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Institutional Investors Corporate Governance 1

Oxford Handbook: Institutional Investors in Corporate Governance

Oxford Handbook: Institutional Investors in Corporate Governance

Edward B. Rock

University of Pennsylvania Law School

October 15, 2014

U of Penn, Inst for Law & Econ Research Paper No. 14-37


This chapter of the Oxford Handbook on Corporate Law and Governance examines the role of institutional investors in corporate governance and the role of regulation in encouraging institutional investors to become active stewards. I approach these topics through asking what lessons we can draw from the U.S. experience for the E.U.’s 2014 proposed amendments to the Shareholder Rights Directive.

I begin by defining the institutional investor category, and summarizing the growth of institutional investors’ equity holdings over time. I then briefly survey how institutional investors themselves are governed and how they organize share voting. This leads me to two central questions: (a) why, over the last twenty five years, have institutional investors not fulfilled the optimists’ hopes?; and (b) can the core incentive problems that subvert Institutional Investor activism be cured by regulation? The U.S. experience, in which substantial deregulation has led to only modest increases in shareholder activism, suggests that a key explanation for institutional investors’ relative passivity is a fundamental lack of incentives. In considering whether imposing positive obligations on institutional investors is likely to succeed, I examine the disappointing results of the S.E.C.’s long experiment with incentivizing mutual funds to vote their shares. The U.S. experience suggests that the E.U. efforts are likely to be similarly disappointing.

I then examine the important role that hedge funds now play in catalyzing institutional shareholders, and consider some of the risks in relying on such highly incentivized actors.

Institutional Investors in Corporate Governance – Introduction

“Shareholders – the corporate governance framework is built on the assumption that shareholders engage with companies and hold the management to account for its performance. However, there is evidence that the majority of shareholders are passive and are often only focused on short-term profits. It therefore seems useful to consider whether more shareholders can be encouraged to take an interest in sustainable returns and longer term performance, and how to encourage them to be more active on corporate governance issues.”

Like poets and revolutionaries, corporate law scholars and policy makers dream. If only we could find the silver bullet, the wonder drug, we could solve the manager-shareholder agency cost problem that is the focus of much of corporate law. For a while in the 1980s, some thought that the hostile tender offer was that magic potion. Then, beginning in the late 1980s, attention shifted to Institutional Investors, where it has stayed, on and off, ever since. Noting that shares of publicly held corporations are largely held by institutions, and that shareholding among institutions is concentrated, some have viewed Institutional Investors as having the potential to act as the responsible owner that corporate law seems to presume: a shareholder that, by virtue of its holdings, will have the skills and incentives to keep an eye on managers and check departures from maximizing firm value, prevent “short termism” and whatever else one wants responsible owners to do.

As with other utopian dreams, reality has proved to be less exciting and less transformative. In this chapter, I try to synthesize what we have learned about institutional investors in corporate governance over the last thirty years or so.

Who and What are “Institutional Investors”?

Robert Clark provides a basic framework for understanding how institutional investors fit within the historical evolution of finance.3 The first stage, characteristic of the 19th century, was the age of the promoter-investor-manager, exemplified by Rockefeller or Carnegie. The second stage, characteristic of the first part of the twentieth century, was the age of the professional business manager who took on the management of the corporation, while leaving the financial claims to the owners of shares. This stage was exemplified by managerial giants like Alfred Sloan who led the way in creating the modern, publicly held business corporation. The third stage, characteristic of the late twentieth century, was the age of the portfolio manager in which the selection of the financial claims (stock, bonds, etc.) was professionalized, while leaving the beneficial ownership to the capital supplier. This age of financial intermediaries is the age of the institutional investors, with great stock pickers like Peter Lynch as representative heroes.

Institutional Investors Corporate Governance 1

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