Trading and Shareholder Voting
Recent regulatory reforms in advanced economies have empowered shareholders by letting them vote on executive compensation, corporate transactions, changes to the corporate charter, and social and environmental proposals. This shift of power from boards to shareholders assumes that shareholder voting increases welfare and firm valuations. It applies the logic of political democracy and takes for granted that aligning the preferences of those who make decisions with those for whom decisions are made – a form of corporate democracy – is optimal.
In our paper, Trading and Shareholder Voting, 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. We analyze how shareholder voting and trading in the stock market depend on each other, compare the effectiveness of shareholder voting with delegation of decision-making to a board of directors, and show how this comparison is affected by the liquidity of the market for the firm’s shares. While the literature has looked at many important questions in the context of shareholder voting, it has so far not examined the effectiveness of voting if the shareholder base forms through trading in the stock market.
We consider a model in which shareholders first trade their shares in a competitive market and then vote on a proposal. We assume that shareholders have different attitudes toward the proposal, which may stem from their ties with the company, common ownership with other firms, social or political views, time horizons, risk aversion, or tax considerations. As a result, some shareholders are biased toward the proposal and changing the status quo. They vote to accept it, and 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 it, and we call them conservative. For example, we could have a vote on a proposal to weaken the anti-takeover defenses of the firm, which, if approved, is likely to shorten the time horizon of the firm’s investment projects. Then shareholders with a short-term view would tend to approve this proposal (activists), whereas shareholders with a longer time horizon would be biased against approving the proposal (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 very different ownership structures and taking very different strategic directions.
Consider first the situation in which shareholders expect a high likelihood that the proposal will be approved. Then those who like the proposal, the short-termists in our example, tend to value the firm more than the long-termists. During trading in the stock market, activists buy, conservatives sell, and the shareholder base becomes more activist. These activist shareholders will apply a low bar toward accepting the proposal. Hence, they frequently vote to support it, which confirms the ex-ante expectation that the proposal is likely to be accepted.
Similarly, for the same firm, the opposite scenario can occur. If shareholders expect the proposal to fail with a high probability, conservatives value the firm more and buy shares from activists, who value them less. The shareholder base becomes more conservative, more biased against the proposal, and frequently votes against it. 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. Importantly, shareholders may not coordinate on the outcome that generates more value for them.
Decision-makers and price setters are different. One of the arguments in favor of shareholder democracy is that the 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 trader.” The attitude of this shareholder is necessarily 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 trader, who is indifferent, has a medium-length investment horizon.
The key insight is that the marginal trader does not make decisions. Decisions are made by a majority vote. Therefore, approval requires support from the more extreme shareholders, who hold the shares after trading and all have shorter time horizons than the marginal trader. However, the marginal trader’s valuation determines the price, and since his time horizon is longer than that of all the other shareholders, he will frequently conclude that a proposal that is expected to gain majority approval reduces value, and mark down the share price accordingly. This divergence in attitudes between the marginal trader, who sets prices, and the majority, who decides on proposal outcomes, has several implications, which we explore next.
Trade can be harmful to shareholder welfare and prices. We ask how shareholder welfare and stock market valuations are affected if market liquidity (depth) increases. Interestingly, we find that greater opportunities to trade may be detrimental for both prices and welfare. The reason stems from the divergence between price setters and decision-makers. If the market becomes more liquid, this divergence may increase and reduce prices and welfare. Put differently, market liquidity allows extreme investors to buy large positions and impose their extreme views on moderate shareholders through voting.
Opposing effects on welfare and prices. The literature in financial economics assumes that stock market valuations are good approximations for “shareholder value,” i.e. the value of the firm to all shareholders, which we refer to as shareholder welfare. However, we show that shareholder welfare and stock market valuations may be very different. For example, consider a change in the corporate charter that affects how shareholders vote, but not how they trade. We show that such a change may increase shareholder welfare and make the average shareholder better off but reduce the stock market valuation of the firm. Again, this happens because a proposal may be approved by the majority and can make the average shareholder better off, but the marginal trader is not representative of the majority, so the stock price may decline. Building on this insight, our results cast doubt on the validity of price reactions to voting outcomes as an empirical proxy for the welfare effects of various proposals.
Biased boards are good, and often better than shareholder voting. Finally, we compare shareholder voting with decision-making by a board of directors. The first important insight is that boards should be biased relative to the preferences of the shareholders who initially own the firm. This bias is optimal because shareholders do not just consider whether the decision taken by the board aligns with their own preferences. Rather, they also consider whether the board’s decision aligns with the preferences of those who have the highest willingness to buy shares, which benefits the shareholders who sell by increasing the stock price. Hence, our result contradicts the view that optimal boards should be aligned with current shareholders.
Shareholders may not delegate to an optimal board. If shareholders can decide to either delegate decisions to a board or retain this right for themselves, they will sometimes decide against delegation to a board, even if the board would be optimally chosen and thus increase shareholder welfare. The reason is that shareholders who intend to buy shares may prefer decisions that reduce the price at which they buy at the trading stage.
Shareholder democracy is fraught with problems. Overall, we strike a cautious note on shareholder democracy. Voting gives rise to multiple outcomes. Shareholders may coordinate on the inferior outcome, and with more liquid stock markets, outcomes may even get worse. Delegating decisions to a board of directors is often better, but, unfortunately, shareholders may decide against delegating to an optimal board of directors in order to increase their trading profits.