Shareholder-Manager Contracting in Public Companies

Jordan Schoenfeld is Assistant Professor of Accounting at the University of Utah Eccles School of Business. This post is based on his recent paper.

Activist investors often want managers to take specific actions, which they accomplish by methods such as installing their own person on the management team or the board or by writing explicit action-based contracts with management. These contracts have received far less research attention in the activist literature even though they are akin to the classical principal-agent model, where the principal knows exactly what actions the agent should take and will contract on those actions to the extent it is possible. This study examines binding bilateral contracts between shareholders and managers called shareholder agreements.

From 1996 to 2015, shareholders and managers executed over 4,400 binding bilateral shareholder agreement contracts. Using hand-collected data from 13D filings, I find that these contracts can specify rights and duties for both shareholders and managers, including director and management appointments, private information access, accounting procedures, dividends, capital structure, strategy, strategic alliances, private placements, and trading restrictions. I also find that these contracts are more prevalent in firms that are more volatile, less profitable, younger, and in firms with weaker information environments. Investors also react more positively to 13Ds that include these contracts, suggesting that these contracts do not arise at the expense of other shareholders.

The above associations suggest that shareholder agreements help to address information asymmetries between shareholders and managers, for example, when the two parties have high geographical separation. It also appears that shareholders prefer to control managers through shareholder agreements when the firm has more cash on hand and when managers have more decision-making latitude, for example, in firms where managers have more influence over the board. Shareholder agreements are also more prevalent in less profitable and younger firms, which suggests that shareholder agreements serve to correct or preempt mismanagement of the firm.

Since these contracts are relatively new to the literature, my study first discusses how shareholder agreement contracts are formed and analyzes the rights and duties that they commonly specify. It then further characterizes in which firms shareholder agreements are more prevalent. I conclude that there are two main types of shareholder agreement contracts—those that involve the conventional activist investor who effects change at a target company, and those that facilitate product development between two corporations. Shareholders, management, and the board typically execute shareholder agreements during private negotiations that occur when a prospective or current shareholder approaches a firm with a value proposition. In some cases, investors motivate management and the board to come to the bargaining table by threatening to: wage a proxy fight, increase their ownership stake in the firm, sell their stake in the firm, release disparaging open letters about managers and directors, and pursue litigation. Once executed, a shareholder agreement usually terminates on a set date or when the shareholder exits the firm.

To provide one example of a shareholder agreement contract, I use the September 11, 2000 shareholder agreement between the transportation technology firm Xata Corp. and its shareholder John Deere, who at the time held a 14% ownership stake in the firm. This shareholder agreement, which is outlined further in Section 4.2 of the study, prohibited Xata from engaging in mergers and acquisitions and from incurring additional debt. The agreement also specified that Xata must maintain a certain level of dividend payouts and severely restricted executive compensation and capital expenditures. Other covenants in the agreement pertained to Xata’s bank account balance and to the activities of Xata’s subsidiary companies.

The remainder of the study provides a more thorough analysis of what shareholder agreements are about, links many of the findings to existing empirical and theoretical studies, includes direct excerpts from shareholder agreements themselves, and discusses in more detail how shareholder agreements terminate.

Collectively, my findings provide some of the first evidence on how the classical principal-agent model, in which the principal knows exactly what actions the agent should take and will contract on those actions to the extent it is possible, plays out in public companies (e.g., Hart, 2017). One implication of my findings is that shareholders can control managers through contracts that bypass conventional governance channels such as directorships.

The complete paper is available for download here.

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