Do Exogenous Changes in Passive Institutional Ownership Affect Corporate Governance and Firm Value?

In our article, Do Exogenous Changes in Passive Institutional Ownership Affect Corporate Governance and Firm Value?, which was recently accepted for publication in the Journal of Financial Economics, we examine whether the increase in passively managed institutional ownership changes the governance of corporations to the detriment of shareholders, or whether index-tracking institutions participate in governance as much as more active institutions. We concentrate on two corporate governance areas which executives may rapidly influence after a change in the balance of power in corporations—the board of directors and their relative power in the organization measured by an accumulation of titles. We also examine whether passive institutional investors use their main governance device, shareholder proposals, more actively. We study announcement returns to mergers and acquisitions to test whether agency costs are higher and whether managers can reap personal gains from empire building after increases in passive ownership.

From 2007 through 2013, U.S. index domestic equity mutual funds and exchange-traded funds (ETFs) received $795 billion in cumulative net new cash and reinvested dividends, and at the end of 2013, index mutual funds and large cap ETFs held $1.2 trillion and $450 billion in assets, respectively. Actively managed domestic equity mutual funds had outflows of $575 billion (Investment Company Institute, 2014). The dramatic increase in ownership of U.S. corporations by passively managed funds raises important issues for the corporate governance of firms because it is uncertain to what extent passively managed funds have the capacity and interest to monitor corporations.

The academic governance literature proposes two main channels through which large institutional investors can affect corporate governance decisions: Voice and exit (the “Wall Street walk”). Both channels, however, appear ill-suited for index-tracking institutions. The voice channel, in which institutional investors actively interact with management to voice their preferences, seems expensive for low-cost and low-overhead passive institutional investors that cover thousands of stocks. The exit channel is not available to institutional investors who track indexes and are often paid by tracking error. Passive institutional investors insist that they have a fiduciary duty to exercise governance and do so, for example, through informal meetings with management and through voting at annual general meetings. It is not clear, however, how active they really are in corporate governance. Organizations such as Institutional Shareholder Services (ISS) that give vote recommendations to institutional investors at annual general meetings have rapidly grown and there exists evidence that many institutional investors mechanically follow their advice so that they can prove to have complied with their fiduciary duties.

One challenge for our analysis is the endogenous nature of a company’s shareholder structure. It is plausible to expect that a firm’s shareholder structure is influenced by firm characteristics that also drive changes in governance. One of the contributions of our paper is therefore to use—in addition to the standard ordinary least squares (OLS) approach—plausibly exogenous changes in a firm’s shareholder structure. The exogenous change is driven by the annual reconstitution of the Russell 1000 and the Russell 2000 indexes, following Chang, Hong, and Liskovich (2015).

Using a sample of U.S. stocks from 1993–2010, we find evidence suggesting that corporate executives use the (index-reconstitution-driven) exogenous change in the shareholder base to influence corporate governance to advance their personal interests. We find that the power of CEOs increases in firms with more passive owners. The likelihood to become chairman or president increases significantly. While the fraction of independent board members does not change, we find that in firms with more passive investors, independent board turnover decreases so that directors serve longer terms. Interestingly, the incidence of a broad basket of governance-related shareholder proposals does not change following changes in the shareholder base.

Are the observed changes in governance good or bad for shareholders? The answer is not obvious. For example, more powerful CEOs may be able to have more influence on the firm and help the firm succeed but are also more entrenched and may be able to carry out actions that are to their personal benefit but to the detriment of shareholders. To answer this question, we examine the announcement returns to two governance changes—the accumulation of titles and new director appointments. We find evidence that shareholders react more negatively to the accumulation of titles and the appointment of new directors in firms with more passive owners, consistent with these governance changes being value-decreasing.

Finally, we examine whether firms undertake more value-decreasing mergers and acquisitions (M&A), after exogenous increases in passive ownership. Jensen (1986) emphasizes that value-destroying M&A activity is one of the main mechanisms for extracting private benefits in public corporations. Masulis, Wang, and Xie (2007) empirically show that managers of firms with less effective corporate governance indeed engage in more value-destroying acquisitions. We find strong evidence that the cumulative announcement returns to mergers and acquisitions decrease after exogenous increases in passive ownership and that the reduction of shareholder value is economically meaningful in dollar terms. In additional tests, we show that the same firms make worse M&A decisions after they experience an exogenous increase in passive ownership.

Our article complements the work by Appel, Gormley, and Keim (2016), discussed on the Forum here. They also analyze how passive investors impact corporate governance and employ the Russell index reconstitution to establish causality. Appel, Gormley, and Keim (2016) examine basic corporate governance characteristics such as removal of poison pills, establishment of equal voting rights, or an increase in board independence. They choose these characteristics because the largest passive institutional investors themselves describe them as important in public speeches or publications. Appel, Gormley, and Keim (2016) argue that these characteristics are targeted because they require a relatively low level of costly monitoring. They find that several governance mechanisms improve with more passive ownership and that voting behavior at annual general meetings changes. Overall, Appel, Gormley, and Keim (2016) therefore draw conclusions that appear more positive with respect to the role of passive institutional investors than ours. We believe that the results of Appel, Gormley, and Keim (2016) and our results are not inconsistent with each other. Much of our evidence on value-reducing actions of managers after increases in passive ownership comes from an analysis of announcement returns to board appointments and mergers and acquisitions which are much more costly to monitor for passive institutions than basic corporate governance characteristics. Hence, it could be that the role of passive institutional investors for corporate governance is more complex than originally thought. More passive ownership affects corporate governance positively when it comes to low-cost governance activities such as consistently voting according to a pre-defined program at annual meetings or endorsing removal of poison pills and staggered boards. However, more passive ownership affects corporate governance negatively and reduces shareholder value when it comes to high-cost governance activities such as monitoring of mergers and acquisitions, the choice of board members, or the accumulation of titles that often happen outside of annual general meetings and require continuous monitoring.

The complete article is available for download here.