27 Oct. 2013 | Comments (0)
- According to Jonathan Macey and Elaine Buckberg in their 2009 “Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation,” there are “[s]everal studies [that] establish that when dissident directors win board seats, those firms underperform peers by 19 percent to 40 percent over the two years following the proxy contest.”
- One of those studies is David Ikenberry and Josef Lakonishok’s “Corporate Governance Through the Proxy Contest” (published in the Journal of Business in 1993), which reviewed 97 director election contests during a 20-year period in order to examine the long-term performance of targeted firms subsequent to a proxy contest. Their findings were striking: “When the incumbent board members successfully retain all board seats, cumulative abnormal returns are not significantly different from zero over the next 5 years. Yet, in proxy contests where dissidents obtain one or more seats, abnormal returns following resolution of the contest are significantly negative. Two years following the contest, the cumulative abnormal return has declined by more than 20 percent. The operating performance of these same firms during the postcontest period is also generally consistent with the pattern observed using stock returns.”
- Michael Fleming obtained similar results when looking at instances where a dissident obtains board representation in “New Evidence on the Effectiveness of the Proxy Mechanism,” a 1995 Federal Reserve Bank of New York research paper. Reviewing a sample of 106 threatened proxy contests between 1977 and 1988, Fleming found statistically significant negative returns of -19.4 percent in the 24 months following the announcement of a contested election for the 65 firms in his sample where dissidents won board seats – either as a result of a shareholder vote or a settlement. Fleming found that the majority of gains resulting from threatened proxy contests were “attributable to firms which [we]re acquired within one year of the outcome of the proxy contest,” suggesting that the gains were due to payment of a takeover premium (consistent with Greenwood and Schor’s findings described below), not from operating improvements or governance changes.
- Lisa Borstadt and Thomas Zwirlein found very similar results in “The Efficient Monitoring Role of Proxy Contests: An Empirical Analysis of Post-Contest Control Changes and Firm Performance,” published in Financial Management in 1992. These authors examined 142 exchange-traded firms involved in proxy contests for board representation over a 24-year period. They found the following: “A dissident victory in the proxy contest does not necessarily translate into superior corporate performance. Positive abnormal returns over the proxy contest period are realized by firms in which the dissidents win the proxy contest and the firm is subsequently taken over. In contrast, no abnormal performance over the contest period is observed for the firms in which the dissidents win but the firm is not subsequently taken over. For these firms, large negative (although insignificant) cumulative returns are observed in the postcontest period.”
- In “Investor Activism and Takeovers,” published in the Journal of Financial Economics in 2009, Robin M. Greenwood and Michael Schor examined Schedule 13D filings by portfolio investors between 1993 and 2006 to investigate the effect of activist interventions on stock returns. They found the following: “[A]ctivism targets earn high returns primarily when they are eventually taken over. However, the majority of activism targets are not acquired and these firms earn average abnormal returns that are not statistically distinguishable from zero. . . . Thus, the returns associated with activism are largely explained by the ability of activists to force target firms into a takeover, thereby collecting a takeover premium.”
- In “Pension Fund Activism and Firm Performance,” published in the Journal of Financial and Quantitative Analysis in 1996, Sunil Wahal reviewed 356 “targetings” by the nine most active funds between 1987 and 1993. “Targetings” included both proxy proposals and nonproxy targeting, and were typically initiated by sending a letter to the target firm (either publicly or privately) followed by a telephone call from the activist fund. Wahal found that, while pension funds “are reasonably successful in changing the governance structure of targeted firms,” these changes have no impact on stock performance. According to Wahal, “targeting announcement abnormal returns are not reliably different from zero,” and “[t]he long-term abnormal stock price performance of targeted firms is negative prior to targeting and still is negative after targeting.” Wahal also found that “accounting measures of performance do not suggest improvements in operating or net income either; accounting measures of performance also are negative prior to and after targeting.”
- Two studies released by the U.S. Chamber of Commerce in partnership with Navigant Consulting reviewed shareholder proxy proposals between 2002-2008 and 2009-2012, respectively, for impact on firm performance. The studies, published in May 2009 and May 2013, both focused on shareholder proposals that were identified as “Key Votes” by the AFL-CIO in annual surveys during the respective time periods, including proposals reflecting board declassifications, proxy access and director removal policies. In the first study, “Analysis of the Wealth Effects of Shareholder Proposals – Volume II,” Joao Dos Santos and Chen Song reviewed 166 shareholder proposals between 2002-2008 and found “no evidence of a statistically significant overall short-run or long-run improvement and some indication of a long-run decrease in market value for the firms in our sample.” In the second study, “Analysis of the Wealth Effects of Shareholder Proposals – Volume III,” which reviewed 97 shareholder proposals between 2009-2012, Allan T. Ingraham and Anna Koyfman came to similar conclusions: “We . . . find no conclusive or pervasive evidence that the shareholder proposals assessed in this study improve firm value or result in an economic benefit to pension plans and plan participants. Given that the proxy process imposes costs on both firms and shareholders, and given that there are no proven benefits in terms of corporate performance, the overall net benefit of these initiatives is likely negative.”
- Andrew K. Prevost and Ramesh P. Rao studied the impact of shareholder activism by public pension funds in their paper “Of What Value Are Shareholder Proposals Sponsored by Public Pension Funds?” (published in the Journal of Business in 2000), examining a total of 73 firms that received shareholder proposals during the period of 1988-1994. They came to the following conclusions: “Firms that are subject to shareholder proposals only once during the sample period experience transitory declines in returns, but firms that are subject to repeat shareholder proposals experience permanent declines in market returns. . . . Long-term changes in operating performance corroborate the event study results: firms targeted only once exhibit positive but insignificant long-term results, while those targeted repeatedly show strong declining performance.”
- Jonathan M. Karpoff, Paul H. Malatesta and Ralph A. Walkling reviewed 522 shareholder proposals at 269 companies between 1986 and 1990 to determine the impact of shareholder proposals on firm performance in “Corporate Governance and Shareholder Initiatives: Empirical Evidence,” published in the Journal of Financial Economics in 1996. After finding that “proposals are targeted at poorly performing firms,” they concluded that, notwithstanding this fact, the “average effect of shareholder corporate governance proposals on stock values is close to, and not significantly different from, zero.” In fact, “[s]ales growth declines for firms that receive proposals in relation to sales growth for control firms,” “[c]hanges in operating return on sales are not significantly larger for proposal firms than their controls, and are not significantly related to the persistence or intensity of proposal pressure, or to the sponsors’ identity,” and “[c]hange in operating ROA are not related to the pressure’s intensity or sponsors’ identity.”
- In “Less is More: Making Institutional Shareholder Activism a Valuable Mechanism of Corporate Governance,” published in the Yale Journal on Regulation in 2001, Yale Law School professor Roberta Romano conducted a review of the corporate finance literature on institutional investors’ corporate governance activities, involving seven different empirical studies and a total of over 4,500 individual shareholder proposals. She found that the shareholder proposals had “little or no effect on targeted firms’ performance” over the time periods considered in the studies and proposed that improvements might be achieved if the rules were revised “to require proposal sponsors either to incur the full cost of a losing proposal or a substantial part of the cost.”
- It is particularly noteworthy that CalSTRS, one of the major public employee pension funds and one of the leaders in proxy voting and investing in activist hedge funds, has recently reported that its aggregate investments in activist funds as of October 2012 trailed the United States public equity market, as shown by this chart from its annual report.
- Approaching the question from another perspective, William C. Johnson, Jonathan M. Karpoff and Sangho Yi investigated the impact of takeover defenses on firm value in “The Bonding Hypothesis of Takeover Defenses: Evidence from IPO Firms” (April 29, 2013 working paper, available at http://papers.ssrn.com/abstract=1923667). Looking at a sample of 1,219 firms that went public between 1997 and 2005, the authors tested the “bonding hypothesis of takeover defenses” – that is, the theory that “takeover defenses increase the value of managers’ commitments to maintain their promised operating strategy and not to opportunistically exploit their counterparties’ investments in the IPO firm,” which, “in turn, encourages the firm’s counterparties to invest in the business relationship, yielding benefits for the IPO firm.” The authors reported the following findings:
(1) IPO firms deploy more takeover defenses when they have large customers, dependent suppliers, or strategic partners; (2) The IPO firm’s value is positively related to its use of takeover defenses, particularly when it has large customers, dependent suppliers, and/or strategic partners; (3) The IPO firm’s subsequent operating performance is positively related to its use of takeover defenses, particularly when it has large customers, dependent suppliers, and/or strategic partners; (4) When the IPO firm announces its intention to go public, its large customers experience a change in share values that is positively related to the IPO firm’s use of takeover defenses; and (5) After the IPO, the longevity of the IPO firm’s business relationship with its large customer is positively related to its use of takeover defenses.
According to the authors, these results are explained by the fact that “takeover defenses … help to economize on the cost of building and maintaining value-increasing trading relationships between the IPO firm and its counterparties.” As a result, “at IPO firms whose values depend heavily on their relationships with customers, suppliers, and strategic partners, takeover defenses appear to increase value by bonding the IPO firm’s commitment to these relationships.”
- In “The Impact of Antitakeover Amendments on Corporate Financial Performance” (published in The Financial Review in 2001), Mark S. Johnson and Ramesh P. Rao examined a sample of 649 antitakeover amendments adopted between 1979 and 1985 to determine the impact of the passage of antitakeover amendments on firm share price. Contrary to the management entrenchment hypothesis, the authors found that “antitakeover amendments are relatively benign events that do not significantly impact managerial behavior,” and that “antitakeover amendments are not associated with deleterious effects to shareholders in terms of their impact on various fundamental firm performance measures.”
- Jie He and Xuan Tian’s “The Dark Side of Analyst Coverage: The Case of Innovation” (forthcoming in the Journal of Financial Economics) examined the effect of analyst coverage on firm innovation to investigate how the pressure to achieve short-term performance impacts managerial behavior. The short-term pressures exerted by activist investors are often no different than those generated by stock analysts, and in many instances activist investors merely piggyback on stock analyst commentary when they launch attacks. Examining a sample of 25,860 firm-year observations relating to U.S. listed firms during the period of 1993-2005, He and Tian explored the “innovation output” of firms (as measured in terms of the number of (i) patent applications filed in a given year that are eventually granted and (ii) non-self citations each patent receives in subsequent years) in relation to the intensity of analyst coverage (as measured by the average number of earnings forecasts issued for the firm each month). The authors found that “an exogenous average loss of one analyst following a firm causes it to generate 18.2 percent more patents over a three-year window than a similar firm without any decrease in analyst coverage” and that “an exogenous average loss of one analyst following a firm leads it to generate patents receiving 29.4 percent more non-self citations than a similar firm without any decrease in analyst coverage.” He and Tian determined that this evidence “is consistent with the hypothesis that analysts exert too much pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative projects.”
- Natalie Mizik published similar findings in “The Theory and Practice of Myopic Management,” featured in the Journal of Marketing Research in 2010. In this study, Mizik reviewed the operating performance, marketing spending, R&D spending and stock price performance of 6,642 firms between 1986 and 2005 to assess the financial consequences of the practice of cutting marketing and R&D spending to inflate short-term earnings. In order to isolate firms that were potentially engaging in “myopic management,” Mizik filtered for firms that simultaneously reported greater-than-normal profits, lower-than-normal marketing expenses and lower-than-normal R&D spending. Mizik then compared the stock performance of these “potentially myopic” firms against the performance of “nonmyopic” firms. Potentially myopic firms initially experienced much better stock performance than the firms that failed to meet performance expectations. However, after four years, “the portfolio of potentially myopic firms ha[d] a negative return of -15.7 percent, far below the return to the two nonmyopic benchmark portfolios (29.2 percent and 13.3 percent) and the S&P 500 return of 21.6 percent.” Mizik concludes that “[m]yopic management might have some short-lived benefits – it leads to higher current-term earnings and stock price – but it damages the long-term financial performance of the firm because the initial gains are followed by greater negative abnormal returns.”
- Aleksandra Kacperczyk’s “With Greater Power Comes Greater Responsibility?” (published in the Strategic Management Journal in 2009) tested the effect of takeover protection on the amount of corporate attention paid to shareholders and non-shareholding stakeholders, respectively. Looking at a sample of 878 firms between 1991 and 2002, Kacperczyk found that “an exogenous increase in takeover protection leads to higher corporate attention to community and the natural environment, but has no impact on corporate attention to employees, minorities and customers,” and that “firms that increase their attention to stakeholders experience an increase in long-term shareholder value,” measured over the two-year and three-year periods following the increase in takeover protection.
- Other empirical studies have shown that pressure from investors with short investment horizons can influence management to engage in financial misreporting. In “Institutional Ownership and Monitoring: Evidence from Financial Misreporting” (published in the Journal of Corporate Finance in 2010), Natasha Burns, Simi Kedia and Marc Lipson examined a sample of firms that restated their earnings between 1997 and 2002, finding that ownership by “transient institutions” (those with short investment horizons) are positively related with an increase in the likelihood and severity of an accounting restatement. The authors concluded that “[i]t is precisely these institutions, which trade frequently and therefore are likely to focus management attention on short-term reported performance, that provide incentives to manipulate earnings.”
- Another relevant study coming out of the financial crisis examined whether the corporate governance characteristics of banks impacted the likelihood of banks requiring government “bailout” support during the financial crisis. In “Shareholder Empowerment and Bank Bailouts” (a 2012 working paper), Daniel Ferreira, David Kershaw, Tom Kirchmaier and Edmund Schuster created a “management insulation” index ranking the degree of banks’ management insulation based on their charter and by-law provisions and on the provisions of the applicable state corporate law that make it difficult for shareholders to oust management. They found that, in a sample of U.S. commercial banks, banks in which managers are “fully insulated” from shareholders were roughly 19 to 26 percentage points less likely to receive state bailouts than banks whose managers were subject to stronger shareholder rights. The authors explained that “[b]ank shareholders may have incentives to increase risk taking beyond the socially-optimal level” and that, “in search for higher returns, bank shareholders had incentives to push their banks towards less traditional banking activities.”
- In his article “Do Institutional Investors Prefer Near-Term Earnings Over Long-Run Value?” (published in Contemporary Accounting Research in 2001), Brian Bushee examined a sample of 10,380 firm-years between 1980 and 1992 to determine whether institutional investors exhibit preferences for near-term earnings over long-run value. Bushee found that “the level of ownership by institutions with short investment horizons (transient institutions) and by institutions held to stringent fiduciary standards (banks) is positively (negatively) associated with the amount of value in near-term (long-term) earnings.” Bushee found no evidence that banks “myopically price” firms by overweighting short-term earnings potential and underweighting long-term earnings potential. However, in transient institutions “high levels of transient ownership are associated with an over- (under-) weighting of near-term (long-term) expected earnings and a trading strategy based on this finding generates significant abnormal returns. This finding supports the concerns that many corporate managers have about the adverse effects of an ownership base dominated by short-term-focused institutional investors.”
- The above result is consistent with an earlier empirical study by Bushee that examined the influence of shareholder demographics on earnings management by managers. In “The Influence of Institutional Investors on Myopic R&D Investment Behavior,” published in the Accounting Review in 1998, Bushee investigated whether institutional investors create or reduce incentives for corporate managers to reduce investment in research and development to meet short-term earnings goals. Examining a sample of all firm-years between 1983 and 1994 with available data, Bushee found that “a high proportion of ownership by institutions exhibiting transient ownership characteristics (i.e., high portfolio turnover, diversification, and momentum trading) significantly increases the probability that managers reduce R&D to boost earnings.” Bushee believed that “[t]his result supports the widely-argued view that short-term-oriented behavior by institutions creates pressures for managers to sacrifice R&D for the sake of higher current earnings” among those firms with high levels of transient ownership.
- William Pugh, Daniel Page and John Jahera, Jr.’s “Antitakeover Charter Amendments: Effects on Corporate Decisions” (published in the Journal of Financial Research in 1992) tested whether managers adopt a longer-term investment strategy after their firm passes antitakeover charter amendments. Examining a sample of firms that adopted antitakeover charter amendments between 1978 and 1985, the authors found that “firms increase spending on fixed capital as a percentage of both sales and assets the year of passage and for several years thereafter,” and that overall results with respect to R&D expenditures “appear to support the managerial myopia hypothesis.”
- A recent survey of 1,038 board members and executives by McKinsey & Company and the Canada Pension Plan Investment Board found startling levels of short-term orientation among corporate executives. As reported in the Wall Street Journal on May 22, 2013, this study found the following:
- 63 percent of business leaders indicated the pressure on their senior executives to demonstrate strong short-term financial performance has increased in the past five years. - 79 percent of directors and senior executives said they felt the most pressure to demonstrate strong financial performance over a time period of less than two years. Only seven percent said they felt pressure to deliver strong financial performance over a horizon of five or more years. - However, respondents identified innovation and strong financial returns as the top two benefits their company would realize if their senior executives took a longer-term view to business decisions. - Yet, almost half of respondents (44 percent) said that their company's management team currently uses a primary time horizon of less than three years when they conduct a formal review of corporate strategy. 73 percent said this primary time horizon should be more than three years and 11 percent said the horizon should be more than 10 years.
- The McKinsey findings are consistent with an earlier study published in the Financial Analysts Journal in 2006. In “Value Destruction and Financial Reporting Decisions,” John Graham, Campbell Harvey and Shiva Rajgopal described the results of a survey of 401 senior financial executives. Going a step further than the McKinsey study, the authors asked executives if they would be willing to sacrifice long-term value in order to smooth earnings. An “astonishing 78 percent admit[ted] they would sacrifice a small, moderate or large amount of value to achieve a smoother earnings path.”