Tuesday, April 23, 2013

With Power Comes Responsibility. Institutional Investors' Role In Corporate Governance.

Author: David Schwartz David Schwartz

Over the past sixty years, as more and more people in the US have begun to participate in the capital markets through retirement plans, mutual funds, ETFs and other pooled investment vehicles, institutional investors have grown from bit players in the markets, owning about 5% of US equities prior to 1945, to being major players today, owning greater than 67% of US equities. This growth in the proportion of assets managed by institutional investors has also been accompanied by a dramatic growth over the same period in the market capitalization of US listed companies.  As a result, institutional investors now own a larger percentage of a much larger market. This massive increase in US equity ownership by institutional investors brings with it great proxy voting power as well.    Given their outsized level of ownership, institutional investors are now faced with new pressures to exercise a real and abiding role in corporate governance.

"Institutional investor" is a broad term covering a wide range of entities, from pension plans and 401(k) plans to mutual funds, hedge funds, and insurance companies.  These wide ranging forms are subject to an equally wide range of regulations and responsibilities, particularly when it comes to voting the proxies of the equities in their portfolios.  Theoretically, allocating a large amount of proxy voting power to a class of professional money managers like those managing large investment pools should be the perfect environment for fostering beneficial corporate governance outcomes. However, the institutional managers are not only subject to different legal and regulatory responsibilities with regard to proxy voting, but also to widely different expectation from their respective shareholders.  These  pressures have preempted the utopian vision some had about institutional investors' beneficial influence in on corporate governance.

Amplifying Influence

It is clear, though, given their size and influence, professionally-managed institutions can still do much good with their proxy voting power.  In a recent address at Georgia State University, SEC Commissioner Luis A. Aguilar called on institutional investors to flex some proxy voting muscle, particularly on vital corporate governance issues like majority voting, splitting Chairman and CEO roles, executive compensation, and board diversity.

Institutional investors also have an important role in monitoring corporate governance issues. In recent years, these issues have included, among others, majority voting, splitting the Chairman and CEO roles, and focusing on the quality and diversity of Boards of Directors, as well as compensation structures and concerns about the runaway growth in executive pay.
Aguilar also made the important point that given the apathy of individual shareholders, the already enormous influence of institutional investors on proxy votes is amplified even further.  Given the low participation rate of individual shareholders, he says, the voting activity of institutional investors is more often than not the deciding factor in any given proxy.  Public companies and shareholder groups have wisely realized this fact, and now engage institutional investors regularly to ascertain which way they may vote on key issues. Aguilar sees this as a key area where institutional investors may influence good corporate governance.

Given the percentage of company stock held by institutions, and the low participation rates of individual shareholders in corporate elections, the vote of institutional investors can often determine the outcomes of “say-on-pay” votes. As a result, public companies now regularly arrange meetings with institutional investors to lobby these large block holders.
Lender Directed Voting

Retaining the power to vote a proxy is vital to an institutional investor's ability to influence corporate governance and make sound proxy voting decisions.  Many institutional investors, however, must make a choice between maximizing the return on their portfolio assets through securities lending, and retaining the ability to vote proxies when they come up.  Given the squeeze on yields being suffered by pension funds and other pooled investments, securities lending revenue is more vital than ever. Yet, currently, when an institutional investor lends a security, they must recall it in order to vote the proxy associated with that security, thereby losing the lending revenue.  This tension introduces an inefficiency into the proxy voting system.  Some investors simply hold back valuable portfolio securities from loan activity to retain proxy authority, while others lend and either forgo the proxy voting opportunity or recall the loan and lose the lending income in order to exercise the proxy.

Lender directed voting (LDV) is a concept developed by CSFME to alleviate this inefficiency by allowing the institutional investor to lend securities, while contractually retaining the right to vote the associated proxies. Under LDV, institutional investors would no longer have to choose between their corporate governance responsibilities and important fee income from securities lending. Those who currently prioritize income would no longer have to forgo voting rights, while others could continue to vote proxies while generating more revenue from securities lending.  LDV has garnered the attention of the SEC, NYSE, and the International Corporate Governance Network, and the support of institutional investors like CalSTERS and the Florida SBA.  The LDV concept represents yet another tool institutional investors may use to maximize their ability to participate in proxy decisions and influence corporate governance.  Yet again, with the low participation of individual shareholders in voting proxies, it is more important than ever for institutional investors to to retain every opportunity to use their voting power.  LDV could be a great help in this regard.