Book Excerpt: Minority Shareholders And The Fight For Equality

Excerpted from Invest For Good, A Healthier World and A Wealthier You, by Mark Mobius, Carlos von Hardenberg & Greg Konieczny, with permission from Bloomsbury.

Investors have never had as much power as they have today. They are not always minded to use it, but, in developed economies, the days when managers of listed companies could afford to ignore importunate investors have passed. This is a new development in the evolution of liberal capitalism, with profound implications for the future allocation of global resources.

After the ‘flash crash’ we know as the ‘South Sea Bubble’, the Bubble Act of 1720 in Britain gave joint-stock company investors the gift of limited liability. Since then, they have tended to hold their peace and give their agents (management) a more or less free rein. In 1776, half a century after that crash, Adam Smith noted that investors in joint stock companies: ‘seldom pretend to understand anything of the business of the company . . .[and]receive contentedly such half-yearly or yearly dividends as the directors think proper to make them’. Things were no different two centuries later, when Adolf Berle (best known for his pre-war collaboration with Gardiner Means on the separation of ownership and control) noted that: ‘stockholders, though still politely called“owners”, are passive. They have the right to receive only. The condition of their being is that they do not interfere in management’. In most Western economies today, they have other rights, too: the right to be heard, the right to hire and fire the directors, the right to be kept informed, the right to fair treatment and more.

Investors are supported by an inquisitive press as well as persistent demands from lawmakers and regulators for ever more ‘transparency’. This means that, even when in a small minority, they can make their views known in board and executive committee rooms, invoke their rights in statutes and stock exchange listing agreements, appeal to regulators, and alert the financial press when managers and majority shareholders try to ride roughshod over their rights. We say ‘can’, because a growing number of shareholders choose not to exercise their voting power. Although ‘still politely called “owners”, [they] are passive’. They ‘seldom pretend to understand anything of the business of the company’. They invest, not because of qualities they see in the company, but because the company is a constituent of an index their fund managers have chosen to track.

So, although they may profess interest in ESG for marketing reasons, their ESG-branded funds simply track ESG-screened indices. In emerging markets, where coverage of ESG indices is limited, their ESG touch on local companies is so light as to be undetectable. They have power, in theory, but, in practice, nowadays, they prefer to be budget asset managers and not vocal investors.

However, although the trend is towards passive investing, there is at the same time an increase in investor and consumer ‘activism’, much of which has come to be associated with ESG issues. We will first focus on investor activism and begin by recalling what the active investors of today are being active about.

Fair Shares

The residual value created by a company after it has paid its dues to the tax authorities belongs, in theory, to all its shareholders equally, according to the number of shares each owns. In practice, it does not always work out that way. Managers may try to divert a disproportionate amount of the value added into their own pockets, take excessive or unnecessary risks, make unforced errors, pursue suboptimal strategies or concede too much or too little in their negotiations with suppliers, partners, associates or unions. It is part of the board’s oversight job to monitor and police these so-called ‘agency costs’ of management.

Another, more incestuous, form of competition for possession of residual value added that is particularly common in, but by no means confined to, emerging markets, is between shareholders.

They may insist, for instance, on dividend payouts, business or marketing strategies, mergers or acquisitions, or management or board appointments that are in their wider interests, rather than in the interests of all of their fellow shareholders.

Devices used to oppress smaller or minority shareholders include complicated cross-shareholdings that give the over-mighty shareholders effective control, with relatively small ‘beneficial’ ownership.When, for instance, company A holds 51 per cent of company B, which holds 51 per cent of company C,which,in turn,holds 51 per cent of company D, company A effectively controls company D despite the fact that its beneficial ownership is only 13 per cent of D’s equity.

Another common way of denying the principle of one share, one vote, at the expense of minority shareholders is for companies to issue non-voting shares, or to retain privileged voting rights for founder shareholders. S&P Dow Jones Indices won plaudits from the investment community in July 2017, when it announced, after the IPO by Snap Inc. (owner of the Snapchat app) of non-voting shares, that companies with more than one class of ordinary share could not join the S&P 500 Index.

The rights of minority shareholders are embedded in rules and regulations, the stability and even-handedness of which are valued by investors. Therefore, it should have come as no surprise to UK regulators when several institutional shareholders reacted angrily to rule changes designed to attract the postponed IPO of Saudi Aramco to the London market.

The Financial Conduct Authority (FCA) confirmed in June 2018 that it was pressing ahead with the creation of a new category within its ‘premium’ listing rules that would exempt companies controlled by governments from rules relating to oligarch-owned and private companies. Under the FCA’s new rules, a sovereign shareholder would not be treated as ‘a related party’ and would not, therefore, need shareholder approval for a transaction with the company. Large institutional investors, including Norges, Norway’s oil fund and the world’s biggest sovereign wealth fund (see p. 54), objected strongly to these changes, on the grounds that they would weaken the protection of minority investors from decisions by the Saudi government that were against their interests.

Such regulatory bribery notwithstanding, minority shareholders are not powerless when a controlling shareholder tries to deny them their rights, but as noted above, they are not always minded to put their power to the test and claim their rights. In some cases, the passive funds enjoy their rights as shareholders only because they have active co-investors on whose diligence and energy they take a free ride.

Worse Than Marxism

According to Thomson Reuters Lipper data, passive funds, including low-cost exchange traded funds (ETFs), manage $8 trillion worth of assets, or about 20 per cent of all investment fund assets worldwide. The figures for equities are even higher. The passive funds manage 30 and 43 per cent of equity assets in Europe and the USA, respectively. These percentages are expected to rise.

Passive funds are increasing their market share because they charge lower fees without imposing substantial extra costs on the investor in the form of serious underperformance. But passive investors abdicate the responsibilities of owners of companies and play no role in shaping economies by allocating resources. They cannot even ‘vote with their feet’ and sell shares because to do so would compromise their index tracking accuracy.

In August 2016, Inigo Fraser-Jenkins of US brokers Sanford C. Bernstein, published a polemical note entitled, ‘The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism’. The title is a reference to Friedrich von Hayek’s seminal book, The Road to Serfdom (1944), which warned that government control of economic decision-making through central planning would inevitably lead to tyranny. Fraser-Jenkins argued that ‘active investment decisions form a crucial part of the capital allocation process . . . a possible alternative is a Marxist economy’, in which the allocation of capital is planned. An economy in which investment is passive is even worse, Fraser-Jenkins claims, because it lacks any capital allocation process.

According to this view, passive investors preserve the status quo by allocating all capital to companies already large enough to be constituents of capitalisation-weighted indices. Perhaps because they are conscious of the growing momentum of ESG investing, for which their hitherto hugely successful business model is not well equipped, passive investors seem to believe they have a case to answer here.

In a letter to investors in early 2018, Larry Fink,the CEO of passive fund giant BlackRock, proposed ‘a new model of shareholder engagement’, which recognised that a ‘company’s ability to manage environmental, social and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth’. Vanguard, another passive fund giant, has also pledged to ‘continue to strengthen our commitment to investment stewardship’. Proposing a new model of shareholder engagement (new to Larry Fink, anyway), and strengthening a claimed commitment to whatever Vanguard means by ‘investment stewardship’, is one thing. Becoming a genuinely active investor is quite another.

Mark Mobius, Carlos von Hardenberg, and Greg Konieczny are the founding partners of Mobius Capital Partners LLP.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.