The Risks and Rewards of Shareholder Voting

[Editor’s Note: This and the following piece offer a point/counterpoint on shareholder voting.] The SEC’s recently proposed rules on proxy advisers and shareholder proposals have made shareholder voting one of the most prominently debated corporate governance issues ever.  In a new article, “The Risks and Rewards of Shareholder Voting,” I seek to shed more light on the role of shareholder voting in the governance of public companies.

Shareholders Are Notoriously Uninformed

Shareholder voting allows shareholders to participate in corporate decisions, but very few public company decisions are based on it.  This is understandable, because shareholder voting suffers from a collective action problem that makes it notoriously uninformed. According to Frank Easterbrook and Daniel Fischel, “When many are entitled to vote, none of the voters expects his votes to decide the contest. Consequently none of the voters has the appropriate incentive at the margin to study the firm’s affairs and vote intelligently.” As stated by Jill Fisch, Asaf Hamdani, and Steven Davidoff Solomon, “This collective action problem, however, characterizes all institutional investor engagement in corporate governance – by both active and passive funds. Costly steps that investors may take to improve the performance of companies in their portfolio benefit all the investors that hold shares of these companies.”

The collective action problem results in a low percentage of retail investors casting their ballots at stockholder meetings.  Institutional investors are also affected, but in a different way.  Because of the collective action problem, the resources they are willing to spend on becoming informed on every vote is minimal.  Such an information deficit cannot be mitigated by receiving voting recommendations from resource constrained third parties such as proxy advisers.

The Objective of Shareholder Voting and the Law

According to Vice Chancellor Travis Laster of the Delaware Chancery Court and quoted with approval by the Delaware Supreme Court, “What legitimizes the stockholder vote as a decision-making mechanism is the premise that stockholders with economic ownership are expressing their collective view as to whether a particular course of action serves the corporate goal of stockholder [shareholder] wealth maximization.”  This means that the courts expect shareholder voting to aim for maximizing shareholder wealth, which is consistent with what I have argued in other writings.  The overwhelming majority of the more than 100 million retail investors in the United States who buy voting stock indirectly through investment advisers or public pension funds “simply want to earn the highest risk adjusted financial return possible.”  Moreover, with the exception of funds that sacrifice financial return for social impact, investment advisers that vote to maximize shareholder wealth come closest to representing the preferences of their retail investors or beneficiaries.

However, even though the general consensus is that institutional investors have a fiduciary duty to vote all of their proxies, the enforcement of shareholder wealth maximization as part of that fiduciary duty is absent from corporate law (despite Vice Chancellor Laster’s compelling dicta), the common law of trusts when applied to public pension funds, the Investment Advisers Act of 1940, and ERISA.  This means that institutional investors may be tempted to utilize shareholder voting for their own purposes (enhancing the welfare of the institutional investor or its managers) and not for maximizing the wealth of its beneficial investors or public pension fund beneficiaries.

Shareholder Voting Provides Value

Corporate governance arrangements appear to acknowledge the problems with shareholder voting.  The default rule under corporate law, for public companies and others, is to leave decisions to those who are most informed about the company: its directors and management. Nevertheless, even with its defects, there is significant value in shareholder voting if it is used sparingly and wisely.  As I have written elsewhere, shareholder voting “shines light on corporate decision-making, moving decision-making away from the private confines of the boardroom and into the public arena where the board’s approach on how to proceed can be debated by those who have the authority to vote. According to Leo Strine, Chief Justice of the Delaware Supreme Court, shareholder voting, even in its limited scope, is one of the components of corporate law that encourages the board to view decision-making through the lens of shareholder interests.” As Strine also made clear, directors must focus on shareholder interests or else be the subject of a shareholder suit for breach of their fiduciary duties.

Obviously, shareholder voting also shines light on shareholder interests and helps realize corporate law’s shareholder-centric objective.  But, as I have also written elsewhere, “[w]hen shareholders vote they are also participating, alongside the board, in corporate decision-making. That is, they are temporarily transformed into a locus of corporate authority that rivals the authority of the board.” This co-decision-making function is what distinguishes shareholder voting from the other tools corporate law uses to make sure the board of directors is focused on the interests of shareholders.  The value provided by shareholder voting applies to a controlled company as well.  Without shareholder voting a controlling shareholder would have no recourse but to file a lawsuit based on a breach of fiduciary duty in order to get the board to take into consideration its interests as the controller.

Implications of Shareholder Voting

The points raised  in the prior discussion would have a number of implications for the corporate governance of public companies.

Shareholder Proposals: The SEC’s recently proposed rule changes for shareholder proposals, which according to the SEC’s own analysis will most likely significantly reduce the number of shareholder proposals submitted to public companies, is a reasonable reaction to the risks of shareholder voting.  This is because the more shareholder proposals submitted to a public company, the more likely companies will make decisions based on shareholder voting.

Substituting the Business Judgment Rule for Entire Fairness: The limitations of shareholder voting also have implications for the development of corporate law.  For example, certain transactions involving controlling shareholders, such as freeze-out merger transactions, are subject to the entire fairness standard of review unless certain procedures are implemented.  Then, the more lenient business judgment rule would apply.  Starting with Kahn v. M&F Worldwide Corp, this approach has expanded quickly over time.

The problem with Delaware’s application of Kahn is that it is premised on the misunderstanding that institutional shareholders are informed voters and perhaps, if the dicta of Vice Chancellor Laster still holds, that shareholder voting is only about shareholder wealth maximization.  While it is beyond the scope of this article to opine on whether Kahn was incorrectly decided, the arguments presented here and in my article do support one reason why this might be the case.

Quality Voting versus Tenured Voting: Some corporate governance scholars have advocated the use of “tenure voting” to address  “short-termism.”  Tenure voting allows shareholders more votes the longer they hold the company’s stock.  However, tenure voting ignores the problems of institutional shareholders not being informed and that voting may potentially represent the preferences of the institutional investors, not the preferences of the beneficial investors or pension fund beneficiaries.

A better option, though not without practical difficulties, is what Professor Lawrence Cunningham calls “quality voting.” Quality voting apportions increased voting power to shareholders who not only hold a company’s shares for long periods but also investment in a small number of companies.  The argument is that longevity and concentration serve as proxies for being informed, representing the interests of beneficial shareholders, and looking out for the long-term interests of the company.

Composition of Shareholders and Its Impact on Share Price: A final implication, and one that is admittedly speculative, is that the greater the composition of shareholders with voting objectives that do not match shareholder wealth maximization or are indifferent to that objective, the more an equity analyst may penalize the company in terms of valuation, putting downward pressure on the value of the company’s stock price.  For example, an equity analyst may mark down her estimated value of a firm’s stock when institutional investors are relatively overrepresented and retail investors are underrepresented.

Conclusion

Shareholder voting is a double-edged sword.  It is a necessary component of corporate governance, but it also has many risks.  It is an inefficient way to make decisions at a public company. Therefore, from a global perspective, regulators, shareholders, and managers should be extremely wary of any proposal to increase the use of shareholder voting as a decision-making tool.

This post comes to us from Bernard S. Sharfman, a member of the Journal of Corporation Law’s editorial advisory board. It is based on his article, “The Risks and Rewards of Shareholder Voting,” forthcoming in the SMU Law Review and available here.