An emerging literature in accounting and finance demonstrates the economic benefits of geographical proximity. Another distinct strand of literature on shareholder activism shows that large institutional investors may influence corporate policies. In our paper, Local Investors and Corporate Governance, forthcoming in the Journal of Accounting and Economics, we link these two strands of research and examine whether physical proximity between firms and investors allows large institutions to monitor corporate activities more effectively. Specifically, we examine whether firms with more local shareholders are better governed and are less likely to engage in corporate misbehavior. We also investigate whether monitoring activities of local investors affect the profitability of local firms. Although there is an obvious free-riding problem associated with the monitoring of geographically proximate firms, the potential benefits from monitoring can outweigh the monitoring costs, especially for large shareholders (e.g., Grossman and Hart (1980), Shleifer and Vishny (1986)).

Our key conjecture is that in an economic setting where monitoring costs vary inversely with distance, firms with high local institutional ownership would have better governance characteristics. In particular, firms with more proximate shareholders would exhibit a lower propensity to engage in undesirable corporate behavior like option backdating or aggressive earnings management. As a result of better monitoring, firms with high local institutional ownership would have a lower propensity to be a target of class action lawsuits. Further, because of geographical proximity, local institutions are more likely to attend shareholder meetings and introduce shareholder proposals, facilitate CEO turnover, or limit excess CEO pay. This form of local activism could also have an indirect influence on the selection of board members and the structure of compensation contracts.

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