By Lawrence A. Cunningham
Want the best result when resolving a difficult debate? Poll those with proven interest and the greatest stakes. In corporate battles, that means shareholders with long-term holding periods and portfolio concentration, called quality shareholders .
Most shareholder votes pass by a simple majority of all shares, each having one vote, whether held for decades or days by a stock picker or an indexer. It’s democratic to have a vote of the full shareholder body. But it may be valuable for all stockholders to count the quality shareholders separately.
In cases where some shareholders have a conflict of interest, particularly a majority shareholder, boards often add a requirement that a majority of the others also approve (called a “majority of the minority” or MoM). In a variation, boards could include another requirement: that a majority of the quality shareholders also approve (call it “MoQ”).
Imagine how a MoQ would have changed the outcome of one of the bitterest corporate battles of the past decade: Dell Inc.’s 2013 deal to go private. Founder and majority shareholder Michael Dell offered a price far below value — less than $14 for a stock later appraised at close to $18. Following conventional practice, a special board committee added a MoM, conditioning the deal on approval by a majority of the non-founder shares.
Fierce fighting followed, pitting Dell against such quality shareholders as Southeastern Asset Management and T. Rowe Price, as short-term speculators piled in and passive indexers stood by. After only slightly improved terms, Dell eked out the required shareholder MoM votes — 51% — and the shareholders ate a loss of $4 per share. A MoQ vote may have prevented this.
A MoQ vote would include only long-term and focused shareholders, excluding two segments of institutional investors: diversified indexers and short-term transients. Most of these other types face problems that most quality shareholders do not.
The first problem is staying fully informed. Indexers face serious constraints on their ability to process information on the tens of thousands of votes they must cast annually. They may snap to attention for some high-ticket mergers, but their low-cost business model means small budgets and lean staffs. Transients, meanwhile, tend to prefer market calculations to business information.
The second problem concerns conflicts of interest. Indexers buy shares in virtually every public company, often owning shares in both sides to a deal, such as a merger. Even if merger terms are unfair to a buyer, therefore, indexers reap offsetting gains on the seller side and approve the buyer’s proposal anyway. Transients pounce when mergers are announced, many taking multiple positions so that their best outcome is for the merger to close, whichever side terms favor.
By adding a MoQ clause, a board would signal the corporate importance of long-term focused shareholders. Other shareholders might balk at first — indexers to guard their influence and transients to protect arbitrage positions. But both cohorts still vote in the usual shareholder approvals, retaining their power. If the work of quality shareholders on the MoQ adds value, as it likely would, all shareholders benefit too, at no cost.
As for practical implementation, segmenting the shareholder list for quality is easier than you might imagine. Researchers use a respected technique based on a combination of holding periods and concentration levels. This helps analyze topics ranging from how relative levels of transient interest influences earnings management to the best approaches to shareholder voting.
The technique is adaptable for a company to determine which of its shares are eligible for a MoQ vote. Duration can be determined directly, as share acquisition dates are routinely maintained in corporate records. Determining concentration is indirect, using data in the public filings of institutional investors. Measures range from the number of positions an investor owns in its portfolio to its “active share,” a common expression of deviation from a passive benchmark.
A corporate board would use its discretion in tailoring eligibility rules to suit, from choosing the minimum holding period to setting how to determine concentration. It would also lay out any special rules for individuals, who make no public filings, as well how to differentiate between various funds in larger fund complexes. The board could even permit shareholders initially excluded from the MoQ denominator to submit evidence that they do meet the board’s definition.
Even with the clearest board rules outlined, expect some wrangling over details, particularly whether a given shareholder qualifies for the MoQ vote. Such disagreements arise regularly in litigation over MoM clauses, including whether certain shareholders might face a conflict of interest. Experience resolving disputes in MoM setting is a basis for handling similar skirmishing for MoQs. An added advantage: Courts repudiate any attempts to game the system, such as funds manipulating ownership duration or portfolio concentration.
There may be incremental costs to adding a MoQ clause, including defining eligibility, administering the vote, addressing borderline cases, and litigating all of this. But these are the same costs associated with MoM clauses, and the MoQ benefits from shareholder protection would likely be significant. Just ask former Dell shareholders.
Lawrence A. Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University. His books include “Quality Shareholders,” “Dear Shareholder” and “The Essays of Warren Buffett.” Cunningham owns stock in Berkshire Hathaway and is a shareholder, director and vice chairman of the board of Constellation Software.