Sometime in the next few weeks, Securities and Exchange Commission chairman Chris Cox will likely have to decide how he will vote on a pair of competing rules on shareholder access. One “proxy access” rule would shift power from boards of directors to cliques of outside shareholders by permitting certain shareholders and groups of shareholders to include in company proxy materials proposals for amendments to bylaws that would mandate procedures to allow shareholders to nominate board of director candidates. The other preserves longstanding rules that make it difficult and costly to for dissidents to mount proxy fights.
The SEC’s commissioners are evenly divided along partisan lines on the question. The Democratic commissioners favor increased proxy access. The Republicans favor the status quo. Cox holds the deciding vote. Which way will Cox vote? We’re not in the predictions game. But if we take Cox at his word about his own agenda at the SEC, it seems clear that he should vote against the new proxy access rules.
After the jump, we look at how the new proxy access rule hurts ordinary investors.
Protecting Ordinary Investors First
In his first speech to Congress after taking office, Cox said that it was the mission of the SEC to “always put ordinary Americans first.”
“Since making the transition from the halls of Congress to the SEC, I have set out to rededicate the agency's ongoing efforts in virtually every area to the service of the individual investor,” Cox said.
Although the proponents of the proxy access rules like to pad their arguments with rhetoric about shareholder democracy, the effect of the rules would be to make stock ownership costlier for most individual investors. Increased proxy access would increase the costs of owning shares because it would open companies up to exploitation by special interests—activist shareholders, hedge funds, union dominated pension funds—whose interest may, and often do, diverge markedly from those of ordinary shareholders. While ordinary shareholders could theoretically resist the attempts at special interest shareholder to manipulate a company for self-interested reasons, the cost of resistance is likely to be quite high.
Rational Ignorance and Special Interests
To understand why resistance is costly we need only to remember Andrew Jackson’s famous warning that “eternal vigilance by the people is the price of liberty.” Vigilance on the part of shareholders under our traditional proxy access rules is well understood. Shareholders who own stock through mutual funds or individually as part of a diversified portfolio do not need to overly concern themselves with the operations or prospects of any one company. They seek to benefit from widespread prosperity and corporate profit growth. As a result they can be rationally ignorant of many aspects of the companies they are invested in. The cost of acquiring the additional information about a particular company is greater than the expected benefits.
But this calculation works differently for shareholders with concentrated interests in a company or shareholders who have interests in a company that do not arise from being shareholders. This is one reason one of the few elements of corporate governance that does attract public attention—and legal regulation—is the activities of large shareholders, company insiders and related party transactions. These special interest shareholders can profit by acquiring knowledge and influence within a company that are practically unavailable shareholders who don’t have special opportunities.
The new proxy rules would further empower these special interest shareholder, leaving ordinary shareholders open to exploitation. To remain vigilant against the self-interested activities of special interest shareholders, ordinary shareholders would have to vastly increase their knowledge not only of a company’s operations but also of the goals of their fellow shareholders. This additional information would come at a cost—either in further reliance on analysts and other experts, money spent on outside advisers, or time spent individually researching companies. Owning shares of a public company would become costlier and more time consuming.
A comment on DealBreaker yesterday made this point, although for quite different purposes. “So most individual investors are likely at an informational and other disadvantage when compared to other investor groups, fine,” the commenter wrote. “In a free market these actions only open up further profit opportunity for the well-informed investor, and should signal investors whose activism consistently results in losses to change their behavior.” That is just another way of saying that the rule changes would result in loss opportunities for less well-informed investors.
Exit Ordinary Shareholders, Stage Left.
The likely outcome is that some investors would decide to exit the market for shares of public companies rather than absorb the additional costs. We’ve seen this before, after the crash of 1929 left the public largely distrustful of stock ownership. The SEC was formed, in part, to restore investor confidence after this debacle. While the new proxy access rules would likely have a smaller, more marginal effect on investor confidence, there's would like be at least some deterrent effect on investors. It would be a frightful irony if an SEC chairman who has announced his mission as protecting the ordinary investor were to adopt a proxy rule under the guise of shareholder democracy that undermined investor confidence.
Most investors won't bail out on public company stock. But Even investors who remained in the stock market would be unlikely to shoulder the burden of eternal vigilance against special interest shareholders. While the benefits of exploitation to special interests can be concentrated, making knowledge and dissident campaigning payoff, the costs would be dispersed among the larger class of ordinary shareholders. The new proxy rules would likely result in a special interest tax, a slow tariff on the benefits of shareholding for ordinary shareholders.
Increasing the cost of stock ownership is a perverse effect of a rule offered under the aegis of shareholder democracy. But it is the unavoidable outcome of that rule. If Cox is serious about protecting the interests of “ordinary Americans” he should reject the rule. It advances “shareholder democracy” only in the most Orwellian sense of the phrase.
Earlier on DealBreaker: Against Shareholder Democracy.