When US investors took on Japan’s executives

Hedge Fund Activism in Japan: The Limits of Shareholder Primacy, by John Buchanan, Dominic Heesang Chai and Simon Deakin, Cambridge University Press, RRP£60

by Sir Geoffrey Owen

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Whose interests should a company serve? Is it the property of shareholders, for them to do whatever they want with it, or does it have a wider social purpose?

This question lies at the heart of an extraordinary battle waged in Japan in the early 2000s between, on one side, activist hedge funds, mostly coming from the US or the UK, and, on the other, a group of Japanese business executives.

The funds, when they surveyed the Japanese corporate landscape at the start of the decade, saw it as littered with companies that were destroying shareholder value; they were hoarding cash that should have been distributed in dividends and sticking too long with low-return businesses.

The opportunity was obvious, and tempting. Tactics that had worked well in the US and to a lesser extent in the UK - identifying likely targets, acquiring a sizeable equity stake and then putting pressure on the directors to disgorge surplus cash - seemed certain to generate higher share prices. The hedge funds saw themselves as the shock troops of shareholder primacy.

Managers of the targeted companies, for their part, had little interest in shareholder value; they barely understood what the words meant. What mattered to them, and what constituted "corporate value" in their view, was not the share price or any other financial measure, but the ability of the company to prosper and to grow over the long term.

Like most Japanese executives, they saw the company as a community, a concept which, as Buchanan, Chai and Deakin explain in this well-researched and illuminating book, took root in Japan in the reconstruction years after 1945. Under this approach the interests of the company, and by extension those of the employees and customers who sustained it, were given priority over those of investors.

Not surprisingly, the invasion of the hedge funds led to confusion and acrimony. When Steel Partners from the US bought shares in Bull-Dog Sauce, a food manufacturer, and later announced its intention to take over the whole company, the Japanese managers were bewildered. Why had a 100-year-old company with a respectable record suddenly been put in play? What did Steel Partners know about the food industry? When the heads of the warring parties met face-to-face, the discussion merely reinforced the Japanese view that Steel Partners was not out to improve Bull-Dog but was simply a predator.

Bull-Dog adopted a defence strategy the Americans claimed was illegal but the Tokyo High Court ruled that the hedge fund was "an abusive acquirer" and that the defensive measures were legitimate. Although the Americans made a useful profit when they sold their shares, the outcome - like that of another contest, involving British hedge fund The Children's Investment Fund - showed that aggressive tactics by activist investors were unlikely to succeed in Japan.

In other ways - and for this the hedge funds can claim some credit - the Japanese system did become more shareholder-friendly during this period. Foreign institutions were increasing their holdings in Japanese companies; while they did not seek confrontation, they expected dialogue with the directors and higher standards of corporate governance, including in some cases the appointment of independent directors.

The head of Steel Partners once said he wanted to "enlighten" Japan about shareholder value. Today, shareholder value is a valid topic for discussion, but in no way the driving force behind management decisions.

The survival of the company as an enduring organisation still remains a more important consideration in Japan than the investors who happen to hold the shares at any given time.

The writer is author of 'The Rise and Fall of Great Companies: Courtaulds and the Reshaping of the Man-made Fibres Industry' and a former editor of the Financial Times

Also posted on FT's Business Books

Don’t shoot the pension fund managers!

By Professor Simon Deakin, Director, Corporate Governance Research Programme, ESRC funded Centre for Business Research, University of Cambridge.

Long-term investment in infrastructure needs a better policy mix

George Osborne's attempts to encourage British pension funds to invest more in infrastructure projects are to be applauded. Canadian and Australian pension funds have already invested heavily in infrastructure, but UK funds are still reluctant investors. Why?

British prime minister David Cameron tours Newton Heath rail depot. Getty images

Pension fund trustees have a fiduciary duty to get the best return for scheme members after taking due account of risk. Government cannot and should not dictate how or where and how these funds invest their assets. If government wants pension funds to engage with the long term needs of the UK economy, it must first understand the particular pressures they face as investors.

Pension funds must invest for the very long term because their beneficiaries, the scheme members, will be receiving their pensions decades after making their contributions. As investors, however, the pension schemes cannot just take the long view. They must balance risks and returns over the investment cycle, which in practice means taking advantage of liquidity when it is available and making the most of opportunities for profit taking when they arise. Thus it is implausible to believe that the interests of pension funds are automatically aligned with the public interest in sustainable infrastructure. The right incentives and structures need to be put in place to support infrastructure investment.

What can be done? We need to address both sides of the issue. On the one hand, an acceptable division of investment risk between pension funds and the government must be found. On the other, the risks associated with the organisation of large-scale infrastructure projects - so-called construction risk - need to be better understood and managed.

Let's take investment risk first. There is demand, on the part of pension schemes, for long-term investments which will provide a stable return. An asset class based on infrastructure investment may well provide part of the answer. Government would need to play a role in inflation-proofing and underwriting part of the financial risks. From the government's point of view, infrastructure bonds which operate in a manner similar to inflation-proofed gilts could be a feasible option, but not if they result in private investors just shifting long-run costs on to the public finances in the manner of PFI (‘moral hazard'). Getting this right, and avoiding the pitfalls of PFI, will require a high degree of transparency and trust on both sides in coming months if a viable solution is to be found.

M4 motorway near Bristol. Getty images

Now let's consider construction risk. Pension funds argue that too many large construction projects don't deliver, pointing to cost overruns and delays in completion on projects like Wembley stadium and the Jubilee Line extension. For this reason, they are more enthusiastic about investing in so-called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management.

From the pension funds' point of view, the government could solve the problem of construction risk for them by simply underwriting potential losses. The difficulty with this is not just that the Treasury has limited capacity to take such an open-ended risk, but that to do so on an open ended basis would risk repeating the ‘moral hazard' problem associated with PFI.

At least part of the solution must lie in addressing construction risk at its source, in the way projects are managed. Enormous strides have been made in recent years in managing the risks of large infrastructure projects, with the construction of the Heathrow Terminal 5 building leading the way. Lessons from Terminal 5 and other successful projects have been embedded in the procurement process and contractual design of the construction of the 2012 Olympics site. The construction industry has been actively promoting good practice through modifications to the standard-form contracts used in infrastructure projects. The government has encouraged this process and needs to continue doing so.

A British Airways aircraft takes off from Terminal 5. Getty images

Getting infrastructure investment right is therefore a twin-track process. The role of government is not to impose solutions on finance or industry, but to identify good practice and encourage information exchange and dialogue between the two sides. If the government sees its role in these terms there is every prospect of a workable set of solutions emerging.

The issue of infrastructure investment has wider lessons for economic governance in the UK. The question George Osborne needs to ask is: what can be done to encourage an investment regime that more effectively internalises the risks of complex projects, not just in infrastructure but more generally in innovative areas of manufacturing?

On the finance side, this means thinking about the way that pension funds are structured and governed, and about the role played by asset management firms and other market intermediaries in the investment process. Are the right structures and incentives in place for pension funds and their agents to represent the interests of scheme beneficiaries in stable returns which also bring wider benefits to the UK economy?

On the corporate side, some thought needs to be given to whether company law and associated regulatory measures, such as the Takeover Code, are sending boards of listed companies the right signals.  A legal and regulatory regime which is widely, if arguably incorrectly, interpreted as requiring listed companies to prioritise short-term shareholder value, is not compatible with the country's long-term investment needs. Are Britain's corporate governance arrangements, so long held up as an example to the world, part of the reason for the continuing decline in investment in R&D by UK firms, by comparison to our competitors, and for the presence of no more than a handful of globally successful British manufacturing companies when Germany and Japan have a dozen or more each?

Also posted on FT's Economists' Forum

Kay needs to replace “shareholder value” with “corporate value”

By Professor Simon Deakin, director, Corporate Governance Research Programme, Centre for Business Research, University of Cambridge

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John Kay's interim report finds that equity markets are failing in their primary tasks, which he identifies as enhancing the long-term growth of listed companies and providing savers with an appropriately high, risk-adjusted return on their investments. The failure lies, he suggests, in the way that market actors are currently incentivised. If asset managers are assessed on a quarterly or biannual basis, it is not surprising that they apply benchmarks based on the short-run performance of the firms they invest in.

Corporate managers, on the other hand, believe that they have a legal duty to maximise short-term shareholder value, and act accordingly. Kay rightly suggests that this view is mistaken as a matter of law but, again, it is no surprise that directors and managers think in these terms, given the way that shareholders are routinely described as the 'owners' of the firms they invest in. Disclosure rules add to the problem, in particular those requiring quarterly reporting of corporate results. Lawyers will recognise that shareholders are the owners of their shares, not the company, and that they have no right to manage the firm, having delegated this power to the board, but these subtleties are clearly being lost in translation.

What can be done?

It is not just a question of getting across a more accurate understanding of the legal structure of the company limited by share capital. The idea that managers should run listed companies in such a way as to maximise share prices is deeply embedded in UK corporate governance practice. It is reflected in the way top managers are remunerated, through bonuses and options linked to share price movements, and in the way that company performance is benchmarked, through metrics such as earnings per share and return on equity. Kay takes aim at some of these practices which, he points out, do not just privilege the short-term, but also tend to discourage large-scale capital investment by companies.

Kay also reports suggestions that there are elements in the regulatory framework beyond company law which favour corporate restructuring and deal-making over long-term growth, notably the City Code on Takeovers and Mergers. While the Takeover Panel's view that the principal aim of the Code is to protect minority shareholders is undoubtedly correct, it is no less clearly the case that its main effect is to facilitate hostile takeovers of UK-listed companies by denying boards the room for manoeuvre that they would have in virtually every other developed economy.

How should these concerns be addressed?

The final report will have to set out a plausible agenda for regulatory reform if it is to be more than a well intentioned review of existing practices. There are some practical changes Kay could suggest such as making clarifying the legal duty of the board to have regard to the long-term interests of the company under section 172 of the Companies Act 2006 and making clear that this duty takes priority over the terms of the Takeover Code. But going forward, Kay also needs to give a clearer account of the philosophy that would guide reform.

Kay argues that shareholders should act as 'stewards' of the companies they invest in. This is fine as far as it goes, and may chime with the ambitions of some pension fund trustees and asset managers to support investment in innovative manufacturing and infrastructure. However, the final report needs to recognise that there are numerous instances in which the interests of shareholders simply do not coincide with the wider public interest in maintaining a sustainable and competitive corporate sector in the UK.

The restructuring of British enterprise through hostile takeover bids, hedge fund activism and private equity over the past three decades was not just the consequence of decisions taken by capital market intermediaries acting without regard to the interests of their shareholder 'principals'. Institutional investors were highly critical of listed companies which did not prioritise shareholder value, and pressed for a greater role for independent directors on boards as a way of getting their views across. There is more than anecdotal evidence that some of the deals involving the restructuring of companies with a core role in the British economy, from the takeover of BAA by Ferrovial through to RBS's bid for ABN Amro, were driven by a combination of pressure from boards and shareholders for quick returns, with considerations of corporate strategy pushed to the margins.

It is naive to see hostile takeovers, private equity and hedge fund activism as addressing problems of 'failed' companies. Much more often, these forms of investment simply extract value from companies for the benefit of investors and intermediaries, at a direct cost to workers (who lose jobs and protected terms and conditions of employment), customers (who experience a deterioration in the quality of products and services) and the taxpayer (who foot the bill through tax reliefs on corporate leverage).

What has brought us to this point?

Since the early 1980s, company law and corporate governance regulation have given shareholders many more rights to 'hold management to account'. Kay recognises that trading in the secondary market for shares does not bring in new capital for firms, but he justifies shareholder influence on the grounds that investors can exercise effective oversight over firms' capital allocation decisions and over their governance. This is implausible.

In today's liquid capital markets, shareholders are for the most part transitory owners who have no lasting connection to the firms whose traded securities they hold. The question we should be asking is why law and regulation have ceded such large influence to this group. It is partly intellectual fashion, a misguided belief in the informational efficiency of liquid capital markets. It is also down to intense lobbying by the market intermediaries (the asset management firms, legal advisers and investment banks) who benefit most from current arrangements.

John Kay is on the right path in arguing for a long-term approach to investment decisions, but too optimistic in believing that shareholders will always act as enlightened owners.

We need to replace shareholder value with corporate value as the objective of management and take a detailed look at corporate governance regulation and practice with this guiding principle in mind. If this means sidelining the Takeover Code and subordinating it to the wider goal of a reformed company law in promoting sustainable enterprise, so be it. This is the kind of hard choice we will have to make if we want capital markets to make a real contribution to prosperity and growth.

Also posted on FT's Economists' Forum

Executive Pay - Your Questions Answered

Professor Simon Deakin, Programme Director CBR

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1. Do bonuses and incentive plans work?

The real problem is that share options benefit executives in the event that the share price goes up and the Company does well, but if the share price goes down executives rarely see a fall in their pay and they simply don't exercise the share options concerned. It is pretty much a one way street for them and there is no real accountability to shareholders or to anybody else by these means.

2. Does shareholder accountability work?

There is a real misunderstanding here. Shareholders don't have the right to manage the company and don't have the right to give direct orders to the Board on matters like this. At the moment they are entitled to give an advisory opinion and that is really as far as it goes so there is a mismatch here between the reality of shareholder powerlessness in the face of what has become an accepted way to pay executives and the view of the politicians and others that if only shareholders could get their act together they could stop these practices. Basically they can't.

3. Is there a culture of short-termism?

The case for paying Stephen Hester, the Chief Executive of the Royal Bank of Scotland Group, is that he was brought in to do a specific job and this is the going rate for people of his position so it is unfair to focus on one person. In the case of Sir Fred Godwin, the former Chief Executive of RBS, the issue would be was one man really to blame for the failure of RBS and the government bailout? The question in his case was why policy makers, regulators and others allowed a bank like RBS to operate in the way that it did to be such an aggressive takeover bidder in the markets for corporate control and why the clear risks that the Bank was running were not taken on board earlier by the regulators?

4. Does naming and shaming work?

If in the case of RBS if there had been a breach of duty by the members of the Board the Executives and the non-Executives the right course of action would have been for legal proceedings to have been brought in the name of the Company against those Directors for a breach of duty or for the Directors to be disqualified under various regulations and to stop them practicing as Directors. That has happened in just one case, but legal action has not been taken against the others. The FSA said there was no case for taking action against Sir Fred Goodwin, the Company itself has presumably decided not to sue former directors for breach of a duty of care either. There are legal mechanisms for dealing with these issues. It is one thing for somebody to be singled out in these circumstances by others, when there are also legal routes that weren't taken for good reasons. Naming and shaming under these circumstances is simply wrong and unfair to the individual concerned.

The real issue here is that the law is inadequate. RBS wasn't well run and had been run for a number of years in a highly risky way sometimes those risks paid off, but eventually they didn't pay off and the taxpayer had to foot the bill for that. This is wrong but the error lies in the regulatory framework and in the view that Companies like RBS should have been active in a takeover market, that hostile takeovers are a good thing for all concerned and that the City and the UK benefits from being at the hub of this international global market for corporate control. Those are all serious errors but those are the errors of- to a large extent - policy makers, the City establishment and also of intellectuals and others who supported this line of work.

5. What else would work, I know you think we could use tax law, how would that work?

One reason why we have seen such great use of share options is because they were encouraged by the tax system. The tax system also encourages takeovers because it allows tax relief to companies where they take on debt which is often the consequence of a takeover or a private equity buy-out. The tax system has been driving hostile takeovers and has been driving private equity deals and it has also been driving share options. The tax system has been driving all the things that have been contributing to excessive risk taking in the financial sector in the run up to the crisis which began in 2008. It is not right to say this is just the consequence of particular corporate strategies or maybe of a particular individual like Sir Fred Goodwin. Policy makers systematically set out to encourage practices, through the tax system, that turned out to be very risky indeed and had a huge public cost.

6. Do we need a more fundamental reform of the legal systems in which boardroom pay is regulated?

For the past thirty years there has been a view that governments should take a back seat in all this and that by giving voice to independent directors, we could deal with the risk of corporate excess and of a lack of accountability. This was a false perspective. Shareholders can only do so much to control managers and if we have a government that just takes a back seat, and even worse if governments' just put in a place a tax regime and a company law regime that encourages the idea that a company should be engaged in the pursuit of shareholder value at all cost and hostile takeovers whenever possible, then what happened in 2008 will simply happen again. We do need a fundamental rethink of what the function and purpose of a big company like RBS is, are they just serving short term financial needs or a wider range of interests?

7. Do we need new laws?

We certainly do need new laws. We need a fundamental review of the way the corporate tax system operates and we also need a review of the way corporate governance is structured which gives an overwhelming voice to the shareholders at the expense of other stakeholder groups but also at the same time not giving those shareholders the power they think they should have to control managerial excess. The simple truth is that at the end of the day neither shareholders nor workers nor customers, these so called stakeholders, can control some of the corporate excess that occurred in the run up to 2008. We need much more effective financial market regulation, but it would certainly help if other stakeholders apart from shareholders were given a voice in corporate governance. Employee membership of remuneration committees is just a first step in this process, we should also be thinking seriously about employee representation at Board level.

8. Codetermination, can we look to other Countries and systems that work much better than our own?

We have rejected the idea here that workers should have a voice in corporate governance, their position has been completely marginalised. In Germany by contrast workers do have a voice they have Board level representation in big companies and they have representation on works councils on issues of workplace representation and this does engender longtermism and also a more co-operative approach to the running of big firms. We can see that this has very clearly benefitted the German economy and its productive base has remained very strong not withstanding globalisation.

The same is true of Japan which doesn't have formal codetermination but on the whole Boards of Directors do not think that their job is just to return value to shareholders. They think the job of the Company is to build up a productive organisation over the long term and to provide jobs and a high level of service for customers and consumers. The German and Japanese models have been very, very, successful in building up productive stable companies that provide jobs and support, public infrastructure and communities in those countries. We instead, have companies which support the City and engage in hostile takeovers sometimes successfully but very often not, and we have also seen the whittling away of our productive economy in the last twenty years.

9. Is more regulation now needed?

There is going to be a need for more regulation through the tax system and through Company law that is unavoidable. The question now is how to get that regulation right. The current government has quite rightly pointed to the need for pension funds to be more serious long term investors in such things as UK infrastructure projects and that is a really promising sign that this Government is taking these issues very seriously. They shouldn't be afraid of pointing to the mistakes of the past twenty or thirty years, we now know that some aspects of the 1980s settlement on the City, unravelled in 2008, so now is the time for David Cameron and George Osborne to really grasp this nettle.