CORPORATE GOVERNANCE

“MINI-ESSAY 3”
(Review the empirical evidence on how different types of institutional investors affect corporate
governance.)

Campus: HeriottWatt University

Instructor- Dr. Faizal Haque
Done by: Varun Chirayil Abraham, H00363398
 Table of Contents
1. Introduction: - Institutional Investors 3

2. Need for Investor Protection 3

3. Mechanisms for Investor Protection 4

3.1. Maintaining the Integrity of Corporate Reporting 4

3.2. Improving Regulations 4

3.3. Prohibiting Insider Trading 5

4. Conclusion  5
5. Reference List 6
1. Introduction:

Institutional investors are the institutional partners of the company, for example, Banks, Insurance
companies, investment companies, etc. They have large ownership in the companies. In the last few
decades, institutional ownership has increased enormously to 70% of American public enterprises.

1.1. Different types of Institutional Investors

In general, there are six types of institutional investors (Chan, Zhang and Zhang, 2013)
 Mutual funds
 Hedge funds
 Pension funds
 Endowment funds
 Insurance companies
 Commercial banks

2. The role of institutional investors on corporate governance:

Institutional investors play a proactive and very important role in the corporate governance of
companies in the USA as well as the U.K. They monitor and analyze the decisions and policies of the
board. Institutional investors have become an integral part of the company They dominate the
management, they avoid wastage by utilizing the company's assets more effectively and efficiently.

Along with ownership and the power it confers comes great expectations—investors are supposed
to play a prominent role in corporate governance. This role of institutional investors has attracted
much attention in the corporate governance. However, institutional investors so far have not been
able to fulfill such expectations.

2.1. Common Law Vs Civil Law:

In general, in common-law countries shareholders will have the strongest protection the most, led
by German countries under civil law countries. The protection of shareholders in civil law countries
in French style is considered to be the weakest.

In common law countries, consistent with convergence and legitimization hypotheses, we find a U-
shape relationship between ownership structure and firm performance. In civil law countries,
consistent with conspiracy and conflict theories, we find an inverted U-shape relationship. We also
find that as institutional investors are categorized as pressure-insensitive and pressure-sensitive by
virtue of the strength of their partnership with managers, pressure-insensitive investors, who work
more independently, are the most likely to increase the value of the business.
 Institutional investors nowadays are faced with the pressure of being more active in their ownership
as to exercise their voting rights subsided by their proxies. The free rider problem is more evident in
passive investment.1

2.2. Pressure Sensitive and Pressure Insensitive

Brickley, Lease, and Smith (1988) and Kochhar and David (1996) use Pound's (1988) hypotheses as a
basis to classify institutional ownership into two groups, Pressure Sensitive and pressure-insensitive
institutional investors.

Pressure Sensitive investors are those who are sensitive to pressure are likely to have an investment
and business relationship with companies in which they hold equity. For Example, Insurance
Companies and Commercial banks.

Pressure Insensitive investors are those who only have an investment relationship with firms in
which they own equity. For Example, Pensions, Hedge Funds, Mutual Funds, etc.

2.3. Active Vs Passive

Bethel, Liebeskind, and Opler(1998) report that when an activist investor buys a block of shares, the
profitability of a company improves. On other hand, Appel, Gormley, and Keim (2016, 2019) find
that passive ownership is associated with more independent directors, fewer antitakeover defenses,
and greater success of activist investors whereas Schmidt, Fahlenbrach (2017) and Heath et al.
(2020) find that passive ownership is associated with more CEO power, less board independence,
and worse pay-performance sensitivity (Gillan and Starks, 2003),

Pension and mutual funds and other institutions are actively involved in corporate governance

The popularity of active funds has been in decline for a number of years, as investors have preferred
lower cost passive index tracking funds. However, the relative performance of active and passive
investing is cyclical. Passive funds do better in some market environments — for example, when the
largest cap stocks outperform. With a notable rise in passive funds, the composition of institutional
ownership has also changed: the proportion of mutual funds owned under passive funds has risen
six-fold from around 5 percent to 30 percent.

Empirical Evidence

Of course, recent study shows that for many years now, passive funds have outperformed active
funds. Despite Covid-19 opportunities, active funds fail to outperform passive rivals. Due to impact
of COVID-192, the low stock market disruption has seen passive funds to improve by six fold, from
around 5% to 30%. (Corum, Malenko and Malenko, 2020)

1
“The free-rider problem is the burden on a shared resource that is created by its use or overuse by people who
aren't paying their fair share for it or aren't paying anything at all.” (Investopedia, 2019)
2
(Wilkinson, 2020)
 2.4. Should Bank hold equity? with Empirical Evidence

During the twentieth century, lending institutions like commercial banks were active but certain
laws and regulations were passed like the Glass-Steagall regulations Act 3, that prohibited banks
from holding equity (Barberis et al., 1999). In countries like the US, laws, and regulations have
prevented commercial banks from holding equity in a firm however in Japan, commercial banks
could take large equity from firms to whom they provide loans.

It shows that equity participation by banks can help overcome a well-documented agency problem,
namely the ability of banks to extract rents from their captive borrowers. By reducing the agency
problem, banks can create values for the firm, the banks and the economy as a whole by improving
the firm's investment incentives.

3. Reference List:

1) Chan, K.C., Zhang, F. and Zhang, W. (2013). Analyst coverage and types of institutional
investors. Review of Accounting and Finance, 12(1), pp.60–80.
2) Corum, A.A., Malenko, A. and Malenko, N. (2020). Corporate Governance in the Presence of
Active and Passive Delegated Investment. [online] papers.ssrn.com. Available at:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3681095.
3) Gillan, S.L. and Starks, L.T. (2003). Corporate Governance, Corporate Ownership, and the
Role of Institutional Investors: A Global Perspective. SSRN Electronic Journal.
4) INVESTOPEDIA STAFF (2019). Free Rider Problem. [online] Investopedia. Available at:
https://www.investopedia.com/terms/f/free_rider_problem.asp.
‌

3
Glass Stegall Regulation Act was passed in year””