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Are staggered boards ever good for shareholders?

by Cydney Posner

In the folklore of corporate governance, is there a governance structure that is more anathema to corporate governance mavens and shareholder democracy activists than the staggered board? (Ok, that’s an exaggeration, but you get my point.)  Proxy advisory firms and activists oppose them, institutional investors vote against them and shareholders proposals to eliminate them are unusually successful.  Staggered boards, where subsets of board members are elected in separate classes every three years—and therefore cannot be easily or quickly voted out—are often viewed as the archetypal technique to prevent hostile takeovers.  Opponents also argue that staggered boards entrench boards and managements by insulating them from the shareholders and making it tough for shareholders to dethrone the CEO. That has to be bad for the company, right? Not so fast, says this study co-authored by a professor at Stanford Graduate School of Business and Stanford Law School. According to the author, quoted in Insights by Stanford Business, “[f]rom Adam Smith on, the concern of corporate governance has been how to mind the managers….Corporate governance has been about building up checks and monitors on the managers. The idea is that if we can fire them, and they know we can fire them, then maybe they will do the right thing.”  But for some companies—in this case, early-life-cycle technology companies facing more Wall Street scrutiny—the evidence showed that, by allowing managers to focus on long-term—perhaps bolder and riskier—investments and innovations, staggered boards can actually be a benefit.

To be sure, the authors acknowledge upfront, there is a substantial body of evidence that shows a “strong and negative association between SBs and firm value”: not only lower shareholder value, but also smaller gains to shareholders in completed takeovers, worse acquisition decisions and weaker board monitoring. Many contend that “SBs harm shareholders by insulating directors and managers from the disciplinary forces of shareholder control, which leads to agency problems such as shirking and empire building (a position known as ‘the entrenchment view’).…Self-interested managers can also use SBs to block acquisition attempts that benefit shareholders.”

Those who favor SBs, however, contend that they can actually improve company value: because “an SB protects the firm from takeovers in the short run, managers protected by an SB can focus on creating long-run value and avoid inefficient short-termism when the value of investments is not apparent to or well understood by outsiders.” Put another way, takeover defenses such as SBs “encourage investment and innovation, particularly at firms whose strategies require a long time horizon to execute and whose outside investors are likely to be less informed about the firm’s value. At such firms, an SB might allow managers to invest in projects whose value becomes apparent to outsiders only in the long run and whose eventual success may require tolerance for early failures.”  Some also maintain that “SBs improve the firm’s bargaining power in the event of a takeover bid: protected by an SB, managers can credibly refuse a bid and bargain for more.”

In the study, the authors capitalized on an anomalous event in the corporate legal history of Massachusetts—in 1990, Massachusetts actually passed legislation mandating SBs. Why would the commonwealth do that, you ask? Because, in 1990, a large British industrial firm launched a hostile tender offer for the shares of a Massachusetts manufacturer. The tender was opposed by the company’s managers and employees as well as Massachusetts legislators, who feared layoffs, cuts in R&D spending and reductions in charitable giving. More significantly perhaps, there was also a lot of press that hyped concerns about a  “second British invasion,” making protection of the company from the invaders a cause célèbre.  Ultimately, the company proposed, and the legislature passed, in rushed sessions, a bill requiring Massachusetts companies to have SBs, thus securing for the company, “via lobbying, a takeover defense that shareholders would not have granted.” The governor signed the bill before cheering company employees, “prais[ing] the firm’s victory in a second ‘War of Independence.’…Less than two weeks after winning a war of independence against a foreign power, [company] managers agreed to an acquisition at a higher price by [a French conglomerate]; the French apparently posed a less serious threat to national security, and thus once again helped Massachusetts repel a British invasion.”

This unusual legislation provided the backdrop and opportunity for the authors to examine the long-term impact of SBs on companies. The authors compared a group of Massachusetts public companies with boards that were staggered due to the state law with a matched control set of similar companies without SBs but in the same industries incorporated elsewhere. The authors also performed placebo and other tests to ensure that the results were not simply the effect of other economic forces. The study showed that, after passage of the legislation in 1990, companies with SBs had higher values than the control firms. They also had greater investment in capital expenditures and R&D, more patents and higher-quality patented innovations, all of which resulted in higher profitability. The Stanford co-author remarked that the study demonstrated “really clean causal evidence of what managers will do when freed from shareholder monitoring in this way….I was surprised that the patent evidence was so clear and that the valuation evidence was so stable and so large.”

Focusing on the 14 years surrounding the 1990 legislation, the authors found that in the seven years prior to the legislation, the Massachusetts companies that would become subject to the new law and the matched control firms “exhibit very similar trends” in value. However, after the 1990 legislation, the Massachusetts group “have higher Tobin’s Q values than control firms, a difference that grows and stabilizes by the mid-1990s.”

More specifically, the study showed that the Massachusetts companies that had SB protection “saw an average increase in Tobin’s Q of 14.3% over the next seven years.” In addition, in the study, the “baseline positive effects of SBs on Tobin’s Q are concentrated in the innovating firms, which experienced a 17.7% increase in firm value following the MA legislation.” The study demonstrated that the benefit of SBs for early-life-cycle companies with “more severe information asymmetries”—discrepancies in the levels of knowledge between management and outside investors about the business and its technology—was “positive and significant.” However, the study found “that the association is negative and significant for mature firms or firms that face lower information asymmetries.” Perhaps even more striking was the impact of pressure from Wall Street: the authors suggest that “the benefits of SBs are most substantial at innovating firms covered by analysts: these firms experienced a 25.32% increase in Tobin’s Q.” In contrast, the study found no significant effect on the subset of non-innovating companies or companies not well covered by analysts.

The study also looked at the “potential channels through which SBs could improve firm value.” What did management do that may have led to these value increases? The authors found that “managers behaved differently when protected from shareholder scrutiny: after the legislation, managers invested more in capital expenditures and R&D, secured more patents, produced higher quality innovations,… and their firms were more profitable.” Additional analyses demonstrated that “all of these changes are concentrated at firms that are young or that invest in R&D intensively (‘innovating’ firms), particularly those innovating firms covered by sell-side analysts and thus particularly subject to Wall Street pressures. Thus, firms that had been subject to the most external scrutiny saw the most improvement.”

For example, the study found a significant increase in investments in capital expenditures and R&D following 1990, specifically, a 9.4% increase in total investments, as well as “a 13.2% increase among innovating firms and an 18.8% increase among innovating-and-covered firms. Both estimates are economically significant and statistically significant at the 1% level, consistent with these firms benefiting the most from SBs’ protections.” Relief from outside pressure could also affect the quality of innovation. The authors suggest that, to “the extent that the protection afforded by SBs facilitated a greater tolerance for failures and more experimentation in firms, we could also expect improvements in innovation quality.” And that’s largely what they found.  Looking at citation-weighted patents (a measure of scientific impact based on the number of times a patent is cited), economic value of patents (based on market reactions to patent approval news) and patent originality (based on the diversity of patents that influenced the particular patent), the authors found statistically significant increases in citation-weighted patents and in the economic value of patents, with even higher increases shown for innovating companies and innovating-and-covered companies. With regard to patent originality, the authors found on average, no statistically or economically meaningful change and only a slight increase in patent originality for innovating companies and innovating-and-covered companies.  The study also found  improvements in affected firms’ return on assets at statistically significant levels.

Interestingly, the study also showed that the SB group experienced a “significant increase” in the percentage ownership of shares held by “institutional investors and ‘dedicated’ institutional shareholders (e.g., shareholders with large and stable ownership blocks…), who are relatively more patient and who could alleviate myopic pressures on managers.” This type of investor also facilitated a long-term perspective.

What does this mean, according to the authors?  Especially for younger, tech-oriented or otherwise “innovating” companies that face intense pressures from Wall Street, SBs, by reducing market pressures, can help to improve company value by allowing management to focus on long-term value. Management at these companies “were more likely to invest in growth and innovation once they were entrenched: they made more long-term investments, created more (and higher quality) innovations, and their firms were ultimately more profitable. These effects were particularly pronounced in firms that relied on innovation and faced scrutiny from Wall Street analysts.” Those conclusions, the authors suggest, “are consistent with the empirical observation that a large proportion of IPO firms—which tend to be younger and face greater information asymmetries—go public with SB structures.”  However, as firms mature and the market becomes more familiar with the company’s investments and strategy, the value of SBs changes and their “adverse entrenchment effects [begin] to dominate as information asymmetry becomes less significant.” That may explain why shareholders typically “prefer the discipline of the market for corporate control for larger and more mature firms.” The authors conclude that their “findings support the view that SBs at young firms may be usefully paired with sunset provisions that phase out these powerful insulating forces as firms mature.”


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