In a privately held company where ownership does not change except by passing from generation to generation, the identity of the shareholders is obvious. Yesterday’s shareholders, today’s shareholders, and tomorrow’s shareholders stay the same. In a modern corporation where millions of shares trade daily, and the specific identity of the shareholders changes by the minute, ownership is dynamic. The tendency is still to think of shareholders as a static group with fairly well-aligned investment goals and financial interests because of their ownership in the company.
That concept makes sense only in a very few instances, however, such as determining who receives a dividend, who can attend annual meetings, or who has standing in certain lawsuits. In most other contexts, it makes much better sense to define shareholders as not only those who own stock now, but also those who might buy stock in the future and those who have owned shares in the past. The law, in fact, clearly recognizes that except in a few instances like those cited earlier, shareholders include past, current, and future owners of stock.
It’s especially logical to include all three groups when considering the obligations of management and directors to provide information on the performance and condition of the business. If a company exaggerates reported earnings or downplays liabilities at any point in time, and these actions are not fully and accurately disclosed, future shareholders will be penalized at the expense of past shareholders. The same argument holds true for current shareholders who bought shares based on incomplete or inaccurate information.
A current shareholder could think, “Who cares about future shareholders? If earnings are overstated, or if liabilities are understated, and the price of my stock goes up today, I’m all in favor. The hell with future shareholders—it’s their problem!” This all-too-human perspective is logical in isolation. It is fatally flawed from the perspective of the shareholders’ fiduciaries and in the context of free-market capital allocation. First, it assumes that current shareholders will not be future shareholders, and it implies that the shareholders in question decided to sell their stock at or near the top price. Second, this perspective assumes that these shareholders will never buy shares at a price that has been inflated. Unfortunately for most shareholders, these two assumptions seldom hold true consistently.
Because shareholders buy and sell securities based, by definition, on imperfect financial and other information, the definition of ownership has to include all shareholders over time. If shareholders were defined as only those who own stock at a given moment, then any action or nonaction that increased share price temporarily would be justified. But the consequences of adopting this point of view would be dire. Capital would be allocated poorly on a risk-adjusted basis (since investors would not be able to fairly judge the risk or the possible reward of inflated stocks), and the entire free-market system could not work.
Real Value: The Fiduciary’s Objective
As fiduciaries for a company’s shareholders, the directors’ goal must be increasing the real enterprise value of the company over time. This objective alone aligns the interests of all shareholders, and it differs markedly from an interest in pushing share price to the highest possible level. When fiduciaries allow share price to be inflated above real value, they put the interests of existing shareholders ahead of the interests of future shareholders.
The job of management is not to persuade investors that share price will rise continuously—unless, of course, true value increases as well. Management certainly should not set out to provide inaccurate or misleading information. Only when management focuses on creating long-term value and when executives and directors ensure that complete and accurate information regarding both risks and rewards is communicated without bias will the collective wisdom of investors set share price at or near its real value. The responsibility for providing complete, accurate, and timely information lies not only with corporate executives, management teams, and boards of directors, but also with research analysts and other corporate advisers such as independent auditors, lawyers, and investment bankers. And all must consider current, past, and future shareholders when fulfilling their duties and responsibilities.
Enron’s management and board were perceived to have performed well for investors when, based on false earnings, the stock rose from approximately $20 to $90 in less than two years ending in the summer of 2000. When the price approached zero, shareholders had a very different perception.
Confusion Over Shareholder Identity
What makes the capital allocation system work well is the ability of an individual investor to do a better analysis of the prospects of a company and to have the patience, courage of conviction, and wisdom to buy and sell based on that knowledge. This is the measure of the investor’s success.
Successful fiduciaries, however, should not be judged on profit or loss records of one investor or a selected group of investors. Fiduciaries should be measured first on the collective performance of all shareholders—past, present, and future—which, over time, will correlate closely to long-term real growth. Their success should also be judged on how well they provide equal and timely access to complete information that allows investors to price securities as closely as possible to real value. Because investors bring emotions to their decisions, prices are sometimes above real value and sometimes below—possibly for extended periods of time. But share price always returns to real value regardless of a fiduciary’s performance.
To fulfill their fiduciary responsibilities to all shareholders, directors must take a longer-term view. Only when stock price truly reflects real value do all shareholders benefit over time.
The Tyranny of the Time Frame
That management may have different priorities or objectives from owners is acknowledged. What is less well understood is that these different considerations stem from the fact that management’s time horizon is far shorter than shareholders’. Certainly some CEOS and management teams serve for fifteen years or more. Others might argue that they expect to serve for that many or more years, which would lengthen their time frame perspective. This argument is certainly plausible, but the fact remains that as a CEO reaches retirement age, his or her time frame will certainly become shorter.
Not surprisingly, CEOs tend to earn at a much higher rate in the last five years of their tenure. All components of compensation usually rise during this time including salary, bonus, and, most important, their proceeds from cashing in options. It makes sense for CEOs who have accumulated stock options over an extended career to cash them in near retirement. What investors should recognize is that such accumulated options give CEOs a tremendous incentive to maintain growth in the last years of their tenure and even to move earnings into current quarters at the expense of future quarters. Both the risk of falling or flattening growth rates and the reward from sustained or accelerating growth is magnified near the end of a CEO’s tenure.
A related part of the time frame problem is that in many instances, new CEOs decide to take a large write-off at the beginning of their tenure. It has been suggested that these write-offs are to establish reserves to allow the new CEO to show growth relatively quickly. It is also likely that write-offs are required to compensate for accelerated earnings that have robbed future periods of the ability to show stable earnings. Whichever it is, shareholders are harmed, and the existing CEO arguably takes home more compensation than earned or anticipated for actual performance achieved.
Because executives are usually shareholders themselves and can control so much of the information a company reports about its financial performance, many have consistently focused on achieving short-term gains to raise the share price at the expense of creating long-term value. Management and CEOs control operations and make daily trade-offs between earnings now or earnings later. They decide how to account for revenue and earnings. It is critical, therefore, that management acts to maximize the long-term value of companies and avoids practices that increase risk without the knowledge of owners.
CEOs seem compelled to operate with two realities. On the one hand, in light of accounting shenanigans (and an extended period of defense spin about their inflated stocks) by the executives at Enron, WorldCom, Adelphia, and the like, there’s a renewed belief that CEOs should run their businesses well and let the markets determine what the stock price should be. On the other hand, because of myriad factors including stock-based compensation packages and the fact that share price has become the primary indicator of corporate health and strength, CEOs, investors, the daily press, and Wall Street remain fixed on stock prices. Harvey J. Goldschmid, now an SEC commissioner, reflected on that in an article in the February 18, 2002, issue of Fortune magazine, saying, “Previously the CEO’s job was much more secure. Today, with CEOs that much more accountable for their stocks’ performance, they’re under greater pressure to keep the share price up.” Keeping share price up certainly benefits short-term investors looking to get out at the top. If that is the only group of shareholders that a CEO is serving, it’s definitely time for that CEO to rethink or relearn the true identity of shareholders—past, present, and future.
Directors have also operated at times with a confused notion of shareholder identity. No one disputes that a company’s board has the responsibility to protect the shareholders’ interests by assisting in building value and identifying risks. Undoubtedly many directors make decisions based on long-term value creation that will benefit all shareholders over time. Like executives, however, directors have too often viewed their fiduciary obligation as being limited to current or short-term shareholders. It’s tempting. Gratification is more immediate, more personal, and often consistent with self-interest when the director has received options or stock as compensation.
Fiduciaries should be measured on the collective performance of all shareholders— past, present, and future—which, over time, will correlate closely to long-term real growth.
Directors have justified, at least to themselves, that any action the company may take to increase stock price benefits shareholders. Many have forgotten that allowing the stock to be hyped will benefit existing shareholders in the short term, but is quite likely to hurt them in the long term, and certainly will harm future shareholders who will buy at inflated, hyped levels.
Although this discussion is really about corporate governance and fiduciary responsibilities to all shareholders, another group—research analysts—has consistently failed to take all shareholders into consideration. This doesn’t make sense considering that the customers for their research reports are investors thinking of both buying and selling shares, which inherently broadens the definition.
Research analysts have two legitimate roles. The traditional role is to collect information from the company and elsewhere and to distill that information for others making investment decisions. The second is to provide visibility for companies so that investors know to consider a company as a possible investment. Fulfilling both roles responsibly requires an impartial, independent view of actual earnings, historical growth rates (that are a proxy for future growth rates), and financial and business risks. Too often research analysts have issued excessively favorable research, justifying it in the belief that shareholders will benefit as stock prices rise in the short term.
Managers’ success should be judged on how well they provide equal and timely access to complete information that allows investors to price securities as closely as possible to real value.
This shortening of the analyst’s view of value is apparent in how research has changed over time. In the old days, it focused on fundamental earning power and included analysis of competitive advantage, value drivers, business risks from changing technology, and financial risks. Now research emphasizes quarterly earnings versus whisper numbers versus last year’s performance and so on. It tends to underestimate or ignore unknowns in the future because the focus is so short term.