Oct-Dec 2011

On Enhancing Shareholder Control: A (Dodd-) Frank Assessment of Proxy Access

This article is a brief summary of the paper “On Enhancing Shareholder Control: A (Dodd-) Frank Assessment of Proxy Access” by Jonathan Cohn, University of Texas (Austin), Stuart Gillan, Texas Tech University and Jay Hartzell, University of Texas (Austin). The paper won the “Citi Best Paper” award at the Centre for Analytical Finance (CAF) Summer Research Conference 2011 out of over 140 submissions.

The optimal level of shareholder control is a central issue in corporate finance research. Shareholders devolving excessive control to managers can exacerbate the principal-agent problem, which arises when the interests of the shareholders and managers are not perfectly aligned. If the manager has too much control, she might undertake actions which, are in her self-interest but not necessarily in the firm’s. On the flip side, if the shareholders retain too much control, the firm might be unable to take advantage of the managers’ superior information about the firm’s projects.

Empirically, establishing a causal link between the level of shareholder control and firm value is tricky. Mere correlation conveys very little. Unobserved characteristics of the firm might lead it to choose a certain level of control and affect the firm’s value. There might even be the problem of reverse causality, where the firm’s value determines division of control between shareholders and managers. Hence, in most empirical analyses, the level of control is said to be “endogenous,” and we can’t make a claim of causality with enough certainty.

This paper’s strength is that it uses “exogenous” variations in control to test whether the market values an increase in the level of shareholder control. The exogenous variation they exploit is due to three unexpected announcements made by policy makers regarding the rules governing Proxy Access. Historically, in the US, activist shareholders faced substantial barriers in seeking to appoint board members in opposition to the management’s nominees. They had no access to the firm’s proxy statements, and had to file their own proxy materials with the Securities and Exchange Commission (SEC). They also bore the substancial costs of distributing proxy materials to shareholders, and soliciting votes. An activist campaign costs around $10 million, with half attributable to the proxy contest alone. In the last decade, there have been attempts to introduce rules that would allow dissident shareholders access a firm’s own proxy materials, thereby substantially reducing the cost of a proxy contest. These Proxy Access rules may shift the balance of control towards shareholders.

These proposed rule changes, alone, aren’t enough. The authors want to see what happens to firm value in response to unexpected changes in the rules governing proxy access. The SEC, which is responsible for framing these rules, consults stakeholders before announcing any proposal. Many of the proposals are probably anticipated by market participants. However, during the summer of 2010, there were three unexpected events that had a material bearing on the proxy access proposals. SEC had been floating a proposal which specified holding period and ownership stake requirements for shareholders to be eligible for proxy access. Investors would have to hold at least 1% stake in large firms (Market Capitalisation > $700 million), 3% in medium-sized firms (Market Capitalisation between $75 and $700 million) and 5% stake in small firms (Market Capitalisation < $75 million), for at least two years.

Event 1: On June 16, 2010, during negotiations on the Dodd-Frank Financial Regulation Bill, the bill’s co-sponsor Senator Christopher Dodd proposed a provision whereby the ownership threshold for proxy access would be 5% irrespective of firm size. This announcement was a major shock since proxy access was not thought to be an issue that would come under the purview of the Dodd-Frank bill.

Event 2: On June 24, 2010, Senator Dodd’s proposal was dropped from the bill.

Event 3: The SEC passed proxy access on August 25, 2010, requiring shareholders seeking access to the proxy statements to own at least 3% of the stock with a holding period of three years. The major surprise was the requirement of a longer holding period than anticipated.

The empirical strategy relies on identifying the impact of the events on affected firms and comparing with a set of control firms unaffected by the announcement. The difference is the actual impact. The authors look at the stock returns of all US listed firms (except financial firms) on the day of/following each event. They compare the returns of firms that have activist shareholders to those that do not, with the expectation that an abnormal reaction in stock returns (due to the events) will be much more prominent for firms with activist investors. The activist investors are identified through a database that documents investors most likely to indulge in proxy contests and other activist actions.

Senator Dodd’s proposal made proxy access tougher for large and medium-sized firms, by increasing the ownership threshold, but was the same as the SEC’s original proposal in case of small firms. Therefore, the effect of the announcement was expected to impact only large and medium-sized firms. In the sample of small firms, the difference between the returns of firms where activist shareholders hold stock and where they do not, is statistically insignificant. However, in the sample of medium-sized and large firms, they find that the difference is negative and significant. Since Senator Dodd’s proposal made it tougher for dissidents to gain access to the proxy statement, the results indicate that the market believes that less shareholder control destroys firm value. The major feature of the third event is the increased holding period of three years. Compared to firms where activist investors would have held stock for more than three years at the time of the preparation of the firm’s next proxy statement, they find that the effect of the announcement is significantly negative for firms where activist investors would have held stock for between two and three years. This further confirms the hypothesis that the market believes more shareholder control increases firm value.

Using three unanticipated changes in the rules governing proxy access, the authors find strong evidence that the market believes that more shareholder control is beneficial. In doing so, they go a long way in informing the debate on the optimal level of shareholder control.

Siddharth Vij, Researcher, Centre for Analytical Finance (CAF) at ISB complied this report for ISB Insight.

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