Initiation Payments

In an article recently published in the Journal of Corporation Law, I propose that corporations implement “initiation payments”—payments for investors that initiate corporate changes that investors would collectively prefer. These would apply to the most obvious forms of investor initiation, shareholder proposals and proxy contests. The initiation payments would be paid by the corporation only if a proposal put forward under Rule 14a-8 or in an investor’s own proxy statement was approved either by a majority of independent investors, or by the board of directors. The payment would be calculated to cover the cost to the investor of initiating the corporate change, and to provide some additional reward for doing so.

Initiation payments would resolve a fundamental question in corporate governance: is there under-initiation of corporate changes? If there is under-initiation, initiation payments would eliminate it. They are a concrete, tractable, and readily implementable solution. In contrast to other potential solutions to under-initiation, initiation payments could be implemented by private ordering, and so would not require (unlikely) legislative, regulatory or judicial intervention. All that would be required is the support of institutional investors. This also means that whether or not initiation payments are implemented is effectively a test of whether institutional investors believe there is under-initiation, and if so, whether they wish to eliminate it.

The Under-Initiation Hypothesis

By “under-initiation,” I mean: are all of the corporate changes that a majority of investors would desire actually initiated, either by directors or executives, or failing that, by investors? This is an important but open question, on which there is likely to be disagreement. Of course, it is possible that there is no under-initiation, that directors and executives initiate all of the corporate changes that a majority of their investors would favor. But it is also possible that they may not.

The under-initiation hypothesis is based on the idea of agency costs, which has long been a central feature of the corporate governance literature. Directors and managers have their own incentives, which may not always align with those of investors, and which may lead them to avoid making certain changes that investors would prefer. The existence of at least some shareholder proposals that receive majority support, and some proxy contests where dissident directors are elected, suggests that there is likely to be some non-zero level of under-initiation of corporate change by directors and executives.

Presuming, arguendo, that directors and executives do not initiate all corporate changes preferred by investors (and only such changes), will investors initiate collectively-preferred changes themselves? The existence of some successful shareholder proposals and proxy contests again demonstrates that shareholders initiate some collectively-preferred changes, but simple economic reasoning explains why they are unlikely to initiate all such changes.

The investor initiating the changes will bear most of the costs of doing so, while they will receive only a small fraction of the benefits. Even for changes that will give them the greatest benefits—hedge fund activism—the proportion of any increase in corporate value that the hedge fund activist will capture is very small—between 1% and 2%. So the expected return to the company must be many multiples of the activist’s own costs (50x-100x) in order for such initiation to be financially worthwhile for the activist. ESG-related changes that investors may initiate through shareholder proposals are unlikely to have financial rewards for the initiating investor that cover even their low cost of preparation and submission. The number of ESG proposals submitted will thus be constrained by the limited financial resources that their proponents can devote to initiation, also leading to under-initiation.

The Solution: Initiation Payments

If there is under-initiation, the solution follows clearly from this explanation: initiation payments. Initiation payments are payments to initiating investors for initiating corporate changes that a majority of investors would prefer, and that would be sufficient to offset the initiating investor’s costs of initiation and provide them with some additional reward.

For proxy contests, initiation payments could be realized through a proposal put forward by the dissident and voted on by investors, that the company pay a specified payment to the investor if the proposal is approved. However, this approach is unlikely to work for shareholder proposals, because of the anti-bundling provisions of Rule 14a-8. Instead, a company could adopt an “initiation payment bylaw,” which would require the directors of the corporation to make an initiation payment to an investor submitting a shareholder proposal in the event the proposal was successful, or if it was withdrawn as part of an agreement with company management to implement the change. An initiation payment bylaw could also apply to changes initiated through proxy contests.

The article makes concrete suggestions for a default method of calculating initiation payments for different types of initiation. Shareholder proposals have relatively low costs, and little variability in those costs, so a fixed payment offers a pragmatic solution that would eliminate the need to establish and verify expenses on a case-by-case basis. Because the costs of successful proxy contests are larger and more varied, an appropriate initiation payment would include both reimbursement of third-party expenses and an additional fixed payment to cover the initiating investor’s time, effort, overhead, risk, and opportunity costs.

Implementing initiation payments would also settle the open question of whether there is under-initiation of corporate changes that investors collectively prefer. If there is, initiation payments would cause such changes to be initiated, because successful initiators would be rewarded with initiation payments. Conversely, if initiation payments were implemented and we did not observe such initiation, or if changes proposed by investors were unsuccessful, we could conclude that there is no under-initiation. And since initiation payments would be conditioned on success, the possibility of reward would not lead to the initiation of changes that investors expected to fail, as those would remain unprofitable for the initiating investor.

Initiation Payments and Institutional Investors

The single, critical requirement for initiation payments to be successfully implemented is institutional investor support. Institutional investors control a majority of the equity of the great majority of U.S. corporations. Their support is thus a necessary condition for initiation payments to succeed. But it is also a sufficient condition: If institutional investors constituting a majority of a company’s shares would support an initiation payment bylaw, and—critically—an initiation payment for an investor that initiated such a bylaw, then investors would be incentivized to propose such bylaws, either through a precatory or mandatory proposal under Rule 14a-8, or through their own proxy solicitation to amend the company’s bylaws. Initiation payments would thus be self-implementing.

Whether institutional investors would support initiation payments is another open question. Initiation payments would offer benefits for institutional investors’ own clients. By design, initiation payments would increase the initiation of votes on changes that institutional investors believe would benefit their own clients (and only such changes).

Implementing initiation payments would also have an important benefit for large institutional investors. It would absolve them of the need to initiate corporate changes themselves. Any changes that a majority of investors are likely to support would be initiated by other investors. The stewardship efforts of institutional investors could thus be focused on evaluating and voting on corporate changes initiated by others. Many institutional investors may prefer not to face pressure to initiate corporate changes, as initiation is likely to be costly for them, both directly and indirectly.

On the other hand, it is possible that some institutional investors would rather that collectively-preferred changes not be initiated. If this were true it would be troubling. It would suggest that even though an institutional investor believes a change to be in the interests of its own investors, it would prefer that the change not be initiated, so that it didn’t have to vote on the change—for instance, because it did not wish to publicly affirm or deny its support for the change.

Putting forward proposals for initiation payments would resolve this question. Such proposals would reveal which institutional investors support them and which do not, allowing us to learn more about the true incentives of those investors.

If initiation payments were implemented, they would resolve any under-initiation of corporate changes. And by observing whether or not they are indeed implemented, we stand to learn important information about under-initiation, and about institutional investors, which would help to resolve these important debates in corporate governance.

The complete article is available here.