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E-MailClifford G. Holderness is Professor of Finance at the Carroll School of Management at Boston College. This post is based on a recent paper by Professor Holderness.
In the United States and a few other countries, management typically needs only board of director approval to issue common stock. But in most countries by law or stock-exchange rule, shareholders must vote to approve equity issuances undertaken by a certain method or exceeding a specified fractional threshold. In some countries shareholders must approve all equity issuances. Even in the United States shareholder approval is mandatory under certain circumstances.
This widespread heterogeneity in shareholder approval, which has been overlooked to date, is associated with several robust empirical regularities. Most notably, shareholder-approved issuances are associated with positive and higher announcement returns compared with managerial issuances, 2% versus -2%. The closer the vote is to the issuance or the greater is the required plurality, the higher are the returns for public offers, rights offers, and private placements. When shareholders must approve equity issuances, rights offers are far more common than public offers. When managers may issue equity without shareholder approval, public offers are far more common than rights offers.
These findings, which emerge from an unconventional meta-analysis of over one hundred existing studies of the stock price reaction to equity issuances by public corporations from 23 different countries, suggest that agency conflicts affect equity issuances by public corporations. This interpretation conflicts with the widely held view that managers are acting solely in their existing shareholders’ best interests when issuing stock. Yet it would be surprising if agency considerations were present with many corporate decisions but absent with something as fundamental as the issuance of common stock.
One agency interpretation that is consistent with the evidence is that stock prices decline when managers unilaterally issue stock because market participants believe the new capital may enable managers to empire build or pursue growth for growth’s sake. When shareholders must approve equity issuances, these threats to firm value are curbed.
In contrast, several findings are inconsistent with broadly held theories of equity issuances. Most of these theories assume the absence of agency conflicts, so shareholder approval should not matter. Yet there are many robust differences both across and within countries associated with shareholder approval on how firms issue equity and the market’s reaction to that decision. Moreover, certain findings are inconsistent with key predictions of these theories. The adverse-selection theory (Myers and Majluf 1984) predicts that firms will choose the issuance method that suffers the least from the inefficiencies caused by information asymmetries between managers and investors on firm value. Yet when managers issue stock without shareholder approval, they choose public offers far more often than rights offers even though a rights offer would reduce these inefficiencies. The adverse selection theory also predicts a negative stock price reaction to public offers of seasoned stock. Yet when shareholders approve public offers, the average stock price reaction is positive. The market timing theory (Baker and Wurgler 2002) predicts that firms will time the public issuance of stock to when their stock is overvalued. Yet public issuances of stock are rare in most countries, which are those countries where shareholder approval is required. The signaling theory (Miller and Rock 1985) predicts a negative stock price reaction to any form of equity financing because it signals that the firm’s cash flows are lower than expected. Yet when approved by shareholders, public offers, private placements, and rights offers of equity are all associated with a positive average stock price reaction.
These findings suggest many follow-on analyses. The most far-reaching one would be to analyze within- and across-country differences in the mandatory shareholder approval of other major corporate decisions. This a fundamental governance issue for any firm but one which has been surprisingly little studied.
The complete paper is available for download here.
