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Firms with strong corporate governance are like democracies, according to Finance Professor Nickolay Gantchev. Through their proposals and votes, shareholders can determine the broad direction of a company. In new research, Nickolay Gantchev of 51��� Cox and Mariassunta Giannetti study the effectiveness of this low-cost form of shareholder activism. As in a democracy, informed shareholders, as voters, can better vet good or bad proposals.

In exploring this form of shareholder governance, Gantchev goes beyond his recognized expertise in hedge fund activism. Hedge fund activism has been found to improve governance and firm performance, but it is costly. Shareholder activism by proposals is a less costly form of external corporate governance but has been shown to have mixed effectiveness. Shareholders can put forward proposals regarding any governance topic, such as demanding more finance experts to serve on a firm’s board.

This form of shareholder democracy carries some costs though. A 2014 New York Times article suggested that many proposals are submitted by the same few “corporate gadflies,” individuals without the ability to analyze a large number of firms. Gantchev says about 40% of proposals are from such individuals. They tend to target many firms with blanket proposals that fail to take into account a firm’s specific situation. “I think these [shareholders] do it for their own good reasons, but sometimes their proposals may not be beneficial for a company,” says Gantchev. The Securities and Exchange Commission is currently studying revisions to current policies and considering raising the costs of submitting proposals.

Shareholder activism’s mixed results

In their research, the authors relied on novel hand-collected data on proposal sponsors and implementation of U.S. S&P 1500 companies for the period 2003-2014. The research shows that proposals, on average, do not produce positive abnormal returns. This is due to large cross-sectional variation in the valuation effects of proposals, a consequence of the low cost of this type of intervention. In other words, the effects of good and bad proposals tend to cancel each other out. Still, shareholder proposals, especially those from individual investors, may be highly beneficial because they can reach companies that are less likely to be targeted by other forms of investor activism. For example, hedge fund interventions are confined to few and relatively small firms—those undervalued but with good profitability and growth prospects.

Given the low-cost of submitting a proposal, unskilled or uninformed shareholders may post a large number of proposals to many different companies. Thus, a small number of individuals and other sponsors, like unions or cause-driven nonprofits, submit an unusually large number of proposals every year. In contrast, investment companies submit very few proposals. Since the most active sponsors are unlikely to have organizational capabilities to analyze dozens of companies, many proposals fail to address the specific firm and its particular context, instead spreading the most recent corporate governance fads.

The study also shows that proposals submitted by the most active individual sponsors produce negative abnormal returns if they pass with a majority vote. However, these proposals are also less likely to be implemented by management and, if implemented, can destroy corporate value. Importantly, the remaining proposals appear to generate positive short- and long-term abnormal returns, especially if they are submitted by individual sponsors. This indicates that low-cost shareholder activism is beneficial given that it reaches firms that are unlikely to be targeted by hedge fund activists.

Institutions matter

Importantly, the costs associated with bad shareholder proposals emerge in companies where shareholders do not seem to collect information before a vote, say Gantchev and co-author. Mutual funds are important shareholders that help weed out bad proposals, if they do their own homework —and not just follow proxy advisory vote recommendations. When mutual funds do not collect information, harmful proposals sponsored by uninformed shareholders are more likely to receive a majority vote and be implemented.
The authors find evidence that shareholder proposals yield, on average, positive abnormal returns in firms with discerning, institutional shareholders. As a positive force, they filter out bad proposals and allow beneficial ones to pass, notes Gantchev. However, when a bad proposal passes, mutual funds may sell their shares if they voted against it.
In general, low-cost investor activism can be beneficial as a form of shareholder democracy. A crucial caveat: It requires that an informed investor base collect information and be able to discern between good and bad proposals. “Like a democracy, if you have more informed shareholders, when they vote, they can figure out which are good proposals, and prevent the bad ones from passing,” says Gantchev.

The paper “The Costs and Benefits of Shareholder Democracy” is authored by Nickolay Gantchev of the Cox School of Business, 51���, and Mariassunta Giannetti of the Stockholm School of Economics.

Written by Jennifer Warren.