Shareholder Proxy Access in Small Publicly Traded Companies

In Business Roundtable v. SEC, the DC Court of Appeals struck down the proxy access rule giving certain shareholders access to the corporate proxy on the grounds that the SEC failed to adequately fulfill its requirement to consider the impact of new rules on “efficiency, competition, and capital formation.” The Court offered a blistering critique of the SEC’s economic analysis in the rule. Criticism of the opinion followed and also led to a series of Congressional hearings on the SEC’s process for weighing the economic costs and benefits of new rules. Many of the critics of the opinion, and indeed of cost-benefit analysis itself, have argued that it is simply too difficult to guide rulemaking, or that costs are easier to measure than benefits and so the approach trends against the status quo.

I counter that critique of Business Roundtable by way of example in an article co-authored with Thomas Stratmann in the Stanford University Law Review, Does Shareholder Proxy Access Damage Share Value in Small Publicly Traded Companies? We suggest a question the SEC might itself have investigated about its approach, if it had submitted a rule proposal first and if it was committed to economic analysis of its rules. We consider a natural experiment provided by the rule’s differential impact on small and large firms above and below the arbitrary $75 million market capitalization separation. We measure the impact of the market’s frustrated expectation of a permanent exemption for small firms, an expectation stemming from prior SEC implementation of other controversial rules and strong language in the Dodd-Frank Act, against a control group represented by large firms who expected application of the rule and for whom the new rule’s impact was largely capitalized into their value.

The field of corporate governance has long considered the costs of the separation of ownership from control in publicly traded corporations and the regulatory and market structures designed to limit those costs. The debate over the efficiency of regulations designed to limit agency costs has recently focused on the SEC’s new rule requiring companies to include shareholder nominees on the company-financed proxy statement to facilitate insurgent challengers to incumbent board members in board elections. Challenges in measuring agency costs have also been a foundation for much of the debate over the corporate governance provisions in Dodd-Frank and increasingly undertaken by the SEC over the last decade.

Much of the SEC’s economic analysis cited literature on proxy fights and other related issues, but a fundamental flaw in the analysis was assuming that self-funded proxy fights would have the same impact on agency costs as proxy challenges taking place on the actual corporate proxy. Event studies of unanticipated regulatory developments will therefore offer a useful tool for the SEC, particularly if coupled with a mandatory sunset or look-back provision in major new rules.

Stock price event studies offer a useful tool for the SEC to fulfill its statutory economic analysis requirement mandate and a recent directive to the independent agencies from the White House Office of Management and Budget to perform a retrospective review of old rules that have become overly burdensome or outdated. Some might criticize the event study method with arguments from the behavioral economics literature, a popular field among critics of cost-benefit analysis, but in a disclosure based regulatory system such critiques lack force and relevance. After all, if shareholders are too irrational to efficiently process regulatory developments into stock prices, then why mandate new disclosure rules in the first place?

A recent vein of empirical literature has examined the stock price effects of events surrounding the new proxy access rule. We present a study that focuses on small companies that expected an exemption from the rule under the Dodd-Frank legislation that preceded the adoption of the SEC rule. We consider the effect of the August 25, 2010 announcement of the proxy access rule, comparing its effect on the value of medium and large firms, which expected to be subject to the full rule, against its effect on the value of small firms, which were unexpectedly given only a temporary exemption from part of the rule (Rule 14a-11) and no exemption from another part of the rule (Rule 14a-8). Supporters of proxy access have long argued that it will enhance shareholder value. Critics of proxy access have argued that it will empower investors with conflicted agendas that will destroy shareholder wealth.

The unexpected application of the rule to small-cap companies on August 25 provides a natural experiment for this question and allows us to examine the differential effect of the rule on firms above and below the arbitrary SEC cutoff of $75 million dollars in market capitalization. We find that the unanticipated application of the proxy access rule to small firms, particularly when combined with the presence of investors with at least a 3% interest (who are able to use the rule), resulted in negative abnormal returns. We present multiple methods to measure that effect and demonstrate losses for our sample of roughly 1000 small companies of as much as $347 million stemming from the rule. To the extent that the effect we observe is maintained over larger firms, those losses would be significantly magnified.

The full article is available for download here.