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Short-Termism in the Financial Markets

Internationaliseringsstipendium | 03/06/2016

This project studies short-termism in the financial markets with the objective of exploring and comparing post financial crisis strategies in the Europe and the United States. The topic’s contemporary relevance is reflected through ongoing policy debates on sustainable capital markets, as well as through several legislative initiatives. The project evaluates recent proposals by the European Commission to combat negative effects of short-termism, and highlights the spillover effect of legal creativity from the United States. Moreover, the project deals with long-term incentive mechanisms that arise from discussions on the role of institutional investors in corporate governance.

Short-Termism

Definition: excessive focus on short-term profits.
Benefits: secures liquidity in markets, which has also been found to have positive governance effects in empirical studies.
Drawbacks: can distort incentives and cause agency conflicts.
Empirical support: weak. Plenty of evidence suggests that short-termism exists in the individual firm, but little supports the notion that markets are generally short-term oriented.

The project also extends to capture how the views and interests of market participants influence policy making in Europe. The project runs from 2014-2016. The project's approach is interdisciplinary, combining legal and economic perspectives. It includes research stays at Yale Law School and Vanderbilt Law School and is expected to result in six peer-reviewed publications, as well as various dissemination activities towards the corporate society.

Relevance

Short-termism currently attracts significant attention. In April 2014, the European Commission published a partly controversial proposal to amend the Shareholder Rights Directive. The proposal, which aims to empower institutional investors to combat short-termism, is currently working its way through the European legislature. Parallel to this, the Florange Act has been adopted in France. The Act rewards shareholders that hold their shares for two consecutive years with double voting rights. The Act is in line with thoughts communicated by influential scholars (see e.g. Bolton and Samama, 2012; Mayer, 2013), but has also sparked much controversy. Furthermore, the revised Transparency Directive (2013) has abolished the requirement to produce quarterly financial information, in an attempt to reduce focus on short-term earnings.

These examples highlight that short-termism currently attracts significant attention in the political establishment. Contemporary debates raise important questions regarding the effects of short-termism on firms, pension savers, and the stability and sustainability of capitalism. The initiatives by the European Commission are also of considerable importance for Denmark as a member of the Union.

The Concept of Short-Termism

EU and the shareholders

• The European Commission holds the right of legislative initiative in the Union.
• Legislative tools are regulations, directives, and decisions. In addition, recommendations can be formulated.
• The Shareholder Rights Directive was adopted in 2007 as a response to perceived passivism among institutional investors.
• The proposed amendments made public in 2014 target continuous passivism, which is considered to have contributed to short-termism problems.

Short-termism refers to an excessive strive for immediate or close-in-time profits. This distorts managerial focus away from investment projects with long term to fruition. Negative economic effects can occur, as well as damaging consequences for stakeholders such as customers, employees, and the environment. Indeed, the financial crisis of 2008-2009 highlighted the risks of short-termism, and in its aftermath, a number of world-renowned and highly influential scholars have published work on the topic (e.g. Dallas, 2012; Bebchuk, 2013; Cremers et al. 2013; Roe, 2013). Despite a lively debate scientific evidence to support the short-termism argument is weak.  

Despite the currently strong interest in short-termism, the concept is not new. The influential economist John Maynard Keynes voiced his concerns over short-termism already in the 1930s. Keynes labelled short-termism a “contemporary evil” and stated that: “the spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy”. In the 1960s the U.S. business magnate Warren Buffett expressed his frustrations that markets had become “increasingly short-term oriented”.

Therese Strand’s project includes an exchange visit to Yale Law School, here seen from the courtyard. Therese Strand has participated in legal studies, faculty events, and made use of Yale’s rich library resources. Photo: Therese Strand.

Project Orientation

European policy initiatives paint a picture of institutional investors as the solution to short-termism problems. On the contrary, discussions in the United States usually highlight institutional investors as the root of short-termism problems due to their investment- and reward strategies. These conflicting views on where short-termism arise are visible in the proposed amendments of the European Shareholder Rights Directive. The first part of the project therefore focuses on a theoretical evaluation of short-termism contradictions, as well as an evaluation of the proposed solutions.

The second part of the project considers relatively new ideas to combat short-termism: fiduciary duties for shareholders, and loyalty mechanisms. In relation hereto, the project explores the extent and nature of foreign investor influence in Europe. As foreigners now constitute the largest investor category (also in the Nordics), their actions and views on short-termism concerns are of a particular importance for the discussion on fiduciary duties and loyalty mechanisms.

The third part of the project explores external influences on the European legislature by measuring to what extent adopted legislative initiatives correspond to the preferences of domestic and foreign market participants. Special interest is directed to measure the relative influence of market participants from the Nordic countries, as Nordic corporate governance has gained much international attention in recent time for its potential to function as a sustainable model.  

The main hallway of Yale Law School: Most of the school’s academic activities occur here. The grand staircase hidden to the left leads to library facilities at the upper floor. Photo: Therese Strand.

Research Stays

The project includes research stays at two foreign institutions – both sponsored by the Carlsberg Foundation. 2014-2015 were spent at Yale Law School, one of the world's most premier institutions for research in the field. The stay has offered invaluable insights on relevant legal perspectives. Professor Roberta Romano - a world-renowned scholar and specialist on corporate ownership and regulation of securities markets, has shared her expertise with great generosity. This year, 2016, is spent at Vanderbilt Law School, where Professor Randall Thomas – a profound expert of American institutional investors and activists, offers likewise invaluable insights on an investor category that appears to become more and more influential also in Europe. By March 2016, three papers have been published or accepted for publication. Another three papers are in progress. 


Published/Forthcoming Articles

Therese Strand, Nytt EU-Direktiv Ska Lösa Oklara Problem, Nordisk Tidsskrift for Selskabsret, no.2 (2015), pp.29-41.

Therese Strand, Short-Termism in the European Union, Columbia Journal of European Law, Vol.22, Issue 1 (2016).

Therese Strand, An Economic Perspective on Shareholder Duties, in H. Birkmose (ed.) Shareholder Duties in Europe, Wolter Kluwers (2016), forthcoming.

Therese Strand, Exaggerated Peril, in FS Focus, (2015). 

Suggested Readings

European Parliament, Long-Term Shareholder Engagement and Corporate Governance Statement, amendments adopted by the European Parliament on 8 July 2015 on the proposal for a Directive of the European Parliament and of the Council amending Directive 2007/36/EC as regards encouragement of long-term shareholder engagement and Directive 2013/34/EU as regards certain elements of the corporate governance statement (COM (2014) 0213 – C7-0147/2014 – 2014/0121 (COD)).

Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 COLUM. L. REV. 863 (2013)

Mark Roe, Corporate Short-Termism – In the Boardroom and in the Courtroom, 68 BUS. LAW. (2013)