Reform brings a renewed focus on short-term results

By Lyle G. Ganske, Robert A. Profusek, and Lizanne Thomas


FORTUNE -- While much has been made out of the sheer heft of the 2,300-page behemoth known as the Dodd-Frank Act, it's a mere 26 pages that address the corporate governance and compensation issues that will have a profound effect on public companies and their investors.

Most critically (and unfortunately), Dodd-Frank portends an increased trend toward short-termism. While proponents give lip service to the noble idea that the governance and executive compensation reforms will preserve stability and will incent management to focus on long-term growth, rather than short-term results, the opposite is true. This is perhaps the greatest legislative irony of our times, given that the bill was originally titled the "Restoring American Financial Stability Act."

The reality is that with its key provisions on proxy access, say on pay and disenfranchisement of retail voters, the "unintended consequences" of this misguided shift to a "shareholder democracy" will result in short-termism that will only destabilize corporate America further.

Proxy access. The most troubling provision of Dodd-Frank is mandating "proxy access," whereby shareholders, without significant effort or expense, will be permitted to put competing candidates for election to the board of directors in any company's proxy statement. This ease of access creates a clear opportunity for short-term and special-interest shareholders to readily reconfigure or eventually replace a board.

Many will ask what's wrong with this -- the shareholders, after all, own the companies, and at least the politicians and pundits believe that failures by corporate boards contributed directly to the financial crisis. What's wrong is that proxy access will supercharge the already existing pressures for companies to focus on short-term quarter-to-quarter results, rather than the kind of long-term investment for sustainable growth that is essential in a rapidly changing, globalizing world.

While there are exceptions, far too many institutional investors are speculators -- more in the nature of traders than true owners. The average holding period of an NYSE-listed company's stock is a mere nine months. As such, the economic interest of those investors is not served by long-term, delayed-return investment, but precisely the kind of pedal-to-the-metal, short-term orientation that brought down much of the nation's major financial institutions.

The activist hedge funds, which comprise an increasing proportion of the institutional investor community, will have a field day with proxy access: sell or bust up the company, institute a massive stock buy-back or jack up the dividend, or there will be a new sheriff in town.

In short, proxy access, previously proposed by the SEC three times and overwhelmingly opposed each time, is a profoundly bad idea at precisely the wrong time, and inevitably will produce the kind of short-termism Dodd-Frank was supposedly aimed to counteract.

Say on pay. Similarly, the Dodd-Frank "say on pay" provision requiring that management's performance be tested periodically with advisory votes on compensation will, once again, promote management and board level decisions designed to shore up short-term performance at the possible expense of long-term enhancement.

Any CEO in his or her right mind knows that if subjected to a vote of confidence on an annual basis, they will be focused relentlessly on producing short-term results to avoid the substantial potential consequences from a no-confidence vote by shareholders. This short-term focus will necessarily be at the expense of long-term strategic investment and other initiatives.

The advisory nature of the vote will not be sufficient to change a CEO's motivation to succeed by all measures, including this clumsy one. And remember, boards will be similarly motivated, because a negative say-on-pay vote presages action against the board in the ensuing year, if not before, from the "activist" investment community, spearheaded by proxy advisory firms.

Blocking retail votes. Perversely, Dodd-Frank will bar broker discretionary voting on executive compensation or "any other significant matter." This disenfranchisement of retail investors (those who hold their shares through brokers) exacerbates short-termism because brokers rarely will be able to exercise voting discretion given them by retail holders, who generally are longer term, pro-management investors.

The likely result is that retail votes simply will disappear, thereby amplifying the voting power of institutional holders whose average holding period of four months results in a decidedly more short-term investment focus. Some might say this will not matter much with the heavy institutionalization of share ownership, but that is simply not true: about 18% of the S&P 500 companies' stock is held in "street name" by retail holders. By disenfranchising these shares, the effective voting power of the short-term, "renter" owners will increase proportionately. Another victory for short-termism.

The unholy trinity of proxy access, say on pay and the disenfranchisement of retail voting will have profound and damaging effects on corporate America. But the most breathtaking, truly tragic aspect of it is that its greatest effect will be to create pressures on non-financial companies across America to move to a more aggressive, short-term orientation. Those who do not will do so at their own peril.

This guest commentary was submitted by attorneys at Jones Day. Lyle Ganske is the partner-in-charge of the Cleveland office, Robert Profusek is the global head of the firm's M&A practice, and Lizanne Thomas heads the corporate governance practice and is partner-in-charge of the Atlanta office. To top of page

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