GW Law Faculty Publications & Other Works Faculty Scholarship 2020 The Case for Empowering Quality Shareholders Lawrence A. Cunningham Follow this and additional works at: https://scholarship.law.gwu.edu/faculty_publications Part of the Law Commons THE CASE FOR EMPOWERING QUALITY SHAREHOLDERS by LAWRENCE A. CUNNINGHAM THE GEORGE WASHINGTON UNIVERSITY Forthcoming in Brigham Young University Law Review (2020) ABSTRACT Anyone can buy stock in a public company, but not all shareholders are equally committed to a company’s long-term success. In an increasingly fragmented financial world, shareholders’ attitudes toward the companies in which they invest vary widely, from time horizon to conviction. Faced with indexers, short-term traders, and activists, it is more important than ever for businesses to ensure that their shareholders are dedicated to their missions. Today’s companies need “quality shareholders,” as Warren Buffett called those who “load up and stick around,” or buy large stakes and hold for long periods. While scholars in recent years have extensively debated indexers, short-term traders, and activists, they have paid scant attention to quality shareholders and their critical role in corporate finance and governance. This Article corrects this oversight by highlighting the quality shareholder cohort. Adding this fresh perspective confirms some of the angst about myopic short- termism on the one hand and ignorant indexing on the other, but rather than regulate related behaviors, the fresh perspective invites attention to empowering quality shareholders. In particular, rather than taxing short-term shareholders or passing through indexer voting rights, this Article explains how companies could simply increase the voting power of their quality shareholders. * * * * * This Article is part of The Quality Shareholder Initiative at the Center for Law, Economics and Finance (C-LEAF), at The George Washington University Law School, Prof. Lawrence A. Cunningham, Faculty Director. THE CASE FOR EMPOWERING QUALITY SHAREHOLDERS LAWRENCE A. CUNNINGHAM* INTRODUCTION 3 I. QUALITY SHAREHOLDERS 8 A. Fragmentation 8 B. Classification 10 C. Behavior 14 D. Competition and Performance 19 E. Advantages 22 II. TIME HORIZON 24 A. Theory and Debate 24 B. Status and Direction 28 C. Policy Implications 30 II. PORTFOLIO CONVICTION 32 A. Theory and Debate 33 1. Incentives 34 2. Capacity 37 B. Guideline Best Practices 38 C. Directors and Boards 40 1. Indexer Guidelines 41 2. Comparing Quality 42 3. A Note on Activists 43 IV. SHAREHOLDER VOTING 44 A. Dual Class: Anti-Activist 45 1. Law and Practice 46 2. Debate and Data 47 B. Tenured Voting: Anti-Transient 49 1. Law and Theory 50 2. Research and Data 53 C. Variations: Anti-Indexer 54 D. Quality Voting: Pro-Quality 55 1. Comparing Regimes 55 2. Pros and Cons 57 CONCLUSION 59 * Henry St. George Tucker III Research Professor, George Washington University Law School. Thanks to the National Association of Corporate Directors (NACD) for the opportunity to present the thesis of this Article on the occasion of bestowing on me its 2018 Lifetime Achievement Award in Corporate Governance, and to Warren Buffett, who generously introduced me at the event. For contributions in developing this work, thanks to law professors Michael Abramowitz, Lucian Bebchuk, Don Clarke, Jack Coffee, Nicholas Georgakopoulos, Jeff Gordon, Kobi Kastiel, Tom Lin, Brett McDonnell, Alan Morrison, Alan Palmiter, Simone Sepe and Randall Thomas; finance professors Paul Borochin, Martjin Cremers and Ankur Pareek; faculty and research assistants Gia Arney, Annie Ezekilova, Lori Fossum and David Templeton; and investors Warren Buffett, Stephanie Cuba, Torkell Eide, Tom Gayner, Ingrid Hendershot, Mark Hughes, Amanda Katten, Steven Keating, Howard Marks, Phil Ordway, Will Pan, and Steve Ross. 2 INTRODUCTION The growing size and power of institutional investors is among the most important contemporary trends in American corporate life.1 In recent years, their rise has drawn special attention to shareholder activists on the one hand and passive index funds on the other. Lively debates address whether such powerful investors have the right vision or conviction to faithfully discharge the trust so many Americans have placed in them. On vision, for two decades scholars have debated whether investors, especially activists, are too short-term oriented for markets and managers to maintain a long-term view.2 On conviction, just in the past two years scholars began to debate whether certain kinds of investors, particularly passive indexers, have sufficient incentives to actively monitor managers to assure performance over any horizon.3 In a related debate on shareholder voice in corporate affairs, some scholars propose reducing the voting power of short-term shareholders to encourage long-term thinking while others propose eliminating that of indexers due to their passivity.4 These are vital debates in corporate America, implicating fundamental questions of the balance of power between directors and shareholders as well as among shareholders. As such, they stoke numerous sub-debates on every aspect of corporate governance, such as board structures, director-officer relationships, and shareholder rights.5 Participants see wide-ranging effects on the national economy.6 Although such debates are sophisticated, increasingly data-driven, and involve overlapping participants, a peculiar binary characterizes the first two that afflicts the third. The horizon debate juxtaposes short-term against long-term visions but mutes the issue of conviction, while the conviction debate juxtaposes passive against active investment styles while muting the issue of 1 See John C. Coates, IV, The Future of Corporate Governance Part I: The Problem of Twelve (September 20, 2018) (available at www.ssrn.com/abstract=3247337) (the trend of rising power of institutional investors increases the “likelihood that in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies”). 2 Lucian A. Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005); Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735 (2006); William W. Bratton & Michael L. Wachter, The Case Against Shareholder Empowerment, 158 U. Pa. L. Rev. 655 (2010); Jesse M. Fried, The Uneasy Case for Favoring Long-Term Shareholders, 124 Yale L. J. 1554 (2015). 3 Compare Lucian A. Bebchuk & Scott Hirst, Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, 119 Colum. L. Rev. 2029 (2019) (agency cost indictment of indexer capability) with Jill E. Fisch, Assaf Hamdani & Steven Davidoff Solomon, The New Titans of Wall Street: A Theoretical Framework for Passive Investors, 168 U. Pa. L. Rev. 17 (2019) [hereinafter Fisch, The New Titans] (ringing theoretical defense of indexer capability). 4 Paul H. Edelman, Wei Jiang & Randall S. Thomas, Will Tenure Voting Give Corporate Managers Lifetime Tenure?, 97 Tex. L. Rev. 991 (2019); Dorothy S. Lund, The Case Against Passive Shareholder Voting, 43 J. Corp. L. 493 (2018); David J. Berger, Steven Davidoff Solomon & Aaron Benjamin, Tenure Voting and the US Public Company, 72 Bus. Law. 295 (2017). 5 See infra Part II.C. 6 E.g., Berger, et al., supra note 4, at 307-309. 3 horizon. Hence in the voting debate, there are calls to limit voting power of both short-term shareholders or indexers, but not both.7 In fact, however, while time horizon and relative conviction are vital, neither taken alone captures the nuanced reality of investor behavior which, at a minimum, calls for examining both features simultaneously. This Article proposes to incorporate such concurrent analysis of horizon and conviction into all three of these corporate law debates. By switching from binary conceptions to one that combines both attributes, analysis permits recognizing another cohort of shareholders whose role has been missing in all three debates: long-term concentrated shareholders. While contemporary data suggest that a large plurality of institutional shareholders qualify as short-term and another plurality as indexers, the long-term concentrated cohort remains a significant force in market and corporate behavior.8 It should accordingly have an important place in debates over horizon, conviction and voting. This Article draws on related literature in finance and accounting, cited in these corporate law debates, delineating multiple shareholder types based on both horizon and conviction.9 To visualize the combined model, blended shareholder cohorts can be identified using a 2 x 2 diagram arraying investment conviction across the top and investment horizon down the side to reveal combinations of conviction and horizon. INVESTMENT CONVICTION Lower Higher Shorter Transients Activists INVESTMENT HORIZON Longer Indexers Quality To animate the approach, descriptive names are assigned: transients to shorter- term/diversifiers; indexers to longer-term diversifiers; activists to shorter-term concentrators; and quality to longer-term concentrators. Investment conviction is measured by the degree of an investor’s portfolio diversification versus concentration, with lower conviction meaning the most 7 See infra Part IV. 8 See Lawrence A. Cunningham, Quality Shareholders (forthcoming Columbia University Press 2020) [hereinafter Cunningham, Quality Shareholders], Appendix. 9 Brian Bushee, Identifying and Attracting the “Right” Investors: Evidence on the Behavior of Institutional Investors,