Trading and Shareholder Democracy

In many advanced economies, regulatory reforms and charter amendments have empowered shareholders of publicly traded firms by enhancing their voting rights. Shareholders not only elect directors, but frequently vote on executive compensation, corporate transactions, changes to the corporate charter, and social and environmental policies. This shift of power from boards to shareholders assumes that shareholder voting increases shareholder welfare and firm valuations by aligning the preferences of those who make decisions with those for whom decisions are made—a form of “shareholder democracy.”

In our paper, Trading and Shareholder Democracy, published in the Journal of Finance, we question this argument. The corporate setting is very different from the political setting. A key feature of the corporate setting is the existence of a market for shares, which allows investors to choose their ownership stakes based on their preferences and stock prices. Thus, who gets to vote on the firm’s policies is fundamentally linked to voters’ views on how the firm should be run. The goal of our paper is to examine the effectiveness of shareholder voting considering that the shareholder base forms through trading in the stock market.

We analyze a model in which shareholders first trade their shares in a competitive market and then vote on a proposal. Shareholders have different attitudes toward the proposal, which may stem from their social and political views, time horizons, risk aversion, tax considerations, or ownership of other firms. As a result, some shareholders are biased toward the proposal and changing the status quo. They have a low bar for accepting the proposal and often vote in favor, so we call them activist shareholders. By contrast, other shareholders are biased toward the status quo and against the proposal. They have a higher bar for accepting the proposal, and we call them conservative. For example, in a proxy fight involving a short-termist dissident, the proposal to elect the dissident’s slate of directors is likely to shorten the time horizon of the firm’s investment projects. Then shareholders with a short-term view would tend to approve the proposal (activists), whereas shareholders with a longer time horizon would be biased against it (conservatives).

Voting outcomes are indeterminate. Our first key insight is that trading aligns the shareholder base with the expected outcome. This happens even if the expected outcome is not optimal. As a result, similar firms can end up having different ownership structures and taking different strategic directions.

Consider first the situation in which shareholders expect a high likelihood that the proposal will be approved, i.e., that the dissident wins the proxy fight in our example. Then the short-termist shareholders tend to value the firm more than the long-termists, so there are gains from trade between them. During trading in the stock market, short-termists buy and long-termists sell. As a result, the shareholder base after trading is more short-termist and approves the proposal more often, confirming ex ante expectations. Likewise, if the proposal is expected to be rejected, the post-trade shareholder base is more long-termist and tends to reject the proposal, again in line with ex ante expectations.

Hence, trading in the market before the vote leads to shifts in the composition of the shareholder base, and these shifts make ex ante expectations about the voting outcome self-fulfilling. The resulting fundamental indeterminacy highlights potential empirical challenges in analyzing shareholder voting, since firms with the same fundamental characteristics can have different ownership structures and adopt different policies. In addition, it shows that outcomes can be inefficient, for example, shareholders may coordinate on the short-termist equilibrium even if the long-term investment strategy would lead to higher shareholder welfare.

Decision-makers and price setters are different. One of the arguments in favor of shareholder democracy is that shareholders who make decisions are also those who hold the shares and, therefore, determine the value of the stock. We show that this argument may be incorrect. Prices equalize the supply and demand for shares and are set by the shareholder who is indifferent between buying and selling shares. We call this shareholder the “marginal shareholder.” The attitude of this shareholder is somewhere in the middle between extreme activists and extreme conservatives. In our example, if shareholders expect the short-termist outcome, shareholders with shorter time horizons buy, those with longer time horizons sell, and the marginal shareholder, who is indifferent, has a medium-length time horizon.

The key insight is that the marginal shareholder does not make decisions. Decisions are made by a majority vote among investors who own shares after trading. Since “buyers” of the stock, and hence voters on the proposal, are investors with relatively short time horizons, the marginal shareholder will frequently conclude that the proposal expected to gain majority support is value-decreasing, which will reduce the share price. This divergence in attitudes between the marginal shareholder, who sets prices, and the majority, who decides on proposal outcomes, has several implications, which we explore next.

Price reactions may offer poor guidance to evaluate effects on shareholder welfare. The share price and shareholder welfare can react very differently to policy changes because the price is determined by the valuation of the marginal shareholder, whereas welfare is determined by the valuation of the average post-trade shareholder, who is more extreme. Hence, the price is not a good aggregator of shareholders’ heterogeneous preferences, which challenges the notion that there is a close connection between shareholder welfare and prices. Accordingly, we show that changes in governance policies, variation in index fund ownership, or a strengthening of shareholders’ social concerns may reduce the share price but increase shareholder welfare. We conclude that prices and price reactions may offer poor guidance for evaluating the implications for shareholder welfare, especially for illiquid shares and close voting outcomes. This conclusion casts doubt on the common interpretation of event studies, which are prevalent in empirical work on shareholder voting.

Trade can be harmful to shareholder welfare. We also ask how shareholder welfare is affected if market liquidity (depth) increases. Interestingly, we find that greater opportunities to trade may be detrimental for shareholder welfare. The reason is that market liquidity allows extreme investors to buy large positions and use their votes to implement their preferred decisions, hurting the more moderate shareholders. In our example, proposals to implement short-term policies may now be much more likely to win, which benefits the most short-termist shareholders but may hurt more moderate investors who hold the firm after trading.

Delegation to the board can be beneficial. Finally, we compare shareholder voting with decision-making by a board of directors. While the scenario with heterogeneous shareholder preferences may appear to advocate for shareholder voting, our analysis reveals that collective action issues during voting, coupled with shareholders’ trading opportunities, can diminish its effectiveness. As a result, delegating decisions to the board could enhance shareholder welfare. We show, however, that for this delegation to benefit the initial shareholders more than voting, the board must cater to the preferences of post-trade shareholders, rather than to those of the initial shareholders. In our example, even if the initial shareholder base includes many investors with long horizons, delegation to the board is welfare enhancing only if the board is sufficiently short-termist and aligns its decisions with the more short-termist post-trade shareholders. Intuitively, long-term investors benefit from such a board as well, since they can sell their shares for a higher price to short-term investors, who now have a higher valuation of the stock.

Challenges of shareholder democracy. Overall, our analysis strikes a cautious note on shareholder democracy. The parallelism to political democracy breaks down in one important respect: shareholders can trade, and trading may exacerbate, rather than alleviate, the collective action problems of the shareholder voting process.