Stockholder democracy...

Today's New York Times carries an article on shareholder democracy that illustrates why there are shades of gray even with proposals that seem absolutely cut and dry at the outset. This one has to do with the proposal from the SEC, allowing institutional investors to propose board members who would then be listed in the proxies that companies send out to stockholders. (Only investors who are not interested in doing an acquisition and have held the stock for more than a year can propose new directors, and even then, only 25% of the directors can be challenged) The idea seems unexceptional. Until now, shareholders have had to vote for those directors proposed by the company or write in their own alternates; only in a proxy fight do shareholders get choices. This rule change would presumably give them more choices even in the absence of a proxy fight.

The fear voiced in this article is that some shareholders may have other interests in the company that overwhelm their interests in seeing stock prices improve. The example given is of a shareholder who has taken a large position on the credit default swap market, betting that the company will fail. Such a shareholder may gain more from seeing the company default than continue as a going concern; consequently he or she may nominate directors who will drive the company into the ground.

I think that the article has a point, though I think it is also a little over the top in terms of hysteria. There are two phenomena muddying the waters of shareholder democracy. The first is investors who own hybrids - convertible bonds, debt with equity options etc., who do have multiple and sometimes conflicting interests in the firm. This is not new but it is a much bigger factor now than two decades ago. The second is that increasing presence of investors who bet not on the direction of the stock price but on its volatility. Many option based strategies are directionless - investors don't care whether the stock goes up or down - but make or lose money depending upon how volatile the stock is. The SEC's implicit assumption that all stockholders have a shared interest in the stock price going up is coming into conflict with the consequences of a more diverse set of interests in stockholders: some want the stock price to increase but some do not.

I do not have an easy solution. We could try restricting shareholder voting only to those investors who have no conflicting interests, but I don't think that proposal can be easily policed and it would not be fair. A bondholder who has an equity position is just as much an equity investor as one who does not, even though the former's interests may diverge from the remaining stockholders. I am also not comfortable with any rule that tries to define "good" shareholders and "bad" shareholders. Good and bad are in the eyes of the beholder... Ultimately, as in any democracy, we have to trust the voters to make the right judgments, even though they may bring in very different interests into the voting booth.