Contracts Between Firms and Shareholders

• DOI: http://doi.org/10.1111/1475-679X.12297
• Author: JORDAN SCHOENFELD
• Published date: 01 May 2020
• Date: 01 May 2020

DOI: 10.1111/1475-679X.12297

Journal of Accounting Research

Vol. 58 No. 2 May 2020

Printed in U.S.A.

Contracts Between Firms and

Shareholders

JORDAN SCHOENFELD ∗

Received 3 December 2018; accepted 8 January 2020

ABSTRACT

Theory predicts the existence of explicit bilateral contracts between firms and

expert shareholders. I assemble and analyze a large-scale data set of these

contracts. Using block investments from 1996 to 2018, I find that these con-

tracts involve mainly corporate owners and activist owners, and often spec-

ify covenants pertaining to financing, trading, directorships, dividends, joint

ventures, corporate investment, financial reporting, and information access. I

also find that some of the contract covenants are stated in terms of accounting

information, and that the prevalence of these contracts is significantly posi-

tively associated with measures of information asymmetry between managers

and shareholders. Overall, this study provides some of the first systematic evi-

dence on explicit bilateral contracts between firms and shareholders.

JEL codes: G32; G34; K22; L22

Keywords: agency problems; corporate governance; shareholder contracts

∗Dartmouth College

Accepted by Philip Berger.I appreciate the helpful comments from an anonymous referee,

Ray Ball, Mary Barth, Patrick Bolton, Brian Cadman, Hans Christensen, James Dow, Joseph

Gerakos, Wayne Guay, Michelle Hanlon, Rachel Hayes, Cliff Holderness, Amy Hutton, Becky

Lester, Karl Lins, Russ Lundholm, Mike Minnis, Arthur Morris, VenkyNagar, Valeri Nikolaev,

Phil Stocken, Sheridan Titman, several discussants, and seminar participants at the European

Winter Finance Conference, the Front Range Finance Seminar, the HKUST Accounting Re-

search Symposium, the Journal of Accounting Research Conference, Boston College, Dartmouth

College, George Washington University, the University of British Columbia, the University of

Chicago, the University of Oregon, and the University of Utah.

383

CUniversity of Chicago on behalf of the Accounting Research Center, 2020

384 J.SCHOENFELD

1. Introduction

Investors’ legal rights to their investments derive in part from their bilateral

covenant contracts with firms (e.g., La Porta et al. [1998], La Porta, Lopez-

de-Silanes, and Shleifer [2008]). For example, in their survey of the gover-

nance literature, Shleifer and Vishny (1997, p. 741) begin with the premise

that “the financiers and the manager sign a contract that specifies what the

manager does with the funds.” However, recent surveys of the literature do

not recognize the presence of explicit contracts between firms and share-

holders (“shareholder contracts”).1Hence, there is virtually no systematic

empirical research on these contracts. This study starts with the observation

that firms and large shareholders often enter into bilateral contracts, and

then assembles one of the first large-scale data sets of these contracts and

examines empirically their prevalence, purpose, and covenants.

Theoretically, the initial studies of ownership control rights, such as

Grossman and Hart [1986], assume that a controlling shareholder is fully

knowledgeable and personally exercises control over a firm’s operations.

The importance of this assumption is developed further in subsequent stud-

ies such as Bolton and Scharfstein [1998], who argue that large sharehold-

ers may not have the knowledge required to run a firm, and may need

to delegate operational decisions to management, thereby introducing ex-

plicit contracting issues, hold-up concerns, and agency problems arising

from asymmetric information between managers and shareholders. Miti-

gating these problems requires (1) control rights and (2) domain knowl-

edge on the nature of these potential problems. Therefore, a shareholder’s

ownership stake and domain knowledge both will determine the type of

contract that a shareholder can write with a target firm’s management.

The above framework is useful for distinguishing the differences between

the two main types of shareholders that I observe in my setting, namely, cor-

porate owners and activist owners. Corporate owners are typically technical

experts who invest in firms primarily for strategic business purposes such

as joint ventures, whereas activist owners are typically investment funds that

take active roles in firms but do not pursue joint business projects. Rather,

activist owners often aim to generate trading profits over a few months or

years, and commonly return their capital and a portion of their profits to

their limited partners (e.g., Brav et al. [2008]). These owners are often gen-

eralists who specialize in optimizing dividend policy and capital structure,

1For example, see the surveys by Armstrong, Guay, and Weber[2010], Brav, Jiang, and Kim

[2010, 2015a], Bushman and Smith [2001], Christensen, Nikolaev, and Wittenberg-Moerman

[2016], Denes, Karpoff, and McWilliams [2017], Edmans [2014], Edmans and Holderness

[2017], Ertimur and Ferri [2019], Gillan and Starks [2007], Khorana, Shivdasani, and Sig-

urdsson [2017], and Mehrotra and Morck [2017]. The importance of studying these contracts

is evident in Hart’s [2017] Nobel Prize article where he calls on researchers to study real-

world contracts that involve shareholders. Also, Becht, Bolton, and R¨

oell [2003, p. 15] argue

that shareholders are residual claimants who have implicit contracts with firms that are “open-

ended” and “without specific protections.”

CONTRACTS BETWEEN FIRMS AND SHAREHOLDERS 385

and rarely possess significant technical expertise in the industries in which

they operate (e.g., Brav et al. [2008, p. 1755], Khorana, Shivdasani, and Sig-

urdsson [2017]). Thus, although ownership typically offers the same con-

trol rights to both corporate and activist owners, the differences in their

objectives and expert domain knowledge mean that the two types of share-

holders may negotiate and contract with target firms differently.2

I create the data set by hand collecting 3,456 shareholder contracts

(“SCs”) from 25,932 SEC 13D filings from 1996 to 2018. These filings

are mandatory for block investments of more than 5% of a firm’s equity

and must include any contract between the firm and shareholder. I first

summarize the main findings for corporate owners. I find that corporate

owners use SCs in about 24% of their block investments in my sample.

I also find that corporate SCs often specify private placement details,

cost- and profit-sharing arrangements, various project-specific managerial

actions, management positions, information access, and directorships. In

addition, corporate SCs are, on average, more complex than activist SCs

based on a linguistic measure of document complexity. In the cross-section

of corporate block investments, corporate SCs are more prevalent when

an investor’s ownership stake in a target is larger, when a target is younger,

and when information asymmetry at a target is higher as proxied for by

a target’s return volatility and the geographical separation between an

investor and target (e.g., Sufi [2007]). At the industry level, the fraction

of corporate investments with SCs is highest in telecommunications firms,

followed by business equipment firms.

I next summarize the findings for activist owners. One key result is that,

relative to corporate owners, activist owners use SCs at a significantly lower

rate of about 11% of their block investments in my sample, which suggests

that contracting is costlier or provides less benefit for activists. I also find

that activist SCs often specify directorships, information sharing, and var-

ious aspects of a target’s payout policy and capital structure. In the cross-

section of activist block investments, activist SCs are more prevalent when

an investor’s ownership stake in a target is larger, when a target is younger,

and when a target’s return volatility and net cash flows are greater. Activist

SCs are less prevalent when a target’s institutional ownership is higher. At

the industry level, the fraction of activist investments with SCs is highest in

telecommunications firms, followed by energy firms.

Overall, the above evidence is consistent with the idea that corporate

owners have more domain expertise and write more complex contracts with

2Prior studies use the term activist to mean a broad spectrum of entities, including labor

unions (e.g., Ertimur, Ferri, and Muslu [2011]), hedge funds (e.g., Brav et al. [2008]), and

pension funds (e.g., Smith [1996]). As section 3 explains, I define corporate owners as those

who identify themselves as a corporation and none of the following: a holding company, an

investment adviser, an investment company, or a partnership. I define activist owners as those

who identify themselves as one or more of the following: a holding company, an investment

adviser, an investment company, or a partnership.