A new mechanism for exercising shareholder voice
The latest craze in corporate activism is majority voting for board elections. The intuition is simple if misguided: boards are elected by shareholders to run the firm; elections everywhere (except maybe North Korea, Cuba, and, er, Chicago) are decided by majority vote; therefore board members should be elected only if they win a majority of shareholder votes. (Currently, shareholder votes in ordinary elections are not dispositive, as board members can be elected with a plurality of votes—only in expensive and rare proxy fights when a rival slate of directors is run do votes actually matter.) This campaign is being waged on many fronts, including by law professor Lucian Bebchuk, who has personally lobbied firms in which he owns a few shares to adopt bylaw amendments requiring majority rule. A recent court decision highlights the problems with this approach, and a new paper offers some alternatives.
Bylaw amendments are one possible way of achieving this governance change, but there is an unresolved question about their legality in this area (a debate well covered elsewhere), and they are practically expensive for shareholders to offer. A recent opinion by the Second Circuit offers some hope for corporate activists on the latter issue. In American Federation of State, County & Municipal Employees v. American International Group, Inc. (05-2825), the court held that shareholders have the right to use the shareholder proposal mechanism in Rule 14a-8, typically used for so-called “precatory proposals”, to offer bylaw amendments on the manner in which firms hold board elections. The virtue of this approach is that it is cheaper, since the firm is paying for the printing and distribution of the proxy materials, which means that we will see much more of it.
While there is some dispute about whether the opinion reads and applies the rule correctly, and whether the ruling is good policy (see here), there is a more fundamental problem with the use of Rule 14a-8 here or in any case. In a forthcoming paper, my co-author and I offer an alternative to the existing shareholder proposal regime. The problem, as we see it, is two fold. First, many of these proposals are absolutely frivolous—like requesting that the board to study proposals for government-run healthcare—and yet firms spend many millions of dollars in an elaborate kabuki dance with the SEC and plaintiffs’ lawyers arguing about whether a proposal can be included. Second, even for legitimate proposals, shareholders are under-informed and lack incentives to become informed. Shareholder apathy is predicted, not only by the standard voting models, but also by standard corporate law models, which show that shareholders sensibly prefer liquidity to control (the “Wall Street rule”). The problem is, in essence, that the questions presented to shareholders are rarely, if ever, couched in terms of economic impact. What is the expected impact on shareholder value from adopting a majority voting rule? No one says, and the average shareholder has no idea.
A solution to the first problem would be to use conditional prediction markets to anticipate the proportion of shareholders who would vote for a proposal if it were placed on the ballot. If the threshold were set at, say, 25 percent, the corporation could easily avoid proposals with little chance of passage, but managers would not be able to exclude relatively serious ones. The SEC might consider requiring firms or shareholders to set up these markets as a pre-condition of including or excluding a proposal.
A more ambitious use of prediction markets would be as a substitute for or alternative to shareholder proposals themselves. Prediction markets provide a neutral, objective estimate of the impact of the proposed strategy or action on firm value. In other words, a well-crafted market would give shareholders a simple but powerful fact on which to base their votes: the likely impact on the firm’s stock price. The market is able to do this because it solves the problem of rational ignorance and is superior to all other existing methods for collecting and aggregating information. Even if only a small number of people participate in the markets, those people will have strong incentives to conduct research and to become informed about the issues, and their opinions will manifest themselves in a price they are willing to pay instead of unsupported, often political, arguments. (Go read the whole thing!)
More experimentation with these markets must be done before they are able to completely replace existing doctrines, like Rule 14a-8. (On that front, I spent a good part of Thursday talking to a Fortune 500 firm that is considering deploying markets for corporate governance issues. Many other firms are already using markets in this and other ways.) The SEC can help reduce the expected costs for firms innovating and experimenting in this area by considering a pilot program to test the use of these markets to solve a variety of nettlesome corporate law problems.