Public company shareholders have long complained that corporate boards don't always act in the best interest of their investors. But does the addition of a shareholder-sponsored board member increase the market value of the firm?
The answer is important because it could support or thwart the US government's regulatory efforts to increase shareholder power at the board level following the recent financial crisis.
To help answer that question, three Harvard Business School professors performed a natural experiment made possible by changes to federal proxy rules, which began last summer.
Allowing owners to have more power and influence in corporate board elections seems to be valuable.
In August 2010, the US Securities and Exchange Commission passed Rule 14a-11, also known as the shareholder proxy access rule, which would allow large investors to nominate board members in the company's proxy materials, forgoing the traditional time-consuming and expensive election process that was rarely successful. In short, the rule would make it much easier for dissident shareholders to nominate and put in place new directors.
The shareholder proxy access rule limited which owners could nominate directors. In order to qualify, shareholders had to have owned at least 3 percent of a firm's shares for at least the prior three years. Still, the announcement drew ire from some business groups, including the US Chamber of Commerce and the Business Roundtable.
They argued that the rule might shift too much power to unions and special interest groups, and that highly experienced directors might not want to serve on a board if they had to work alongside shareholder-sponsored candidates. In addition, shareholders would be penalized by a decrease in the company's market value.
In September, the two organizations jointly filed a lawsuit against the SEC, arguing that the rule violated the Administrative Procedure Act and that the SEC failed to properly assess the rule's effects on "efficiency, competition and capital formation" as required by law.
The complaint did not come as a surprise to industry observers, but the SEC's reaction did. On October 4, the SEC unexpectedly announced that it was indefinitely postponing the implementation of shareholder proxy access, pending the outcome of the lawsuit.
A Natural Experiment
The delay was just what the HBS professors needed to conduct an impromptu experiment. They hypothesized that the market reaction to the SEC announcement could help determine whether increasing shareholder power would be considered good or bad in the eyes of the stock market. They detail their research in a new paper: Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge.
"The delay was a big surprise," says Bo Becker, who coauthored the paper with colleagues Daniel B. Bergstresser and Guhan Subramanian. "Nobody thought the case had much merit. But all of a sudden you sort of pulled the rug out from under any owners planning to use this rule as a tool. It was a unique situation for [research] because it was unpredicted and legally important for a subset of firms with large activist owners who might take advantage of a proxy access rule."
The professors compared stock market returns for different firms on October 4, the day the SEC announced the delay.
In particular, they compared the return for companies where investors known for being activists held large stakes. ("Activist investors" is used here to refer to hedge funds with a history of trying to change company behavior.) Presumably, these were the shareholders who would have been most likely to nominate new board members if the SEC hadn't delayed the rule.
"The Business Roundtable could be right that some shareholders have ideas that destroy firm value," Becker says. "But it is also possible that some activist hedge funds go through the trouble of taking concentrated risk for an extended time only when they believe they have good ideas for improving the firm's performance. If this is true, and if they are sometimes right, taking the proxy access rule out of their toolbox is going to reduce firm value."
The latter possibility appears more consistent with stock market evidence. The overall market fell on October 4. More importantly, the news had an especially negative effect on companies that would have been most heavily affected by the proxy access rule because they had activist investors. The stocks of those companies fell the most.
"We find that share prices of companies that would have been most exposed to shareholder access declined significantly compared to share prices of companies that would have been most insulated from the rule," the professors write in their report.
Firms in which historically activist institutions held significant ownership stakes lost considerable value on the announcement: a drop in 55 basis points for a 10 percentage point change in activist institution ownership.
"The biggest conclusion we draw from this is that allowing owners to have more power and influence with corporate decision-making, on balance, seems to be valuable in the eyes of the stock market," Becker says. "And this particular rule or some similar rule seems like it might be one way to do it."
Most people who study corporate governance and large firms, both inside and outside academia, would say that it's plausible that there are at least a few firms in the S&P 1500 where shareholders might have some useful ideas, Becker says. "This is not to say that firms in general are mismanaged, but that there are some firms out there where owners could have a positive influence."
The research could prove to be a helpful tool for the SEC.
"The best argument that the Business Roundtable raised in its criticism of the SEC rule was that the SEC did not have a careful analysis showing that the rule would be helpful, which it is required to do," Becker explains. "The SEC needs to justify its rules. So, potentially, the SEC could look at our paper to support the idea that this type of rule might be useful."