Monday, January 12, 2015

Stockholder Activism at DuPont: A Conflict of Interest for Management

In American corporate governance law, the business judgment rule gives management expertise the benefit of the doubt over stockholder proposals. Compared with executive skill, they look rather populist and thus potentially irrational in nature. Nevertheless, with the rule chaffing up against the property-rights foundation of corporate capitalism, the managerial prerogative can be said to be dubious. Indeed, a strict private-property basis justifies displacing the default profit-maximization mission for a given corporation. Alternatively, stockholders may want to use their concentrated, collective wealth for other purposes, such as to alleviate hunger. Once enough profit has been made for the business to be sustained for another year or two, any additional surplus would be spent on food pantries, for example, rather than going out as dividends or being retained by the corporation. Because managerial skill is premised on the profit-maximization goal and its associated strategies, corporate executives intrinsically resist alternatives proposed by stockholders. The managers face a conflict of interest in providing their recommendation for stockholders. Even when the proposal assumes profit-maximization but differs from a current strategy (i.e., adopted by management), a conflict of interest exists should the management seek to provide a recommendation for the stockholders. In this essay, I use the activism of Trian Fund Management at DuPont to illustrate this point.

A conflict of interest can be characterized as a conflict between two roles held by a person or organization. The roles or functions differ in how broadly the associated benefits reach. Simply stated, one role tends to be more oriented to private benefits while the other typically has a responsibility to provide benefits to the public, or relatively public. For example, a financial ratings agency is in business to make a profit (private benefit) and to provide the benefit of accurate ratings on financial securities for the investing public and other parties. The inherent conflict between these two roles lies in the tension between the private and public benefit; the temptation is to exploit the public benefit at the expense of the public (i.e., risking or reducing its benefit) in order to increase the private benefits. Even if such a conflict is not exploited, the temptation to play with the broader benefit for the sake of the narrower is inherent in the institutional arrangement (i.e., the two roles held by one party, and the related private and public benefits to that party and stakeholders).[1]

Often, the temptation goes unnoticed even by the very public whose benefit is at risk. At DuPont, a huge conglomerate based in the chemicals industry, institutional and individual stockholders learned on January 8, 2015 that the company’s management would come out with its recommendation on Trian’s proposal to add four directors to the board of directors. The management claimed it would “make a recommendation that is in the best interest of all shareholders.”[2] That is to say, the management sought to present itself as a neutral party working to protect the stockholders as a body from possible over-reaches by one. This salubrious “selfie” image can reasonably be regarded as a subterfuge, for the management clearly had its own vested interest “in the game.”

Interestingly, the proposal itself lies beyond the domain of managerial expertise. The question of board size lies in the realm of corporate governance, and is thus exclusively for stockholders and/or board members to decide. Put another way, the business judgment rule does not (or else should not) apply here. So the management’s decision to provide a recommendation involves over-reaching, which in itself is not in the interest of the stockholders.

Furthermore, the management faced a conflict of interest in making a recommendation because the four additional seats were likely to take a minority position hostile to the management. Robert Gentry at Stewart & Patten said “dissenting viewpoints on the board could actually be a healthy thing.”[3] It would take a self-confident (i.e., strong) management to say, in effect, what is dissent to us! Let them have their say.[4] Typically, however, a management cadre will fight any opposition, even if that means overstepping on to corporate governance.

Regarding stockholder proposals that involve changes in strategy, managers would of course be tempted to substitute protecting themselves and their policies for protecting all of the stockholders. Managers are only human, after all. Indeed, an alternative strategy, which does involve managerial expertise in strategy, is the impetus behind the proposal to expand the DuPont board. Trian had argued that DuPont’s conglomerate structure is too unwieldy, and so the seven business lines should be split into three companies—agriculture and nutrition, industrial materials, and performance chemicals.[5] Citing synergies from the integrated research and sales efforts, the management agreed only to split off the performance chemicals. This managerial rationale is likely not the whole story though.

Splitting DuPont into three companies would go against the instinctual “empire-building” mentality that tends to grip corporate executives. That is to say, the spinning off only the performance chemicals may not actually be in the stockholders; rather, the management has wanted a relatively large company on account of the intangible and tangible private benefits to management even at the expense of the stockholders’ financial benefit. Shirking this relatively public benefit for the relatively private ones represents an exploitation of a structural or institutional conflict of interest. If merely permitting a management to be tempted is itself unethical, then it should not be allowed to make a recommendation (i.e., given its vested interest). Stockholders could rely on third-party analyses and discussion between themselves, effectively treating management as part of the topic up for debate and thus not a party to it.

In short, realizing structural or institutional conflicts of interest “right under our very noses” is only part of the treatment back to ethical recovery; the source of temptations—even those previously not acted on—must be eradicated for the problems associated with conflicts of interest to be effectively obviated. To naively assume that people subject to such conflicts will somehow not be tempted or will never act to exploit a conflict of interest is to ignore human nature or minimize its orientation to self-interest above public good. I suspect that one of the major blind-spots in modern society pertains to not just existing institutional conflicts of interest, but also how naïve we are concerning the people and groups in them. We tend to assume that people occupying high-status positions are enlightened and are therefore above the lure of such temptations. In fact, we tend to take them at their word, as if being on television on print lends sufficient validity to their asseverations. I submit we would be better off with a public policy aimed at deconstructing all institutional conflicts of interest.

[1] The temptation being inherent to a conflict of interest makes it inherently unethical, even if it is not exploited in practice. Simply having a person or institution in a conflict of interest is unethical if knowingly subjecting a person (or group) to an ongoing temptation to shirk a duty to provide “public” benefits in favor of additional private gain is itself unethical. Surely standing by even as you know that another person has been put in a situation in which he or she is tempted to commit murder is unethical; you would have an ethical duty to do what you could to get the person out or deconstruct the situation that he or she is in. Similarly, I contend that the general public, or society, has an obligation to deconstruct institutional conflicts of interest, such as exist in public accounting, rating agencies, and even campaign finance.
[2] David Benoit and Jacob Bunge, “Activist’s Bid Sets Stage for Brawl for DuPont,” The Wall Street Journal, January 9, 2015.
[3] Ibid.
[4] Here I am following Nietzsche, who writes that the strong are apt to say, “What are these parasites to us!” That is to say, the strong can afford to be generous, whereas the weak who seek to dominate are naturally petty and small.
[5] Benoit and Bunge, “Activist’s Bid.”