Business Law Advisory Council

December 12, 2016

Business Law Policy
Consumer and Business Policy Unit
Ministry of Government and Consumer Services

Re: Business Law Advisory Council Report to Minister of Government and Consumer Services for reform of Ontario’s corporate and commercial legislation

Thank you for the opportunity to comment on the Business Law Advisory Council Report to the Ministry of Government and Consumer Services (“Ministry”) on recommended changes to Ontario’s corporate and commercial legislation, which was published for comment on November 16, 2016. We appreciate the opportunity to be a part of this legislative process and to contribute to these important developments.

Hurt Capital Inc. is a founder centric investment and venture capital platform. Since 2008, our investment selections in the capital markets have outpaced the S&P 500. This was achieved with minimal trading, and predominantly a buy-and-hold approach to investing. We attribute this success to a research-driven investment methodology powered by proprietary governance analytics, alongside the traditional value investing principles taught by Ben Graham at Columbia University in the 1930’s and espoused by Warren Buffett with much success in recent years.

The origins of our founder centric methodology were discovered during intensive research at the intersection of law and economics on the inherent efficiencies of certain concentrated ownership structures in publicly-traded companies.[1] This novel economic discovery, with its legal foundations published in a highly ranked peer-reviewed law journal, is conceptualized alongside Good Corporate Citizen Theory™[2] – an innovative framework that challenges the dominant paradigms of shareholder primacy and stakeholder theory.[3] Our Founder Centric™ Governance Analytics Platform is a proprietary governance ranking system connected to our investment analysis on firms with dominant shareholders. This academic work has powered a highly scalable eight-year track record in the capital markets that rivals those of the world’s greatest investors. In expanding this theory’s real-world applications to new ventures, Hurt Capital actively promotes Founder Centricity™ in innovative companies.[4]  

Over the next two decades, with bold leadership from all levels of government and the private sector, the Canadian Innovation Triangle[5] – marked by Montréal, the Toronto-Waterloo Corridor, and Vancouver – will become the nexus of a value creation engine that rivals the economic output of ‘Silicon Valley’[6]. Our research indicates that fostering growth in founder centric technology companies – from early stages to well-beyond IPO – is a crucial step in Canada’s economic transformation. For start-ups and growing ventures, we leverage over 600 professionals and partners in 14 offices to help founders build their vision of the future. Our work strives to contribute to Canada’s economic prosperity and competitiveness as a jurisdiction of choice for entrepreneurial activity, investor engagement, and business expansion.

We applaud the Ministry for undertaking this initiative as part of its broader commitment to ensuring that Ontario’s legislative structure facilitates an efficient market and prosperous business climate. We are supportive of the intent of the Business Law Advisory Council Report and we recognize the Business Law Advisory Council’s (“Advisory Council”) significant efforts and difficult task in developing recommendations. Our comments focus on shareholder democracy within the Business Corporations Act (the “OBCA”) and are broad in nature with a view to informing the trajectory of legislative reform and advancing the overall policy objectives of the Ministry.

SHAREHOLDER DEMOCRACY

In reviewing the Advisory Council’s recommendation on shareholder proposals, our research indicates these reforms may be beneficial to the extent that they succeed in aligning the long-term interests of shareholders and management. However, a careful balance must be maintained between broader access to shareholder democracy and heightened management focus on long-term value creation. The Advisory Council’s recommendation is to allow shareholder proposals with growing support to be continually advanced, as follows: 

Shareholder Proposals in Offering Corporations

Shareholders of a corporation should have the right to resubmit a proposal each year if it received a prescribed (and minimal) level of support in the first year of submission or achieved a prescribed increased level of support in subsequent years. [7]   

We recognize the above recommendation will amend the OBCA to mirror the Canada Business Corporations Act (the “CBCA”). Also, we acknowledge that proposing shareholders do not typically solicit proxies – unless they are also soliciting votes, for example in a proxy battle. Proxy solicitation is a prohibitively expensive undertaking for many shareholders, as it requires the distribution of a dissident information circular related to that solicitation. Nonetheless, the above noted reform is an evolution in shareholder democracy that reflects a trajectory toward greater levels of shareholder engagement with publicly-traded companies.

Concentrated and Dispersed Ownership Structures

In analyzing the underlying tensions associated with the above recommendation, it may be helpful to consider the role of ownership structure in regulating, through extra-legal mechanisms, the relationship between directors/management and shareholders. Generally, two distinct forms of ownership structure exist in Ontario’s capital markets – (1) corporations with dominant or influential shareholders engaged in direct monitoring,[8] and (2) corporations with a dispersed shareholder base with relatively minimal engagement.[9] Within the first structure, significant shareholders are often active within the board of directors and/or senior management, and an individual or group of shareholders actively monitors business operations. This has the effect of insulating management from non-controlling shareholders. Canada has a long history of world-class companies, many of which were built and sustained over decades by controlling shareholders. Conversely, in the second structure, directors and management may be subject to greater shareholder pressure to outperform in the short- to medium-term, which can inadvertently result in suboptimal long-term decision making and a correlated drag on the economy. This is consistent with our research on Founder Centricity™, which indicates that concentrated ownership structures, contingent upon the ethical inclinations of the dominant shareholder, may enhance economic efficiency. When these distinctive governance factors converge with robust business fundamentals, among other things, competitive agility amplifies, productive output surges, and long-term value accrues. Importantly, the fiduciary duty of directors is the relevant ethical standard and legal framework to reconcile divergent interests within the shareholder collective.

Fiduciary Duty and Governance Standards

After considerable academic debate, recently published literature has clarified that directors owe a “tripartite fiduciary duty”, composed of (1) an overarching duty to the corporation, which contains two component duties — (2) a duty to protect shareholder interests from harm, and (3) a procedural duty of “fair treatment” for relevant stakeholder interests.[10] In Canada, legal mechanisms have developed over four decades in response to the prevalence of controlling shareholders in Canadian enterprise. The legal foundations of Canadian corporate law have evolved within this context, which is almost precisely obverse to the principal-agent ownership structure detected by Berle and Means[11] in 1932 – specifically, the separation of ownership and control in U.S. firms.[12] This tripartite structure encapsulates the duty of directors – within both controlled and dispersed ownership structures – to act in the “best interests of the corporation, viewed as a good corporate citizen”.[13] In contrast to the U.S. and UK landscapes, the Canadian regime has advanced along a trajectory that contemplates a divergence of interests between dominant and dispersed shareholders, alongside conventional agency issues.[14]

Narrowing within the Separation Between Ownership and Control

In the U.S., the era of the Berle-Means dispersed share ownership structure is in decline.[15] The magnitude of this shift is under-appreciated, yet seismic in its implications. Increasingly, shareholders wield the power to determine or significantly influence corporate policy in U.S. firms. In focusing upon this evolution in share ownership structure – specifically, narrowing within the separation between ownership and control – a distinct economic theory for the enhanced efficiency of business corporations is emerging. In contrast, dispersed ownership structures may lag due to inefficiencies. In the present context, for example, the threat of an undesirable shareholder proposal can be a distraction from longer-term value creation activities.[16] Meanwhile, engagements from committed shareholders focused on business fundamentals may increase productive output. Legislative reforms and extra-legal mechanisms that move these tensions toward equilibrium will enhance the vitality of Ontario’s economic landscape. 

A Novel Perspective on Shareholder Activism

Over the next decade, a common misconception will fade – that all shareholder activism is short-term oriented. This anachronistic view is rooted in an antiquated phase in capital markets history – mainly, highly opportunistic transactions by “corporate raiders” in the 1980’s.[17] For example, research by John Armour (Oxford) and Brian Cheffins (Cambridge), leading scholars in the field of law and economics, distinguishes between two forms of shareholder activism (1) offensive, and (2) defensive.[18] Traditional views of shareholder activism fall within the first. Institutional investors are described as falling within the second[19]. Building upon this research, we define the broad category of “shareholder activism” as containing three distinct sub-categories of participant:

(1)  Engaged Activists™ – longer-term, fundamental investors aspiring to capture value through business level decision making. Engaged Activism™ is the active focus on value creation rooted in business fundamentals, as distinct from Financial Activism™. This broad definition includes institutional shareholders, alongside “business builder” activists.[20] Generally, this form of activity contributes meaningfully to expansion in the “real economy”, including building or acquiring new technologies, factories, and lines of business, or hiring new management.[21] For example, Pershing Square Capital Management (“Pershing Square”), through its CEO William A. Ackman and others, actively engaged with Canadian Pacific Railway (“CP”) as a long-term shareholder in proposing a slate of directors, occupying board positions, and bringing in a new CEO. As expounded in a recent letter to Pershing Square shareholders, this engagement improved operating performance and resulted in significant value enhancements:

[d]uring the course of our investment, CP’s share price increased nearly four times, its operating performance went from worst to nearly tied for first with Canadian National, and its credit rating improved from a weak Baa-/BBB- to a strong Baa+/BBB+. While critics often accuse activists of being short-term investors focused primarily on stock buybacks and dividends, CP is a paradigmatic example of the long-term sustainable business performance enhancements and shareholder value creation we have achieved in our core activist holdings.[22]                                     

(2)  Financial Activists™ – shorter-term, speculative traders involved in technical analysis of stock price charts, and/or financial ‘engineers’[23] – with a tendency to capture value in a manner consistent with traditional views on shareholder activism.[24] Financial Activism™ involves primarily an active focus on value transfer rooted in financial engineering[25], as distinct from Engaged Activism™. Generally, this form of activity contributes to expansion in financial apparatus, including liquidity, financial transparency, and informational efficiency. However, short-term pressures on management may also result in sub-optimal long-term decision making. 

(3)  Community Activists ­– concerned with issues that do not significantly relate to the business or affairs of the corporation.

These categories illuminate useful distinctions within the shareholder constituency. In the absence of an ethical dominant shareholder, the commitment of Engaged Activists™ may offer enhancements to economic efficiency. As distinct from the other forms of activism, such as those rooted in considerations that are disengaged from business fundamentals, Engaged Activism™ is more highly correlated with the long-term interests of the shareholder collective and the broader economy.

In reviewing legislation on shareholder democracy, the potential for divergent interests within a corporation’s shareholder constituency should be considered. When the interests of one group are advanced, often there is a tension with another. All the while, management is in a precarious position. Tasked with exercising business acumen, management must frequently make decisions in high pressure situations of uncertainty. Within an increasingly competitive global landscape, even minor distractions may negatively compound alongside other factors, resulting in significant and rapid economic erosion. Legal frameworks intending to enhance shareholder democracy should encourage business-focused governance. With minimal distraction and suitable incentives, boards of directors and management will be emboldened to prioritize long-term value creation. From this perspective, Ontario stands to benefit from the Advisory Council’s informed recommendations and robust legal analysis of the underlying issues and complex tensions at play.

We encourage the Advisory Council to consider this perspective and its connection to the ownership structures that are prevalent in Ontario’s capital markets. Concentrated share ownership patterns have inherent efficiencies that are implicitly shifting the U.S. landscape toward greater levels of shareholder influence over corporate policy. Companies with a dispersed shareholder base may also benefit from shareholder engagement that promotes long-term value creation. As captured by prominent Harvard scholar Michael C. Jensen[26] at an earlier stage of this movement, “[a]ll of this takes on more importance in light of the fact that we are in the midst of an unusually powerful shift in the worldwide economy, one strong enough to be labeled the Third Industrial Revolution.”[27] In sum, the Advisory Council’s recommendation to broaden access to shareholder democracy may be beneficial to the extent that this reform incentivizes management toward greater levels of economic productivity.

Over the next two decades, innovative business will both contribute to- and respond to this shifting governance landscape. In undertaking this review process – alongside the Ministry’s commitment to advance legal frameworks that are responsive, flexible and adaptable – Ontario will be well-positioned for powerful growth within the global economy.

Legal Notice: The terms Founder Centricity™, Founder Centric™, Good Corporate Citizen Theory™, Engaged Activist™, Engaged Activism™, Financial Activist™, Financial Activism™ and others, are trademarks of Hurt Capital Inc.

[1] Claudio R Rojas, “An Indeterminate Theory of Canadian Corporate Law” (2014) 47:1 UBC L Rev 59 at 108-28, online: SSRN <http://ssrn.com/abstract=2391775>.

[2] Ibid at 127.

[3] Ibid at 98-103 (stakeholder theory), 103-109 (shareholder primacy), 110-124 (challenge to the dominant paradigms).

[4] For non-commercial purposes, the proprietary terminology in this document may be used with academic attribution – suggested citation: Claudio R Rojas, “Submission to the Ministry of Government and Consumer Services re: Business Law Advisory Council Report for reform of Ontario’s corporate and commercial legislation” (12 December 2016), online: Hurt Capital Inc. <http://hurtcapital.com>. 

[5] We have coined the term “Canadian Innovation Triangle” to encourage inter-provincial unity within Canada’s technology ecosystem through geographically inclusive language­. This approach is consistent with the evolution of the term ‘Silicon Valley’, which does not delineate a rigid boundary and now references an expansive area beyond the narrow geographic region that initially gave rise to the term. See generally Turo Uskali & David Nordfors, “The Role of Journalism in Creating the Metaphor of Silicon Valley” (Paper presented at the Innovation Journalism Conference, Stanford University, 23 May 2007) at 7, online: <http://www.innovationjournalism.org> (“Silicon Valley is today a metaphor known worldwide for an area of successful entrepreneurship and innovation… ‘if you were to name it today, it would probably be called “Innovation Valley”’, citing Doug Henton, “A Profile of the Valley ́s Evolving Structure” at 46 in Chong-Moon Lee et al, eds, The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship (California: Stanford University Press, 2000)).

[6] Uskali & Nordfors, ibid (“It is believed that the term Silicon Valley was coined by editor Don Hoefler (1922– 1986) in the weekly trade newspaper Electronic News in January 1971”, citing Lee et al, ibid at 47).

[7] Specifically, the recommendation cites the CBCA’s prescribed five year limit, which allows shareholders to resubmit proposals when the following thresholds of support are satisfied:

-        3% of the total number of shares voted, if the proposal was introduced at an annual meeting of shareholders;

-        6% of the total number of shares voted at its last submission to shareholders of the proposal, if the proposal was introduced at two annual meetings of shareholders; and

-        10% of the total number of shares voted at its last submission to shareholders, if the proposal was introduced at three or more annual meetings of shareholders.

[8] See generally Rojas, supra note 1 at 72-74 and accompanying text (using the term “concentrated” shareholder).

[9] Ibid (using the term “diffused” shareholder).

[10] Ibid at 82-98 (tripartite fiduciary duty).

[11] Adolf Berle & Gardiner Means, The Modern Corporation and Private Property (1932), (New York: Harcourt, Brace and World, 1967).

[12] Ibid.

[13] Rojas, supra note 1 at 61-62, 82, 86-88, 96-98; BCE Inc v 1976 Debentureholders, 2008 SCC 69, [2008] 3 SCR 560 [BCE] at paras 38-39, 66, 81-82, 102-05 (evident in the numerous judicial pronouncements on fair process, the duty to consider the interests of relevant stakeholders, and references to the best interests of the corporation acting "fairly and responsibly", "viewed as a good corporate citizen", and "responsible corporate citizen").

[14] Rojas, ibid at 114-18.

[15] See generally Investor Responsibility Research Center Institute, “Controlled Companies in the Standard & Poor’s 1500: A Ten Year Performance and Risk Review” (October 2012), online: <http://irrcinstitute.org>; Michael C Jensen, Theory of the Firm: Governance, Residual Claims and Organizational Forms (Cambridge: Harvard University Press, 2000) at 5.

[16] See e.g. Dominic Barton & Mark Wiseman, “Investing for the Long Term” (December 2014), online: McKinsey <http://www.mckinsey.com> (“About half of the executives surveyed said that the pressure to deliver strong short-term financial performance stemmed from their boards—but the board members made it clear that they were often just relaying increased short-term pressures from investors, including institutional shareholders”); Dominic Barton & Mark Wiseman, “Focusing Capital on the Long Term”, Harvard Business Review (January 2014); Michael C Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Objective Function” (2001) 14:3 Journal of Applied Corporate Finance 8 at 17 (“Value creation does not mean responding to the day-to-day fluctuations in a firm's value. The market is inevitably ignorant of many managerial actions and opportunities, at least in the short run”).

[17] John Armour & Brian R Cheffins, “The Rise and Fall (?) of Shareholder Activism by Hedge Funds” (European Corporate Governance Institute, Working Paper No. 136/2009, September 2009) at 4-5 [Armour & Cheffins], online: SSRN <https://ssrn.com/abstract=1489336> [citing Lawrence A Cunningham, ed, The Essays of Warren Buffett: Lessons for Corporate America, 3d ed (Durham, NC: Carolina Academic Press, 2013); Amar Bhide, “The Hidden Costs of Stock Market Liquidity”, (1993) 34 J Fin Econ; Steve Fraser, Wall Street: A Cultural History (London: Faber and Faber, 2005)]:

Berkshire Hathaway aims to invest in well-run companies that happen to be out of favour with the market… In contrast, an offensive shareholder activist typically accepts that a target company may not simply be out-of-step with market sentiment but instead may only fulfill its potential as an investment if management, perhaps under activist-induced duress, makes major strategic and/or financial changes. [Warren] Buffett treats this sort of aggressive investment style with disdain, saying disparagingly of 1980s corporate raiders… ‘They aren’t creating value – they are transferring it from society to shareholders.’  

[18] Armour & Cheffins, ibid at 2, online: SSRN <https://ssrn.com/abstract=1489336> (“Employing the adjectives ‘defensive’ and ‘offensive’ provides a convenient way to distinguish the sort of activism in which traditional institutional shareholders engage from the sort for which hedge funds have achieved notoriety”).

[19] Ibid at 3 (“Defensive shareholder activism is by no means limited to interventions by institutional investors. Instead, the label is apt whenever an investor who owns a sizeable stake in a company subsequently relies on shareholder rights to take rearguard corrective action. An example is John D Rockefeller, who organized a successful proxy fight at Standard Oil of Indiana in 1929”: citing Carter F Henderson & Albert C Lasher, 20 Million Careless Capitalists (New York: Doubleday, 1967) at 75-77).

[20] Armour & Cheffins, ibid.

[21] Defined as the production of goods and services, in contrast to the buying and selling of securities in the financial markets (i.e. the “financial economy”).

[22] Pershing Square Capital Management, L.P., “Letter to Shareholders” (New York, 7 December 2016) at 3.

[23] Financial engineering is also known as financial mathematics, computational finance, and mathematical finance. It is the application of technical methods, to the solution of problems in finance. See Tanya S Beder and Cara M Marshall, Financial Engineering: The Evolution of a Profession, Wiley (June 7, 2011) [Beder & Marshall].

[24] Armour & Cheffins, supra note 17.

[25] Beder & Marshall, supra note 23.

[26] Michael C Jensen is the Jesse Isidor Straus Professor of Business Administration Emeritus at the Harvard Business School. His research and writing is prominent in the U.S. national debate on corporate governance.

[27] Michael C Jensen, Theory of the Firm: Governance, Residual Claims and Organizational Forms (Cambridge: Harvard University Press, 2000) at 5.