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I’m generally fond of companies that find creative ways to access the public equity markets while not giving away all the “rights” that traditionally go to “owners” of “companies.” I mean, you want money, you ask people for money, you give them the terms that you need to give them to get the money: what is so sacred about shareholder voting rights?
At the same time though I’m a little skeptical of some of the reasons that private companies give for not wanting to go public. These seem to me to be basically two:
- High-frequency-trading computers robots algorithms crash scary scary.
- “If we go public our shareholders will force us to focus on quarterly earnings rather than the long-term good of the company.”
The first one, as you might notice from its grammar, seems ill-defined, though the fact that like every high-profile IPO this year has suffered from a computer glitch makes me think that it’s on to something. Something vague though. The second one: I mean, just don’t do that. What’s gonna happen to you if you manage for the long-term good of the company? Your stock will go down this quarter? Who cares? I thought you were in this for the long haul?
But they’ve got a point. Today in “shareholders are assholes,” here’s a delightful recent paper by three business professors about how stronger shareholder rights make companies more likely to manage earnings.1 As they point out, you could have two models of how strong public-shareholder rights (i.e. things like robust shareholder voting rights, weak anti-takeover provisions, etc.) affect corporate behavior:
- Shareholders are good and will make companies do good things if they’re empowered,2 or
- Shareholders are self-interested jerks and will make companies do bad things if it makes them more money.
There’s no particular reason to believe the first one but, y’know, it’s a hypothesis; it is also wrong:
We find that when shareholder rights are stronger, managers are more likely to manage earnings both upward and downward. Firms that meet or slightly beat the analyst forecast report greater accruals in the current quarter relative to the subsequent four quarters if they offer strong shareholder rights. Similarly, firms that easily beat the analyst forecast report lower accruals in the current quarter relative to the subsequent four quarters if they offer strong shareholder rights. Both results are consistent with accruals showing more reversal (i.e., greater discretionary reporting) for firms with strong shareholder rights. These results are not consistent with the traditional view that shareholder rights serve a governance role by reducing discretionary reporting behavior.
The overlapping intuitions here are something like:
- Strong shareholder rights mean that shareholders are more likely to effectively complain if you miss earnings or generally have volatile earnings, which causes managers to manage earnings to avoid complaints and things like votes against their pay packages.
- “Strong shareholder rights” is a euphemism for “weak takeover protections,” and companies that miss earnings are easier pickings for takeovers, which causes managers to manage earnings to avoid takeovers and the associated firings.
- The cause is some third thing that leads to both weak shareholder protections and lack of giving a damn about quarterly earnings – Facebook’s IPO, for instance, evidenced both terrible shareholder rights and a Silicon-Valley-mandatory letter expressing a theoretical indifference to quarterly earnings, though, y’know, there’s the Instagram thing, so how long did that last?
Anyway! Are there lessons here? And, for whom? Like, if you were in charge of the world – or at least the SEC, which in turn is sort of in charge of securities markets – how do you weigh the value of “shareholders’ rights to control the companies that they own” against the value of “honest and reliable accounting”? Is the answer “who cares”? Both of those are extremely abstract values, are they not? No one’s ever gone to war over shareholder rights or accurate accounting.3 But perhaps they represent larger things: if you squint, “shareholder democracy” can be confused with “democracy,” and “honest accounting” can be confused with “honesty and fair dealing.”
Or if you’re a company thinking about going public, what does this tell you? “Don’t go public,” I guess, but that’s not a great answer. “Manipulate your earnings,” maybe, though that also has some faults.
Perhaps somewhat surprisingly, the result in this paper is reversed for companies with a lot of long-term institutional shareholders: strong shareholder rights + long-term holders = less earnings manipulation. So “sell your IPO to a lot of long-term institutions” is a good answer for companies who want to go public but don’t want to devote their energies to managing earnings. Perhaps you do this by incentivizing long-term shareholding with loyalty rewards. Or perhaps you do it by having your IPO bankers target and persuade long-term institutions. With Facebook’s IPO endlessly in the news, this is strangely controversial – favoring big institutions rather than retail traders seems to have been a problem there4 – but that doesn’t make it wrong.
Or just, y’know, go public with poison pills and staggered boards and supervoting shares and no fiduciary duties. And then when people yell at you about it, say that you’re doing it to protect the integrity of your accounting. That could work too.
Lail, Martin & Thomas: The Influence of Strong Shareholders on Earnings Management [SSRN via Professor Bainbridge]
1. You can be a little unsatisfied about the terms “stronger shareholder rights” and “manage earnings” but they’re basically fine. Shareholder rights are measured using a twelve-factor index from RiskMetrics with things like classified boards, poison pills, blank check preferred stock, golden parachutes, restrictions on shareholder bylaw amendments, etc. Earnings management is measured by looking at analyst earnings expectations and a model of discretionary accounting accruals; the intuition is that what “earnings management” looks like is (1) accruing above-trend amounts when you beat expectations by a lot and (2) accruing below-trend amounts when you meet or barely beat expectations. I.e. you borrow earnings from big quarters to make up earnings in weak quarters, because beating by a little is much better than missing, while beating by a lot is not that much better than beating by a little.
2. Does this sound idiotic? I mean I feel like it’s the intuition behind a lot of disclosure and advisory-vote and whatnot rules and proposals. Like the one where companies should tell their shareholders what they’re contributing to political candidates, because the shareholders are better situated to decide that than the companies are, or something.
3. Asserted without evidence. I would love to be wrong about this. If Bolivia and Paraguay mobilized over LIFO reserves in 1931, or something, please tell me about it.
4. TBF the favoritism shown to institutions in the Facebook IPO was telling them not to buy it, but that won’t usually be the case.