The Proxy and Risk Taking
The board of directors of publicly traded firms have historically had one solemn duty: to maximize intrinsic share value and increase shareholder wealth. However, as a result of the egregious risk taking exhibited in the form of sub-prime lending, boards have been placed under increased scrutiny for their role in risk management. The current economic downtown is a direct result of the wanton disregard for risk assessment and risk minimization exhibited by large financial institutions and their boards. Because of this fact, new legislation entitled the Dodd-Frank Act, signed into law by President Barack Obama in July of this year, gives the Securities and Exchange Commission (SEC) more control in regulating the risk taken by businesses at the expense of the public good.
One of the most important elements of Dodd-Frank is the provision entitling shareholder access to the proxy statement. Shareholders are now able to nominate directors without incurring the “significant costs of a proxy fight”. Qualifying shareholders and groups can modify the proxy statement sent to shareholders to include their own nominees for directors. In order to qualify, shareholders must hold “three percent of the total voting power for at least three years”. In addition, also as a result of Dodd-Frank, shareholders have been granted more disclosure as to corporate directors and governance. For example, companies are now required to 1) Describe board leadership structure, 2) Discuss why each director is suited to serve and 3) Explain the board’s role in risk oversight. Each element in Dodd-Frank is designed to increase transparency so as to decrease malicious risk taking and, if in the event of egregious risk taking, allow shareholders to replace board members with more suitable candidates. However, when considering the potential for abusing this new regulation, it is possible that activist investors will use Dodd-Frank as a pulpit for their own self- aggrandizing agenda. If actions are taken by biased directors with the sole purpose of benefiting the constituents that voted him or her into power, the entire purpose of the new provision under Dodd- Frank will be null and void.
While Dodd-Frank and the modification to shareholder proxy access is likely to provide shareholders with more means to combat aggressive risk taking by companies, it will also allow activist investors to pursue their own agenda. There is some evidence that the provision will do more harm than good. For instance, it is likely that directors who are nominated by a group of shareholders will remain “beholden to the group that brought them to the table”3 and seek ways to carry out the agenda of the shareholders who put them in place. A director with an agenda that runs counter-stream to the true purpose of the board, which is to maximize profit and to increase the stock’s intrinsic value, can potentially increase risk, thus decreasing intrinsic value. Instead of creating long-term shareholder value, proxy fights instigated as a result of Dodd-Frank could “handcuff boards and directors by increasing costs and creating additional uncertainty”. Thus, it is possible that the new shareholder allowances brought forth by Dodd-Frank could inevitably decrease share value by adding additional instability within a company’s board. Furthermore, the Dodd-Frank Act could result in a “loss in shareholder value due to the threatened or actual election of certain shareholder nominees using company proxy materials,”
While risk is a natural part of a company’s operations, the new provisions promulgated by Dodd-Frank could potentially cause investors to factor in board members elections and potential proxy battles into the overall equation of business risk. Historically, business risk has centered around a company’s future cash flows, which derive from the company’s operations and the environment it does business in. The elements of risk, including business risk, factor into the overall risk premium, or return investors require above the risk-free rate for uncertain or risky securities. Given the events that caused the recent economic downturn, which stemmed from aggressive risk taking, perhaps investors should factor in an additional component into the risk premium, one that takes into account proxy health and the stability of the board. If, as a result of Dodd-Frank, an increasing number of activist-investors are installed on the boards of large firms, the potential exists for those directors to pursue agendas that benefit the group of shareholders they represent, rather than the company, thus increasing business risk and the risk premium.
As of today, the SEC is engaged in a suit brought by the Business Roundtable and the U.S. Chamber of Commerce. The suit seeks to overturn the shareholder proxy access allowed by Dodd- Frank and the SEC. It contends that large unions and pensions will use proxy access to serve special interests, rather than “the interests of shareholders as a whole” On one hand, the shareholder provision is a benefit, increasing transparency and providing a new set of checks and balances for shareholders. On balance, the provision could result in an increase in risk taking and eventual harm to the shareholder. Only time will tell whether the new SEC provisions are a benefit or a detriment, but the stakes are high enough that potential investors should consider incorporating proxy stability and shareholder influence into the risk premium prior to investing.