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AUTHOR:
Moshe Pinto
TITLE:
The Role of institutional Investors in the Corporate Governance
SUGGESTED CITATION:
Moshe Pinto
(2006)
"The Role of institutional Investors in the Corporate Governance",
German Working Papers in Law and Economics:
Vol. 2006:
Article 1.
http://www.bepress.com/gwp/default/vol2006/iss1/art1
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ABSTRACT:
Corporate governance has recently received much attention due to Adelphia,
Enron, WorldCom, and other high profile scandals, serving as the impetus to
such recent U.S. regulations as the Sarbanes-Oxley Act of 2002, considered to
be the most sweeping corporate governance regulation in the past 70 years,
and enhancing the long standing bandwagon for increasing shareholder
power. More broadly, the Berle and Means model, in which professional
managers control large public companies, is being questioned. The separation
of ownership and control creates an agency problem, that managers may run
the firm in their own, rather than the shareholders' interest, choosing the
maximization of their own utility over the maximization of shareholder value.
Commentators with a Law and Economics bent have long claimed that
shareholder passivity is inevitable. Modern companies have grown so large
that they must rely on many shareholders to raise capital. The shareholders
then face severe collective action problems in monitoring corporate managers.
Each shareholder owns a small fraction of a company's stock, and thus
receives only a fraction of the benefits of playing an active role, while bearing
most of the costs. Passivity serves each shareholder's self-interest, even if
monitoring promises collective gains. Thus, commentators have entrusted the
hostile takeover mechanism to discipline the managers by threatening to oust
poor performers by bidders who would consolidate ownership and control.
Anti takeover legislation and the spread of intra-corporate mechanisms such as
poison pills have, in effect, sterilized the hostile takeover mechanism of its disciplining effect, and have turned commentators’ attention to Institutional
investors as potential monitors of management. Institutional Investors, such
as pension funds and mutual funds, which control over half of publicly traded
equities in the United States, by virtue of their size are an exception to the
small, rationally apathetic shareholder envisioned by Berle and Means, and
thus become the natural candidates to watch the watchers.
Bernard S. Black has eloquently stated the case for institutional over sight
noting that:
“The case for institutional oversight, broadly speaking, is that
product, capital, labor, and corporate control market constraints
on managerial discretion are imperfect, corporate managers
need to be watched by someone, and the institutions are the
only watchers available.”
And indeed, Institutional investors have, in the past decade, increasingly
engaged in corporate governance activities, introducing proposals under rule
14a-8, the Securities and Exchange Commission's (SEC) proxy proposal
rule, and privately negotiating with management of targeted firms with the
stated goal of improving corporate performance (jawboning). Shareholder
activism, championed by institutional investors and embraced by individuals,
has revolutionized U.S. corporate governance. Investors have assumed a
looming presence in corporate boardrooms, and the stories of ousted CEOs, emboldened outside directors, shareholder “target” lists, and corporate
capitulations fill the financial headlines.
The evident Increase in Institutional Investor’s activity, stemmed, inter alia,
from the change of position of U.S. government agencies regarding
institutional involvement in corporate ownership, control, and monitoring. For
instance, the Labor Department now encourages pension funds to be active in
monitoring and communicating with corporate management if such activities
are likely to increase the value of the funds’ holdings11. In 1992 and 1997
decisions by the SEC allowed shareholders more flexibility in communicating
with each other and submitting shareholder proposals. And, in 1999, the U.S.
Congress repealed the Glass-Stega Act, ending restrictions on direct
ownership of U.S. equity by banks. More recently, in July 2003, the
Securities and Exchange Commission proposed opening up the director
nominations process to shareholders (“SEC Roundtable”). The General
feature of the above regulatory milieu change is enabling Institutional
Investors to take action not aimed at control and enable Institutional Voice.
To be sure institutional activism hasn’t been monolithic and different
institutions vary in their craving for the task and there are reasons to suspect
that even further reducing legal encumbrances won’t stir the more lethargic
institutions of their somnolence.
Taking them as a whole, I conclude that there is a strong case for enhanced
legal measures that will further facilitate joint shareholder action not directed
at control, and further reduce obstacles to particular institutions owning stakes
not large enough to confer working control. Narrowly speaking, I purport that
the core of legislative action should be on requiring companies, under certain circumstances, to include in their proxy materials shareholder-nominated
candidates for the board.
The concerns about institutional oversight arise for two main reasons. First,
controlling shareholders may divert funds to themselves at the expense of noncontrolling
shareholders or may pursue interests of special interest groups that
will use their power as lever vis-à-vis corporate management. Second, the
institutions are themselves managed by money managers who need (and often
don't get) watching and appropriate incentives.
Several factors limit the downside risk from increasing institutional power:
First, the accumulated evidence concerning the consequences of the increased
institutional investors activism proves that much of the alleged adverse effects
of institutional voice did not materialize. On the contrary, with a few
exceptions the institutions are mainly passive. Second, institutional voice
means asking one set of agents (money managers) to watch another set of
agents (corporate managers). Money managers have limited incentives to
monitor because they keep only a fraction of the portfolio gains. But, money
managers also won't take the legal chances that an individual shareholder
might, because they face personal risk if they breach their fiduciary duty or
break other legal rules. The institution, however, realizes most of the gains
from such misdeeds. That limits the downside risk from institutional voice.
Third, institutional voice requires a number of institutions, including different
types of institutions, to join forces to exercise influence. That further limits the
downside risk from institutional power, because money managers can monitor each others' actions to some extent, and won’t cooperate unless a proposed
initiative benefits all the shareholders; Reputation is a central element in this
second form of watching. Diversified institutions are repeat players that
interact over and over, at many different companies, over a span of years.
Game theory teaches us that a repeat game of this sort induces the actors to
cooperate earn good reputation and elicit cooperation from other institutions;
realizing that cheating will invite retaliation (“tit for tat” strategy). Fourth,
corporate managers can watch their watchers, and if the institutions abuse their
power, corporate managers can complain -- loudly and often -- to lawmakers.
If the costs to other shareholders, including smaller institutions, of abuse of
power by the largest institutions exceed the other shareholders' gains from
better monitoring, those shareholders will support corporate managers' efforts
to clip the large institutions' wings. Money managers know that, which limits
their incentive to misbehave in the first place.
Much of the promise of shareholder monitoring lies in informal shareholder
efforts to monitor corporate managers or to express a desire for change in a
company's management or policies. But, in order to induce managers to
cooperate with the active shareholders in the pursuit of improved corporate
performance, shareholders must have a “big stick” in the form of a viable
option to remove the board of directors and subsequently the underperforming
management. Moreover, because institutional incentives push against direct,
company-specific monitoring, facilitating indirect monitoring through the
board of directors would enhance the chance of awakening private institutional
investors from their alleged somnolence. If the institutions can more easily
select directors, at least for a minority of board seats, they can hire directors to
watch companies on their behalf and be accountable to them. Currently,
directors are often more loyal to corporate officers than to the shareholders
whom the directors nominally serve. Reform should focus on the process of voting, rather than on substantive
governance rules. To be sure, lawmakers should not mandate activism or
impose large regulatory costs on companies or shareholders; rather they
should empower the institutions to make their own decisions about optimal
governance structures. They have incentives to make good choices -- or at
least better choices than lawmakers would. Oversight will take place only
where the institutions conclude that the benefits of monitoring outweigh the
costs. The desired policy goal will let six or ten institutions collectively have a
significant say in corporate affairs, while limiting the power of any one
institution to act on its own. The focal point of lawmakers’ efforts should be
on measures that would sway the incentives of shareholders towards more
active monitoring of corporate management; the final decision should be left
to the shareholders.
This paper proceeds as follows. Part 2 develops the qualitative case for
believing that institutional voice can improve corporate performance in
general and specifically through evaluating the issue of CEOs succession. I
evaluate the potential benefits of greater oversight examining the domains in
which institutional oversight is more likely to be value enhancing. Moreover, I
explore the SEC’s proposal to enable shareholder access to the ballot and
stress the importance of indirect monitoring through trade groups and through
the board of directors. Finally, I explore the role of indirect monitoring
through trade groups and the role of the Institutional Investor Service (“ISS”).
Part 3 contends that the downside risk from institutional voice is negligible. It
responds to the predominant concerns with institutional power, including the
risks inherent in asking one set of agents to monitor another set of agents;
whether money managers will use their power to obtain private benefits or
promote special interest; and concerns about institutional or managerial focus
on the short term. Part 4 deals with the evidenced disparity in scope and focus
of institutional oversight between different types of institutional investors, and
examines the incentive structure of different institutional investors. In
addition, since monitoring has to be done by money managers within the institutions, I investigate the incentives of money managers and the impact of
promanager conflicts of interests. Furthermore, I asses the regulatory milieu in
which various institutional investors operate in order to determine whether
legal barriers the cause of relative somnolence of certain types of institutional
investors. And finally, I consider the policy questions raised by increased
shareholder activism and try to determine the optimal format policy-makers
should pursue regarding shareholder activism. Part 5 concludes this paper.
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