Are Staggered Boards Ever Good For Shareholders? – Corporate/Commercial Law

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{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} 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{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} 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{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} 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{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} increase in total investments, as well as
“a 13.2{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} increase among innovating firms and an 18.8{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} increase
among innovating-and-covered firms. Both estimates are economically
significant and statistically significant at the 1{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} 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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