Corporate Governance

Week 2-Lec

The Role of Owners (Share holders and Specifically

Institutional Investors in the Corporate Governance

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Shareholders: Ownership• Historically, ownership is one of the major issue• Dispute over property, ownership- started right

from the very beginning……..Again human nature…….

• The modern western concept also follow it; as it emphasize on the ownership and believes that ownership can enhance the competitiveness of the companies, businesses……..

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Shareholders: Ownership (Cont’d)

• Regarding the early concepts of corporations, as already discussed in the previous week lectures……– Initially corporations were formed by

municipalities, universities etc.– Later on, East India Company and Dutch

companies.– Later on the modern companies– multiple

owners with different amount of shares to own it.

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Shareholders: Ownership• Shareholders are often referred to as the

owners.• Generally there are accepted principles that;

– Owner has the right to use property as wishes.– Owner has the right to regulate anyone’s else use of

property.– Owner has the right to transfer the rights to property

on whatever terms he wishes.– Owner is responsible for making sure that his use of

property does not damage others.• So we can say Ownership is a combination of

rights and responsibilities with respect to a specific property.

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Shareholders

• What is a Shareholder in a Company?

• Types of Shares and controls

• What is their position/role in the company?

• The real owners of the company• What shareholders want/expect from the

company?

Tools available to shareholders

• Voting power/AGM (at least 1 AGM per year, legal condition, one vote per share, proxy is allowed)

• Larger transactions (class 1, in excess of 25% of company’s equity), requires shareholders approval

• All transactions with related parties (directors, major shareholders and other companies, in which directors or majority shareholders have interests) must be reported to them

• Law requires to provide financial reports to shareholders• Directors remuneration must be approved by

shareholders

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Communication b/w shareholders and board

• A continuous communication b/w the board and shareholders remain intact

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Shareholders activism

• SHs taking a stand against the recommendations made by the BoD at the AGM or general meeting

• Signals the board about SHs feelings– Re-election of directors– Re-appointment of auditors– Approval of directors’ remuneration– Approval of annual accounts– Dividend recommendations– Changes in the share capital– Approval of proposals to issue rights shares– Approval of transactions with the related parties

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The Role of Institutional Investors in CG

• BoD are not the only ppl with responsibility for ensuring the effective CG.

• Shareholder, especially institutional investors have an important role to play.

• Different type of main II found usually in all countries are:– Pension funds– Life insurance companies– Financial institutions and mutual funds etc

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Definition

• Institutional Investors are:

“Organizations which raise funds from individuals and corporation and invest, as principle in the stock markets, using professional management and operating within the constraints provided by their own articles and trust deeds and tax and legal considerations”.

(Briston and Dobbins 1978)

II defined

• Institutional ownership is defined as share ownership by financial institutions (both banks and non-bank financial companies) and non-financial corporations. These include both the public owned as well as privately owned institutions. Typically institutions are categorized as follows:

– Non-banking Finance Companies (NBFC): insurance companies, mutual funds, investment companies, leasing, venture capital companies etc

– Banking Companies: These include the commercial banks– Non-financial Corporation– All other non-financial entities including trusts and non-profit organizations– Development Financial Institutions and International organizations/fund

managers

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The Growth

• In may countries, Institutional Investors (II) became a significant if not majority.

For example: (in term of Ownership of Equities)

• U.S. II grew from 6.1% (1950) to over 50% (2002)

• E.U. II grew more than 150% between 1992 and 1999

• U.K 45% domestic II, and 40% rest of the world - the majority of

them foreign II (National Office in U.K 2006)

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0 10 20 30 40

Rest of the World

Insurance Companies

Pansion Funds

Individuals

Unit Trusts

Investment Trusts

Other Financial Institutions

Charities

Private Non-Financial Companies

Public Sector

Banks

Beneficial Ownership of UK shares, end-2006

Percentage of UK quoted shares owned

NATIONAL OFFICE UK 2006

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What Role Can They Play in Corporate Governance?

• This kind of shareholders has an important role to play in corporate governance, because they represent another powerful corporate governance mechanism that can monitor company’s management.

• They have competent staff to analyze, maintain records,

• Professional approach towards investment

• Can influence the companies

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Institutional Investors Have The Potential To Influence Management’s Activities :

• Directly: through their ownership.

• Indirectly: by trading their shares.

An institution’s indirect influence can be quite strong.

For instance, institutional investors may act as a group to avoid investing in a particular company, thereby increasing that company’s cost of capital.

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When Institutional Shareholders Are Dissatisfied With A company They Can:

a. Sell their shares “voting with their feet” ----- Exit

b. Hold their shares and voice their dissatisfied (Proxy contest) -- Voice

c. Hold their shares and do nothing -------- Loyalty

d. Acting as group to avoid investing in a particular company --- Boycott

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The Role of Institutional Investors in CG

• II can perform a very effective role in the CG of the companies by representing the shareholders.

• Over a period of time IIs role and contribution has increased in the companies to a larger proportion.

• So we can say that the ownership structure has changed considerably tilting more towards, IIs.

• Because IIs have more money to buy shares.• It has been calculated that IIs have more than

60 % holdings of all the listed companies in the UK.

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The Role of Institutional Investors in CG

• And that’s why in the USA and UK this transformation has resulted in changing the role of IIs from mere being a cause as shareholder in the agency problem to the problem solver.

• And they are more and more into the process of monitoring the companies in which they have invested and this is known as the shareholder’s activism

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The II’s activism- Its Growth

• As discussed earlier, it has been noted that the more and more II are now taking interest in the monitoring activities of the companies they have invested in……….this is known as activism.

• Cadbury (1992) has emphasized on the role of shareholder’s rights and responsibilities too.

• Now due to different CG reforms the role of II is not a passive one but a very active role.

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The II’s activism- Its Growth

• Cadbury report (1992) recommended that investors; – Should encourage regular 1-to-1 meetings with

directors of their investee company– Should make positive use of their voting rights– Should pay attention to the composition of the board

of directors in their investee companies.

• Institutional shareholders can also form representative groups and present resolutions to company management (however, this is rarely done). As few years back in case of BP Amoco……regarding their environmental issues.

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The II’s activism- Its Growth

• Similarly, different other reforms have suggested that II should monitor the effectiveness of their intervention in companies and their monitoring activities, in order to improve and refine their engagement, voting and related practices.

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The Institutional Investor Voting• Until1990, the voting right of IIs was very low.• However, in recent years the use of this right

has increased significantly.• After Cadbury report of (1992), companies have

increased this right and have established their own voting policies regarding voting.

• Again there was an issue of whether or not to declare the voting by IIs as Mandatory…….– In the UK it has become mandatory to vote for IIs.

• A lot of IIs activism was witnessed in the executive remuneration policy of the companies in the recent years.

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The Institutional Investors and Engagement

• Cadbury and Myners report (1995) stressed on the importance of institutional investors holding regular meetings with executives of investee companies.

• Similarly different other reports have stressed on the active engagement of shareholders with the investee companies.

• As discussed earlier too, the Higgs report also added the dimension of Non-Executive Directors into this engagement too.

Reference from Pakistan

• The Code of Corporate Governance encourages effective representation of independent non-executive directors on their Boards of Directors. According to Section (b) of Clause (i) of the Board of Directors:

• “The Board of Directors of each listed company includes at least one independent director representing institutional equity interest of a banking company, Development Financial Institution, Non-Banking Financial Institution (including a modarba, leasing company or investment bank), mutual fund or insurance company; and the independent director representing an institutional investor shall be elected by such investor through a resolution of its Board of Directors and the policy with regard to selection of such person for election on the Board of Directors of the investee company shall be disclosed in the Directors’ Report of the investor company”.

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Empirical Evidence

• Company performance improves after an activist investor purchases a block of shares.

• The presence of large shareholders is associated with increased management turnover, because these shareholders may provide a monitoring function.

• The presence of a large shareholder on the board is associated with tighter control over executive compensation.

• A positive association between institutional ownership concentration and the pay-for-performance sensitivity of a firm’s executive compensation.

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Empirical Evidence

• A negative association between institutional ownership concentration and excess salary.

• Firth, and Kim (2002) hypothesize that there will be less opportunistic earnings management in firms with more institutional investor ownership because the institutions will either put pressure on the firms to adopt better accounting policies or they will be able to unravel the earnings management ruse so it will not benefit the managers. As expected, they find that when institutional investors own a large percentage of a firm’s outstanding shares, there is less opportunistic earnings management.

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Heavy Institutional Selling Can:

• Put downward pressure on the stock price. (e.g., Brown and Brooke, 1993)

• Institutional selling might be interpreted as bad news, thus triggering sales by other investors and further depressing the stock price.

• Finally, the composition of the shareholder base might change. For example, from institutional investors with a long term focus to

investors with a more myopic view.

This last effect might be important to directors if the types of institutions holding the stock affect share value or the management of the company.

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The Monitoring Problems

• Although a large institutional shareholder could receive benefits from monitoring, it could also bear costs.

(Effective monitoring is costly in term of time and money)

• Free rider problems

(The monitoring gains are divided among all shareholders but the cost born by the involved shareholder).

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The Monitoring Problems

• Some argue that portfolio managers lack the expertise to advise corporate management.

• An institution’s ability to monitor the firm by means of voting might be limited by certain features of the legal and regulatory environments.