Career Consequences of Proxy Contests

The following post comes to us from Vyacheslav Fos of the Department of Finance at the University of Illinois at Urbana-Champaign.

Shleifer and Vishny (1997) explain that “corporate governance deals with the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment.” The fundamental feature of corporate governance is shareholders’ right to elect directors to represent their interests. This shareholder representation by the board of directors is a central component of corporate governance. For corporate governance to be effective, shareholders who are dissatisfied with a board’s performance must have a mechanism to replace directors. If shareholders’ impact on electing and replacing directors is weak, so is the connection between owners and managers.

In our paper, Shareholder Democracy in Play: Career Consequences of Proxy Contests, which was recently made publicly available on SSRN, my co-author, Margarita Tsoutsoura, and I investigate whether proxy contests affect the careers of directors whose companies have been targeted. Specifically, the paper aims to shed light on whether shareholders are able impose a career cost on directors when they are dissatisfied with firm performance. This question is particularly important in today’s environment when activist shareholders often demand reforms in corporate governance. For example, the process of shareholders nominating and electing directors was at the heart of the recent (failed) proxy-access reform that was motivated by the Dodd-Frank Act. Proponents of the reform argued its necessity in increasing the power of shareholders to be able to elect or remove directors from the board (Bebchuk, 2007). On the other hand, critics of this view argued that shareholders already have tools to hold directors accountable (Bainbridge, 2006).

Shareholders have two main tools to remove poorly performing directors. First, shareholders can use uncontested election. Prior literature has shown that attempts to remove directors through uncontested elections have not been effective. In regular elections, shareholders cannot technically vote against a director, but instead can only withhold their authority to vote in favor of a nominee. Most US firms have plurality voting rules in uncontested elections. As a result, removing directors in uncontested elections is almost impossible. Specifically, a director can be re-elected even if just a few shareholders vote for him. The prospect of shareholders having an effective voice in removing directors in uncontested elections seems limited, and directors do not appear to suffer reputational effects from low votes (Cai et al., 2009).

The second mechanism shareholders have is to discipline directors through proxy contests. Dissatisfied shareholders can nominate an alternative slate of directors by initiating a proxy contest and therefore provide all shareholders with a clear alternative to incumbent nominees. Nevertheless, no evidence exists supporting the idea that directors who are targeted in proxy contests suffer any career consequences. Moreover, existing evidence has led to the conclusion that proxy contests are rarely successful (e.g., Pound, 1988; DeAngelo and DeAngelo, 1989; Ikenberry and Lakonishok, 1993).

Using hand-collected data on all proxy contests during 1996-2010, this paper fills the gap in the literature and studies whether proxy contests have an impact on the careers of incumbent directors. In contrast to “normal” shareholder meetings when shareholders have no real choice in terms of board nominees, incumbent directors face a direct threat of replacement because dissident shareholders nominate an alternative slate of candidates. That is, corporate elections in these cases resemble real democracy.

We show that proxy contests are associated with significant adverse effects on the careers of incumbent directors. First, following a proxy contest, incumbents lose seats from targeted boards. Four years after the proxy contest, more than 80% of the directors will not be on the board of the targeted company. Most importantly, following a proxy contest, directors experience a significant decline in other board seats held. The total number of other directorships falls by more than 30% over the five years after the proxy contest. Overall, facing a direct threat of removal is associated with losing more than one board seat over following five years, which corresponds to more than $1.9 million over 12 years in foregone income until retirement for the median incumbent director.

We next move to establish the causal effect of proxy contests on director careers. The challenge in empirically identifying the causal effect of proxy contests is to find a suitable counterfactual to convincingly isolate the proxy contest effect. The targeted companies are not random. A potential alternative, for example, is that activist shareholders might have no effect on career of incumbent directors; instead, the directors of the targeted companies were directors of poorly performing companies and therefore were expected to lose seats on the boards in which they held directorships, even in the absence of the proxy contest. To address this and other alternative explanations, we suggest a novel instrument for a director to face contested nomination.

Our instrument starts with the observations that more than 50% of the boards are staggered. In a staggered board structure, directors are divided into separate classes serving staggered terms, with only one class of directors up for reelection at a given annual shareholder meeting. As a result some of the directors in the staggered boards have “protection” from being voted out even if the company is targeted in the proxy contest. This protection depends only on the predetermined schedule of the staggered terms. We use whether the director has protection due to the staggered board structure as an instrument for facing contested nominations. Specifically, within the same targeted company we compare change in other directorships for directors that can be replaced (i.e., nominated) and change in other directorships for directors that cannot be replaced (i.e., non-nominated). Thus, our instrument exploits plausibly exogenous within-firm variation in a director’s exposure to being nominated for election, by exploiting the predetermined schedule of staggered boards that only allows a fraction of directors to be replaced every year. The main evidence shows that nominated directors lose more directorships than non-nominated directors. Specifically, nominated directors lose on average 0.65 directorships whereas non-nominated directors are expected to lose 0.44 directorships. The results suggest the career cost imposed on nominated directors is almost 60% higher than the career cost imposed on non-nominated directors. Our analysis using the instrument further validates that proxy contests have significant career effects for directors.

We next investigate two potential mechanisms that drive the incremental effect of contested nomination on careers of incumbent directors. First, we provide evidence that nominated directors receive more media coverage than non-nominated directors. Second, we observe that nominated directors face the possibility of being voted out, and being voted out has a stronger negative effect on a director’s career. Whereas incumbent nominees who keep their seats are expected to lose 0.36 seats, incumbent nominees who are fired by shareholders are expected to lose 0.81 seats.

The final part of the analysis investigates whether the effect of proxy contests varies with observed director or proxy contest event characteristics. We find that independent incumbent directors experience more severe loss of other directorships than insider incumbent directors. Overall, the results indicate the proxy-contest mechanism imposes a significant career cost on incumbent directors. Following a proxy contest, incumbent directors are likely to lose directorships in both targeted and non-targeted companies. Therefore, the proxy-contest mechanism is effective in imposing significant career costs on incumbent directors.

The full paper is available for download here.

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