Institutional Investors: Power and Responsibility

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent CEAR Workshop in Atlanta, GA; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

I am particularly pleased to be at a conference that focuses on the role of institutional investors and their impact on corporate control, market liquidity, and systemic risk. The SEC has a great deal of interest in these areas and I hope that you will provide us with any observations that can help inform the SEC’s understanding.

Role Played by Institutional Investors

The topic of your conference recognizes the important role played by institutional investors and the great influence they exert in our capital markets. The role and influence of institutional investors has grown over time. For example, the proportion of U.S. public equities managed by institutions has risen steadily over the past six decades, from about 7 or 8% of market capitalization in 1950, to about 67 % in 2010. The shift has come as more American families participate in the capital markets through pooled-investment vehicles, such as mutual funds and exchange traded funds (ETFs).

Institutional investor ownership is an even more significant factor in the largest corporations: In 2009, institutional investors owned in the aggregate 73% of the outstanding equity in the 1,000 largest U.S. corporations.

The growth in the proportion of assets managed by institutional investors has been accompanied by a dramatic growth in the market capitalization of U.S. listed companies. For example, in 1950, the combined market value of all stocks listed on the New York Stock Exchange (NYSE) was about $94 billion. By 2012, however, the domestic market capitalization of the NYSE was more than $14 trillion, an increase of nearly1,500%. This growth is even more impressive if you add the $4.5 trillion in market capitalization on the NASDAQ market, which did not exist until 1971. The bottom line is, that as a whole, institutional investors own a larger share of a larger market.

Of course, institutional investors are not all the same. They come in many different forms and with many different characteristics. Among other things, institutional investors have different organizational and governance structures, and are subject to different regulatory requirements. The universe of institutional investors includes mutual funds and ETFs regulated by the SEC, as well as pension funds, insurance companies, and a wide variety of hedge funds and managed accounts, many of which are unregulated.

And, of course, institutional investors don’t all buy or sell the same asset classes at the same time. To the contrary, they have a wide variety of distinct goals, strategies, and timeframes for their investments. As a result, their interaction with, and impact on, the market occurs in many different ways.

The growth in assets managed by institutions has also affected, and been affected by, the significant changes in market structure and trading technologies over the past few decades, including the development of the national market system, the proliferation of trading venues – including both dark pools and electronic trading platforms – and the advent of algorithmic and high-speed trading. These changes – largely driven by the trading of institutional investors – have resulted in huge increases in trading volumes. For example, in 1990, the average daily volume on the NYSE was 162 million shares. Today, just 23 years later, that average daily volume is approximately 2.6 billion shares – an increase of about 1,600%.

Simply stated, institutional investors are dominant market players, but it is difficult to fit them into any particular category. This poses a challenge for regulators, who must take into account all the many different ways institutional investors operate, and interact, with the capital markets.

It is clear, however, that professionally-managed institutions can help ensure that our capital markets function as engines for economic growth. Institutional investors are known to improve price discovery, increase allocative efficiency, and promote management accountability. They aggregate the capital that businesses need to grow, and provide trading markets with liquidity – the lifeblood of our capital markets.

In doing all this, institutional investors – like all investors – depend on the assurance of a level playing field, access to complete and reliable information, and the ability to exercise their rights as shareowners. That is why fair and intelligent regulation is necessary for the proper functioning of our capital markets.

With that in mind, I would like to discuss two specific regulatory issues of particular interest to institutional investors:

  • First, the importance of reliable information to investors, and some troubling efforts to scale back disclosures and reduce transparency; and
  • Second, the need for institutional investors to be heard on corporate governance issues, especially on executive compensation.

The Importance of Reliable Information – How the JOBS Act Affects Institutional Investors

As you well know, disclosure is the foundation of our federal securities laws. Fair and accurate disclosure has been the central goal of U.S. securities laws for 80 years. This goal is so fundamental to our understanding of securities regulation that the benefits of transparency might almost be taken for granted.

A recent academic paper demonstrates the value of public disclosure in a compelling way. This paper found that newly public companies with the highest levels of institutional investment significantly outperformed those with the lowest levels. According to the study, institutional investors were not appreciably better than individual investors at picking big winners, but they were much better at avoiding the worst-performing investments. The interesting thing is how they did it: The authors found little evidence that institutions were able to exploit private information to improve investment returns. Nor did the evidence of that particular study suggest that institutions were able to improve the performance of companies they invest in through active monitoring. Instead, it seems that these institutional investors succeeded by making better use of the available public information – focusing on fundamentals like operating history, prior earnings, size, and liquidity.

This is a significant observation for securities regulators and lawmakers. If investors improve performance by focusing on a company’s publicly available information, then preserving access to such information is critically important, for both investor protection and capital formation.

Now here’s my concern. Just last year, Congress enacted legislation – the so-called Jumpstart Our Business Startups Act, or “JOBS Act” – that actually reduces the amount of information required to be provided by a wide category of public companies.

Supporters of the JOBS Act hoped that the legislation would encourage so-called “emerging growth companies” to raise capital through initial public offerings (IPOs), enabling them to expand and – hopefully – create jobs. To achieve that goal, the legislation tries to reduce the cost of going public for these companies. This is an extremely broad swath of the market. The JOBS Act defines emerging growth company to include businesses with up to $1 billion in annual gross revenue, for up to five years after their IPO. This definition would encompass more than three-quarters of all active filers today – and it has been estimated that 98% of all IPOs since 1970 would have fit into that category.

Unfortunately, the JOBS Act tries to cut the cost of capital raising by limiting the financial and other information that these companies are required to provide to their investors. This reduced disclosure can make it harder for investors to evaluate companies by obscuring the company’s track record and material business and financial trends. The result could be an adverse impact on capital formation.

For example, under the JOBS Act, an emerging growth company only has to provide two years (rather than the typical three years) of audited financial statements, and the company can omit the selected financial data otherwise required for any earlier period. In addition, these companies may also omit certain compensation-related disclosures. Moreover, in certain cases, the JOBS Act allows emerging growth companies to postpone compliance with new or revised financial accounting standards. This exemption may result in inconsistent accounting rules, damage financial transparency, and make it difficult for investors to compare the merits of investing in emerging growth companies against other investment options.

Adding to these concerns, emerging growth companies are also exempted from the outside audit of internal controls required by the Sarbanes-Oxley Act, and from future rules that the Public Company Accounting Oversight Board (PCAOB) may issue with respect to certain auditor reporting requirements. This is particularly problematic because audits of internal controls, and other audit requirements, provide important information in assessing the reliability of an issuer’s financial statements. Failure to comply with those standards makes the financial statement audit less informative, and could potentially reduce the reliability of financial information available to investors.

In that regard, there is good data to suggest that independent attestation of internal controls actually promotes good financial reporting. For example, last year, the SEC’s Office of Chief Accountant completed a study and recommendations on the attestation requirement for certain mid-cap issuers. The study concluded that financial reporting is more reliable when the auditor is involved with the assessment of internal controls.

In particular, the study observed that auditor testing resulted in disclosure of control deficiencies that were not previously disclosed by management, and that companies that relied solely on management certifying their own internal controls were more likely to restate their financial statements. The benefits of auditor attestation are also confirmed by other commenters, including the Council of Institutional Investors, the Center for Audit Quality, and the AICPA.

Given the number of studies indicating the positive impact to capital formation when investors have access to useful and reliable information, it is troubling that disclosures are being scaled-back. Reducing the quality of information is simply unproductive.

Regrettably, there continues to be efforts to lobby for limiting disclosure requirements, on the claim that reducing the amount of required disclosures will lower the cost of capital raising. In my view, that would be penny-wise and pound-foolish, as money raised for inefficient uses does not in the long-term create jobs or help the economy grow. The goal should be capital formation, not just capital raising.

Proponents of less disclosure lose sight of the fact that capital raising is not the same as capital formation. By itself, selling a bond or a share of stock doesn’t add a thing to the real economy, no matter how quickly or cheaply you do it. True capital formation requires that the capital raised be invested in productive assets – like a factory, store, or new technology – or otherwise used to make a business more productive. The more productive those assets are, the greater the capital formation from the investment – and, importantly, the more jobs created. And study after study makes it clear that high-quality public information gives investors the confidence they need to invest, and ultimately results in better allocation of assets – which, after all, is what grows our economy and creates jobs.

So, what can be done? Institutional investors, as well as members of the academic community, can play a valuable role in this debate, by monitoring the performance of emerging growth companies that elect to provide limited disclosure and determining if real capital formation is being helped or hurt. Your insights into the impact of these rules would be invaluable.

Empowering Investors to Exercise Rights as Shareowners

Institutional investors also have an important role in monitoring corporate governance issues. In recent years, these issues have included, among others, majority voting, splitting the Chairman and CEO roles, and focusing on the quality and diversity of Boards of Directors, as well as compensation structures and concerns about the runaway growth in executive pay.

Let me briefly talk about the so-called “say-on-pay” provisions of the Dodd-Frank Act. The “say-on-pay” provisions empower all shareholders, both institutional and retail, to vote on the executive compensation paid by the companies they own. As Senator Carl Levin has said, these provisions are intended to “instill a culture of accountability in the executive pay arena.” Although these “say-on-pay” resolutions are not directly binding on the corporation, early experience suggests that corporate boards are paying close attention to the voting results and will seek to avoid “no” votes that are greater than 25-30%. As a result, “say-on-pay” is an opportunity for shareholder engagement – providing investors with a forum to discuss compensation and other corporate governance issues with management, and enhancing the ability of institutional investors, in particular, to have their voices heard.

Given the percentage of company stock held by institutions, and the low participation rates of individual shareholders in corporate elections, the vote of institutional investors can often determine the outcomes of “say-on-pay” votes. As a result, public companies now regularly arrange meetings with institutional investors to lobby these large block holders.

Beyond “say-on-pay” issues, institutional investors are involved in a wide range of corporate governance and other important issues. For example, and just to mention a matter recently in the press, news reports have highlighted how, in the wake of the infamous “London Whale” trading losses, the management of J.P. Morgan Chase & Co. has engaged in substantial efforts to reach out to a number of large institutional investors. Reportedly, management wants these investors to oppose a shareholder proposal which seeks to separate the CEO and board chairman role at the bank.

But it’s not only management that is seeking support from institutional investors. The supporters of the proposal are also taking their arguments directly to institutional investors, including meeting with funds that are substantial shareholders in J.P. Morgan.

Campaigns like these – which are becoming more and more common – underscore the tremendous importance of institutional investors and the influence that they can have. The experience also underscores the potential impact of shareholder proposals on corporate governance matters. It has been reported that companies received over 600 shareholder resolutions this proxy season. Each of these resolutions provides an opportunity for institutional investors to engage with management and have an impact on corporate governance. After all, it is often their votes that can make the difference.

Conclusion

Clearly, institutional investors have a great deal of power in our capital markets. And, as Franklin Delano Roosevelt wrote, on another April night in Georgia – “great power involves great responsibility.” The responsibility of institutional investors stems, in large part, from their stewardship of assets that belong to others. The one indispensable fact to remember is that behind all institutional investors and their portfolio managers are millions of American workers, savers, policy holders, retirees, and other individual investors, who rely on those they entrust with their monies to provide for a safe and secure retirement, to help them save for a home or college education, and to participate in the American dream.

Too often, public company management and other issuers – represented by their lawyers, investment bankers, and industry groups – dominate the regulatory discussion. Institutional investors need to exercise their collective influence to improve the ongoing dialogue. We need to hear their views on the benefits of transparency through disclosure, corporate governance, appropriate compensation structures and amounts, and other important issues. That call to action is also applicable to those academicians and researchers who have salient information on the roles of institutional investors and how their actions impact corporate America and the economy. As an SEC Commissioner, I also would be particularly interested in how SEC rules affect – and are affected by – the behavior of institutional investors.

The SEC needs to hear from all credible voices that can add value to the ongoing public dialogue on the issues facing the capital markets today. You should speak out, and hold the SEC accountable to act on behalf of investors. I look forward to hearing what you have to say.

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