Corporate Governance
Week 2-Lec
The Role of Owners (Share
holders and Specifically
Institutional Investors in the
Corporate Governance
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?
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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
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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)
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II defined
• Institutional ownership is defined as share ownership by financial
institutions (both banks and non-bank financial companies) and nonfinancial 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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Beneficial Ownership of UK shares, end-2006
Percentage of UK quoted shares owned
Rest of the World
Insurance Companies
Pansion Funds
Individuals
Unit Trusts
Investment Trusts
Other Financial Institutions
Charities
Private Non-Financial Companies
Public Sector
Banks
0
10
20
30
40
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.
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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.
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