Short-termism is a concern based on the idea that management objectives abandon long-term outlooks in favor of short-term gains based on movements of stock markets that eventually impact the value of companies and negatively affects the economy. There are critics to this view. Some sustain that short horizon are an agency issue. Others state that short-termism is done on purpose, based on what management think is correct on the long-term. Some even argue that the problem is imaginary. So, there is still debate as to whether short-termism causes harm and what are its roots.1 However, if we start from the premise held by most scholars, that short-termism is an existing problem that causes harm, then it would be prudent to consider both market behavior and executive compensation as part of the problem.2 These two factors have been addressed by policies adopted in both the UK and the U.S. In this paper we discuss two regulatory approaches to curb short-termism. One is the alignment of director’s duties with a longer horizon (steering away from stock prices) and the other is regulating managerial compensation. As we shall see, the solution for the problem both go hand to hand, but follow a different approach. We first review in more detail the issue of short-termism.
The health of a publicly traded company is often measured by its share price. Investors often focused on short-term goals with a watchful on the price to make decisions on what to buy, keep or sell. This continuous vigilance has a direct impact on the company’s management and value of their stock. While the value by itself is not indicative of the performance and long-term sustainability of the company, it is a metric that reflects how it is perceived by the stakeholders including shareholders, lenders, suppliers and so forth. This pressure has enormous impact on the stability of the business and how management decides to deal with this matter often with a short-term lens.3 From a broader perspective, governments have debated the effect of short-termism on the stability of the economy ,4 particularly since the 2007-9 financial crisis which many consider was caused by the near-minded focus of business leaders bowing to the fluid movement of share prices in both UK5 and the U.S.6 It has been widely argued that this vision undermines the long-term value of companies, causes trillions of dollars lost in returns on investment capitals7 and affects the wellbeing of the economy8 and the world. 9
Since shareholder prices are constantly assessed by investors, it is to expect that management will prioritize decisions to boost short-term gains favored by trading-focused investors and while doing so improve their remuneration. This issue seems much less prevalent in most other countries where large blocks of shares are generally held by large families and companies that tend to hold their participations and control for the long-term.10
Examples of pursuing short-term profit to increase share value include reduction of discretionary spending in advertising, research and development, upgrades, replacements and hindering long-term strategies and value creation. 11 This attitude was documented in a 2005 survey of over 400 executives which asserted their willingness to sacrifice long-term value to favor short term objectives. 12
Policy makers have evaluated possible recommendations to avoid “market structures that create perverse incentives” 13 at the expense of long-term interests. Too focused on meeting expected favorable quarterly earnings disrupts the process of generating value and sustainability that require long-term strategies not necessarily traducing into immediate results. These types of decisions generate conflicting interests between the financial outlook of a company and its short-term success with increased agency costs, risks, and conflicts between investors. These policies have also, addressed compensation issues, perhaps not because of agency problems but because of the influence the stock market has on remuneration.
A regulatory strategy to curtail short-termism is to have the director focus more on aligning the company’s long-term objectives and less on the ups, downs, and pressures of the stock markets. There are several laws and policies attempting to tackle this concern.
Laws regulating companies In the UK are set out in the Companies Act of 2006 supplemented by detailed regulations that have been enacted in support thereof. These pertain to compensation but influences proper alignment of long-term director’s duties. The Act requires large companies to disclose considerable information on its operations to shareholders in a Directors’ Remuneration Report that includes managerial remuneration for each financial year including the performance criteria and justification of pay-ratios and the payments to each director by name.14 By promoting transparency, opportunistic investors are dissuaded from using their influence to obtain short-term gains disregarding long-term value. Directors will also need to explain to shareholders when voting, how executive pay is affected by future share price. Companies other than small are required to prepare a strategic report detailing the firms’ operations, risks, and uncertainties as part of their yearly financials15 and is quite comprehensive.16 It must include besides the information already mentioned, a balanced analysis of the firm’s performance at the beginning and end of the year. This analysis must be conducted using financial key performance indicators, and when appropriate factor in information relating to environmental and employee matters.17 These indicators must measure the performance and development of the company effectively including metrics that will consider trends and factors likely to affect the development, performance and position of the business. 18 Companies must also take into account social community, human rights environmental matters and employees when assessing their performance and it effectiveness towards those matters.19 Quoted companies must include in their report the company’s business model and strategy. Directors must approve this information and are criminally liable and subject to conviction for any misstatements. 20 All these regulations have a favorable impact on director’s long-term alignment of duties.
The principles of the UK Corporate Gov Code21 emphasize long-term success expecting boards to establish the purpose, value, and the strategy of the company. Requirements include assessing how the company generates and preserves long-term value. Boards are also directed to keeping all stakeholders thinking long-term. Enforcing the power and independence of the board is proposed by several policies including separating positions for Chair and CEO, having half of the composition be non-executive and being the prime role appointing and removing executive directors. These rules provide guidance for boards to reduce short-termism. As boards become independent and strong they can define the vison, mission and strategy of their companies for the long-term success. They promote this never-ending process by embedding this view as part of the culture and by making sure officers to align with the policies dictated applying the mechanism of hire, supervise and/or fire.
The UK Stewardship Code22 promotes stewardship through transparency and integrity standards for asset managers as guardians of stockowners within their portfolio of investments. The Code wants to assure that institutional investors are creating long-term value for its clients by being responsible in the allocation, management, and oversight of capital they have been trusted on.
The Code is important because institutional investors are the voice of the shareholder and intermediary with board management that always present an agency problem for shareholders. Their sense of responsibility and stewardship may cascade towards directors of the companies they invest in by conducting a more responsible oversight of the boards in the role of active shareholders pursuing long-term value for their clients.
How effective can a company move towards future planning and accountability and less on short-termism depends on how executives are incentivized to do so with their compensation package. 23 We will discuss the incentive matter on the following topic.
Compensation packages for executives have been rising dramatically over the years in the UK and elsewhere. This reasoning is mostly based on the premise that stock markets are well informed and efficient evaluators of the company and its fundamental value. The premise is that boards work on behalf of shareholders and in this regard can negotiate with executives at arm-length and constrained24 by stock prices which are “unbiased estimators of firm fundamentals on which CEO pay could be based to reward managerial effort”.25 These stock prices operate in markets that make decisions with sufficient information and thus reflect their expected fundamental value. Having the price reflecting a firm’s value, it follows that CEO has participated in its success and should be compensated accordingly. Others disagree. There is concern that the board is unable to resolve the agency problem either as principals to the managers or as agents of the shareholders. This governance failure promotes abuse of power and compensation driven by detached shareholders unable or unwilling hold managers and officers properly accountable.26 Excessive compensation exists so does short-termism. However, one camp sees executive compensation as the result of agency problem and the other as a mitigating factor.27
UK Company Act addressed the issue of compensation abuse by following three principal strategies. The first, requiring disclosure of compensation to shareholders. The second, independent board compensation committees and the third veto power on remuneration.28
The UK Corporate Governance Code29 has provided important directives addressing compensation abuse. It recommends companies to develop a transparent remuneration policy that includes a designated remuneration committee comprised with independent non-executive directors30 that would be less prone to influence by the executives in charge. Shares granted should be released in a phased basis with a vesting period of five years or more.31 This would increase managers consideration to long-term value. In addition, these compensation schemes should provide discretionary decisions to override outcomes and recover/withhold awards when appropriate. 32
The Code suggests that when structuring compensation the parameters should address clarity, simplicity, risks from excessive rewards, predictability of rewards, proportionality of the compensation with the company as a whole and alignment with the purposes, value and strategy of the company.33
While there is a wide salary gap between the US and UK executives, there is still debate in the US. on why the gap and whether the short-termism threat is real and some attribute it to the fact that the answer is fundamentally unknowable, and studies have been ambiguous. 34 Furthermore the ability to generate uniform laws to address this problem is difficult. While the U.S. Congress can enact federal law for corporations, it has not done so. Instead, it has handpicked regulatory areas and left to each state to enact their own laws to regulate corporations and other institutions. Federal laws regulating certain aspects of publicly traded firms include the Securities Act (1933), the Securities Exchange Act (1934), Sarbanes-Oxley Act (2002) and the Dodd-Frank Act (2010) and related regulations. Furthermore, firms listed in the Nasdaq or NYSE must follow certain practices. Governance strategies for best practices are issued by various organizations such as the American Law Institute and proxy advisors such as ISS and Glass Lewis. The Dodd-Frank Act is prominent on the short-termism debate because it was enacted after the 2008–2010 economic crisis with mandates regulating corporate governance including executive compensation, director nominees and shareholder voting on pay. 35 Attempts have been made to loosen regulations. 36
Corporate caselaw from the state of Delaware, where over half of all US publicly traded corporations are incorporated is routinely interpreted through the Court of Chancery. While court decisions cannot change existing laws in other states, Delaware is influential. Some argue that they are addressing short-termism with decisions aimed at directing corporate directors into a long-term horizon. This includes the broadening of fiduciary duties in corporate risk-assessment and decision-making so that the legal duty to take action in the “best interest of shareholders” includes an obligation to maximize the long-term the value of the corporation.
Short-termism has to do with agency problems and market influence. Laws and policies such as the ones discussed help minimize the problem but there is debate as to how best to address these issues and from what angle. There is widespread consensus that aligning directors to a long-term vision supported by similarly focused remuneration packages should contribute to long-term strategic and value-creation goals.
Discussion remains as to who is the final stakeholder charged with determine long-term objectives. Some argue that the ultimate stakeholder is the company itself and that it is the duty of directors to develop and protect the long-term subsistence of the firm based on its chartered purpose and overall social responsibility. Others argue that the primary interest of a company’s long-term survival is matter to be decided by its owners and thus directors cannot detach themselves from its owners and draft their own agenda.
Shareholder Rights Directive37 is a European Union directive on the right path towards shareholder engagement. It was enacted to improve transparency and stewardship of firms traded on markets regulated by the EU and encourages investors to reduce short-termism and focus on long-term sustained value for ultimate shareholders. It includes public disclosure of investment strategies and the engagement policy of the asset managers. As amended, it promotes shareholder engagement through a variety of mechanisms.
Aligning directors’ duties and, regulating of executive remuneration to promote long-termism will continue to be difficult39 regardless of what role shareholders and directors assume. However, the matter can be addressed through the intervention of both stakeholders. Collaboration will have to be promoted and sustained through the boards’ own initiatives. Success will depend on how ethical, competent, and independent the board is and its willingness to engage with apathic or sporadic participation of shareholders. They many create mechanisms to promote more voting and ease of participation on issues such as long-term strategy and executive compensation. They could assist shareholders to develop internal committees to increase interaction amongst them and promote a unified front to push forward important agendas and accountability. This ongoing engagement would generate progress towards aligning the company’s long-term vision with the main stakeholders. It would also reduce by default the level short-termism and incoherent compensation better than any legislation enacted.
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