CFA Institute Journal Review 01 Feb 2013 Volume 43 Issue 1
The Vote Is Cast: The Effect of Corporate Governance on Shareholder Value (Digest Summary)
Journal of Finance
The authors find that on the day of a vote, the passage of a shareholder-sponsored governance proposal produces an abnormal return of 1.3% relative to the failure of a proposal. The one-week cumulative abnormal return is 2.4%. They also find that implementing a governance-type proposal can increase the market value by $600 million of the average firm in their sample.
Previous literature has suggested that firms with strong shareholder rights experience large and positive abnormal returns. But quantifying the abnormal returns has been difficult because of the heterogeneity of firm governance structures and issues regarding the extent to which such preexisting governance structures have been priced prior to the observation period. The authors formulate a method to identify the effects of shareholder governance proposals on share price and discover that the passage of shareholder-sponsored proposals affects managerial behavior.
They find that successful proposals to reduce antitakeover provisions translate into a quantifiable increase in shareholder value and a reduction in acquisitions and capital expenditures in the following years. These effects may be the result of the increased expectations of takeover premiums and/or the increased possibility of a takeover, which may impose greater managerial discipline.
How Is This Research Useful to Practitioners?
The authors observe that the average abnormal one-day return for successful shareholder proposals is 1.3% and the seven-day cumulative abnormal return is 2.4%. Most of the effect comes from proposals to reduce antitakeover provisions.
More than half of the relevant proposals are G-Index proposals. The G-Index is an index of 24 antitakeover provisions and is a proxy for shareholder rights. The higher the G-Index, the lower the shareholder rights; the more entrenched the managers, the more insulated they are from takeover threats. Most of the sampled G-Index-type proposals are designed either to repeal a classified board or to eliminate a poison pill. Most of the proposals that are not part of the G-Index are designed either to expense stock options or to elect directors through a majority vote.
Firms with high levels of concentrated institutional ownership that pass G-Index-type proposals exhibit a 2.1% same-day return and a seven-day cumulative abnormal return of 4.2%. This return is 1.76 times the average seven-day cumulative gain, perhaps because these firms are more closely monitored.
The authors find that as firms’ G-Index scores are reduced, the passage of proposals to drop additional G-Index provisions exhibits a diminishing abnormal return. One possible reason is that firms with low G-Index scores have takeover barriers that are already low. Proposals by institutional shareholder activists also exhibit above-average abnormal returns, as do firms that are currently engaging in shareholder activism (two or more shareholder proposals in the previous two meetings).
Finally, the authors observe increased abnormal returns for the past proposals of firms with high R&D expenses. Shareholder proposals that successfully pass translate into a reduction in acquisitions and capital expenditures in subsequent years. The book-to-market value and Tobin’s q also show increases in the years after the vote, indicating a change in managerial behavior.
How Did the Authors Conduct This Research?
The authors test for abnormal returns after shareholder proposals pass. There are two basic challenges with the regression they choose: (1) Expectations about the outcome of the vote may have been priced ex ante into the firm’s market value, and (2) heterogeneous firm characteristics can have an effect on vote outcome. To deal with these challenges, the authors use a modified discontinuity regression.
A discontinuity regression samples only those votes that pass or fail by a slim margin (“close-call” votes). The unpredictable nature of close-call votes ensures that vote expectations were not incorporated ex ante into the price. The authors then modify the sample data on each side of the close-call threshold with a polynomial factor to nullify any correlations between firm characteristics and vote outcomes. The discontinuity regression and the polynomial factor allow them to randomize the data and to isolate a clean relationship between a passed proposal and an abnormal return.
Passing a proposal is not the same as implementing a proposal, but passage provides a discrete change in the probability of its implementation. The authors’ final model adds parameters to account for the dynamic effect that a passed proposal in the focal meeting has on proposals in subsequent meetings. The model also aggregates the votes to account for instances of multiple votes per firm meeting.
Shareholder proposals from 1997 to 2007 are obtained from Riskmetrics on S&P 1500 Index firms plus 500 widely held firms. Approximately 4,000 proposals were made at annual shareholder meetings for 948 firms. From these, the authors select 910 close-call proposals (within +10% or –10% of the passage threshold). They calculate abnormal returns using price data from CRSP and incorporate Fama–French and Carhart factors to mitigate the small-company, value, and momentum effects on stock returns.
Although the authors find that passed proposals have little effect on firm earnings, advocates of good corporate governance now have additional evidence that improved shareholder rights produce quantifiable positive market and agency effects. The findings may persuade investors to consider firms with good corporate governance structures because of positive long-term effects on managerial spending. The authors present an elegant exposition of their discontinuity regression, which is a method that can be used for many different types of event studies.