The Shareholder Value Of Empowered Boards
University of Notre Dame
Seth Klarman On Margin Of Safety Investing
This is part nine of a ten-part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m taking a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers. All of the material Read More
University of Arizona – James E. Rogers College of Law; Northwestern University – School of Law; IAST – Fondation Jean-Jacques Laffont – TSE ; University of Toulouse 1 – Industrial Economic Institute (IDEI)
In the last decade, the balance of power between shareholders and boards has shifted dramatically. Changes in both the marketplace and the legal landscape governing it have turned the call for empowered shareholders into a new reality. Correspondingly, the authority that boards of directors have historically held in U.S. corporate law has been eroded. Empirical studies associating staggered boards with lower firm value have been interpreted to favor this shift of authority, supporting the view that protecting boards from shareholder pressure is detrimental to shareholder interests.
This Article presents 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. Employing a unique and comprehensive dataset covering thirty-four years of board staggering and destaggering decisions — from 1978 to 2011 — we show that staggered boards are associated with a statistically and economically significant increase in firm value. In light of these novel empirical results, we then show theoretically that a corporate model with staggered boards emerges as a rational institutional response to market imperfections that are more complex and more significant than shareholder advocates have realized. Boards that retain their historical authority – empowered boards – benefit, rather than hurt, shareholders. This Article concludes with a normative proposal to revitalize the authority of U.S. boards.
The Shareholder Value Of Empowered Boards – Introduction
At the turn of the nineteenth century, America invented the most successful business model of all time: corporate capitalism. At the center of that economic success was the “management corporation.” As the name suggests, management corporations revolved around managers-salaried, professional executives—brought in to “hire capital from the investor.” Underlying this arrangement was a “tacit societal consensus” that corporate growth took priority over corporate profits, as long as managers could compensate their shareholders with stable dividends-a goal they successfully accomplished. 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 U.K., American shareholders have historically been relegated to the role of spectators, with only a limited capacity to intervene in corporate affairs.
However, starting in the late 1970s through the early 1980s, and with increasing intensity in the 2000s, a competing corporate model has gained popularity. This model is conceptually built on the idea of “shareholder empowerment,” with enhanced shareholder governance rights, and correspondingly weakened board authority. 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.
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, rather than annually, as under unitary board structures. 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 to protect board authority against short-term shareholder and market pressure, thereby promoting long-term value creation. 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. 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. In light of this evidence, they have concluded that “insulation advocates”-as they have dubbed defendants of board authority—should surrender to the view that enhancing shareholder power moves corporate governance in an efficient direction, unless they can expose flaws in current empirical research and “counter it with research that avoids such flaws.”
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