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The Short-Termism Debate: Are There D&O Liability Issues Involved, Too?

 In recent months, commentators from across the political spectrum, largely in response to perceived excesses of activist investors, have called for changes to discourage “short-termism” – that is, the perceived excessive focus of businesses on short-term results rather long-term value creation. Voices ranging all the way from Democratic Presidential candidate Hillary Clinton (about which refer here) to Republican SEC Commissioner Daniel Gallagher (refer here) have voiced their concerns about what they characterize as the inappropriately short term focus that they suggest is driving American business decision-making. This topic raises a number of issues of importance for a variety of different constituencies, including, as discussed below, those of us in the D&O insurance industry.

Background

In recent days, as part of this continuing drumbeat of concern about short-termism, prominent New York lawyer Martin Lipton of the Wachtell, Lipton, Rosen & Katz law firm caused something of a stir by calling for the end of quarterly reporting requirements.

In an August 19, 2015 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), Lipton cited European asset manager Legal & General Investment Management’s recent statement of support for the discontinuation of company quarterly reporting. Lipton also cited with approval to areport by Oxford University Professor John Kay, who said that “rigid quarterly reporting requirements can promote an excessively short-term focus by companies,” which in turn can “harm the interests of shareholders seeking long-term growth and sustainable earning.”

Lipton himself suggested that “the SEC should keep these observations in mind in pursuing disclosure reform initiatives and otherwise acting to promote, rather than undermine, the ability of companies to pursue long-term strategies.”

Lipton’s article has garnered significant attention, including an August 19, 2015 Wall Street Journal article (here) that leads with an opening sentence saying that “Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.”

For all of the enthusiasm for ending short-termism, there have been some important dissenting voices.

In an August 9, 2015 Financial Times article (here), Harvard University Professor and former U.S. Treasury Secretary Lawrence Summers, while calling generally for “long-termism,” sounded a note of caution, observing that “skepticism about whether all horizons should be lengthened is appropriate.” He noted that Japanese companies insulated by the keiretsu system from share price pressure proved to lacked market discipline and squandered market share leads in a wide variety of industries. In the U.S., companies that are dissipating the most value, such as General Motors before its 2009 government bailout, “have often been the most enthusiastic champions of long-termism.” Investors who are pouring money into Silicon Valley startups with bold plans but little revenue “may be putting too much, not too little, weight on the distant future.”

In an August 17, 2015 Wall Street Journal op-ed piece entitled “The Imaginary Problem of Corporate Short-Termism” (here), Harvard Law Professor Mark Roe takes these questions even further. Roe suggests that short-termism is “a small issue on which we could do better but that’s been blown out of proportion by those fearful of change.” Roe cites various evidence he suggests shows that overall stock markets don’t discourage long term business plans. Roe argues that “critics need to acknowledge that short-term thinking often makes sense of U.S. businesses, the economy and long-term employment.”

There can of course be bad short-termism, Roe notes, as when boards and managers “forgo good long-term business opportunities simply to meet quarterly earnings targets.” There is also such a thing as bad long-termism, as, for example, “when [company officials] invest in businesses that have no future.” There is, Roe argues, “an increasingly fine line between the two.”

Given that the evidence for short-termism is, he says, at best “weak and mixed,” why is short-termism suddenly such a hot topic at both ends of the political spectrum? Because, he suggests, “it satisfies the desires of people who don’t want rapid change.” Both boards and managers, on the one hand, and workers, on the other hand, want to preserve the status quo, to conserve their own positions or advantages.

Discussion

The rare unity of diverse political voices might give the impression that there is consensus on this short-termism issue. However, a deeper look suggests that there are actually a diversity of views on the topic, and the skeptics have raised enough questions to suggest that it might be a good idea to slow the short-termism bandwagon down a little bit.

I have to say that I come to this topic with something of a bias left over from the worst of the excesses of the Internet stock bubble in the dot com era. I recall all too well how pressure on many companies, particularly in their tech sector, to make their quarterly numbers, led to excesses such as channel stuffing, invented quarterly reporting criteria that told the story management wanted to tell, and hockey stick quarter-ends.

Indeed, memories from that era suggest that this is an issue in which D&O insurers have a stake. If short-termism drives corporate management into an exaggerated focus on short term results, then steps – such as Marty Lipton’s proposal to do away with quarterly reporting – could help reduce the likelihood of events and activities that can lead to claims against corporate directors and officers.

However, before we all rush off and start instituting dramatic change – like for example doing away with quarterly reporting — I think it might be a good idea to slow down and think about this some more. First of all, the questions the skeptics have raised and that I highlighted above, do suggest that there are a number of sides to this issue.

Second, I think it is worth noting that one of the things driving this discussion now has been the recent events involving activist investors. For many of the commentators, the short-termism debate is really just a part of the larger battle against activist investors’ activities and campaigns.

However, as discussed in The Economist magazine’s February 7, 2015 leader, entitled “Capitalism’s Unlikely Heroes: Why Activist Investors are Good for the Public Company” (here), an effective new generation of activist investors increasingly are a “force for good.” According to the magazine’s longer cover article, activism is “a breath of fresh air in the stuffy, complacent world of the big American corporation.” Moreover, analysis shows that activist investor involvement has led to “a sustained, if modest, improvement in operating performance and better shareholder returns.”

In other words, there are a variety of reasons to question whether the current campaign against short-termism represents that as much of as a panacea as it often is portrayed.

Because of my existing biases noted above, based on concerns about pressures on management to make quarterly numbers, I am drawn toward the short-termism bandwagon. For that same reason, I am attracted to the idea of doing away with quarterly reporting. But I also recognize there are two sides to this issue. I am very interested to know what readers think about this issue. I hope that those who have views on either side of this issue while share their thoughts using this blog’s comment feature.

The Serious Litigation Action Arising Out of the Tesco Accounting Scandal is in the U.K.: As I noted at the time (refer here), the accounting scandal revelations last fall involving U.K. grocery store chain Tesco led to a U.S. securities class action lawsuit against the company and certain of its directors, filed on behalf of holder of the American Depositary Receipts that trade over the counter in the U.S. As I also noted in a separate post (here), law firms acting with the financial support of litigation funding firms are trying to organize to mount a separate lawsuit in the U.K. on behalf of investors who bought their Tesco shares on the London Stock exchange.

As Alison Frankel discusses in an interesting August 19, 2015 post on her On the Caseblog (here), while the U.S. lawsuit is interesting, the action worth watching is in the U.K. As Frankel notes, because Tesco’s U.S. traded ADRs are unsponsored, there are grounds under case law based on the U.S. Supreme Court’s holding in Morrison v. National Australia Bank from which to argue that investors who purchased the unsponsored ADRs on the U.S. exchanges cannot assert claims under the U.S. securities laws. Moreover, the vast majority of Tesco’s shares trade on the LSE (only about 2.5% of the company’s float is in the U.S. ADRs) .

In light of these considerations, a number of prominent U.S. securities plaintiffs’ firms are “devoting their time and effort to litigating abroad on behalf of Tesco shareholders rather than in the U.S. for holders of ADRs.” The Tesco case, Frankel says, “exemplifies how the Supreme Court’s Morrison ruling, in conjunction with the U.K.’s Financial Services and Markets Act of 2000, has changed securities litigation against global companies.”

As Frankel explains, while one group of law firms is focused on mounting an action under U.K. law on behalf of LSE investors, a separate group is organizing an effort under Dutch law. Though Dutch law does not allow investors to file a lawsuit, investors can apply for approval of a class action settlement of shareholder claims, as in the 2009 Royal Dutch Shell case. By forming a Dutch foundation, the two U.S. law firms leading the effort have given Tesco a mechanism to resolve the U.K. litigation investors are threatening.

There is no doubt that these developments raise a number of important issues that will be interesting to watch, including investors ability to mount an effective action under U.K. law; the role of litigation financing; the way in which the separate procedural efforts being mounted by different plaintiffs’ groups interact; and the extent to which these efforts in connection with the Tesco accounting scandal pave the way for similar efforts in future cases. These developments could have important implications for D&O insurance underwriters in the U.K. and elsewhere.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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