Frenemies - how impartial is shareholder voting between finance organisations?
Financial sector firms are unique in that their major institutional shareholders may also be their competitors. This research looks into how this relationship affects shareholder voting, and what it means for governance of the industry.
Shareholding of financial firms is dominated by institutional investors, meaning that the sector has the distinction of being controlled by shareholders who are also its members. This throws up concerns about the governance of financial firms relative to non-financial sectors. Could it be possible that shareholders would act to undermine their competitors, for example. Alternatively, might they take a more relaxed approach to monitoring their peers within the industry? This paper examines the issue.
The paper focuses on three types of potential conflict of interest. Firstly, the "old boys' network" effect. Decision-makers at both the investing firm and the investee are quite likely to share similar backgrounds in education, and may well have worked at the same or similar organisations previously. Therefore, it's possible that this history of relationship may influence decision-making.
Secondly, there is the conflict of interest between an institution's responsibility to improving an investee firm's value and position, when that firm itself is a competitive rival to the investing firm.
Finally, a conflict of interest may be observed when there is a cross-holding of shares between investor and investee. A financial firm may hold shares in its own institutional shareholder, giving a potential means for retaliating against hostile voting by that shareholder. Conversely, both parties may support each other.
Having established these 3 potential conflicts of interest, the study focused on a sample of 14,554 votes cast by 108 mutual fund companies during 2004-2013 to see if voting was influenced by them. Mutual fund companies were selected as their voting behaviour is consistently observable.
The researchers found the rate of acquiescence to be significantly higher when the subject of the vote was another mutual fund company than when it was a firm in a different line of business. It found that these companies are almost 50% more likely to oppose management of firms in other industries than oppose management in their own.
As a whole, investor support for management proposals is higher for firms with more sector peers among their investors.
The research identifies several reasons for this. First, voting appears to be influenced by fear of retaliation. Second, social ties between the voting and target firms increase the voting firm's support for the target's management. To our knowledge, this paper is the first to advance and find support that financial institutions indulge their industry peers in this way, and that this indulgence may undermine the financial sector's governance, the quality of which has been widely questioned, particularly in the wake of the 2008 financial crisis.
To improve governance of the finance sector, the paper recommends two policy changes:
1) Voting at financial firms should be required to be confidential, ie - company management must not be allowed to see how each shareholder voted;
2) Institutional investors' voting policies should address not only conflicts of interest due to client/supplier relationships, but also conflicts through competitive interaction and reciprocal investments.
Without reform, not only will governance continue to be compromised but ultimately director efficacy and firm value may suffer.
A working paper version of the paper is available for download at the link below. The paper is forthcoming in Management Science.