Print
E-MailMichal Barzuza is Caddell & Chapman Professor of Law at University of Virginia School of Law. This post is based on her recent paper.
One-size-does-not-fit-all in corporate law and governance. But do firms really choose their right “size” of governance as conventional wisdom holds? That one-size-does-not-fit-all is frequently used to object mandatory corporate law and other sorts of intervention, such as proxy advisory firms’ voting recommendations, which presumably interfere with firms’ tailoring governance arrangements to their specific needs. Surprisingly, this assumption has not been systematically assessed against available evidence, incorporated rigorously to corporate law theory, or thought through carefully.
My paper argues that not only that firms do not always choose their right size, but firms that need governance the most are frequently less likely to self-constraint (Resisting Firms). The need for governance arises when alternative constrains, such as disciplining market forces, are weak. The lack of alternative constraints, however, could be the very reason why managers might be reluctant to voluntarily adopt these terms. Furthermore, if differences among firms are not observable by outsiders, IPO pricing might not provide sufficient incentives either. Governance terms should add high premium to firms that face weak market forces. If, however, managers have more information than investors on the particular constraints they face, investors would pay only an average value for governance terms. As a result, due to adverse selection at the IPO, firms that could benefit most from governance constraints might not adopt them. This paper’s first contribution thus is to develop a comprehensive theory of corporate law and heterogeneity.
The paper second contribution is to assess the assumption that firms choose their right “size” against available evidence. Synthesizing evidence from dozens of studies the paper argues that there is little support for the assumption this assumption. Take for example a highly researched governance mechanism—independent directors. In a series of studies, firms with independent directors did not perform better than their peers. For years thus, the consensus has been that independent directors do not add value to U.S. boards. Accordingly, when SOX and the exchanges’ listing standards required listed firms to have a majority of independent directors, they were heavily criticized for acting with no supporting evidence and for applying a one-size-fits-all approach. But recent studies find that firms that were forced to add independent directors due to these mandates benefited from adding them more than the firms that added them voluntarily.
A similar pattern emerges with respect to private ordering of foreign firms via cross-listing on U.S. exchanges. Firms in which controlling shareholders’ voting power is high, and cash flow ownership is low, are less likely to cross-list even though the market highly rewards them if they choose to do so. Similarly, cross-listing from countries with weak investor protections triggers the largest declines in costs of capital, but the inclination to cross-list from these countries is actually lower than average.
Evidence on firms’ choice of state of incorporation also raises questions with respect to how firms self-select. If firms choose their right “size” Nevada relaxed fiduciary duties should attract firms with low agency costs. As I have found in a separate work with David Smith, firms that choose to incorporate in Nevada, as compared to firms that incorporate in Delaware, have an exceptionally high frequency of accounting restatements, and are ranked high on aggressiveness in financial reporting. Similarly, a recent study of foreign firms’ reverse mergers into the U.S., finds that reverse mergers into Nevada are associated with the most egregious accounting restatements.
Furthermore, recent evidence from shareholder proposals to implement governance changes shows that managers disproportionately contest shareholder proposals in firms with weak governance, measured by having a combined CEO chairperson and large boards, and in firms that investors believed could benefit most from proxy access arrangements. Similarly, a recent study of the proliferation of majority voting terms, private ordering’s poster child, finds that early adopters of majority voting were less likely to experience withhold votes in previous years (Indifferent Firms). Firms in which shareholders voted against directors in previous elections resisted implementing these terms for a while. Not surprisingly, in these latter firms, majority voting mattered more in annual elections results.
The paper also discusses evidence that is consistent with the assumption that firms choose their right “size.” Small firms that face relatively higher costs of implementation are less likely adopt governance constraints. Second and more important, abnormal negative performance increases the likelihood that shareholder will submit a governance proposal and that the proposal will be implemented, and decreases the likelihood that managers will contest it. Weakly performing firms were also more likely to nominate independent directors and implement proxy access and majority voting terms. Abnormal weak performance however, could be transitory and is not necessarily aligned with firms’ needs for governance. Indeed, the evidence also shows these were not the firms that needed governance the most.
The paper discusses implications for data interpretation and policy. The analysis suggests caution in drawing policy implications from evidence on voluntarily adopted governance terms. While in analyzing data, self-selection is frequently taken into account, inefficient self-selection of the form described here is rarely acknowledged. The paper argues that as a result of such overlooked self-selection, assessments of the value of corporate governance could suffer from a downward bias.
With respect to the trade-offs between mandatory corporate terms and private ordering, policy makers should weigh the costs of mandating one-size governance against potential costs of inefficient self-selection. An informed policymaking would inquire into patterns of self-selection, the reasons why some firms did not adopt governance terms—for example, whether in these firms there was no shareholder support for these terms, or whether managers resisted shareholder proposals to implement them—the characteristics of these firms, their governance and performance, as well as the merits of a proposed regulation, and the extent to which mandatory law could apply selectively to firms with different needs.
Second, the paper argues that the SEC should reconsider the high rate of awarding no-action letters in 70% percent of requests since it may deny shareholders their right to vote on proposals that could benefit their firms. The analysis provides support to the SEC’s recent decision to withdraw a no-action letter given to Whole Foods’ management and to limit the use of Rule 14-a8(i)(9) to “direct conflicts,” and suggests that a broad interpretation of the “added restrictions” qualification of a “substantially implemented” basis to exclude a shareholder proposal, may be warranted.
Third, the paper highlights an important overlooked role of proxy advisory firms in pressuring Resisting Firms to adopt governance terms. In weighing management responsiveness in annual elections, ISS and Glass Lewis limit managers’ incentives to exclude, or refuse to implement, a shareholder proposal. If the Corporate Governance Reform and Transparency Act of 2016 passes, self-selection might worsen. Finally, hedge fund activism also pressure firms that would otherwise resist governance, to adopt constraints. Thus, with respect to the proposed Brakow Act, one overlooked dimension that should be taken into account is whether and to what extent hedge funds promote efficient tailoring.
The complete paper is available for download here.
