The shareholder value of empowered boards.

• Author: Cremers, K.J. Martijn
• Position: Introduction through II. New Empirical Evidence, p. 67-108

Table of Contents Introduction I. The Staggered Board Debate A. Institutional Background B. The Theoretical Divide 1. Board and shareholder power 2. The "end of history" for staggered boards? C. Empirical Evidence and Corporate Practices 1. Existing empirical studies: methodologies and limitations 2. Practical effects and the Harvard Shareholder Rights Project. II. New Empirical Evidence A. Data Description B. Staggering and Destaggering Decisions C. Staggered Boards and Firm Value 1. Cross-sectional and time-series analysis 2. Disentangled effects III. Empowered Boards: Microeconomic Foundations A. General Equilibrium Theory in a Shareholder Economy B. Asset Pricing Theory and Shareholder Commitment 1. Price dynamics and shareholder value. 2. Pricing inefficiencies and ownership reconcentration C. Governance Tradeoffs and Priorities: A Contract Theory Approach 1. Dynamic contracts and renegotiation 2. Tradeoffs and priorities 3. Empowered boards as commitment devices IV. The Empirics of the Shareholder Limited-Commitment Problem A. Transmission Mechanisms 1. Innovation and intangible assets 2. Stakeholder participation B. What Really Matters in Corporate Governance? V. Rescuing American Corporate Law A. Disempowering Shareholders B. (Re-)Empowering Boards Conclusion Appendix Table A Appendix Table B Introduction

At the turn of the nineteenth century, America invented the most successful business model of all time: corporate capitalism. (1) At the center of that economic success was the "management corporation." (2) As the name suggests, management corporations revolved around managers--salaried, professional executives--brought in to "hire capital from the investor." (3) Underlying this arrangement was a "tacit societal consensus" that corporate growth took priority over corporate profits, (4) as long as managers could compensate their shareholders with stable dividends--a goal they successfully accomplished. (5) Corporate law accommodated the development of this business model, privileging a board-centric system under which firm insiders--directors and managers--retained virtually exclusive authority over the corporation. Unlike in capitalistic models elsewhere, such as in the United Kingdom, American shareholders have historically been relegated to the role of spectators, with only a limited capacity to intervene in corporate affairs. (6)

However, starting in the late 1970s through the early 1980s, and with increasing intensity in the 2000s, a competing corporate model has gained popularity. (7) This model is conceptually built on the idea of "shareholder empowerment," with enhanced shareholder governance rights, and correspondingly weakened board authority. (8) Economically, the case for shareholder empowerment rests on the assumption that shareholders, as the corporation's residual claimants, are better placed than boards, which may be captured by opportunistic management, to provide value-enhancing governance input. Recent changes in both the legal landscape and the marketplace have rewarded the efforts of shareholder advocates, with the result that empowered shareholders are no longer merely an aspiration but a reality in today's corporate environment. (9)

The rise of shareholder power has revitalized the debate on staggered boards, a longstanding and central issue in the confrontation between shareholder advocates and traditionalists who defend the board-centric model. With a staggered board, directors are grouped into different classes (usually three) such that each class of directors stands for reelection in successive years. Because this board structure requires challengers to win at least two election cycles to gain a board majority, a staggered board helps to protect directors from the threat of early removal by shareholders.

Board advocates defend staggered boards as a means of protecting board authority against short-term shareholder and market pressures, thereby promoting long-term value creation. (10) In the view of shareholder advocates, however, the staggered board is undesirable because it diminishes the accountability of directors and the managers they oversee, and thus encourages managerial moral hazard. (11) In the past decade, this belief has garnered sufficient support such that shareholder advocates now hold the upper hand, emboldened by empirical evidence suggesting that the adoption of a staggered board is detrimental to firm value. (12) In light of this evidence, they have concluded that "insulation advocates"--as they have dubbed defenders of board authority (13)--should surrender to the view that enhancing shareholder power moves corporate governance in an efficient direction, (14) unless they can expose flaws in current empirical research and "counter[] it with research that avoids such flaws." (15)

This Article meets that challenge by presenting new empirical evidence on staggered boards that not only exposes the limitations of prior empirical studies, but also, and more importantly, suggests the opposite conclusion. (16) Employing a unique and comprehensive dataset covering thirty-four years of staggering and destaggering decisions--from 1978 to 2011--we document that staggered boards are associated with a statistically and economically significant increase in firm value. (17) In light of these novel empirical results, we then take up the additional challenge of providing a theoretical account of the merits of "empowered boards" that can resist short-term shareholder and market pressures. These empowered boards may be staggered, but the term more broadly refers to any board that retains the authority U.S. boards historically had in the received legal model. Combining insights from general equilibrium theory (18) and contract theory, (19) we show that a corporate model with empowered boards--the same model that was key to the enduring success of American corporate capitalism--emerges as a rational institutional response to market imperfections that are more complex and more significant than shareholder advocates generally realize.

Following the recommendations of staggered board critics, this Article begins its analysis by revisiting prior cross-sectional studies on staggered boards and "tak[ing] the empirical evidence seriously." (20) These studies associate board staggering with lower firm value and take that association as evidence for the claim that board staggering is a causal antecedent to managerial moral hazard. Sound empirical methods, however, must reduce the possibility of correlation being mistaken for causation. Despite their enormous influence, cross-sectional studies on staggered boards are limited in their ability to address this concern. Because of the limited amount of data available, these studies are constrained to a comparison of the association between the level of firm value and the level of staggering provisions across different firms. (21) As a result, these studies cannot affirmatively exclude the possibility that differences in firm value might be attributable to differences in firm characteristics other than having a staggered board (a "specification" problem), or that low firm value might motivate, rather than result from, the adoption of a staggered board (a "simultaneity," or "reverse causality," problem). (22)

Whereas the 1995-2002 time period that has been the focus of many prior studies exhibits comparatively little variation in staggering or destaggering activity, our 1978-2011 sample considers a significantly larger number of changes in board structures. This expanded dataset allows us to more accurately interpret the relationship between staggered boards and firm value by applying a time-series analysis (23) that employs firm fixed effects. Including firm fixed effects is equivalent to controlling for any and all firm-level variables in a dataset that do not change over time, thereby determining what change in firm value within the same firms occurred before or after a change in board structure. (24)

Our analysis delivers striking results. First, in replicating prior cross-sectional analyses for the period 1995-2002, our results indicate that the identified negative association between staggered boards and firm value is not as robust as previously suggested. More importantly, the time-series analysis documents a strong positive association between staggered boards and firm value over both the subperiod of 1995-2002 and the overall sample period of 1978-2011. Adopting a staggered board ("staggering up") is associated with a statistically and economically significant increase in firm value, while decisions to destagger a board ("staggering down") are associated with a corresponding reduction in firm value. This result calls into question the interpretation of prior cross-sectional studies. As this Article later illustrates, reverse causality explains those previous results. That is, less valuable firms seek board protection through staggering provisions (and firm value would go up, not down, with the adoption of a staggered board), rather than board protection causing firms to become less valuable.

Having shown that staggered boards add value, the question becomes by what mechanism. In addressing this question, it is useful to reconceptualize the relationship between the shareholders and the directors and managers as a long-term contract under which the shareholders have a right of unilateral renegotiation. Indeed, shareholders enjoy the right to both remove incumbents and rapidly exit through the financial markets, which may trigger a change in control. Assuming that market prices aggregate information effectively, shareholder advocates view these institutional features as providing both an efficient ex post response to mismanagement, as signaled by a drop in stock performance, and beneficial ex ante disciplinary effects. (25) However, this account of market mechanisms ignores the possibility that current market prices may...