Wednesday, 16 May 2018

Carillion: shareholder primacy plus shareholder inaction

As most people will be aware, the Work and Pensions and BEIS committee have published their joint report on the Carillion collapse today. I won't bother rehashing much better summaries of what it says that you can read elsewhere, rather I want to focus in on a couple of things I found particularly interesting.

First, whilst clearly the Carillion collapse in first and foremost the responsibility of the directors of the company, I think there is an accomplice in the room that is not identified: shareholder primacy, or at least the Actually Existing version of it.

One of the quotes I found most interesting in the report is below:
Mr Murchison said that, while dividends should be “a residual”, payable once liabilities had been met, there was a problem with “corporate cultures where a lot of management teams believe dividends are their priority”. Carillion’s board was a classic such case, showing:
desire to present to investors a company that was very cash generative and capable of paying out high sustainable dividends. They took a lot of pride in their dividend paying track record. Such an approach was inconsistent with the long-term sustainability of the company. (page 19)
This comes from the head of Kiltearn Partners which was one of Carillion's largest shareholders. I think it is spot on, and is exactly the point that Colin Crouch made a few years back (longer blog on these sorts of issues here):
In theory, shareholders’ earnings, their dividends, based on profits, are the residuum in a firm’s trading activities, the last claim that is made on a firm after all claims from bond-holders, employees, creditors, investment needs and other requirements have been met. This is the risk-bearing activity at the heart of capitalism that enables firms to be innovative and that justifies shareholder maximisation: if the shareholders must wait until all other contractual claims on a firm have been met then they need to be able to have the final say over how the firm is managed. Also, their rewards from successful transactions must be high, as these must compensate them for the losses that will come from risks that go wrong. 
This principle remains valid if a firm goes bankrupt; shareholders have the last claims on any assets. But during routine operations of a viable company it has been heavily compromised by the emergence of profit expectations within today’s highly volatile stock markets. Ideas spread as to what short-term return on profits ought to be available in the market; remember shares are being bought and sold with an eye primarily on the secondary markets. There will therefore be a flight from shares of firms not meeting the prevailing idea of a good return. Such firms become vulnerable to hostile takeover, something which senior managers are keen to avoid, as it often leads to them losing their jobs. Managers are therefore under strong pressure to meet or exceed a target level of return to shareholders. If necessary, investment plans, customer service and employee compensation will have to be held back to meet this target. Once this occurs, distributed profits are no longer a residuum but are an early call on a firm’s earnings.
I think this pretty much how many public companies are run. Although the theory is that shareholders are a residual claimant, in practice directors put them much higher up the pecking order. Of course, it doesn't always end up like Carillion, but we should be worried that even asset managers acknowledge that there is a problem with directors prioritising dividends. 

The other interesting thing that Carillion shows us is that shareholders (really asset managers) don't necessarily pressure management, at least not all the time, but they don't need to. Directors would rather keep one step ahead of the pack, so I think they've internalised shareholder demands to the extent they don't often have to be explicitly made. 

When you look at the engagement that took place with Carillion it's surprising to me how limited it seems to have been in some cases. Some investors don't really seem to have done a lot, even as the warning lights were flashing. What's more it's difficult to see any real change in behaviour compared to how shareholders engaged with banks in the run up to their collapse. 

It's good that this report refers to the Stewardship Code, but I think they let the shareholders off the hook. Is there much evidence of any process to stewardship activity? I can't see any indication of escalation for example, despite a) the seriousness of the situation and b) this being part of the Stewardship Code. The report says that shareholders were "rational" to sell their shares. Fair enough, but that option is there in every case and was the pre Stewardship Code era defence asset managers used to deploy. So why even pretend that stewardship is a meaningful activity in a situation like this? 

Remember, this was a company in serious trouble, and there were plenty of signs that financial market participants thought so. In that case, shouldn't we have seen a great deal of 'stewardship'? Wasn't the whole point of the Code to try and get investors to engage effectively rather than be hands-off and/or just flog their shares if things were going wrong. And remembers to that this was a case of business performance, not some abstract governance issue, so shouldn't the Investor Forum have been in there? There are a lot of threads still hanging in my opinion.

Finally, there are a few minor points about other market activity I would make. First, there was a major shareholder sitting on the register that did nothing - Deutsche Bank. According to the report it held 5.8% of Carillion in March 2017, and here's the reason why:
Not proprietary investments. Shares held on behalf of clients and for hedging purposes. No engagement with Carillion management.
I'm not clear exactly what this means. Is it this institutional asset management clients sitting behind a nominee account, shares held to hedge derivatives exposure, a mixture of both, or what? Large positions held by banks - rather than asset managers - often have an interesting story behind them. I think the report should have dug into this a bit, especially given the size of holding. 

Secondly, the issue of shorting is hardly touched on. The question I still grapple with is if you are short on the active side but long on the passive side, does this create a conflict in how you approach stewardship? More precisely, are your active team going to want you to engage with the company to address any cause of underpreformance?

Thirdly, who was lending all the stock? According to reports, the total short position in Carillion at its peak was about 25%. That is a lot of shares. So where did they come from? I know that data on stock lending is made available to market participants (and regulators?) but it's not public. But I would put money on it, given the scale of shorting, that some of our pension funds let stock that was used to short. Maybe that's fair enough (a question for another day), but maybe it also ought to be disclosed somewhere that us ordinary mortals can see it?

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