A confluence of recent research and the evolution in perspective of the Delaware courts presents an opportunity for both companies and investors to systematically improve performance while reducing unwanted risk exposures. However, investors must make the first move.
A growing body of research confirms that companies managed under a long-term strategic business plan substantially outperform their short-term peers over time. In addition, the primary referees of corporate law in the United States, the Delaware judiciary, are signaling a readiness to confirm there is a fiduciary duty for corporate directors to consider strategic business planning focused on sustainable long-term success.[2]
Long-term investors are uniquely positioned to take advantage of these developments by bringing cases framed to give Delaware courts an opportunity to confirm what they have been hinting about in recent cases and commentary: that fiduciary duties of corporate directors (outside of sale of the company) run primarily to creation of sustainable value for the long-term providers of equity capital. Confirmation of this duty would incentivize corporate directors and their advisors to focus on long-term strategy, aligning them with the interests of investor beneficiaries as the ultimate holders of investment risk. It would also drive improved reporting to shareholders about strategic planning processes.
Investors could reap substantial rewards from imbedding a strategic planning fiduciary duty principle in corporate law, as it would force change across companies. The resulting enhanced risk management and company performance over time could easily generate more predictable additional investment returns than those associated with zero-sum trading strategies.
However, the Delaware courts can only address this strategic planning issue if investors bring carefully selected cases that frame the issue appropriately. Investors hold the key to fostering corporate behavior that boosts performance and lowers risk on a sustainable basis through robust adoption of long-term strategic planning practices.
Companies Managed for the Long Term Outperform
Research presented in the February 9, 2017 Harvard Business Review from the McKinsey Global Institute (“MGI”) and Focusing Capital for the Long Term (“FCLT”) found that companies managed with a long-term mindset consistently outperform their industry peers across almost every financial measure that matters. From 2001 to 2014, the average revenue and earnings growth of companies managed for the long term were respectively 47% and 36% higher than their peers. Average company economic profit was 81% higher and market capitalization increased during that time period by 58% on average over peers.
MGI further reported in the McKinsey Quarterly (April 2019) that revenue growth of long-term oriented companies is less volatile, with a standard deviation for growth of 5.6%, versus 7.6% for other companies. During the global financial crisis, long-term companies had smaller declines in revenue and earnings and continued to increase investments in research and development. From 2007 to 2014, research and development spending at those companies grew at an annualized rate of 8.5%, versus 3.7% for others.
Such results are no surprise, given that companies rarely engage in truly long-term strategic thinking. A 2014 survey by McKinsey and the Canada Pension Plan Investment Board found that 85% of executive management teams primarily use a time horizon of four years or less in their strategic planning, shorter than a typical business cycle. Furthermore, the potential advantages of long-term strategic planning are particularly relevant for companies in sectors like technology, media, software and pharmaceuticals, where (according to 2014 Organizational Capital Partners research published by the IRRC Institute) often half or more of current equity valuations are based on future value creation expectations.
Given this landscape, the expansion of corporate law obligations across companies through a long-term strategic planning fiduciary duty would “lift all boats” and substantially benefit long-term investors. It would also supplement current shareholder engagement initiatives aimed at promoting corporate governance improvements, which (in the aggregate) are less efficient and more costly drivers of systemic change than corporate law. For example, even a successful proxy contest that replaces board members cannot ensure adoption of internal company improvements in strategic planning processes as effectively as would a fiduciary duty under corporate law.
Delaware Courts Appear Primed to Address the Systemic Causes of Short-Termism
Investors have an unexpected and powerful ally for moving companies toward long-term management practices. The Delaware courts have shown increased willingness to confirm that director fiduciary duties include consideration of long-term risk assessment and strategic planning processes.
For instance, in a 2017 case, the Delaware Chancery Court stated, “the fiduciary relationship requires that the directors act prudently, loyally, and in good faith to maximize the value of the corporation over the long-term . . . . The fact that some holders of shares might be market participants who are eager to sell and would prefer a higher near-term market price likewise does not alter the presumptively long-term fiduciary focus.” [Frederick Hsu Living Tr. v. ODN Holding Corp., No. CV 12108-VCL, 2017 WL 1437308, at 18 (Del. Ch. Apr. 14, 2017), as corrected (Apr. 24, 2017).]
As early as 2005, now Chief Justice Strine of the Delaware Supreme Court, gave a speech to the European Policy Forum in which he said, “[M]ost of us think that the market’s fetishistic preoccupation with quarter-to-quarter profits is stupid. Anyone who is honest will admit that this obsessional behavior contributed to wrongdoing at corporations like Enron and Health South.”
More recently, writing in the 2016 Harvard Civil Rights & Civil Liberties Law Review, Chief Justice Strine chastised institutional investors for short-term actions that fail to promote corporate development of sustainable wealth.
“In sum, real investors want what we as a society want and we as end-user, individual investors, want, which is for corporations to create sustainable wealth. Until, however, the institutions who control and churn American stocks actually act and think like investors themselves, it is unrealistic to think that the corporations they influence will be well-positioned to advance that widely shared objective . . . [To] foster sustainable economic growth, stockholders must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock price.”
These are just a few of the instances where the Delaware courts have stressed that Delaware corporate law already contemplates creation of value over the long term to benefit of the providers of equity capital.
Investor Action Would Bring Rewards
A roadmap for investors to focus corporate directors on the long term was laid out by Ken McNeil and Keith Johnson in The Elephant in the Room: Helping Delaware Courts Develop Law to End Systemic Short-Term Bias in Corporate Decision-Making, published in the Fall 2018 Michigan Business & Entrepreneurial Law Review. It presents investment research and outlines the legal foundation for selecting and framing cases that would provide an opportunity for Delaware courts to confirm that corporate directors have a fiduciary duty to consider strategic business planning.
The McNeil and Johnson article suggests engaging with underperforming companies that have a short-term corporate governance profile but a high future value expectation component of current stock price and no apparent or realistic strategic plan for delivery of sustainable long-term value. Indicators of this mismatch in governance and value drivers at those companies include things like executive incentive compensation that is primarily short-term; unaddressed industry risk exposures; limited expenditures on innovation or research and development; and persistent inability to generate return on invested capital that exceeds the company’s weighted average cost of capital.
Where shareholder engagement is unsuccessful in addressing these governance issues at Delaware companies, the roadmap for ensuing legal action to clarify corporate law obligations includes either prospective or retrospective litigation. The fiduciary duty questions could be framed appropriately through either: (a) a shareholder books and records inspection request and litigation focused on preventing future losses from the failure to consider a good faith strategic planning process or (b) where the board’s failure to strategically evaluate long-term risks and opportunities has resulted in shareholder losses, filing an action to recover those losses.
Mutually agreed settlements would create precedents to cite in future engagements at other companies, fostering systemic change over time. Successful court outcomes would immediately refocus company directors and their advisors across all companies on implementation of long-term strategic planning fiduciary duties, steering companies toward improved risk management and long-term performance.
A Win-Win Opportunity for Both Investors and Companies
Given that the emphasis of this fiduciary duty would be on use of a good faith deliberative process rather than a specific result, corporate directors and their advisors should welcome the encouragement to focus on strategic planning. Long-term investors would ultimately benefit from the improved company performance and risk management associated with long-term planning.
The first step is for investment and legal officers at institutional investors to talk. Integration of legal and investment perspectives into a well-planned strategy for better alignment of corporate law with the interests of long-term investors and their beneficiaries would help both companies and investors. The stars are aligned for success – but investor action is required.
[1] Keith Ambachtsheer is Director Emeritus of the International Centre for Pension Management affiliated with the Rotman School of Management at the University of Toronto. He is the author of four books on pension management, most recently The Future of Pension Management (Wiley, 2016). Keith L. Johnson heads the Institutional Investor Services Group at Reinhart Boerner Van Deuren s.c. He previously served as Chief Legal Officer for the State of Wisconsin Investment Board, one of the top 10 public pension funds in the USA. He is also co-editor of the Cambridge Handbook on Institutional Investment and Fiduciary Duty.
[2] A more detailed analysis of the research and legal principles highlighted in this article is available in McNeil & Johnson, The Elephant in the Room: Helping Delaware Courts Develop Law to End Systemic Short-Term Bias in Corporate Decision Making, Michigan Business & Entrepreneurial Law Review, Volume 8 (2018), at https://repository.law.umich.edu/mbelr/vol8/iss1/2/.
