Does shareholder proxy access damage share value in small publicly traded companies?

• Author: Stratmann, Thomas

The field of corporate governance has long considered the costs of the separation of ownership from control in publicly traded corporations and the regulatory and market structures designed to limit those costs. The debate over the efficiency of regulations designed to limit agency costs has recently focused on the SEC's new rule requiring companies to include shareholder nominees on the company-financed proxy statement to facilitate insurgent challengers to incumbent board members in board elections. A recent vein of empirical literature has examined the stock price effects of events surrounding the new proxy access rule. We present a study that focuses on small companies that expected an exemption from the rule under the Dodd-Frank legislation that preceded the adoption of the SEC rule. We consider the effect of the August 25, 2010 announcement of the proxy access rule, comparing its effect on the value of medium and large firms, which expected to be subject to the full rule, against its effect on the value of small firms, which were unexpectedly given only a temporary exemption from part of the rule (Rule 14a-11) and no exemption from another part of the rule (Rule 14a-8). Supporters of proxy access have long argued that it will enhance shareholder value. Critics of proxy access have argued that it will empower investors with conflicted agendas that will destroy shareholder wealth. The unexpected application of the rule to small-cap companies on August 25 provides a natural experiment for this question and allows us to examine the differential effect of the rule on firms above and below the arbitrary SEC cutoff of $75 million dollars in market capitalization. We find that the unanticipated application of the proxy access rule to small firms, particularly when combined with the presence of investors with at least a 3% interest (who are able to use the rule), resulted in negative abnormal returns. We present multiple methods to measure that effect and demonstrate losses for our sample of roughly 1000 small companies of as much as $347 million.

INTRODUCTION I. AGENCY COSTS AND SHAREHOLDER VOTING II. THE SEC AND THE PROXY ACCESS RULE III. LITERATURE A. Three Prior Modes of Scholarship in Corporate Governance B. Empirical Studies of Proxy Access C. The Advantages of a Control-and-Treatment-Group Comparison IV. STUDY DESIGN V. EMPIRICAL MODEL VI. DATA VII. RESULTS CONCLUSION APPENDIX A: CONTEMPORANEOUS FINANCIAL-MARKETS NEWS ON AUGUST 25 AND AUGUST 26, 2010 A. List of Headlines Not Solely Involving Individual Companies from the Money and Investing Section of the Wall Street Journal for August 25, 2010 and August 26, 2010 1. August 25, 2010 2. August 26, 2010 APPENDIX B: AVERAGE VOLUME TRADES PER STOCK BY MARKET CAPITALIZATION ON AUGUST 24 AND AUGUST 25, 2010 INTRODUCTION

The separation of ownership from control has long been a focal point for debate in corporate governance literature. (1) Much of the academic community views shareholders as facing a collective action problem in exercising their right to vote in elections for directors of publicly traded corporations. (2) It is argued that finding ways to empower shareholders--for instance, by making election contests easier or less costly--will generate positive shareholder returns through a reduction in agency costs. (3) A few members of the academic community have urged caution, citing the benefits of a director-centric structure or the risks of conflicted shareholders using their voting rights to push social or political agendas. (4) The most recent and lively iteration of this debate has been over granting shareholders access to the corporate proxy. Under the status quo, incumbent directors have their election expenses, including the cost of sending out proxies, paid for by the company. (5) The proxy card, essentially an absentee voting card, is the primary voting and vote-solicitation vehicle for director elections because most shareholders do not attend the company's annual meeting. (6) Proponents of shareholder empowerment have pushed in recent years to give shareholders, under certain circumstances, the right to include nominees on the company proxy card rather than requiring challengers to send out their own proxy card. (7) The SEC considered proposed rules to provide for proxy access three times in the last decade, but owing to the controversial nature of the topic, did not follow through with those proposals. (8)

On August 25, 2010, the SEC adopted a rule granting shareholders with more than a 3% equity interest in publicly traded companies the right to place nominees on the company's proxy statement. (9) The rule was adopted pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). (10) The Dodd-Frank Act gave the SEC authority to adopt the rule, but instructed the SEC to consider an exemption for small firms. (1l)

The language of the Dodd-Frank Act led to three surprise events on August 25, 2010 that each increased the probability and magnitude of proxy access use at small firms compared to expectations based on the initial Dodd-Frank legislation released on June 25, 2010. The rule ultimately adopted by the SEC did not permanently exempt small firms from the proxy access rule. (12) Instead, it gave small firms only a temporary exemption from one part of the proxy access rule (Rule 14a-11), which provided for a minimum proxy access default rule, and provided for immediate application of another part of the proxy access rule (Rule 14a-8), which allowed shareholders to modify the SEC's default rule to make it easier for shareholders to use. (13) Additionally, the SEC's proposed rule in 2009 required 5% stock ownership for a shareholder to use proxy access at small firms, (14) but the rule adopted on August 25, 2010 would require only 3% ownership, making it much easier for shareholders to use proxy access at small firms than shareholders would have assumed based on the SEC's prior proposal. The final rule therefore increased the likelihood of small firms experiencing proxy contests or dissident board members by denying a permanent exemption for small firms from Rule 14a-11, by providing for immediate application of Rule 14a-8, and by decreasing the shareholder ownership barrier to proxy access for small firm shareholders. The unexpected nature of these events forms a suitable experiment to determine the effect anticipated by shareholders of proxy access on small firm value.

Our Article rests on the assumption that shareholders of small firms anticipated a permanent exemption from Rules 14a-8 and 14a-11, and believed that even if the proxy access rule applied to them, it would require a 5% ownership threshold, which would limit use of the mechanism. (15) We considered the possibility of an alternative to our assumption that the market anticipated a complete opt-out from the rule: it is possible that the market already knew of the details of the August 25 rule prior to its announcement. There are three reasons why this is unlikely. First, no publicly available comment from legislators or regulatory officials at the SEC prior to August 25 indicated the unexpected changes. Second, no available news media on the topic of proxy access hinted at the changes prior to the event, (16) and the SEC's news release describing the new rule was not released until the meeting at which the rule was adopted. (17) Third, the SEC staff is subject to stringent ethics rules (18) which provide criminal and civil penalties in the event the staff shares information with individuals they are aware will trade on the information. (19) Our results will remain consistent as long as shareholders viewed it to be more likely than not that a full exemption and a higher ownership threshold would be included in the August 25 rule. Indeed, if shareholders assumed a full exemption and a high ownership threshold for small firms were just barely more likely to be included in the August 25 rule than not, then our results actually underestimate the negative impact of the rule on small firms. (20)

This Article considers the existing institutional literature on shareholder proxy access, which precedes the debate leading up to the adoption of the proxy access rule in 2010. It also reviews the existing empirical literature on proxy access and shareholder empowerment. Two empirical studies considered the effect of an announcement of the proxy access rule on firm value using dates prior to the Dodd-Frank Act and discovered that events that increase (or decrease) the probability of proxy access result in lower (or higher) abnormal returns. (21) Still another study considered the effect of the legal challenge to the rule and the resulting announcement by the SEC that it would delay application of the rule until after the legal challenge has been resolved. (22) None, however, have focused on the small firm exemption.

This Article's contribution to the debate is to offer a stock price event study to determine the stock price effects of the SEC's 2010 proxy access rule. It considers the date of August 25, 2010, when we assume the prevailing assumption was that firms with a market capitalization of less than $75 million would be exempt from the rule, and a surprise announcement from the SEC revealed that they would be (1) subject to part of the rule, (2) only temporarily exempted from the remainder of the rule, and (3) subject to a lower ownership threshold for the rule to apply. Our focus is the disparate impact of the SEC's proxy access rule announcement on firms with a market capitalization of greater than $75 million, which are subject to the rule, as compared to firms with a market capitalization of less than $75 million, which are currently exempt for a three-year period from part of the rule. We also consider the effect of the presence of institutional owners with greater than 3% ownership.

We provide a methodological improvement over previous event...