Doron Levit, Nadya Malenko, Ernst Maug,
Based on: Journal of Finance, forthcoming DOI: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3463129
In many advanced economies, regulatory reforms and charter amendments have empowered shareholders of publicly traded firms by enhancing their voting rights. Shareholders not only elect directors, but frequently vote on executive compensation, corporate transactions, changes to the corporate charter, and social and environmental policies. This shift of power towards shareholder meetings takes for granted that shareholder voting increases shareholder welfare and firm valuations by aligning the preferences of those who make decisions with those for whom decisions are made—a form of “corporate democracy.”
But does democracy really work in a corporate setting? Unlike the political setting, a key feature of the corporate setting is the existence of the market for shares, in which investors trade, and thereby choose their ownership stakes based on their preferences and the stock price. Thus, who gets to vote on the firm’s policies is fundamentally linked to voters’ views on how the firm should be run. Trading prior to voting can exacerbate the inefficiencies of the shareholder voting process, which suggests caution in the move to shareholder democracy.
Shareholders often have different attitudes towards the proposals they vote on. For example, shareholders with different time horizons would disagree about the choice between long- and short-term investment strategies, shareholders with different tax rates would disagree about payout policies, and shareholders with different degrees of optimism would disagree about investment policies. Such disagreements imply that different shareholders will have different valuations of the firm, choose to hold different ownership stakes, and vote differently.
When shareholders disagree, trading prior to voting creates self-fulfilling expectations. Investors with a preference for the expected voting outcome are particularly likely to buy shares, which aligns the composition of the shareholder base with the expected voting outcome. This, in turn, makes the expected outcome more likely, even if this outcome decreases shareholder welfare. For example, consider a proxy contest between the firm’s management and an activist who advocates for short-term policies. If the activist is expected to win the proxy contest and obtain board seats, investors with a shorter time horizon value the firm more than those with a longer horizon. Then investors with a short horizon buy the firm’s shares, investors with a long horizon sell, and the shareholder base becomes more short-termist. These short-termist shareholders are then likely to support the activist in the proxy contest, which confirms the ex-ante expectation that he is likely to win, even if this outcome is not optimal for shareholder welfare. However, with different expectations, the opposite scenario can take place for the same firm and the same proposal: If the activist is expected to lose, investors with a longer horizon value the firm more and buy shares from short-termist investors, who value them less. Then the shareholder base becomes more long-termist and thus more skeptical about the activist’s motives, so the activist is more likely to lose the contest, as expected.
Given this feedback loop between trading and voting, similar firms can end up having very different ownership structures and adopting very different corporate policies. This highlights potential challenges in analyzing shareholder voting since firms with the same fundamental characteristics can take different strategic directions.
There are also challenges to studying the shareholder welfare implications of voting outcomes. Typically, price reactions to voting outcomes are used to measure their effects on shareholder welfare, which implicitly equates shareholder welfare with the firm’s stock market valuation. However, changes in the firm’s policies can affect shareholder welfare and prices in opposite directions. Intuitively, the stock price and shareholder welfare can react differently to policy changes because the price is determined by the valuation of the marginal shareholder, who is just indifferent between buying and selling shares, whereas shareholder welfare is determined by the valuation of the average post trade shareholder, whose preferences are more extreme.
The figure illustrates this intuition through an example in which a short-termist activist is expected to win a proxy contest. It plots shareholders’ valuations under the activist’s (blue line) and management’s (black line) proposed investment policies against shareholders’ preferences, with more short-termist shareholders located more to the right. Under the long-termist policy proposed by management, the long-termist shareholders have higher valuations than the short-termist shareholders (the black line is downward-sloping), whereas under the activist’s short-termist policy, the more short-termist shareholders have higher valuations (the blue line is upward-sloping). The dark red line plots shareholders’ expected valuations, given their anticipation of the voting outcome. Since the activist is expected to win and implement the short-termist policy, the long-termist shareholders value the firm less and sell their shares to those who are more short-termist, so the average post trade shareholder is relatively short-termist and has a stronger preference for the activist to succeed compared to the more moderate marginal shareholder. The stock price reflects the valuation of the marginal shareholder, whereas shareholder welfare reflects the valuation of the more short-termist average shareholder. Suppose now that the information revealed shortly prior to the shareholder meeting (e.g., through proxy advisors’ reports or additional disclosures by management) convinces some moderate short-term shareholders to vote against the activist, so that the management wins the proxy contest and the long-termist policy is implemented (the red arrows in the figure). Since the marginal shareholder is relatively long-termist, he benefits from this outcome, so the price reaction to the vote is positive. In contrast, since the average post trade shareholder is relatively short-termist, shareholder welfare declines.
Thus, the stock price reaction to a vote is not always a good proxy for its shareholder welfare effects. The discrepancy between the stock price and shareholder welfare is likely to be particularly large when the firm is held by a dispersed shareholder base that has strong disagreements about the issue on the agenda.
Figure: The stock price is not a good aggregator of shareholders’ heterogeneous preferences.
Finally, given all the above, it is natural to ask whether the opportunity to trade shares, which is unique to the corporate democracy setting, increases shareholder welfare. The answer is: not always. On the one hand, trading is beneficial because it helps reallocate shares from investors who value the firm less to those who value it more. On the other hand, trading allows investors with extreme preferences to accumulate large positions and use their votes to implement their preferred decisions. For example, a reduction in trading frictions can allow short-termist investors to acquire more shares prior to voting. As a result, proposals to implement short-term policies may be much more likely to win, which could hurt the relatively more long-termist investors who hold the firm after trading, and may decrease overall shareholder welfare.
Overall, we conclude that policy makers might overstate the advantages of shareholder democracy and, thus, might have driven the move towards empowering shareholders too far. Voting has known limitations even in political democracy. Moreover, the parallelism of shareholder voting to political democracy breaks down if shareholders can trade prior to voting. Trading can exacerbate, rather than alleviate, inefficiencies in voting. As a result, the optimal balance of power between boards, management, and shareholders may need to be reassessed.
Associate Professor of Finance and Business Economics
Foster School of Business, University of Washington
Associate Professor of Finance
Stephen M. Ross School of Business, University of Michigan
Professor of Corporate Finance
University of Mannheim Business School