The Myth that Insulating Boards Serves Long-Term Value

In a new study, The Myth that Insulating Boards Serves Long-Term Value (forthcoming, Columbia Law Review, October 2013), I comprehensively analyze – and  debunk – the view that insulating corporate boards serves long-term value.

Advocates of board insulation claim that shareholder interventions, and the fear of such interventions, lead companies to take myopic actions that are costly in the long term – and that insulating boards from such pressure therefore serves the long-term interests of companies and their shareholders. This claim is regularly invoked to support limits on the rights and involvement of shareholders and has had considerable influence. I show, however, that this claim has a shaky conceptual foundation and is not supported by the data.

In contrast to what insulation advocates commonly assume, short investment horizons and imperfect market pricing do not imply that board insulation will be value-increasing in the long term. I show that, even assuming such short horizons and imperfect pricing, shareholder activism, and the fear of shareholder intervention, will produce not only long-term costs but also some significant countervailing long-term benefits.

Furthermore, there is a good basis for concluding that, on balance, the negative long-term costs of board insulation exceeds its long-term benefits. To begin, the behavior of informed market participants reflects their beliefs that shareholder activism, and the arrangements facilitating it, are overall beneficial for the long-term interest of companies and their shareholders. Moreover, a review of the available empirical evidence provides no support for the claim that board insulation is overall beneficial in the long term; to the contrary, the body of evidence favors the view that shareholder engagement, and arrangements that facilitate it, serve the long-term interests of companies and their shareholders.

I conclude that, going forward, policy makers and institutional investors should reject arguments for board insulation in the name of long-term value.

Here is a more detailed account of the analysis in the article:

According to the board insulation view, inefficient capital markets and short investor horizons couple to produce a problem of “short-termism.” Short-termism refers to companies taking actions that are profitable for the short term but value-decreasing in the long term, such as increasing near-term earnings by cutting research that would pay off later on. Activist investors with short investment horizons, it is argued, seek such actions and often succeed in pressuring companies to take them. Furthermore, it is argued, when corporate arrangements facilitate shareholders’ ability to replace or influence directors, fear of activist intervention in the absence of satisfactory short-term results produces pressure on management to focus excessively on these results to the detriment of long-term value.

Insulation advocates contend that the long-term costs of short-termism, produced by both shareholder interventions and fears of such interventions, make it desirable to shield boards from shareholders. The long-term interests of companies and their shareholders are best served, these advocates argue, by insulating boards from shareholder pressure and enabling them to focus on enhancing long-term value.

The stakes in this debate are large. Arguments supporting the long-term benefits of board insulation have played a central role in corporate law policy debates for at least three decades. These arguments have been advanced by prominent legal academics, significant economics and business school professors, management thought leaders, influential business columnists, important organizations, a recent report commissioned by the British government, and noted corporate lawyers. Indeed, invoking the alleged long-term benefits of board insulation has been a standard and key argument in a wide range of significant corporate law debates, including those in support of takeover defenses, impediments to shareholders’ ability to replace directors, and limitations on the rights of shareholders with short holding periods.

Furthermore, insulation advocates have been successful in influencing important public officials and policy makers. Chancellor Leo Strine and Justice Jack Jacobs, prominent figures in the Delaware judiciary, have expressed strong support for this view. Congress held hearings on the subject. William Donaldson, when he was chair of the SEC, accepted that short-termism is “a critical issue,” and short-termism arguments persuaded the SEC to limit use of the proxy rule adopted in 2010 to shareholders that have held their shares for more than three years. Even institutional investors, which are otherwise reluctant to support limiting shareholder rights, have shown significant willingness to accept the validity and significance of short-termism concerns.

The substantial impact of the claims made by insulation advocates may be at least partly due to the asserted gravity of the concerns they have expressed. Insulation advocates have argued that short-termism has “substantial corporate and societal costs,” “has created a national problem that needs to be fixed,” represents “a disease that infects American business and distorts management and boardroom judgment,” and has “eroded faith in corporations continuing to be the foundation of the American free enterprise system.” Indeed, insulation advocates have even viewed shareholder pressure as causes for the Enron and WorldCom scandals, the crash of 1987, and the excessive risk taking by financial firms in the run-up to the financial crisis of 2008–2009.

While insulation advocates have used strong rhetoric in expressing their concerns, they have failed to provide an adequate basis for their claims. These claims rely on critical and unsubstantiated premises, overlook the significant long-term costs of board insulation, and are not backed by evidence. Indeed, I show in this paper that an analysis of the long-term effects of board insulation, informed by the relevant theoretical and empirical literature, does not support such insulation.

To begin, insulation advocates often fail to acknowledge that they are advancing empirically contestable propositions whose validity cannot be derived from theory or intuition. Contrary to what insulation advocates commonly presume, even assuming the existence of inefficient capital markets and short investor horizons, it does not follow from these assumptions that the long-term effects of board insulation are overall positive. Under these assumptions, board insulation might produce some long-term benefits – but these benefits might still be outweighed by significant countervailing costs.

In particular, with inefficient market pricing and short investor horizons, it is theoretically possible that activists might in some cases seek actions that are not value-maximizing in the long term. The question remains, however, how often such situations do arise and, furthermore, whether the expected costs of such situations exceed the expected benefits from activists’ clear interest in seeking actions that are positive for both the short term and the long term.

Similarly, with inefficient market pricing and short investor horizons, fears of activist intervention and the arrangements facilitating it might theoretically lead some management teams to make distorted decisions with respect to long-term investments. However, the expected costs of such decisions have to be weighed against the expected long-term benefits of activist stockholder interventions and the accountability and discipline they produce. Such accountability and discipline provide incentives to avoid shirking, empire building, and other departures from shareholder interests that are costly for both the short term and the long term.

Turning to examine the balance of costs and benefits associated with board insulation, I point out patterns of behavior that reflect a widespread and consistent view among sophisticated and well-informed market participants that activist interventions, and arrangements facilitating them, do not overall decrease value in the long term. The lack of investment products and services based on the prediction that companies targeted by activists underperform in the long term suggests the absence of any significant group of long-term investors that are willing to bet money on the validity of this underperformance claim. Similarly, the overwhelming opposition to insulation-increasing arrangements reflected in the voting decisions of institutional investors, including investors with long investment horizons, indicates that these investors do not subscribe to the view that such arrangements serve long-term value.

These patterns should give insulation advocates some pause. They should be reluctant to maintain that they know the interests of investors better than investors themselves unless they have significant empirical evidence to back up their views. Insulation advocates, however, have thus far failed to provide such evidence. They often failed to acknowledge the need for evidence or offered their experience as evidence.

Fortunately, empirical evidence that can shed light on the long-term effects of board insulation has been accumulating over the past decade. I provide a full review and analysis of the relevant empirical work by researchers, including work in which I have participated. As to activist interventions, existing empirical evidence – including a recent study by Alon Brav, Wei Jiang and I that analyzes the long-term effects of a large universe of activist interventions – provides no support for the view that such interventions are followed in the long term either by losses to the shareholders of targeted companies or by declines in the companies’ operating performance of these companies. As to the fear of activist interventions, the body of existing empirical work again does not provide support for the view that stronger board insulation serves the long-term interest of companies and their shareholders.

To the contrary, the existing body of evidence favors the view that shareholders’ ability to intervene and engage with companies provides long-term benefits to companies, shareholders, and the economy. This evidence indicates that activists target companies whose operating performance has been declining, and that their interventions are followed by improvements in operating performance that do not come at the expense of performance later on. Anticipating such improvements, market capitalization of targeted companies appreciates upon the announcement of activist campaigns to levels that are not reversed in the long term. Furthermore, arrangements that insulate boards from shareholders and shareholder pressure have been consistently associated with lower firm value as well as with worse operating performance.

Given that available theory and evidence do not support the claims of insulation advocates, public officials and institutional investors should not be receptive to claims based on the asserted long-term benefits of board insulation. They should reject the use of such claims as the basis for rules, arrangements, and policies that limit the rights and powers of shareholders.

The study is available here.