4 Shareholders

Governance Role of Shareholders
Semester A, 2022-2023
FB5690, City University of Hong Kong
© 2021 City U of HK All rights reserved 1

Shareholder Type
Individual investors
State
Institutional investors: mutual funds, pension funds, insurance

companies, banks, foundations etc.
Institutional ownership is mostly an indirect individual ownership: the
majority of institutions’ beneficiaries are individuals

Shareholder Right
Elect directors
Approve charter amendment
Approve mergers & acquisitions
Ratify executive compensation and the appointment of external auditors

Channel of Influence
Indirect influence. Shareholders do not have direct control over the

corporation. They influence the firm by:
Communicating their concerns.
Withholding votes from directors.
Waging a proxy contest to elect an alternative board.
Voting against company proxy items.
Sponsoring their own proxy items.
Selling their shares.

Discussion
Have you ever attended any shareholder meetings? Why did you attend
or not attend?
Will you attend the shareholder meetings?

Free-rider Problem
Shareholder monitoring: cost and benefit

A shareholder must bear all costs associated with its action to monitor
managers.
The benefit brought by monitoring, however, is shared by all shareholders.
Dispersed ownership and free-rider problem

The ownership of large modern corporations is so dispersed that almost no
shareholders own a significant amount of shares in any company.
The cost of monitoring usually outweighs the benefit.
Free-rider problem (collective action problem): small shareholders take no
action and hope that the others can monitor management; as a result,
nobody monitors.

Class Action Lawsuit
A form of lawsuit in which one or more named plaintiffs, on behalf of a

proposed class, brings to court against a business entity and/or its
executives.
The proposed class must consist of a group of individuals that have

suffered a common injury caused by the defendants: e.g., shareholders
who were misled by fraudulent disclosures to buy or sell stocks.
Originated and prevalent in the U.S.

Class Action Lawsuit
Advantages: the associated costs are shared by all shareholders, so are

the benefits.
The attorney fee is paid only the case is successful.
The judge determines how much the lawyers should be paid (usually 30% of
the total compensation).
The net compensation is paid to the proposed class on an equal basis.
Case: Tyco International

http://securities.stanford.edu/filings-case.html?id=102326
Top 10 class action lawsuits:

http://www.jiwlp.com/contents/top10-class-actions.html

Block Shareholders
Block shareholder: a shareholder who owns a significant portion of

shares (e.g., 5%) and thus can exercise significant influence over the
control of the company.
Can be both individual or institutional.
Block shareholder can exercise effective monitoring.

The benefit they obtain could outweigh the monitoring cost they bear.
They have significant influence over voting outcome.
They have incentives to collect information and exercise efforts.

Voice or Exit by Institutional Investors
McCahery et al. (2016), Table 2

Evidence on the role of large shareholders
Large shareholder monitoring can compel a company to adopt better

governance standards
Lower CEO compensation (Core et al. 1999; Crane et al. 2017)
Less “pay for luck” (Bertrand and Mullainathan 2000)
Higher likelihood of firing a poorly performing CEO (Aggarwal et al. 2011)
Independent long-term institutional investors are associated with better

performance in mergers and acquisitions (Chen et al. 2007).
Higher institutional ownership leads to higher dividend payments (Crane

et al. 2017)
Evidence on activism…

Institutional Investors
Mutual funds
Hedge funds
Pension funds
Commercial and investment banks
Insurance companies
Foundations and endowments

The rise of institutional investors
Shareholders of Stocks by Investor Type (USA)

1970 2002
Kim and Nofsinger (2007), Page 96

The rise of institutional investors

Institutions are not all the same
Investment horizon
Long-term investors might tolerate volatility if they believe value is being
created. Short-term investors might prefer management focusing on
quarterly earnings and stock price.
Objectives
Mutual funds might care primarily about economic returns. Other funds
might emphasize how results are achieved and the impact on stakeholders.
Activity level
Passive investors might focus on index returns and pay less attention to
individual firms. Active investors might care greatly about individual
outcomes.
Size
Large funds can dedicate significant resources to governance matters.
Small funds lack these resources.

Proxy Voting
A primary method for shareholders to influence the corporation is

through the proxy voting process.
Each year, shareholders are asked to vote on a series of corporate

matters, either in person at the annual meeting or through the annual
proxy.
Institutional investors are required by SEC regulation to vote all items

on the proxy and to disclose their votes to investors.
•Institutional investors vote “for” a proposal 95% of the time when

management recommends a vote in favor.
• They vote “against” 56% of the time when management is “against.”

Proxy Voting
Management proposals are those sponsored by the company, including

the election of directors, ratification of the auditor, approval of equity-
compensation plans, say-on-pay, anti-takeover protections, and bylaw
changes.
Shareholder proposals are those sponsored by investors. They generally

relate to compensation, board structure, antitakeover protections, and
bylaw changes.
Companies may exclude shareholder proposals if they violate the law,

deal with management functions, involve dividends, or involve other
substantive matters.
•33% of shareholder proposals relate to compensation; 20% are

board-related (e.g., proposal to require an independent chairman).
• Union funds and individual activists sponsor > 80% of proposals.

Proxy Advisory Firms
Many institutions rely on the recommendations of a third-party advisory

firm to assist them in voting the proxy.
(+) Proxy firms examine all issues on the proxy.
(+) Small investors lack the resources to do this in-house.
(+) Large investors might want a second opinion.
(–) No evidence that their recommendations increase value.
(–) Guidelines tend to apply a one-size-fits-all approach.
(–) Proxy firms might not have sufficient staff or expertise.
•The largest proxy advisory firms are Institutional Shareholder Services (ISS) and
Glass Lewis, whose clients manage $25 trillion and $15 trillion in equities.
• An unfavorable recommendation from ISS can reduce support by 14% to 20%.
•No evidence that recommendations lead to improved performance. Some

evidence that ISS recommendations for option exchanges lead to worse outcomes.

Activist Investors
An activist investor is a shareholder who uses an ownership position to

actively pursue governance changes. Examples might include:
Union-backed pension funds.
Socially responsible investment funds.
Hedge funds that take an active position.
Individual investors with strong personal beliefs.
Some investors face restrictions to exercise activism.

Diversification requirements hinder mutual funds from acquiring the large
positions needed to exercise control.
“Prudent man” rules constrain pension funds from acquiring stakes in
troubled firms in need of intervention.
Activist investors play a prominent role in the governance process,

sometimes for the better and sometimes not.

Shareholder Activism
Utilize shareholder rights to pressure the company in which they invest

(+): Reduce agency problem
(+): Prevent management entrenchment
(+): Prevent complacency by pressuring management to pursue shareholder
interests first
(–): Takes management/board attention away from important matters
(–): Used to boost short-term stock prices
https://www.youtube.com/watch?v=jaFssOBAqkY

Activist Hedge Funds
Hedge funds are private pools of capital that engage in a variety of trading
strategies to generate excess returns.
Hedge funds are known for their high fee structure. They face pressure from
clients to generate superior performance to justify these fees.
Pressure to perform might encourage activism.
•Activist hedge funds accumulate an initial position of 6.3%; many coordinate

their actions with other funds (“wolf pack strategy”).
• Target companies realize positive excess returns following the announcement.
• A majority of hedge funds achieve the stated objective of their activism (such
as replacing the CEO, sale of company, or increased share buybacks); however,
the effect on long-term operating performance remains controversial.
•Inthe U.S., hedge fund activists are successful in achieving at least one
engagement outcome 61% of the time; this figure is 50% in Europe but only
18% in Asia. Japan is particularly marked by high initial market reactions but
few successful eventual outcomes (Becht et al. 2017).

Pension Funds
Public pension funds manage retirement assets on behalf of state, county, and
municipal government employees, e.g., California Public Employees’ Retirement
System (CalPERS).
Private pension funds manage retirement assets on behalf of trade union

members, e.g., American Federation of Labor and Congress of Industrial
Organizations (AFL-CIO).
Pensions are active in the proxy voting process. However, their activism has not
been shown to have a positive impact on shareholder value or governance
outcomes.
•Companies that are the target of activism by CalPERS experience marginal

excess stock returns following the announcement; no excess returns or
improvement in operating performance is discernable over the long term.
•The AFL-CIO is likely to vote against directors at companies in the middle

of a labor dispute, particularly when the AFL-CIO represents the workers.
Barber (2007); Agrawal (2012)

Socially Responsible Funds
Socially responsibility funds cater to investors who value specific objectives and
want to invest only in companies whose practices are consistent with those
objectives.
Examples include fair labor practices, environmental sustainability, and the

promotion of religious or moral values.
These funds are visible in the proxy process. Even though proxy items sponsored
by these funds generally do not receive majority support, they can still influence
governance outcomes.
•Shareholders submitted 136 resolutions relating to social and environmental

objectives at Fortune 250 companies in 2014. Of these, 135 were defeated.
On average, they received support from 5% to 20% of shareholders.
•Research is mixed on whether socially responsible funds succeed in their
dual objective of achieving market returns and advocating social mission.
• Firms targeted by environmental activism campaigns reduce their
greenhouse gas emissions, but experience lower profitability and operational
efficiency around such campaigns (Naaraayanan et al. 2021)

Shareholder Democracy
In recent years, there has been a push by Congress, the SEC, and
others to increase the influence that shareholders have over governance
systems (“shareholder democracy”).
Advocates of shareholder democracy believe that it will make board

members more accountable to shareholder concerns, such as excessive
compensation, risk management, and board accountability.
Elements of shareholder democracy include:

Majority voting in uncontested elections.
Investor right to nominate directors (“proxy access”).
Investor vote on executive compensation (“say on pay”).

Majority Voting
Shareholder advocates believe that plurality voting lowers governance

quality by insulating directors from investors.
They advocate a stricter standard—majority voting—under which

directors must receive 50% of the votes to be elected.
The impact of majority voting on governance is unclear. Dissenting

votes are often issue-driven and not personal to the director (e.g.,
withhold votes for directors on comp committee to protest CEO
compensation levels).
This might inadvertently work to remove directors who bring important

strategic, operational, or risk qualifications.
•More than 80% of the largest 100 companies in the U.S. use majority
voting. However, only 46% of all U.S. companies use majority voting.

Proxy Access
Historically: the board of directors has had sole authority to nominate

candidates whose names appear on the proxy.
Recently: shareholders or groups of shareholders owning 3% or more of

a company’s shares for at least 3 years are eligible to nominate up to
25% of the board.
This rule has been challenged in court (2011).
Proxy access (or the threat of proxy access) is likely to increase the
influence of activist investors over boards.
• The market reacts positively to proxy access regulation, and the

reaction is more positive among poorly performing companies
while less so among firms targeted by labor-friendly funds.
•The evidence is consistent with value-creation by necessary
shareholder access or interventions.
Cohn et al. (2016); Becker et al. (2013)

Say on Pay
The practice of granting shareholders the right to vote on a company’s

executive or director compensation at the annual shareholder meeting.
Variations of “say on pay” have been enacted in the U.S., U.K.,

Netherlands, Australia, Sweden, Norway, Denmark, etc.
Under Dodd-Frank, companies are required to hold a nonbinding say-on-

pay vote at least once every 3 years.
•Share prices for firms with high excess compensation reacted in a

positive manner to the passage of say-on-pay legislation.
•Research indicates that say-on-pay votes in the U.K. have not reduced
the overall executive compensation; it has been shown to change the
structure of pay contracts.
• Evidence in the U.S. suggests that capping or regulating executive pay
results in less efficient contracts and negatively affects shareholder wealth.
Cai and Walkling (2011); Ferri and Maber (2013); Larcker et al. (2011)

Case: Honeywell 1989
Incorporated in 1927.
Design and manufacture of thermostats and other electronic control

devices for buildings, aircraft, and other industrial applications.
After World War II, diversified into weapons and computer industries.
Late 70’s and 80’s:

Growth in assets (from $2.8 billion in 1978 to $5.3 billion in 1989).
Enhanced reputation for benevolence among its workers and other
stakeholders.
But, productivity and stock returns below industry average.

1986: Recorded accounting loss.
Went through restructuring

Consolidated basic controls business.
Sold most of computer business.
Purchased Sperry Aerospace Group from Unisys for $1.03 billion.
Price too high?
Later Honeywell sued Unisys charging that it had misrepresented Sperry’s worth.
October 21, 1988

Q3 loss of $22.2 million
According to October 24, 1988 WSJ’s “Heard on the Street” : ‘size of the
loss staggered some analysts and investors and the management lost
credibility on Wall Street’.

December 1988
Loss exceeded $400 million due to restructuring write-off.
Analysts questioned internal controls.
Late 1988
Dissatisfaction among Honeywell shareholders, including takeover
investors who increased their stakes.

February 1989 board meeting

Directors voted to propose 2 antitakeover amendments to firm’s charter at
the shareholder meeting.
Classify the 12 member BOD into three groups, only one of which would come
up for reelection in any year.
– Deny any outsider the opportunity to gain control at one annual meeting.
Eliminate shareholders’ right to act by written consent.
– No shareholder action can be taken without calling a shareholders’ meeting.
Management mailed proxy materials on 23 March.

 Was the management trying to insulate itself?

After proposal, North American Partners, L.P. (NAP) took actions

Worked with ISS
Brought CalPERS and PennPSERS to cosponsor the dissident
solicitation (these three had 4.4% of the stock) ensuring that NAP
will pay all costs.
After the CEO refused the shareholder requests, filed proxy
materials with the SEC.
April 28: distributed proxy materials.
Started making calls to vote against management’s proposals.

Source: Nuys (1993)

May 12, 1989: management defeated

Proposal supported by majority of shares voting.
But failed to receive support from 50% of the shares outstanding.
July 24, 1989: announce reorganization

Success: CAR was over 35% from mailing of management’s proxy to
completion of restructuring program in 1990.

Effects of solicitation

Discussion question:
Do you think Honeywell would have committed to restructuring before

NAP came along?

Structure of BOD
Edson W. Spencer (former CEO) was on board during the
countersolicitation.
Every board member in 1989 was elected during Spencer’s term as
chairman.
 Did this friendship made the directors reluctant to force any changes to the
policies?
Nine institutions with commercial relationship (e.g. banks, insurance
companies) had board members or other employees who sat on Honeywell’s
BOD.
 Conflict of interests?

Conclusions
In theory, shareholders should be in a strong position to influence the

structure of governance systems.
In practice, shareholders have limited access to influence governance,

and in some cases they have conflicting agendas.
Regulators have attempted to increase the influence of shareholders by

mandating elements of “shareholder democracy.”
However, the effects of enhanced shareholder influence (e.g., activism

and democracy) on governance quality or firm value are yet to be
conclusive.

4 Shareholders

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

4 Shareholders

Uploaded by

Copyright:

Available Formats

Governance Role of Shareholders

© 2021 City U of HK All rights reserved 1

Institutional investors: mutual funds, pension funds, insurance

© 2021 City U of HK All rights reserved 2

Approve charter amendment

Approve mergers & acquisitions

Ratify executive compensation and the appointment of external auditors

© 2021 City U of HK All rights reserved 3

Indirect influence. Shareholders do not have direct control over the

© 2021 City U of HK All rights reserved 4

Will you attend the shareholder meetings?

© 2021 City U of HK All rights reserved 5

Shareholder monitoring: cost and benefit

Dispersed ownership and free-rider problem

© 2021 City U of HK All rights reserved 6

A form of lawsuit in which one or more named plaintiffs, on behalf of a

The proposed class must consist of a group of individuals that have

Originated and prevalent in the U.S.

© 2021 City U of HK All rights reserved 7

Advantages: the associated costs are shared by all shareholders, so are

Case: Tyco International

Top 10 class action lawsuits:

© 2021 City U of HK All rights reserved 8

Block shareholder: a shareholder who owns a significant portion of

Block shareholder can exercise effective monitoring.

© 2021 City U of HK All rights reserved 9

McCahery et al. (2016), Table 2

© 2021 City U of HK All rights reserved 10

Large shareholder monitoring can compel a company to adopt better

Independent long-term institutional investors are associated with better

Higher institutional ownership leads to higher dividend payments (Crane

© 2021 City U of HK All rights reserved 11

Commercial and investment banks

Foundations and endowments

© 2021 City U of HK All rights reserved 12

Shareholders of Stocks by Investor Type (USA)

Kim and Nofsinger (2007), Page 96

© 2021 City U of HK All rights reserved 13

© 2021 City U of HK All rights reserved 14

© 2021 City U of HK All rights reserved 15

A primary method for shareholders to influence the corporation is

Each year, shareholders are asked to vote on a series of corporate

Institutional investors are required by SEC regulation to vote all items

•Institutional investors vote “for” a proposal 95% of the time when

• They vote “against” 56% of the time when management is “against.”

© 2021 City U of HK All rights reserved 16

Management proposals are those sponsored by the company, including

Shareholder proposals are those sponsored by investors. They generally

Companies may exclude shareholder proposals if they violate the law,

•33% of shareholder proposals relate to compensation; 20% are

• Union funds and individual activists sponsor > 80% of proposals.

© 2021 City U of HK All rights reserved 17

Many institutions rely on the recommendations of a third-party advisory

• An unfavorable recommendation from ISS can reduce support by 14% to 20%.

•No evidence that recommendations lead to improved performance. Some

© 2021 City U of HK All rights reserved 18

An activist investor is a shareholder who uses an ownership position to

Some investors face restrictions to exercise activism.

Activist investors play a prominent role in the governance process,

© 2021 City U of HK All rights reserved 19

Utilize shareholder rights to pressure the company in which they invest

© 2021 City U of HK All rights reserved 20

Pressure to perform might encourage activism.

•Activist hedge funds accumulate an initial position of 6.3%; many coordinate