Which Shareholders Benefit from Low-Cost Monitoring Opportunities?

The traditional view in the finance literature is that shareholders that hold a large stake in a company are more likely to take costly actions, such as initiating a proxy fight or confronting management, while small shareholders will enjoy a free ride. In our recent paper, entitled Which Shareholders Benefit from Low Cost Monitoring Opportunities? Evidence from Say on Pay, we examine which shareholders are likely to take advantage of a low-cost monitoring opportunity, specifically, the Say-On-Pay vote (SOP). As we shall specify, we contrast SOP voting behavior on three levels: the aggregate level, the mutual fund level, and the institutional level to provide a finer granularity of voting patterns. Our primary finding is that, compared to large-scale shareholders (those who own greater than 5% of outstanding shares), small institutional shareholders are more likely to vote against management on the SOP vote. This voting pattern implies that, when ownership is dispersed, the low-cost SOP vote provides an opportunity for many small institutional shareholders to coordinate, and to voice a unified message.

We focus on the SOP vote to examine low-cost monitoring opportunities because this vote is held annually, by the majority of Russell 3000 companies, and is the best low-cost opportunity for shareholders to provide clear feedback to management. By comparison, director elections do not provide a direct feedback on management’s performance, and these elections suffer from a lack of a clear alternative for shareholder voting, since in almost all cases only one slate is proposed.

The first voting level we examine is at the aggregate level. We find that, in companies with a large percentage of shares held by blockholders (shareholders holding at least 5%), shareholders are more likely to vote in support of management on SOP. We estimate, for example, that, if a company were to shift from the median value of the shares held by blockholders to having no blockholders, the SOP opposition rate would be expected to increase by approximately 12.1%. Thus, when ownership is more concentrated, shareholders appear to enforce less stringent monitoring.

The results on the aggregate level do not reveal whether small shareholders, or alternatively, large shareholders, are those voting against SOP when large blockholders are present. To understand how the magnitude of the holding influences the vote cast by a shareholder, we examine a second voting level: the mutual fund level. Mutual funds cast an estimated 35.6% of all SOP voted shares. Here, we find evidence that the smaller the holding, the more likely the fund is to oppose management on SOP (henceforth, “against SOP”): the smaller the portfolio weight represented by a holding in a particular stock, and/or the fraction of outstanding shares held by a fund, the more likely the fund is to vote against SOP.

Why, then, do small shareholders tend to oppose SOP? We propose two explanations for this result. First, large-scale shareholders are less likely to challenge management through voting, as they have access to management and are able to confront corporate managers directly and in private. Second, blockholders, who have more “skin in the game” than ordinary shareholders, may prefer to avoid the negative short-term stock price decrease following a negative SOP vote. Indeed, we estimate that in a four-day window around the SOP vote, the abnormal return of a company that receives 100% support for the SOP vote is 1.7% larger than that of a company that receives 0% support.

Because a substantial fraction of funds vote consistently at the institutional level (e.g., Vanguard funds all tend to vote the same way), we examine a third voting-level: the institutional advisor level. We estimate that institutional investors cast 88% of all voted shares, and, therefore, institutions clearly have a large impact on the ultimate vote outcome. Similar to our results on the fund level, we find that, the smaller the portfolio weight, and the smaller the fraction of outstanding shares held by a 13f institution, the more likely the institution’s mutual funds are to collectively oppose SOP.

In a model that includes both “holding variables” (portfolio weight and fraction of company held), on both levels (mutual fund and institution), we find that the larger the portfolio weight both of the fund and of the institution, the more likely a fund/institution is to vote in favor of management on SOP. We also find that the fraction of outstanding shares held by the institution dominates the parallel variable at the fund level. For example, the funds of an institution that shift its holdings from the 75^th percentile to the median “fraction of outstanding shares held by the institution,” are 2% more likely to oppose SOP. We interpret the latter finding as indicating that shares held on the institutional level pose a larger threat to a target company’s management, than the substantially smaller number of shares held by each of the institution’s funds.

We also document, unsurprisingly, that executives vote in support of SOP. We estimate, for example, that Yahoo’s 2012 SOP vote would have failed, if Yahoo’s executives had not held 11.9% of Yahoo’s stock. We highlight this point because it demonstrates the tension between awarding large stakes to executives in an attempt to align management’s interest to that of other shareholders, as opposed to what executives can later do with those stakes—e.g., block governance measures that non-executive shareholders attempt to enforce.

Finally, we examine whether management is likely to demonstrate responsiveness to the SOP vote, given the ownership structure. We find that companies that have a non-executive blockholder and receive low support rates for the SOP vote are significantly more likely to: (1) pick more reasonable (modest) peer-companies for determining executive compensation, (2) decrease the growth rate of the excess compensation, and (3) experience CEO turnover within 12 months of the SOP vote.

In sum, our study suggests that providing low-cost monitoring opportunities increases the extent to which small shareholders monitor and govern the companies they hold.

The full paper is available for download here.