Investors' Attention to Corporate Governance

Investor Activism

A study at Drexel University’s LeBow College of Business shows that the research conducted by investors on the governance of companies in their portfolios puts pressure on those companies to make value-increasing changes. However, investor research is selective, leaving a substantial portion of companies subject to less scrutiny.

Key Insights

• Mutual funds are more likely to utilize the SEC’s EDGAR website to conduct research on companies in their portfolios wh their holdings of those companies are larger; there are contentious items up for vote at the company’s annual meeting; t company has performed poorly; and the shareholder meeting falls outside the busy second-quarter season.
• Following research on EDGAR, investors are more likely to undertake actions that suggest an active governance role in t researched company. These actions are: reducing or divesting ownership of the researched companies relative to other portfolio holdings; voting against management; and voting contrary to the recommendations provided by proxy advisory firm Institutional Shareholder Services (ISS).
• Companies respond to this increased monitoring by reducing capital expenditures, increasing payouts, and decreasing mergers and acquisitions activities. Since mutual funds focus their research on a specific subset of firms, the management of other firms may receive relatively little scrutiny.

Summary of Complete Findings

A central function of corporate governance is to mitigate the costs associated with the friction caused by the separation between ownership and control of public companies, ensuring that management acts in the best interest of shareholders.

Shareholders can benefit from a more in-depth knowledge of a company to determine whether its governance structure is effective in fulfilling its function. However, gaining this knowledge through active research is costly. This study evaluates to what extent shareholders conduct governance research of companies in their portfolio, whether this research affects their investment decisions, and whether greater scrutiny from shareholders drives changes at the company.

The authors use the EDGAR database for company filings of the U.S. Security and Exchange Commission (SEC). Their findings focus on one type of large investor, mutual funds. Larger investors conduct significantly more governance research because they are better able to recoup the costs of monitoring via their larger portfolio holdings.

Determinants of governance research by investors

As a measure of governance research, the authors use the number of viewings of firm proxy statements that the SEC requires public companies to produce.

The study finds that investors focus their research on larger firms, on more contentious meetings, and on firms in which their investments are larger. They also exercise more scrutiny on firms with deficient performance and on firms that do not hold their annual meetings during the busy spring period. Among these factors, firm size is the most important because it explains the larger proportion of the variation in investors’ research (almost 38%). Overall, investors only research approximately 11.5% of their holdings on EDGAR.

Larger firms receive over 41% more research, while firms with a high default risk receive 20% more research. A firm with a proxy contest (a campaign to solicit votes against management) receives 33% more governance research. Finally, a firm in which a mutual fund’s equity holdings (as a percentage of the fund’s total holdings) are highest receives 12.5% more research than a firm in which the fund’s holdings are lowest.

Approximately 75% of U.S-listed firms host annual meetings in the second quarter, between the 18th and 24th weeks of the calendar year. Firms with meetings during this busy spring period receive 22.2% fewer views of their proxy filings.

The finding that investors focus on firms with specific characteristics means that there is a subset of firms that are typically overlooked. A firm at the bottom 10% of governance research in a year has a 63% probability of sitting in the bottom 20% in the subsequent year. This is evidence that the same firms tend to receive less scrutiny by investors over time.

Impact of governance research on investors’ decisions

An in-depth understanding of a firm’s governance influences voting and investment decisions.

The study finds that the votes of more informed investors at the firm’s annual meetings are more likely to differ from ISS recommendations. It also finds that greater research leads to lower support for management, with a reduction of 3.2 percentage points of votes in favor of proposed executive remuneration. This suggests that governance research results in a sharper monitoring of management.

Investors do not always influence corporate decisions via voting. Those who conduct greater research are more likely to divest their entire holding in the firm or to reduce their holdings relative to their total portfolio.

Effects of governance research on firms’ investment policies

Empire-building and cash hoarding are two strategies that can benefit the interests of management but can be costly to shareholders. The study finds that greater monitoring by investors encourages firms to implement shareholder-friendly changes in their investment and pay-out policies, reducing the tendency of managers to invest for prestige and power (empire building) or to hold on to excessive cash as a safety net (cash hoarding).

The study finds that more governance research causes a 14.8% decrease in capital expenditures and a 19.7% reduction in mergers and acquisitions. The pressure from more intense scrutiny also drives firms to increase pay-outs to shareholders in the form of dividends and share repurchases.

In conclusion, this study provides empirical findings on the impact of investor activism and on the value of an independent, firm-specific assessment of a company’s governance. The study also highlights that there is a large subset of firms that are subject to less governance scrutiny.

“Investors’ Attention to Corporate Governance” by Peter Iliev (Pennsylvania State University), Jonathan Kalodimos (Oregon State University), Michelle Lowry (Drexel University), was published in The Review of Financial Studies, December 2021.
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