Independent blockholders on the board
Can independent directors who are blockholders help your firm?
Tareque Nasser, an Assistant Professor at the College of Business Administration, examined this question in his recent research published in the Quarterly Journal of Finance. The articles are coauthored with Professor Anup Agrawal from the University of Alabama, and they examine the relation between the presence of an independent director who is a blockholder (IDB) with various corporate policies and outcomes.
As representatives of shareholders, boards of directors are charged with hiring, compensating, monitoring and disciplining CEOs. Given their substantial powers, boards can serve as an important governance mechanism. But boards’ ability to monitor CEOs hinges on having strong, motivated and independent directors. A director is truly independent if she is not under undue influence of the CEO, allowing her to challenge the CEO if he pursues his interests at the expense of shareholders. A powerful CEO can usually subdue nominally independent directors, who often owe their board seats to the CEO. But a CEO’s co-option of the board can break down in the face of a strong dissenting voice. Hence, often all that is needed to overcome a CEO’s ‘rule’ over the board is one truly independent director with a significant equity stake in the firm, who has a strong incentive to monitor the CEO and the ability to confront him should the need arise. This requirement is satisfied by an IDB.
One article, titled “Corporate Financial and Investment Policies in the Presence of a Blockholder on the Board”, examines the relation between the presence of an IDB and corporate policies, risk-taking and market valuation. It found that firms with an IDB have significantly (1) lower levels of cash holdings, payout and R&D expenditures, (2) higher levels of capital expenditures, and (3) lower risk. The market appears to value IDB presence and the associated decrease in dividend yield. About 75% of the IDBs in the sample are individual investors, who drive most of the results. The findings suggest that IDBs play a valuable role in reallocating corporate resources and reducing agency costs.
The other article, titled “Blockholders on Boards and CEO Compensation, Turnover and Firm Valuation”, finds that the presence of IDBs in firms promotes better CEO contracting and monitoring, and higher firm valuation. It finds that firms with IDBs have lower excess CEO pay, lower flow and stock of CEO equity incentives, and higher valuations. These effects are substantial and robust. These findings imply that by making it easier for blockholders to obtain a board seat, proxy access rules or bylaws can benefit shareholders.
So what can firms do to benefit from the presence of an IDB?
- Professors Bebchuk and Jackson published a paper in Harvard Business Law Review arguing against SEC’s rulemaking, using Nasser’s research findings, in tightening outside blockholder disclosure. They argued that the Commission should not adopt new rules that would tighten the disclosure thresholds that apply to blockholders such that it would discourage block formation, which significantly reduces the chance of having an IDB.
Under the SEC’s proxy access rules adopted in 2010, holders of 3% of a company’s shares for three years would have been allowed to place a director-nominee on the corporate proxy statement. In striking down the rule in 2011, the D.C. Circuit Court of Appeals said the SEC failed to back up its claim that the rule would improve shareholder value and board performance. However, Nasser’s findings that the presence of an IDB is beneficial for shareholders imply that a proxy access rule that makes it easier for blockholders to obtain a board seat can improve corporate governance.
Therefore, those firms who care about good governance should provide comment letters to the SEC, if such opportunity arises, to promote block formation and proxy access. Taking this stance in SEC rulemaking will be viewed positively by investors, resulting in an enhanced firm value.
- Often firms need to be insulated from pressure and clamoring by biased or uninformed shareholders. Nasser finds that IDB presence does not affect CEO turnover-performance sensitivity. The absence of greater turnover-performance sensitivity in IDB presence suggests that IDBs do not rely solely on stock performance, which is not within the CEO’s direct control, to discipline managers, instead relying on soft information gleaned from their first-hand experience on the board. This implies IDB is able to counteract any unreasonable shareholder pressure based on short-term market price movement. Firms make better long-run decisions on hiring and firing the CEO by having an independent blockholder on the board.
Hence, both the firm and its shareholder should try to bring in independent shareholders with substantial ownership on the board.
- Nasser finds that CEO’s equity-based pay is lower in firms with IDBs. Also, an IDB presence lowers excess CEO pay. These effects are particularly strong when IDBs are on the compensation committee. Moreover, IDBs play a valuable role in reallocating corporate resources and reducing agency costs.
This suggests that firms should try put IDBs on their audit, compensation, and nominating/corporate governance committees.