Wilfredo Cáceres Ghisilieri, LL.M in International Financial Law at King’s College London, M&A Associate at Estudio Muñiz (Peru).
“Mark Zuckerberg’s prepared testimony highlights a simple fact: He doesn’t understand how a large, global and publicly-held company is run,” Open MIC CEO Michael Connor said in a statement. “He currently has two jobs at Facebook — CEO and Chairman of the Board. It’s time for him to give up at least one, if not both, titles. It is long past time for Facebook to separate the roles of company CEO and Chairman,” Connor continued, “and for Mark Zuckerberg to resign or be fired.”[i]
The recent Facebook scandal involving Cambridge Analytica manipulating Facebook’s users’ personal data (the “Facebook Case”) may have encouraged minority shareholders to propose changes to Facebook’s board and management. These investor groups (the “Activist Shareholders”) have different reasons for requesting Zuckerberg’s removal as CEO and Chairman of the tech giant: from financial motives – shares’ value fell dramatically after the Facebook Case was made public – to ethical or social ones. Yet Zuckerberg holds 60% of the company’s voting rights, hindering the possibility of forcing his resignation or to voting for his removal.
How can Activist Shareholders instigate change in Facebook? Can shareholders pressure Zuckerberg to step down? This post explains which mechanisms are available to shareholders for resolving dissatisfaction with the company management, and how the choice to activate them will depend on the type of shareholders involved.
AVAILABLE APPROACHES TO SHAREHOLDERS WHO FACE DISSATISFACTION WITH COMPANIES’ MANAGEMENT
According to Hirschman[ii] all shareholders have three options when dissatisfied with management in a company: (i) they may directly express their dissatisfaction with management (voice); (ii) they may obey management’s decisions (loyalty); or, (iii) they may sell their shares in the company (exit). When a shareholder “tries to change the status quo (of a company) through ‘voice’, without a change in control of the firm”[iii], he is participating in “shareholder activism”.
Activist Shareholders’ agendas may include (a) changing corporate strategy, (b) improving business performance, including board changes, (c) addressing management issues, and (d) influencing corporate events, in particular the outcome of takeovers or other M&A situations.[iv]
In the Facebook Case, voice was exercised by means of public campaigning in the media to improve Facebook’s business performance. Katelouzou[v] acknowledges other methods Activist Shareholders consider when exercising their shareholders’ rights through voice and distinguishes them between “informal” and “formal”. The former involves activities such as writing letters, behind-the-scenes intervention, one-on-one meetings with the management, as well as public campaigning. Formal exercise of shareholder rights involves shareholders’ proposals, formulating enquiries in shareholder meetings for acquiring company information and the use of corporate voting rights. Litigation is not usually seen as an appropriate tool for shareholder activism “as it is considered expensive and unpredictable, and rarely leads to immediate results which activists wish to achieve.”[vi]
Although all these tools are available to Activist Shareholders, in practice there are some minority shareholders – like institutional shareholders or hedge funds – with more bargaining power than others. For example, institutional investors can utilise their strong position within financial markets to perform certain actions which will gain notoriety among other market participants. Conversely, individual shareholders usually do not have the same strength, reducing their chances to achieve change in a company through “voice”. As a consequence, individual shareholders often opt for loyalty or exit strategies in the case of frustration with the company.
- Hedge Funds
A particular situation arises with hedge funds, which, according to Market Watch,[vii] account for considerable participation share within Facebook.
Hedge funds tend to have an active participation in their investee companies. Most commonly they will apply tactics involving both informal and formal exercise of shareholders’ rights to incite change in their investee companies. According to PwC, the main reasons a company may suffer an “activism attack” from hedge funds are (i) excessive CEO compensation; (ii) long-tenured directors or lack of board diversity; (iii) insufficiently independent directors; (iv) lack of clear strategic plan; (v) disparate or under-performing business; and (vi) excess cash in books.[viii]
Hedge funds’ active and aggressive behavior towards their investee companies is due to the fact that their investments are directly tied to their portfolio[ix]. It may also be a result of the pressure put on them by groups or representative bodies to act in a specific way. For example, in the UK, the Hedge Fund Working Group has set governance recommendations that UK-based hedge fund managers should follow under a “comply or explain” approach with their clients[x].
- Institutional Investors
Institutional investors, such as pension funds or insurance companies, traditionally tend to take a more passive approach with their investee companies. This is allegedly the result of considerations such as consequences to reputation, the cost of activism or the risk of becoming an “insider” by being involved in the day-to-day company business. Institutional investors concentrate upon the economic benefits to their clients rather than the efficacy of the management in investee companies. They are also reluctant to be seen as “insiders”, in fear of becoming subjected to financial regulations such as insider trading and market abuse provisions, limiting their free trading on the market.[xi]
However, recent trends to boost institutional investors’ activism through corporate governance tools and legal and regulatory framework may change their approach. Representative bodies like the National Association of Pension Funds (NAPF) and the Association of British Insurers (ABI) in the UK have also played an important role in influencing institutional investors’ behaviour in providing guidance for the preparation of corporate governance guidelines alongside the adoption of the UK Corporate Governance Code[xii] recommendations[xiii].
An important corporate governance tool for institutional investors in the UK is the Stewardship Code 2010 (revised in 2012)[xiv] which aims to increase activism through a “comply or explain” approach. Under this code, institutional investors are encouraged to report and disclose to their clients whether and how they have complied with the Stewardship Code[xv]. These rules better protect clients as they are based on the principles that “institutional shareholders should develop and disclose a policy on the discharging of stewardship responsibilities, should monitor the companies they invest in, should have clear polices on voting, should establish guidelines on when and how they will intervene in the affairs of companies in which they own shares and should act collectively with other investors where appropriate”[xvi]. However, Cheffins argues that as long as the model is based on “self-governance”, the Stewardship Code will fail as a proper enforcement structure has not been developed. [xvii]
CONCLUSIONS: SHAREHOLDERS VERSUS POWERFUL FOUNDERS WITH SUPERMAJORITY. A MATTER OF REGULATORY FRAMEWORK
Since Facebook became a quoted company in 2012, there has been continuous criticism and concerns to its corporate governance model. It is one which is common in U.S. tech-companies, for instance Microsoft and Amazon, where founders have supermajority decision-making powers as well as a position in the board and management.
Although, it is perfectly understandable for Zuckerberg to adopt this structure to protect Facebook from corporate raiders and activist hedge funds’ attacks, but should a publicly traded company such as Facebook have the power to limit investors’ participation in the company? Should Facebook’s investors have more tools to deal with this situation?
Facebook’s situation is really the result of the US corporate governance regulatory framework, which, through laws and regulations (i.e. corporate laws, federal laws, listing rules, the Dodd-Frank Act, etc.), as well as by rulings and opinions from the Delaware courts, forces companies to implement many corporate governance practices.[xviii]
It has been noted that U.S. law “discourages coordination amongst shareholders in several ways”. [xix] For example, the Securities Exchange Act § 13(d)[xx] requires “extensive disclosures from any person or group that acts together to acquire beneficial ownership of more than 5 percent of shares […] and ultimately, controlling shareholders can be held liable for failing to protect the interest of other minority shareholders, which thereby discourages the formation of large blocks and exercise of control by institutional investors”.[xxi] Likewise, the U.S. board-centric approach reduces shareholders’ engagement as investors have limited power to “directly nominate their own candidates to the board and have few incentives to engage in proxy contests”[xxii]. The Board will then exercise the majority of decision-making of the company leaving US shareholders only to ratify certain narrow matters.
Despite these issues, there have been cases where U.S. tech-companies capitulated to activist shareholders’ requests. One of the most influential reasons for doing so is that institutional investors often side with hedge funds because they pitch innovative ideas geared towards higher returns. Hedge funds can thus win proxy fights and apply pressure for change, especially in underperformed companies[xxiii] For example, Starboard Value, a hedge fund with a shareholding of 1.7% in Yahoo, put the company on the verge by pressing to replace Yahoo’s entire board[xxiv]. Yahoo finally decided to grant Starboard Value four seats in its board to focus on other relevant matters for the company (i.e. its sale to Verizon in 2017)[xxv].
In contrast, the UK’s shareholder-centred approach in company law allows shareholders to overrule the board’s decisions, making them more empowered than U.S. shareholders and allowing for more effective corporate governance practices. However, such practices are seen as guidelines rather than enforceable legal instruments.
In conclusion, it is hard to predict an outcome to the Facebook Case. It may pivot away from Zuckerberg’s predominance in Facebook, or at least force him to make structural changes to its corporate structure. However, it should be kept in mind that the difficult position of Facebook’s shareholders is not exceptional and is merely the result of the US regulatory framework. Thus, only a change in the law and in the courts’ approach can tackle similar situations recurring.
Regardless of the result of the Facebook case, shareholder activism is increasing and becoming standardised practice.[xxvi] A publicly traded company must be prepared to face it through different tools, which include clear corporate governance guidelines and other statutory remedies.
[i] R. Brandom, “Investor groups call for Mark Zuckerberg to resign”, The Verge, 9 April 2018, https://www.theverge.com/2018/4/9/17216474/mark-zuckerberg-resign-investor-groups-facebook-scandal (accessed 25 April 2018).
[ii] A.O Hirschmanm, Exit, Voice and Loyalty., Harvard University Press, Cambridge, MA, 1970, cited in C. Mallin, The Role of Institutional Investors in Corporate Governance, from Corporate governance, Oxford: Oxford University Press, p. 106.
[iii] S. Gillan and L. Starks, A Survey of Shareholder Activism: Motivation and Empirical Evidence, 1998 cited in D. Katelouzou. “Week 4: Shareholder Activism.” October 2015. Microsoft PowerPoint presentation. Slide 4.Comparative Corporate Law module, Master of Laws (LLM) in The Dickson Poon School of Law, King’s College London.
[iv] G. Davies et al, Shareholder Activism. There’s a lot of it about. Legal and Commercial Publishing Limited, June 2008, p. 2.
[v] D. Katelouzou. “Week 4: Shareholder Activism.” October 2015. Microsoft PowerPoint presentation. Slide 21.Comparative Corporate Law module, Master of Laws (LLM) in The Dickson Poon School of Law, King’s College London.
[vi] G. Davies et al., ibid 4, p. 7.
[vii] In 2017, 27 of the 50 biggest hedge funds globally held shares in the social network company according to Market Watch, see S. Langlois, “Facebook is racking up the likes among the world’s biggest hedge funds”, Market Watch, 23 February 2017, https://www.marketwatch.com/story/facebook-is-racking-up-the-likes-among-the-worlds-biggest-hedge-funds-2017-02-23 (accessed 25 April 2018).
[viii] P. Loop, “10 Minutes on hedge fund activism”, PWC US, June 2016, https://www.pwc.com/us/en/10minutes/assets/pwc-10minutes-on-hedge-fund-activism.pdf (accessed 25 April 2018).
[ix] D. Katelouzou. “Week 4: Shareholder Activism.” October 2015. Microsoft PowerPoint presentation. Slide 19.Comparative Corporate Law module, Master of Laws (LLM) in The Dickson Poon School of Law, King’s College London.
[x] Ibid 4, p. 6.
[xi] Davies et al, Ibid 4, p. 2.
[xii] Financial Report Council. UK Corporate Governance Code. September 2014. https://www.frc.org.uk/getattachment/59a5171d-4163-4fb2-9e9d-daefcd7153b5/UK-Corporate-Governance-Code-2014.pdf
[xiii] C. Mallin, The Role of Institutional Investors in Corporate Governance, from Corporate governance, Oxford: Oxford University Press, p. 109.
[xiv] Financial Report Council. UK Stewardship Code. September 2012. https://www.frc.org.uk/getattachment/d67933f9-ca38-4233-b603-3d24b2f62c5f/UK-Stewardship-Code-(September-2012).pdf
[xv] C. Mallin, The Role of Institutional Investors in Corporate Governance, from Corporate governance, Oxford: Oxford University Press, p. 112.
[xvi] B. Cheffins, The Stewardship Code’s Achilles’ Heel. The Modern Law Review, Faculty of Law, University of Cambridge, 2010, p. 1012.
[xvii] Above, 1013.
[xviii] R. Kraakman et al. The Anatomy of Corporate Law. A Comparative and Functional Approach. Oxford University Press, 2009, p. 68.
[xix] G. Jackson, “Understanding Corporate Governance in the United States”, Hans Böckler Foundation, October 2017, https://www.boeckler.de/pdf/p_arbp_223.pdf (accessed 26 April 2018).
[xx] U.S. Securities Exchange Commission. Securities Exchange Act 1934 (as amended March 2018). http://legcounsel.house.gov/Comps/Securities%20Exchange%20Act%20Of%201934.pdf
[xxi] S. Bainbridge: Director vs. Shareholder Primacy in the Convergence Debate, UCLA School of Law, Research Paper No.02-04, 200, cited in G. Jackson, “Understanding Corporate Governance in the United States”, Hans Böckler Foundation, October 2017, https://www.boeckler.de/pdf/p_arbp_223.pdf (accessed 26 April 2018).
[xxii] G. Jackson, “Understanding Corporate Governance in the United States”, Hans Böckler Foundation, October 2017, https://www.boeckler.de/pdf/p_arbp_223.pdf (accessed 26 April 2018).
[xxiii] S. Davidoff Solomon, “As Activist Investors Gain Strength, Boards Surrender to Demands”. DealB%k (New York Times Business Section blog). 14 October 2014, https://dealbook.nytimes.com/2014/10/14/as-activist-shareholders-gain-strength-boards-surrender-to-demands/ (accessed 4 May 2018).
[xxiv] M. de la Merced and V. Goel, “Yahoo Agrees to Give 4 Board Seats to Starboard Value”, The New York Times, 27 April 2016, https://www.nytimes.com/2016/04/28/business/dealbook/yahoo-board-starboard.html (accessed 2 May 2018).
[xxv] V. Goel, “Verizon Completes $4.48 Billion Purchase of Yahoo, Ending an Era”, The New York Times, 13 June 2017, https://www.nytimes.com/2016/04/28/business/dealbook/yahoo-board-starboard.html (accessed 2 May 2018).
[xxvi] W. Turvill. “Watch your step: Shareholder activism is on the rise and UK companies are among the most vulnerable”. City A.M. 15 February 2017, http://www.cityam.com/259145/watch-your-step-shareholder-activism-rise-and-uk-companies (accessed 2 May 2018)