

Tobias: I’m glad you raised some of the activist story because I think that there’s been an evolution in activism, or maybe it’s the activists who survived have tended to become, perhaps, they’re more engaged shareholders than the activists that we saw in the early 2000s or the corporate raiders from the 80s. I’d include in that list that you gave before are Starboard and ValueAct.

I’m not sure where they’re continuing on anymore, but ValueAct was certainly like that, where they were very long-term shareholders, which is in total contradistinction to the way that they’re perceived as being very short-term shareholders and in for a quick pop, they tend to hold and seek to make operational changes. You talk a little bit about engagement as shareholders. Can quality shareholders be engaged shareholders who can affect change, or is that not their role?

Lawrence: Oh, they sometimes do. You’re absolutely right on that. Dan Loeb is particularly good at engaging, and companies with whom which he’s engaged, having engaged in return. A couple of years ago, he signaled to Microsoft that he had some ideas and they responded by putting them on the board or inviting them in. I think they got a designee of his. The activists are, many of them anyway, are seen as much more valuable to everybody to engage than to fight, and plenty of boards appreciate that too. I do think it’s possible and it’s favorable.

More, within the second part of your question, within that traditionally non-activist quality shareholder community, there certainly are times when a long-term focused shareholder is frustrated with strategic direction or a particular major decision, and tries the traditional routes of quiet diplomacy and cajoling the CEO or working with the CFO, or calling a board member or something like that, but still don’t get anywhere. In some cases, the old-fashioned thing to do was to sell. They used to call that the Wall Street rule, disaffected shareholders can simply sell their stock and move on. For some quality shareholders in particular that the stakes are so high, the positions that they hold are so high, that unwinding them would take a significant period of time, and maybe even some costs. That’s not a realistic option.

I give an example in the book of Methanex, a Canadian– one of the largest ethanol manufacturers in the world, and one of their longest shareholders, I think it was 12 years, maybe a 16% stake or something like that, objected to an imminent decision. They were going to build a huge new ethanol plant in Louisiana, at a huge cost. They’re going to borrow a substantial portion of the development price and they were going to do this alone. They didn’t have a partner. This quality shareholder didn’t think that was a prudent approach. A lot of leverage, a lot of risk, why not get a partner? Let’s think this through. The board told the total shareholder to sell, this is what we’re going to do. I think it was 16% because it would take them– You can’t just sell that tomorrow. The float won’t support it. It’s just chaotic.

They went hostile in that sense. They tried– they exhausted all possible discussions and finally announced a slate of directors for the next annual meeting, four directors, and that got the board’s attention, they eventually settled, as most of these things do with one or two of the slate on the board, and they did a whole review of the investment and so on, and eventually reached some sort of accommodation.

I think that quality shareholders have different temperaments that they don’t just– is not one of the kind thing. Again, the core definitional elements are long horizons, as long holding periods, empirically long average holding periods, and relatively high portfolio concentrations, that is their active share is large, is above 90%, or something like that. You can define these things in different ways. But beyond that, temperaments vary, and some are very highly diplomatic like Warren, and others are a little more widely public, like Dan Loeb or Bill Ackman.

I think that every shareholder, every intelligent shareholder, knows that there will be times when management needs a tap on the shoulder, or a board is supine and needs awakening. People will pursue that need or make that tap in different ways, but that wouldn’t necessarily knock them out of quality category.

Quality Shareholders Improve Returns

Tobias: Much of the book is about the action that management can take to attract quality shareholders and the advantages of having quality shareholders on your register. Are there any advantages to being a quality shareholder, and what are they perhaps?

Lawrence: Yes. This is an ongoing research project, of which the book is a significant part. The broader research project investigates the performance of quality shareholders as well as portfolios of high-density quality shareholder companies. What we see on both sides is outperformance. Let me just break that down a little bit, and hastily add some qualifications. On the investor side, as your listeners undoubtedly know, and as you know, a raging debate contests whether any active strategy can systematically outperform a passive strategy.

The active-passive debate been going on since index funds were proliferated in the late 80s or 90s, and has a lot of empirical scholarly work around it and also more disputatious fights among different investors out there. Even a bet, the famous bet that Warren Buffett made against Ted Seides. I think the general evidence may seem to suggest that the passives won, that there is no active strategy that can be proven systematically to have a propensity to outperform. There’s a huge caveat to that, which is the strategy of the quality shareholder and work by Martin Kramer’s in particular from the University of Notre Dame and others, following the approach, demonstrates that a strategy of patient-focused investing can systematically outperform.

I think it’s sort of a logical theory that if you’re quite careful in your selections, you’ve got a rigorous approach to not only financial analytics, valuation, and so on, as a value investor might, but also an appreciation of characteristics that signal competitive advantages, durable moats, a conviction that is logically appealing to a long-term investor, it might be that if you pick 7 or 9 or 14 of those rather than thousand off the S&P, then you might outperform, and so there is empirical academic evidence that suggests that this strategy or quality shareholder strategy has the capacity for systematic outperformance.

It’s not a guarantee. You can use a filter such as this, and then still come up with errors, selection problems, and so on. But there is an intellectual academic case that this methodology, this approach does have this capacity. That’s on the investor side and then you look down investor list that I identify as high on the quality shareholder’s list, if they’ve got strong such references, including you. [laughs] I should say.

Then on the other side, on the company side, what we did in the research that’s beyond the book, but it’s available online if you search for my name in the research, I can give it to you later, but it’s called the Research on the Quality Shareholder Initiative. What we did in there is, we ranked to 2070 companies, I think it’s US, there may be some Canadians in there, by their propensity to attract quality shareholders in high density. Then just did an experiment, imagined a portfolio of the top 60, portfolio of the bottom 60 over the prior five years and the top 60 significantly outperform, I think, by 200 basis points, a full two percentage points outperformance. Then within that 60, the overwhelming portion had outperformed.

There were some laggards, but it was a significant outperformance. It’s one data point. It’s one study. It’s one metric, but it’s a reasonable basis. Again, lots of reasonable basis for believing that the companies that attract quality shareholders may well outperform. We don’t make any assertions about causation. I don’t have a claim that says that if you attract quality shareholders you do better, or if you do better, you attract quality shareholders.

I think there are some, what we then do with the data is we go around and try to figure out, well, why do these companies tend to attract these holders. We looked at 40 different practices, companies might or might not follow to see if there’s any correlation, such as– some of the examples that we looked at our director ownership of the stock, attendance at shareholder meetings, rankings of the clarity and candor of shareholder letters, degree of sophistication and achievement around capital allocation and a bunch of others. We’ve looked at about 40. We see correlations among ones I’ve just mentioned.

Incidentally, we also find some interesting practices where there’s no correlation. This includes staggered boards and dual class stock, two hot button issues in the governance world that our evidence shows that there’s no correlation. So, company with or without either of these things, doesn’t have a higher or lower density of quality shareholders, it’s just a random distribution. Our inference from that is, these are not policy practices that quality shareholders rank as always good, or always bad, they take each one on a case-by-case basis. For some companies, a staggered board is a terrible idea.

The Correlation Between High Director Ownership And Quality Shareholders

Lawrence: For others, it’s quite productive and useful. We get into some of that in the book. We then make some inferences around some of these examples about causation. I don’t want to push this too hard, but I’ll just give you one example, where we found that companies whose board has higher levels of director ownership in the stock tend to attract higher levels of quality shareholders. Again, I don’t want to insist on causation, but here’s at least a story about it. Well, these directors are probably acting much more like venture capitalists, that is they’re actually helping develop and implement strategy.

Conventional board member today will very often instead be there to promote compliance and assure the auditing is fair, to conduct governance surveys or check the CEO’s decision making and so on, but a director that who has a significant part of her net worth in the company may do more, may really try to engage with the CEO with strategy. How are we allocating capital? What’s our hurdle rate? Should it differ for larger/small acquisition and really get in there do what venture capitalists do, which is really– it’s not telling the CEO what to do but coaching and nurturing and really caring about the return on invested capital, let’s say.

So, that’s our hypothesis. Our thought was, if a quality shareholder seeing that kind of board is very likely to be attracted to it and a director who has that stake is very likely to have that additional commitment. So, it’s not merely a correlation. It’s something quality shareholders are looking for, and something that if a company does it, will attract them. That’s a thesis, and again, I don’t want to push it too hard. I think that that’s what we’re doing when we look around and see what practices tend to correlate. The reader will have to decide for herself, we’re trying to keep the research up to date on the internet so that people can follow along.

The Intersection Of Investing And Management

Tobias: You’ve had a long interest in Berkshire and Buffett and you’re an academic, you’re a professor. How do you characterize your body of research or your research focus?

Lawrence: The intersection of investing and management, sort of a Venn diagram there, I guess, in a way, and then it’s the other, maybe the horizontal, vertical is governance, Venn diagram around governance, so it’s business and law. That sweet spot right there in the center is really where Warren has been living his life. Since he started writing his letters, he’s thought very hard about how to be a good investor and how to be a good manager. You mentioned earlier that Berkshire Hathaway is both a quality shareholder of other companies and attracts quality shareholders to it.

That’s because Warren is ultimately both an investor and a manager. It’s neat to study him, because you see both parts of that equation. A lot of companies that CEO doesn’t really have the investor experience and the investor viewpoint, harder for that person to get what I’m talking about or to understand things from the shareholder side.

Likewise, there are a lot of investors who’ve never managed a company and it may be harder for them to appreciate the challenges. It’s really neat to illuminate that intersection. That’s an important part of what attracts me to Berkshire or other companies like that, especially in the insurance sector. You’ll find more companies that succeed in attracting quality shareholders in the insurance sector than any other. It’s partly because those managers are also investors, they have enormous amounts of float, typically, that they have to invest in a portfolio typically diverse, particularly one that was bonds, but also equities, and so that intersection between investing and management, very interesting to me.

Lawrence: Then the governance space, I’m a law professor by background focused on business and governance and what boards do, how they can do it better. Overseeing companies and that sort of thing, and so I spent a lot of time thinking about this relationship. I’ve got well-formed views around what I think the ideal mix is. To shorten it for you, I think that it’s much more– law does a better service to society, when it simply creates lots of flexibility, some guardrails and some boundaries, and then lets individuals make decisions within that. It’s especially true, I think, in corporate governance.

I’m skeptical of very specific rules that require every board to do this, that, and the other thing. That would be say, not allowing a staggered board, not allowing dual-class stock, requiring a certain number of directors or a certain committee type, or a certain balance of gender or balance of race or separating the CEO and board chair. I’m sure your readers are familiar with the list of topics where there are some governance devotees who believe there is only one right way to do it. Others, this other group who believes that there are many different approaches and that the right one will be vary by company. I’m so very interested in that. That’s the two Venn diagrams, [laughs] if you like.

The Impact Of Corporate Governance On Business Judgment

Tobias: There used to be this principle of business judgment decision sort of being outside the review of law courts and it seems that as we’ve progressed over the last decade or so, they’ve become increasingly you must check all of these boxes. If anything, I think that that’s sort of made the corporate governance a little bit worse, because people are so focused on checking the boxes, then they’re able to sort of sneak through a whole lot of other stuff where previously had to take it in its totality and look at what they were seeking to achieve. Do you see any of that– is that a fair characterization, do you think?

Lawrence: I’m troubled by the– Thank you very much, and I would make this observation that I think that the business judgment rule, which is what you that first described is a doctrine in law courts of deference so that a judge asked to evaluate or review a board of directors’ decision about dividend policy or divestiture or a spinoff or tracking stock, whether this person should be hired or fired. Those business decisions have classically been seen as outside the competence of a lawyer, of a judge. And rightly so, because those are quintessential business decisions, they must be made in real-time with lots of contending pressures, so it’s best to have those decided in the boardroom rather than a courtroom. Judges for hundreds of years, from England, Australia, and India, to Israel, the US, and Canada have said, “That’s a business judgment and the rule is, don’t second guess it.”

Now, I think that that legal standard is still alive and well. I think what’s happened and this is where I think it’s disturbing, because the second half of what you described is this proliferation of prescriptive governance, of saying you must do this, that, or the other thing, or you may not do this, that, or the other thing, includes the examples I gave. Staggered boards have declined precipitously, separating the chairman and the CEO is a very popular thing. There’s been enormous criticism against dual class. We could have a list. Where’s this coming from? It’s actually not so much coming from law courts, it’s coming mostly from the passive indexing community, that includes the big investors there, BlackRock, State Street, Vanguard, and especially includes the two big advisory firms, Institutional Shareholder Services and Glass Lewis. All five of which are, in effect, either managing or examining many, many thousands of companies– trillions of dollars in assets deployed in tens of thousands of companies around the world.

Their business model, the three big indexers in particular, but then the clients of the two advisors, their business model, is to exercise no judgment in investing, that we buy every stock in the basket. We do have to make sure we keep up with the basket and have a program to buy and sell as things change, but we’re not deciding Berkshire is appealing at this price, Microsoft is wobbly these days, Salesforce is the future.

They’re not making judgments about that at all. They’re buying the S&P 500 or the Russell 3000 or the Dow or whatever it is. But then, they’re asked to vote on a whole bunch of things. They’re asked to vote at Berkshire’s annual meeting and Microsoft spinoff and so on. They simply lack– there’s no budget in their business model to evaluate these things. Now, when a big deal comes along, Dell is selling off, Dell is going private. Dell put a few people on that deal and look and see the economics, receiving good price, should we support this going private? For most things, they cannot possibly study. Is the staggered board good at Boeing? Is the dual-class stock good at the New York Times company?

They can’t do that. It’s practical matter, and that instead migrated to have, well, we’ve got generalized rules and requirements, that we have just determined to be the best practice. Unless we have some contrary evidence, that’s how we will vote or we recommend our clients will vote. That’s, I think, the principal source of the rule orientation now around governance. It’s a simple product of a business model.

Now, in their defense, they counter me, say, “Well, no. We’re not doing this simply because it’s efficient or cost-effective because we lack a budget. We actually look at systematic empirical data about what is best. We look at academic research. We look at your research and we’ve seen it in general, and we look at logic too, as a general matter. Separating the chair and CEO function is smart, is natural, because the board’s job is to hire that CEO and then oversee. You can’t have the guy doing the same thing.” They’ll have an argument that there’s a law logic and even an empirical basis for a lot of their assertions.

I simply take a different view. I’ll agree this much, I’ll say, “Look, you may have identified best practices.” That means that the best for some sizable cohort, maybe it’s a majority, it might even be three-fourths. It admits that it’s not right for lots of them. There are plenty of companies. Bank of America, it’s far better off having Brian Moynihan to have both of those roles because it’s efficient, it’s useful to have the person in charge of the company also running the board and setting the agenda. Why? Well, in part because he’s trustworthy, and really has a good view of things. In part, because the other directors are really strong. They’re not going to let him get away. They’re not supine ornaments and fixtures. That’s a good board.

That’s how I would decide. I’d say, “Well, who is this person and who are the other people there in that room?” It’s not feasible for ESS to look at 10,000 companies and say, well, is this really Brian Moynihan here, are we looking at in a monomaniacal nut? [chuckles] I think that’s where it is, Toby, I think it’s not so much that law, it’s certainly not corporate law. Judges still regard their bailiwick as law and not business. It’s ironic almost in a way that the governance gurus, the investor, large part of the investor community have decided to do something different. The law judges were basically saying, “Let 1000 flowers bloom. There may be lots of different good ways to do this, we simply don’t know. We’ll leave it up to the boards.” Oddly enough, the governance community has elected to impose a fairly specific set of expectations or requirements in corporate life that the judges had the wisdom to say, ought to vary a lot more than it does.

A Solution To Improve Proxy Plumbing

Tobias: I think one of the difficulties with Glass Lewis and ESS is that they almost always support incumbent– they always support the management, the incumbent management, and there’s not much of a– I don’t know how much consideration they give of the activist sort of role. I’ve seen many instances where I’ve thought that the activist was probably in the right, and both the ESS and Glass Lewis. It’s a very heavy stamp that they’re able to put on these things. It’s like a third party has– this interested third party who only has your best interest as a shareholder has reviewed this, and they’ve decided that we’re going to support management, but then I don’t know how many– there are many small shareholders out there who rely on that advice, almost exclusively, without realizing that that’s what they always do. Do you have any view on why they behave that way, it’s helpful to get the next job if you’ve supported management?

Lawrence: Well, thanks. It’s a serious problem and that is one of the reasons potentially, we see conflicts of interest among the big indexers and even among those proxy advisors that they’re not sure independent objective observers. They have other relationships with companies or prospective relationships with companies that might be important to them. That may enter into their judgment. Now, they will all respond to that criticism by saying, “We have very thick walls between these different activities within our firm,” and say, “That’s not a problem,” and isolated that.

Another problem is, and I’ll add one statistical observation is that there has been a slight increased propensity of those indexers and the advisors to break with management. You’re right that historically, there has been– if you look at the voting outcomes and large numbers, there’s been a tendency of the passives to support management and the actives to support proponents of shareholders, not just on activist campaigns, but sure, more proposals around emissions or other sorts of things. There has been that divide or that different propensity. It’s starting to change a little bit, and you’re starting to see some indexers say, “Well, no, we’re against this” just ever so slightly, and I take that and partly to be a response to the criticism that you just referenced. It is a small part that I said, they’re trying to increase their budgets to look at the big deals, to look at Dell going private or where this or that merger, and when they sit down and analyze, they say, “Oh, wait a second. We’re not going to go along with this.”

But I’ve got a different idea, I’m thrilled to share it. I put this out in the MarketWatch home just a couple weeks ago too. What I’d like to see is because right now the way I’ve just described it is, the indexers lack a sufficient budget to investigate all the votes and even if they have enough of a budget to get most of the important votes, there’s still a lot of votes where they’re probably not rendering the optimal decision, they certainly lack the optimal information base. On the other hand, the active shareholders, especially my quality shareholders, even the day traders and the ARBs and so on, that the incentive to study and see– especially the ARBs in a merger transaction, buy the stock from the quality shareholders, and then get to vote on the merger. Those people have the incentives to become informed and have the information set. There’s at least a reasonable chance to suppose that the active share cohorts vote is a higher quality vote, let’s say than the indexers.

At least the possibility of this. If that’s true, then what would be nice, if the indexers could become aware of the likely vote of the active cohorts before the indexers have to cast their vote, and indexers could ignore whatever the active investors think. It could be helpful to them to say, “Well, here’s our standard matrix and we’ve had one person look at this, and we think yes, but let’s see what Neuberger Berman, let’s see what Tobias Carlisle is likely to do on this. Let’s look at Fidelity or T. Rowe Price or the other famous, active shareholders who tried to look and study.”

We developed, we patented a product actually, it’s just proxy plumbing, in effect that would enable those active voters to release their intended vote before they have to cast–[crosstalk]

Tobias: That’s a great idea.

Lawrence: Yeah. We just hook it up to there. We don’t even need to be involved in this, all those what we publish it. Here’s what Tobias and we’re not soliciting, we’re not doing anything, so we don’t have to be regulated or anything. The indexers don’t have to– they can ignore it. We don’t really care because we’ve got our matrix or where we made our judgment, and we know what we’re doing. Or they could say, “Well, gosh, that’s really interesting.” So, we’re hoping to create– we’ve got the technology, we think we can do it. If any listeners are interested in just reading a little more, again, you can go– MarketWatch column from perhaps around late early February or January has a little more of the details on that.

Tobias: That’s a really simple, elegant solution to the problem. That’s a great idea. We should implement that 100%.

Lawrence: Thank you very much. Tell everybody.


Tobias: Larry, we’re coming up on time. If folks want to follow along with what you’re doing, or find the book, would you let them know how they can do that?

Lawrence: Yeah. I think the best way to get access to everything I’m up to is, the Quality Shareholder Initiative. I think if you put that phrase in Google, boom, it’ll come right up to my page that includes all the research around this topic, links to the book, and other materials, much of which is free, and the list of all the MarketWatch columns, incidentally, where I talk about those these topics once a week.

Tobias: Lawrence Cunningham, thank you very much.

Lawrence: Thank you very much.

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