Center For The Study of Financial Regulation

Summer 2011 - Issue NO.6

Should the SEC Require Options Exchanges to Produce Monthly Execution Quality Statistics?

by Jonathan Cohn, Assistant Professor, McCombs School of Business, University of Texas.


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Would shareholders of publicly traded companies benefit from being able to exert more control over the companies they own? This question has important regulatory implica­tions. For example, regulation to protect shareholders may be needed if entrenched corporate managers pursue perquisites and other forms of self-enrichment at the expense of shareholder value maximization. The potential for such “agency conflict” must be weighed, though, against the fact that a company’s management is likely to possess relevant informa­tion that shareholders lack, and may therefore be better-positioned than shareholders to make the company’s important decisions.

Our study provides evidence on the shareholder value conse­quences of changes in the extent of shareholder control. Specifically, It analyzes stock price responses to news substantially affecting expecta­tions about the cost to shareholders of exercising control through proxy contests. At present, a shareholder seeking to nominate directors to a company’s board to run against man­agement’s own nominees must typi­cally send out his or her own proxy ballot to shareholders to solicit votes, a costly process. In 2010, the SEC passed a “proxy access” rule (which has yet to be implemented) guar­anteeing shareholders the right to nominate directors on the company’s own proxy ballot. This rule substan­tially lowers the cost to shareholders of exercising control through a proxy contest. We conduct an event study in which we examine how different stocks responded to news relating to the details of the SEC’s proxy access rule as it was evolving.

The biggest challenge in trying to conduct such a study is that the market may well have anticipated any change to the proxy access rules before the SEC actually announced it. This makes it difficult to inter­pret stock price responses to the announcement of the change. While this is a challenge in conducting event studies in general, it is particu­larly problematic here. We learned from conversations with current and former SEC staff that the SEC regularly consults with affected par­ties, including investors and investor groups, while in the process of con­sidering rule changes. Fortunately, the politics leading up to passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act allow us to get around this problem.

Early the evening of June 16, 2010, Senator Dodd made a proposal to the Dodd-Frank Bill that would have required the SEC to mandate that investors hold at least 5 per­cent of a firm’s stock for at least two consecutive years before gain­ing the right to nominate directors on the company’s proxy ballot. This contrasts with the SEC’s proposed minimum holding requirements at the time of 5 percent for small firms, 3 percent for medium-sized firms, and 1 percent for large firms. Senator Dodd’s proposal would therefore have substantially increased the hurdle to proxy access for medium-sized firms and, even more so, for large firms. Senator Dodd’s proposal was dropped in late night negotiations between the House and Senate to finalize the bill on June 24, 2010. We study returns around these two “events,” which not only did not originate with the SEC, but actually appeared to take the SEC by surprise, and are therefore unlikely to have been anticipated by the stock market.

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We compare the returns around these events of firms with sharehold­ers who are likely willing to initiate proxy contests (i.e., activist investors) and those without such shareholders. This approach allows us to control for aggregate market movements, which should affect both groups of firms. The underlying logic is that few investors are willing to initiate proxy contests, and all variants of the proxy access rule that were proposed had some minimum holding period requirement before an investor could nominate directors on a company’s proxy ballot. Thus, events relating to proxy access should matter much more for firms that already had an activist investor as a shareholder at the time than for those that didn’t.

We identify activist investors using a third-party classification, sharkrepellent.net’s SharkWatch50 list of activists. Consistent with the stock market viewing a reduction in shareholder control unfavorably, we find that the stocks of firms with SharkWatch50 investors as sharehold­ers substantially underperformed those without in the window imme­diately surrounding Senator Dodd’s proposal on June 16. The difference was substantial: 49 basis points for medium-sized firms and 85 basis points for large firms. Consistent with the stock market viewing an increase in shareholder control favorably, we find that the stocks of firms with SharkWatch50 investors as sharehold­ers outperformed those without in the window immediately surrounding the dropping of Sen. Dodd’s proposal. The difference here was 43 basis points for medium-sized firms and 76 basis points for large firms.

We supplement our analysis by examining returns around the SEC’s announcement of its final proxy access rule on Aug. 25, 2010. The announcement itself was clearly an­ticipated. However, the final rule re­quired investors to hold a company’s stock for a minimum of three years before being able to nominate direc­tors on its proxy ballot instead of the two years that news articles on Aug. 24 suggest were likely anticipated. We find evidence consistent with the market disliking this increase in the hurdle to proxy access. Firms with SharkWatch50 investors who would have held the firm’s stock for more than two years but less than three years at the relevant date for submit­ting proxy materials underperformed by 43 basis points in the narrow window around the announcement of the final rule.

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While proxy access may allow shareholders to more easily challenge managers who are failing to maxi­mize shareholder value, one concern that the business lobby has expressed is that it may also allow sharehold­ers with motives other than value maximization to influence compa­nies’ behavior. One set of investors that might have such motives are union- and pension-affiliated funds. Supporting the business lobby’s concerns, we find that firms that have been targeted with a shareholder proposal by these funds in the recent past underperformed in the window around the dropping of Senator Dodd’s proposal, which lowered the hurdle to proxy access. However, we do not find that these firms outper­form in response to Senator Dodd’s proposal itself. So the evidence here is not definitive.

To sum up, our study indicates that the stock market responds favor­ably to expectations that sharehold­ers will gain more control via proxy access. From a regulatory standpoint, the results suggest that managers currently may have too much power vis-à-vis shareholders, and that poli­cies aimed at protecting shareholders are likely to lead to an increase in the values of the companies they own.

Reference

1. Cohn, Jonathan, Stu Gillan, and Jay Hartzell, 2011, On the Optimality of Shareholder Control: Evidence from the Dodd-Frank Financial Reform Act, Working paper, University of Texas.

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