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German Working Papers in Law and Economics
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Volume 2006

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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