Speech by SEC Staff:
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a great pleasure to speak at the Rutgers University Conference on "Improving Corporate Governance: Markets vs. Regulation" before such a distinguished group of participants, including a number of very senior former SEC officials. I appreciate the very kind invitation from Michael Crew and my old friend Jim Bicksler from the Rutgers Center, which gives me the opportunity to pull together my thinking about the economic aspects of voting and corporate governance. These are central issues in the regulatory arena, but complicated ones with a multitude of facets and interesting economic dimensions in which markets and legal institutions interact. At the onset of my remarks, I want to emphasize that the views and perspectives that I am expressing today are my own, and not those of our Commissioners or my colleagues on the SEC staff.
2. The Goal of the Firm
I'd like to begin the substance of my remarks by highlighting the objective of the firm. In simplest terms many observers view the objective of the firm as value maximization, i.e., maximizing the overall value of the claims issued by the firm. In classic financial theory under "complete markets" with full risk-sharing the shareholders of the firm unanimously agree that value maximization is the appropriate criteria for firm decision-making. However, absent complete markets there need not be unanimity. In some circumstances voting is viewed as a mechanism to construct aggregate or social preferences of the shareholders of the firm as well as a mechanism to make decisions when the shareholders have different signals or viewpoints about value-maximizing actions by the firm.1 In recent years there has been a lot of attention to agency problems and poor decision-making by senior management-attention to corporate governance, such as voting by the firm's shareholders, can be a way to limit the exercise of private benefits by management. However, "democracy" per se isn't obviously the desired "objective" associated with the corporate governance process, unlike in some other contexts in society.
3. The Free-Rider Problem
The corporate voting mechanism is one of the ways in which shareholders can attempt to influence corporate governance and decision-making. However, the incentive of investors to invest in assessing the appropriate vote is much less than their incentive to form an improved portfolio. In particular, the investors receive all of the benefits of forming a better portfolio, while to the extent that their votes improve the choices made by the companies in which they invest, the investors receive only the portion of the resulting benefit associated with their proportional holdings. Consequently, investors may under-invest in producing information that can help them improve their voting decisions and the production of such information can be viewed as being subject to a "free-rider" problem. This observation is related to the "paradox of voting" in which if the individual's probability of affecting the outcome is sufficiently small, then the individual will not vote given the cost of voting.2 The underinvestment in producing information also ties to some asset managers routinely handling the voting decisions along with its clearance and settlement process, rather than through it portfolio management process.
Several years ago the SEC implemented a requirement that mutual funds disclose their votes on corporate proxy issues, potentially increasing the incentives of funds to invest in decision-relevant information.3 However, the disclosure of votes to investors in the fund is accompanied by disclosure of votes to the remainder of the public. In particular, because the management and interested third parties, such as special interest groups, can observe the fund's vote and potentially punish voting behavior with which it does not approve, there can be effects from the disclosure of the voting decisions by mutual funds that could either improve or diminish the quality of their choices.4
4. Activist Investors
To the extent that the goal is improved corporate decision-making to raise the value of the firm's equity, one solution to the "free-rider" problem is to provide relatively greater power to activist investors. Much of the value to activist investors for improving firm decision-making flows from the enhancement to the value of the toehold shares that they possess. Because of the toehold position, the activist investors may have incentives to increase their influence upon the outcome. This is potentially possible by borrowing shares with voting rights, though the direct purchase of votes is precluded.5 Of course, the cost of acquiring the voting rights may be greater than if outright purchase of votes were allowed. Obviously, if activist investors help to "solve" the governance problem, then tighter restrictions more generally on these activist investors could have "unintended consequences."
One of the central intuitions of financial economists with respect to governance is the potential optimality of "one share, one vote."6 Roughly, this suggests that under certain conditions it is efficient to allocate control rights proportionally to cash flow rights. While I previously suggested that activist investors can help solve governance problems, this depends upon the context. The interests of such activist investors can depart from value maximizing passive investors-for example, the activist investor may be interested in negotiating a greenmail arrangement that would lead to private benefits for itself, so that agency problems would not necessarily be resolved and indeed could be amplified. The lending of shares to activists can lead to "empty voting," reflecting misalignment between the cash flow and control rights, which has been one aspect of the voting process that has been strongly criticized.7
One other facet of the issue of the allocation of control rights is the voting rule used by the firm. Some firms use cumulative voting for electing directors. This tends to be favored by activists and dissidents because it becomes relatively easier for holders of relatively small stakes to win some board seats. On the other hand, some corporate rules specify "supermajority" provisions for some decisions, which make it relatively difficult for outsiders to prevail and can be a device to enhance managerial entrenchment. The voting rules are important ex ante design issues.
5. Proxy-Voting Advisors
Returning more explicitly to the free-rider problem discussed earlier and the impact of the SEC's mutual fund voting disclosure requirements, note that because their voting decisions are publicly revealed, at least some fund organizations may be anxious to improve the quality of their decisions. Scale economies in the supply of voting information may explain the widespread tendency of funds to retain the services of proxy-voting advisors. Indeed, this practice may have been spurred in recent years by mutual fund vote disclosure requirements and/or the microscope on governance and the fiduciary obligations of asset managers. Of course, this in turn creates additional potential distortions. Specifically, is an intermediary well positioned to provide input to the fund making these judgments? Of course, having the same entity offer advice to many investors overcomes some aspects of the public goods or free-rider problem. On the other hand, the incentives of the intermediary advisor are not necessarily aligned with those of the mutual fund organization. Indeed, some intermediaries sell governance advice to the corporate community, so a firm whose issue is being voted upon could also be a client or potential client of the intermediary.
Motivated by this, some of my SEC economist colleagues and I are pursuing an academic style study of the role of proxy advisors in proxy "contests."8 We focus upon contests as compared to more routine proxy votes because there is relatively more uncertainly about the outcome and therefore, relatively greater potential impact and effects associated with the recommendations. In our sample of contests with publicly-announced advisory vote recommendations, we find evidence that recommendations lead to price responses and in particular that the market tends to assess recommendations for the dissident as relatively positive news. That there appears to be a substantial valuation impact in the marketplace at the announcement of a contest recommendation also suggests that the recommendations reflect more than just previously public information or conflicts. In addition, our empirical evidence shows that the recommendations are good predictors of contest outcomes; for example, a recommendation that supports the dissident is a good predictor that the dissident will prevail. The findings are associated with both "influence" and "prediction" hypotheses on the role of the advisor-that the recommendation either influences or helps investors to predict the outcome, or both.
6. Securities Lending
When securities are loaned the borrower typically gets the right to vote the shares. Typically, the lender would forego the right to vote, while retaining the possibility of recalling the loan, if the lender were to later choose to exercise the right to vote. Yet the brokerage firm's bookkeeping mechanism in which retail loans arise often does not distinguish which shares are being loaned and therefore which owners should be denied the vote. In fact, one type of procedure that is sometimes followed is that the votes of borrowed shares are covered by the brokerage firms out of abstentions. Consistent with the paradox of voting small account holders will often abstain. While arguably there is at least a small issue with this procedure, the scale of the problem may not justify redesigning the mechanism. The distinction between shares which have voting rights and those that in principle gave up their rights due to being borrowed is analogous to the distinction that arises between shares that have claim to the firm's dividend vs. claim to the payment of a dividend substitute, which is taxed much more heavily under the current tax rules in which actual dividends potentially qualify for long-term capital gains treatment. This points to two distinct costs for a retail investor of loaning shares-the potential loss of voting privileges (which may or may not have value) and the heavier tax on a dividend substitute compared to the actual dividend. This suggests that a broker should be compensating a shareholder who allows his shares to be loaned for the greater tax liability at least, assuming that the shareholder does not receive a substantial portion of the lending fee.9
In my view, securities' lending itself is important in our marketplace because securities loans facilitate the short-selling of assets, which in turn help protect investors against purchasing overpriced assets. Short-selling can enhance market competition by allowing the pricing process to fully benefit from the insights of investors with negative as well as positive opinions. In fact, investment funds can slightly increase their returns by being ready to loan securities. Of course, typically the returns from lending are slight due to considerable market competition in the lending market.
I previously commented on voting difficulties associated with securities lending and the possibility of "over-voting." Even for "long" investors and customers using "cash" accounts, a fail to deliver can deny the owners the ability to vote the shares. In some circumstances brokers may be able to obtain shares through other means, such as through borrowing, using proprietary shares or buy-ins.
7. Concluding Comments
My broad conclusion is that voting issues are rather complicated. There are scale economies in the information acquisition decision and related free-rider problems. While these are addressed in part by activist investors and through requiring disclosure of mutual fund votes and the use of proxy-voting advisors, such approaches have their own costs. Difficulties in the voting process, such as empty voting and overvoting, arise as a byproduct of some aspects of securities lending procedures and voting rules, but yet securities lending is important to facilitate short-selling and the efficiency of the prices in our marketplace. There are rich and interesting interconnections-as in many contexts how to structure effective regulation may not be obvious, as fixing one aspect of the voting problem may leave others more exposed.
Voting rules themselves are very important as they help define the structure of governance and so are an especially important topic for securities regulators. While there are at least some difficulties in the implementation of voting processes with respect to retail investors, it is not obvious that this has substantial allocative import, especially in light of the inherent free-rider problems that these investors face. Certainly there may be scope for greater disclosure from brokers on their voting procedures and room for greater education of retail investors about voting and governance more generally, but of course close governance contests are not particularly common.10
I welcome your questions.
Alexander, C. R., M. Chen, D. Seppi and C. Spatt, 2006, "The Role of Advisory Services in Proxy Voting," unpublished manuscript.
Christoffersen, S., C. Geczy, D. Musto, and A. Reed, 2007, "Vote Trading and Information Aggregation," Journal of Finance, forthcoming.
Cremers, M. and R. Romano, 2007, "Institutional Investors and Proxy Voting: The Impact of the 2003 Mutual Fund Voting Disclosure Regulation," unpublished manuscript.
Davis, G. and E. H. Kim, 2007, "Business Ties and Proxy Voting by Mutual Funds," Journal of Financial Economics, forthcoming.
Grossman, S. and O. Hart, 1988, "One Share/One Vote and the Market for Corporate Control," Journal of Financial Economics 20, 175-202.
Harris, M. and A. Raviv, 1988, "Corporate Governance: Voting Rights and Majority Rules," Journal of Financial Economics 20, 203-236.
Hu, H. and B. Black, 2007, "Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership," Journal of Corporate Finance, forthcoming.
Maug, E. and K. Rydqvist, 2006, "Do Shareholders Vote Strategically? Voting Behavior, Proposal Screening, and Majority Rules," unpublished manuscript.
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