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E-MailBenjamin Bennett is an Assistant Professor of Finance at the A.B. Freeman School of Business, Tulane University, René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business, The Ohio State University, and Zexi Wang is an Associate Professor of Finance at the Lancaster University Management School. This post is based on their recent paper.
There is much debate about whether corporate governance should follow the doctrine of shareholder primacy or stakeholder theory. With shareholder primacy, directors and officers owe their fiduciary duties primarily to shareholders. Under this view, the central obligation of directors and officers is to maximize shareholder wealth. To enforce this objective, shareholders rely on a range of disciplining mechanisms, including capital markets, the market for corporate control, and legal remedies. In contrast, stakeholder theory posits that corporate fiduciaries should consider the interests of a broader set of constituents, including employees, customers, suppliers, and communities. However, stakeholder theory offers limited guidance when decisions affect stakeholders differently, thereby granting directors and officers substantially more discretion. As a result, weakening shareholder primacy may worsen agency problems by making it easier for insiders to pursue their own interests and may therefore make firms less efficient in allocating capital.
Empirically, it is difficult to assess whether weakening shareholder primacy to give boards and officers more leeway to take into account the interests of stakeholders does actually worsen agency problems. In our paper, we use the adoption of a law in Nevada that weakens shareholder primacy to examine this issue and find strong evidence that increasing the discretion of officers and directors to pursue stakeholder interests has an adverse impact on agency problems within firms.
In the U.S., the corporate law that applies to a corporation is determined by the firm’s state of incorporation. Delaware is the state of incorporation for an extremely large fraction of public corporations. Delaware law is explicit about the duty that the board of directors owes to the shareholders. The second most popular state for incorporation of public firms is Nevada, often dubbed the “Delaware of the West.” Nevada law does not have the doctrine of shareholder primacy, and it protects directors and officers against litigation by shareholders. Despite Nevada’s corporate law, before 2017, the Courts in Nevada still followed the Courts in Delaware, so that for practical purposes the doctrine of shareholder primacy still impacted judicial decisions for Nevada corporations. In 2017, the Nevada legislature put a stop to this practice by passing Senate Bill No. 203. This Bill made it crystal clear that the doctrine of shareholder primacy does not apply in Nevada and that directors and officers are protected against shareholder litigation. Using this Nevada law change as a quasi-natural experiment, we investigate the implications of weakening shareholder supremacy for shareholders and firm policies.
The advantage of the Nevada experiment is that it represents a change in the level of shareholder protection for only some firms in the U.S. Hence, differences in economic development or national institutions do not affect our experiment. We can therefore focus directly on the impact of changes in corporate law that weaken the rights of shareholders and give more leeway to insiders to pursue other goals than shareholder wealth maximization. If market mechanisms predominate, the Nevada experiment should have little or no impact on firm governance and shareholder wealth. However, if the law plays a crucial role in firm governance in the presence of strong market mechanisms, we expect the Nevada experiment to affect governance and shareholder wealth adversely.
Our analysis reveals that the enactment of the law has a pronounced negative impact on corporate governance. For example, we find that the entrenchment index worsens, board independence falls, and director attendance drops. While the law frees insiders to pursue policies that are stakeholder friendly, we find no evidence that such discretion is used to advance stakeholder interests. If insiders pursued actions favorable to stakeholders, we would expect the ESG performance of firms to increase. Instead, we find a deterioration in ESG performance, suggesting that the increased discretion is not used to promote stakeholder welfare.
The quality of a firm’s accounting is generally considered as an indicator of good governance from the perspective of capital providers. We find Nevada firms experience an increase in accounting issues after the passage of the law. In particular, the firms’ auditors become more likely to have concerns. We also find that these firms are more likely to receive an SEC letter pointing to issues with their reporting to the SEC. Regarding executive compensation design, we investigate the impact of the law’s adoption on the excess pay and performance sensitivity of compensation of CEOs of Nevada companies. We find that the excess pay of these CEOs increases, and the performance sensitivity of their compensation falls.
Institutional shareholders are often viewed as having a monitoring role. When shareholder primacy is weakened, institutional investors may find it more difficult to influence corporate decisions without complementary governance mechanisms. As a result, we expect a decline in overall institutional ownership. Accordingly, we find strong empirical support in the data for this prediction. We also find that the frequency of securities lawsuits drops after the adoption of the law, consistent with the weakening ability for shareholders to use securities litigation as a disciplining mechanism following this Nevada law change.
Our findings show that firms did not try to offset the impact of the law on shareholder supremacy. We thus expect the law to have an adverse impact on firm value, which is confirmed by data. Specifically, we find significant negative abnormal returns on the effective date of the law. Moreover, Nevada-incorporated firms underperform over the subsequent two years. We also find that Tobin’s q significantly decreased for Nevada-incorporated firms compared to firms incorporated elsewhere following the law change, especially when the quality of governance deteriorated more. Firms also experience a higher cost of debt following the adoption of the law. Our evidence suggests that the market mechanism is at work in penalizing firms for the weakening of shareholder primacy and investor rights.
Lastly, we investigate how firms’ investment policies respond to the weakening of shareholder primacy. The law may have enabled officers and directors to pursue their own objectives at the expense of shareholders. We find that firms make more acquisitions after the law and decrease asset sales. The market responds more poorly to acquisition announcements after the effective date of the law. Consistent with weaker governance, we observe a deterioration in efficiency of capital expenditures and R&D expenses. Furthermore, capital investment becomes largely unresponsive to Tobin’s q, suggesting a breakdown in the efficiency of capital allocation.
In sum, our findings show that firms do not strengthen internal governance to offset the law’s weakening of shareholder primacy. Instead, reduced shareholder oversight harms both shareholders and economic efficiency. Although the law permits consideration of broader stakeholder interests, we find no evidence that firms act accordingly: ESG ratings of Nevada corporations declined after the law’s passage. These results contribute to the corporate governance literature by demonstrating that, even in settings with strong market discipline, weakening shareholder primacy has significant negative consequences for firm value, governance, and investment behavior.
This post is based on their recent paper What are the Costs of Weakening Shareholder Primacy? Evidence from a U.S. Quasi-Natural Experiment.
