United States: The Elephant In The Room: Helping Delaware Courts Develop Law To End Systemic Short-Term Bias In Corporate Decision Making

Co-authors: Kenneth McNeil, Susman Godfrey L.L.P.1 & Keith Johnson, Reinhart Boehner Van Deuren S.C.23

Short-termism in corporate decision making by 85% of companies in the S&P 1500 is costing pension funds and other long-term investors dearly. Recent empirical research shows that the small minority of corporations actually doing long-term planning and risk management had long-term profitability that was 81% higher than their peers during the 2001-2014 time period—with less volatility. This is especially troubling given that at least half of the value of companies in the S&P 1500 is generated by expectations of "future value." It also appears to be a substantial unmeasured drag on market returns and risk management which has contributed to the underfunded status experienced by many pension funds.

Delaware court justices, the primary referee of corporate director fiduciary duties in the United States, are so frustrated with the persistent effects of short-term pressures—illustrated by corporate fraud and compliance breaches—that they are actively encouraging investors to bring the right cases to help change the rules. This analysis looks at the effects of short-termism and the Delaware judiciary's responses, then shows how existing Delaware law could be extended to address the underlying causes of corporate short-term bias, rather than merely imposing punishment on the symptoms.

Pension funds and other investors with long-term liabilities today are at a watershed moment—facing both a life-threatening crisis and an unexpected opportunity to resolve the predicament through the use of Delaware courts.4

Pervasive short-termism in corporate decision making is the underlying elephant-in-the-room crisis.

Recent empirical research shows short-termism is a recipe for disaster for pension funds and other retirement-related institutional investors. Over half of the market value of the S&P 1500 is now "future value."5 Corporations with long-term planning have generated 81% more profits long-term from 2001-2014 than other corporations without such planning—and with far less volatility.6

Yet 85% of the S&P 1500 have no long-term strategic business plan longer than three to five years.7 To the contrary, most directors myopically focus on quarterly returns—with all the accompanying risk and corner-cutting.8

The amount of money lost to long-term investors is enormous, despite it being largely invisible to investors exclusively using market-relative performance benchmarks. Furthermore, corporate governance reform efforts by pension funds have made no serious dent in this short-termism problem. It is no surprise that many pension funds are underfunded.9

But there is an unexpected and powerful emerging ally seeking to help reverse this short-termism trend: the Delaware courts. Indeed, these Delaware courts are actually seeking assistance from pension funds in this battle. It is not often that courts actively seek help from long-term investors or anyone else, but here is why:

  • Delaware courts are the key architects that define the rules of the game for corporate decision making.
  • In that role, they are on the front lines dealing everyday with the magnitude of corporate meltdowns and financial cataclysms of recent history.
  • From that front-line perspective, it is obvious to Delaware justices that much of the corporate fraud and failure to comply with laws that triggers these meltdowns are merely symptoms of short-termism, and that short-termism is the underlying cause of these catastrophes.
  • As a result, Delaware courts are showing increasing willingness to broaden the relevant director fiduciary duties that govern the process of corporate risk-assessment and decision making.
  • But the Delaware courts cannot bring these cases on their own. They need enlightened pension funds to press to expand Delaware law to coincide with what the United Kingdom and European Union have already done, e., require directors to consider long-term consequences in decisions.
  • Delaware courts can also provide pension funds with another valuable reform tool—the Delaware books and records statute—to give leverage to current pension fund corporate governance reform efforts, such as corporate disclosure and cooperative engagement.
  • As a result, Delaware courts are showing increasing willingness to broaden the relevant director fiduciary duties that govern the process of corporate risk-assessment and decision making.

Delaware courts can also provide pension funds with another valuable reform tool—the Delaware books and records statute—to give leverage to current pension fund corporate governance reform efforts, such as corporate disclosure and cooperative engagement.10

This crisis, like Enron, Worldcom, Lehman Brothers, and an ever increasing volume of unsustainable business model calamities, is exaggerated by an economic culture incentivized to seek quick wins at the expense of long-term risks or long-term sustainable profits.11

But these fraud-related collapses are mere symptoms of the bigger problem of short-termism in corporate decision-making generally.

Delaware Supreme Chief Justice, Leo E. Strine, Jr., has put the problem and the solution succinctly:

"[T]o foster sustainable economic growth, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock price."12

But our thesis is that the Delaware courts—frustrated by this trend of short-termism—have been laying the legal groundwork to adapt corporate jurisprudence—and particularly the Business Judgment Rule (BJR)—to include long-term strategic risk planning processes.

The legal devices necessary to obtain evidence to substantiate such claims already exist.13 Further, Delaware jurists have signaled willingness to explore this pathway of responsible corporate planning. And long-term planning is a goal that public policy should encourage, in light of recent legal14 and economic history.15

Finally, the ideal plaintiff has awakened: pension-funds and similar institutional investor stewards of assets invested to cover longstanding obligations that owe fiduciary duties with the most literal requirements for long-term planning.16

In this article we chart a path through the law, demonstrating how the BJR has evolved and narrowed in exculpatory scope over time. We highlight recent cases and prominent jurists that are explicit in their support of long-term strategic planning as a core goal. We chart out a new framework that includes a process requirement for long-term risk evaluation. And we suggest that the time is right for a test case to push this theory.

We further identify the ideal plaintiff for such a test case—pension funds, sovereign wealth funds, foundations and similar asset owners: Institutional entities with litigation power that are organized for the purpose of long-term and sustainable wealth creation and therefore have a strong incentive to evolve the law. These institutional stewards of long-term funds have the obligation to provide profits for hundreds of years and the power to influence corporate directors.

1. Imbalance between Pension Fund Long-term Investor Goals and Short-termism in Corporate Decision-making

Just a few simple facts highlight how far out of balance—and intractable—the situation has become.

Corporations that do long-term planning had economic profits 81% higher between 2001 and 2014—with less volatility—than other firms.17 Because pension funds and other institutional investors control about 70% of the U.S. equities market, market pressures alone should therefore encourage long-term strategic planning.18

Yet the opposite is happening in the overall corporate marketplace:

  • At least 50% of the current value of the top 1500 S&P corporations is "future value." And the trend toward a future value as a higher percentage of total equity value is growing.19
  • Yet 85% of these corporations have no strategic planning horizon longer than 5 years.20
  • 75% of the S&P 1500 have no long-term measures of capital efficiency.21
  • 85% of investee companies have no disclosed future value metrics—like amount of innovation and R&D.22
  • 85% of the S&P 1500 have long term incentive plan performance periods of less than 3 years.23
  • And astoundingly, only 100 of the top S&P 1500 companies do any significant "research and development," which is key to long-term value maximization in today's world.24
  • As future value increases (often to 20 times earnings or more), a huge disconnect has developed in companies where there is no strategic assessment of long-term profitability.

And to make matters even worse, it is "a black box" situation. Not only is the long-term assessment "process" flawed, there is also little disclosure. The result is that institutional investors, in particular pension funds, cannot effectively monitor and evaluate how a company will manage its large component of "future value"—and the extent to which future value component may realistically be a sham.

This is not merely an abstract or academic problem. Pension funds and their delegated fiduciary agents owe strong legal duties to millions of workers.25 As with the corporations themselves, these fiduciaries are making vital investment decisions with those "other people's money."

Those ultimate fund beneficiaries must have a long-term investment horizon to protect their retirement.26 But that is far too often not happening with their fund investments at the corporate level. And corporate reform efforts by institutional investors are not yet making a serious dent in these stark realities of short-termism.

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1 Kenneth McNeil is a 31-year partner at the law firm of Susman Godfrey, LLP. It is a national boutique litigation firm. He has been involved in large-scale litigation both representing pension funds in securities and other litigation, as well as litigation protecting shareholder rights in Delaware and other courts. He holds a JD from the University of Wisconsin Law School where he was Article Editor, and served as a judicial clerk for Judge Sam Johnson on the U.S. Fifth Circuit. He has been Chair of the Antitrust and Business Litigation Section of the State Bar of Texas, and has served on the 12-member board of the Civil Justice Institute of the American Bar Association Litigation Section. He is on the Board of Directors of the Lawyers Committee on Civil Rights Under Law. In 1999-2001, he was president of the board of directors of the national alumni association for all graduates of the University of Wisconsin Law School. He is also a former assistant professor of sociology at the University of Wisconsin-Madison, specializing in legal regulation of complex organizational behavior. In that position, he was Principal Investigator of a National Science Foundation Law and Social Sciences Division study on warranty protection in the auto industry, which focused on the consequences of short-term accounting bias in undermining that auto industry in the late 1970s and early 1980s. He has also published in a series of academic journals, including The American Sociological Review, The Administrative Science Quarterly, and The Law And Society Review.

2 Keith L. Johnson chairs the Institutional Investor Services Group at Reinhart Boerner Van Deuren, s.c. He previously served as Chief Legal Counsel at the State of Wisconsin Investment Board (one of the largest pension funds in the United States), Program Director of the University of Wisconsin Law School's International Corporate Governance Initiative and President of the National Association of Public Pension Attorneys. He holds a JD from the University of Wisconsin Law School.

3 The authors wish to thank Mark Van Clieaf, Head of Organization Capital Partners, a leading international consultant to top corporations on strategic planning and succession of leadership, for his assistance and feedback on framing the arguments in this article. We also wish to thank Adam Kuhn, a Senior Research Fellow at The McCarthy Institute for assistance on legal research and editing.

4 See Knowledge@Wharton, Underfunded Pensions: Tackling an 'Invisible Crisis,' Wharton (Jan. 26, 2015), (noting that "Chicago's unfunded liabilities are 10 times its revenues."). See also David Crane, California's $500-billion pension time bomb, LA Times (April 6, 2010), ("The state of California;'s real unfunded pension debt clocks in at more than $500 billion, nearly eight times greater than officially reported."); Darren Behar, Fears of Pensions Timebomb, Daily Mail.

5 Dominic Barton, James Manyika, & Sarah Keohane Williamson, Finally, Evidence That Managing for the Long Term Pays Off, Harvard Business Review (February 7, 2017), available at ("New research . . . found that companies that operate with a true long-term mindset have consistently outperformed their industry peers since 2001 across almost every financial measure that matters.").

6 Id. ("From 2001 to 2014 those managing for the long term cumulatively increased their economic profit by 63% more than the other companies. By 2014 their annual economic profit was 81% larger than their peers, a tribute to superior capital allocation that led to fundamental value creation.").

7 IRRC Institute, The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design (2014).

8 Alex Edmans, Vivian Fang, & Allen Huang, The Long-Term Consequences of Short-Term Incentives, IIRC Institute (Oct. 4, 2017). ("The concern with short-term incentives is that they lead to the CEO taking myopic actions that boost the short-term stock price at the expense of long-run value."). See also Dominic Barton, Jonathan Bailey, and Joshua Zoffer, Rising to the challenge of short-termism, FCLT Global (2015).

9 Michael Edesess, The Reason Underfunded Pensions Are A Disaster Waiting To Happen, MarketWatch (Apr. 5, 2017); Thomas Born, Nearly Half of Americans Will Retire Broke, RT.com (Mar. 17, 2018).

10 Tom McParland, Chancery Court Opens Health Care Company's Documents to Investors, Delaware Business Court Insider (Mar. 7, 2018), https://www.law.com/delbizcourt/2018/03/01/chancery-court-opens-health-care-companys-documents-to-investors/?kw=Chancery%20Court%20Opens%20Health%20Care%20Company%27s%20Documents%20to%20Investors.

11 Malcolm Salter, How Short-Termism Invites Corruption ...And What To Do About It, Harvard Business School (April, 2012), available at http://www.hbs.edu/faculty/Publication%20Files/12-094_8260785f-0417-45d1-8abc-0afe86f87eaa.pdf.

12 Leo E. Strine, Jr., One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term?, 66 Bus. Law. 1, 26 (2010).

13 McParland, supra note 10.

14 Leo E. Strine, Jr., Corporate Power Ratchet: The Courts' Role in Eroding 'We the People's' Ability to Constrain Our Corporate Creations, 51 Harvard Civ. Rights-Civ. Lib. L. Rev. 1, 21 (2016) (describing how the Supreme Court's Citizens United decision augmented corporate power to influence society through political lobbying and mass media).

15 See, e.g., Wall Street Journal, The 2008 Financial Crisis: How it All Began (Aug 17, 2017), https://www.wsj.com/articles/the-2008-financial-crisis-how-it-all-began-1502997466.

16 David Webber, The Rise of the Working-Class Shareholder: Labor's Last Best Weapon (2018).

17 See Barton et al, supra note 1.

18 Id.

19 Mark Van Clieaf, Stephan O'Byrne, & Karel Leeflang, The Alignment Gap Between Creating Value, Performance Measurement, and Long-term incentive design, Organizational Capital Partners (2015), available at https://irrcinstitute.org/wp-content/uploads/2015/09/alignment-gap-study1.pdf.

20 Barton, D., J. Manyika, T. Koller, R. Palter, J. Godsall and J. Zoffer, Where Companies with a Long-term View Outperform Their Peers, McKinsey Global Institute (Feb. 2017), https://www.mckinsey.com/global-themes/long-term-capitalism/where-companies-with-a-long-term-view-outperform-their-peers ("Recent surveys of C-suite executives that we have conducted suggest that pressure to deliver strong short-term results has increased in the past five years and, as a result, many executives believe their companies are using excessively short time horizons in their strategic planning.").

21 Equilar, Executive Incentive Plans: How leading companies pay for performance (April 6, 2016), http://www.equilar.com/reports/35-executive-incentive-plans.html.

22 Van Clieaf, supra note 24.

23 Id.

24 Id.

25 See, e.g., T. Leigh Anenson, Public Pensions and Fiduciary Law: A View from Equity, 50 U. Mich. J.L. Reform 251, 254 (2017) ("All states recognize that pension assets are held in trust and that managers are fiduciaries.").

26 Larry Fink, Larry Fink's Annual Letter to CEOs: A Sense of Purpose BlackRock (Jan. 16, 2018), https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter (In a January 2018 letter to the CEOs of the largest global companies, the CEO of BlackRock observed: "As a fiduciary, BlackRock engages with companies to drive the sustainable, long-term growth that our clients need to meet their goals. . . . Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to the investors who depend on it to finance their retirement, home purchases, or higher education.").

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