How Proxy Contests Affect Corporate Policy

Activist investors that believe an agency problem exists between shareholders and management may attempt a proxy contest aimed at specific issues or control of the board.  Research shows that, in anticipation of a proxy contest, managers make significant adjustments in favor of shareholders on a wide array of corporate policies, including R&D expenditures, capital expenditures, leverage, dividends, management compensation, and CEO tenure.  Furthermore, Brav, Jiang, Partnoy, and Thomas (2008) and Klein and Zur (2009) document that activist hedge funds often use a proxy threat to get what they want from incumbent managers. From this perspective, the threat of a proxy contest may be seen as a method for ensuring alignment between board policies and shareholders.

While this evidence suggests a proxy threat can be effective against agency problems, it is not conclusive. The paradox is that, if proxy contests are so effective, why aren’t there more of them? Further complicating the paradox is that proxy contests are not only rare, but they rarely improve the performance of targeted firms as much as expected, which undermines their reputation as effective disciplinary measures.  For instance, Ikenberry and Lakonishok (1993) find that, following proxy contests, operating performance, on average, drops and cash dividends show little if any improvement.

In our recent paper, we attempt to reconcile the divergent perspectives on how proxy contests affect corporate governance. We investigate the impact of proxy contests on board reaction to perceived agency problems and argue that the disciplinary effects of a proxy contest are driven by the credibility of a proxy threat. Incumbents pursue policies favorable to shareholders if they believe they will lose a proxy contest but will otherwise not take a proxy threat into account, such as when the firm’s current performance is good (Cai, Garner, and Walkling, 2009) or there is no well-organized block of shareholders like hedge funds or former insiders to push a proxy contest through (Kahan and Rock, 2010).  In other words, when managers perceive that the likelihood of loss — whether of their reputations, jobs, or control — in a proxy contest is substantial, they are more likely to comply with dissidents’ demands and adjust corporate policies to avoid the contest or win should one materialize.

To see how the threat of losing a proxy contest may for managers be as important as, or more important than, the threat of facing a proxy contest, consider the situation facing Lawndale Capital Management LLC and P&F Industries, Inc (PFIN) in 2010.  The incumbent managers of P&F industries collectively owned 37.55 percent of the voting stock and had the protections of a staggered board and one person in the combined position of CEO and chairman. Even though dissidents were clearly upset about the “excessive compensation paid to PFIN’s Chairman and CEO” (13D filed by Lawndale Capital Management on P&F Industries in February 2010), the managers rejected the main proposals submitted by the dissidents, who owned 7.42 percent of the voting stock – one-fifth of the managers’ voting power.  The high probability of being targeted in – but not losing – a proxy contest was not enough to prompt the managers to compromise by adjusting corporate policies.

We also investigate whether managers continue to promote the interests of shareholders after a proxy threat no longer exists. This research question is motivated by the fact that a short-term disequilibrium in a firm arising from internal or external forces may lead to a temporary power imbalance between managers and stakeholders. Though managers may change corporate strategy in response to a proxy threat or a shift in the balance of power, they can, if they prevail, reverse the policy changes when power shifts back to them.

These predictions have not been tested in the context of proxy contest, and we do so using a sample of 169 proxy contests between 1988 and 2009.  Collecting data from several sources, we make sure that our estimations control for firm stock performance, accounting performance, institutional ownership, corporate governance structure, and other factors.  We find evidence that the probability of managers facing a proxy contest influences corporate capital structure, dividend payout, and acquisition policies in a manner that alleviates agency problems.

These findings support the view that proxy contests play a disciplinary role in aligning the interests of shareholders and managers, consistent with Fos (2015). We further show that the disciplinary role of proxy contests is both temporary and driven by the credibility of a proxy threat. Our findings reveal that once the credibility of a proxy contest threat is controlled for, a proxy fight alone does not significantly discipline corporate policies.  An increase in the credibility of a proxy threat, on the other hand, leads to more leverage, greater dividends, and fewer acquisitions. We infer from these results that it is not the likelihood of a proxy contest per se, but rather the credibility of a proxy threat, that leads to significant changes in corporate policies in favor of existing shareholders. More important, we find that incumbent managers reverse the policy changes at the expense of shareholders when the perceived credibility of a proxy threat is eliminated or subsides.

This post comes to us from professors Jian Huang at Towson University, and Gökhan Torna at the State University of New York at Stony Brook. It is based on their recent paper, “Anticipating Loss from Proxy Contests”, available here.