STANFORD GRADUATE SCHOOL OF BUSINESS — Whose job is it to oversee corporate governance if a board fails at its duties? Historically, the onus has fallen on large shareholders to engage in acts of "shareholder activism" such as takeovers, proxy fights, and shareholder proposals when the interests of management and shareholders diverge.
Yet rather than take part in such costly and risky actions, many large shareholders—who increasingly are institutional investors such as pension funds and mutual funds—prefer to employ what is known as the "Wall Street Walk," and sell their shares outright when they are unhappy with management rather than become active and attempt to impact decisions from within the firm. Although in the past many considered this action a form of abrogating responsibility for corporate governance, new research by Anat Admati and Paul Pfleiderer argues that rather than sidestepping a difficult issue, the threat of a major shareholder selling—with its potential to cause a fall in the stock's price—can significantly impact the behavior of top management of the firm in question.
"There are more ways than have been previously considered that trading and governance can interact," said Admati, the Business School's Joseph McDonald Professor of Finance and Economics and a professor, by courtesy, of management science and engineering in the Stanford School of Engineering.
Since the Wall Street Walk (or "voting with your feet") seems to be an alternative to overt activism, it has traditionally been perceived as inconsistent with activism. This has led some observers to argue that a market that allows potentially active shareholders to exit easily and therefore opt out of monitoring and governance activities actually works against effective corporate governance.
What seems to have been not as widely recognized is the fact that the Walk itself can be a form of shareholder activism. "Some people say that the Wall Street Walk is inconsistent with shareholder interests, but we actually believe that walking, or the threat of walking, can actually discipline managers and increase firm value," said Pfleiderer, the Business School's C.O.G. Miller Distinguished Professor of Finance and a professor, by courtesy, of Law.
If the possibility of exit exerts disciplining impact on managers, then regulatory changes that would make it harder for large shareholders to sell could get in the way of this type of shareholder activism.
Precisely what role large shareholders should play in improving corporate performance has been discussed extensively over the past two decades, and Admati and Pfleiderer—who have conducted a great deal of research together—have been interested for some time in the issue of corporate governance and shareholder activism. "Given the events of the past few years, corporate governance has become important not only for academic finance but for the greater business community as well," said Pfleiderer.
Although institutional investors such as pension funds and mutual funds hold a substantial and increasing fraction of shares in U.S. public companies, such large shareholders typically play a limited role in overt forms of shareholder activism such as takeovers, proxy fights, strategic voting, and shareholder proposals.
"One reason for this is that many forms of shareholder activism are both risky and costly to the active shareholders, and those shareholders may realize only a relatively small fraction of the benefits," said Admati. "In other words, you have the classic 'free rider' problem."
But people have worried that if larger shareholders, not wanting to invest the resources needed to improve the firm, just decide to abandon ship and walk away, then "that would mean that corporate governance was even worse," said Admati. However, this new research reaches the opposite conclusion.
"In fact, the threat to sell actually sounds more credible than the threat to mount a proxy fight, because a proxy fight is a costly and risky thing for a large shareholder," said Admati.
One way the model works is that a large shareholder obtains some information that the market does not have—for example, knowledge that a manager intends to purchase costly liability insurance for the firm. Based on that information, the large shareholder threatens to leave the firm, which in turn causes management to fear that the stock price would drop. Since most managers' compensation depends at least in part on share price, this fear would theoretically motivate managers to take actions that were more in the interest of shareholders.
What was surprising, said Admati, is that the act of walking—or the threat of walking—can be more or less effective (and at times completely ineffective) depending on the precise type of perceived management problem and on the type of information that the large shareholder has.
Admati and Pfleiderer's paper makes a distinction between situations in which shareholders are trying to encourage management to take an action they deem beneficial, such as taking a bold research initiative, and situations where the conflict of interest involves shareholders attempting to prevent an action deemed "bad" for the investors, such as spending money on a corporate jet.
Calling these the "good action" and "bad action" scenarios, respectively, Admati says that although they may seem to be mirror images of each other, in fact whether and how effective the threat of exit is in disciplining managers can be dramatically different in the two scenarios. "Exit can be a form of discipline, but it works sometimes in rather subtle ways, so you have to understand the context to know if and when it will work," agreed Pfleiderer.
The implications of this study are potentially important in formulating regulatory policies meant to improve corporate governance. For starters, people should be very cautious about recommendations that attempt to improve corporate governance by making it harder for large shareholders to trade their holdings. "By imposing transaction taxes or other kinds of impediments to trade, this mechanism of threatening to walk—which we've seen can be helpful—would be rendered useless," said Pfleiderer.