Institutional Investor Engagement: How to Create a “Stewardship Culture”

Mark Fenwick is Associate Professor at Kyushu University Faculty of Law; Erik P. M. Vermeulen is Professor of Business & Financial Law at Tilburg University. This post is based on their recent paperRelated research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst.

Institutional investors matter.

The share of equity investments held by institutional investors, such as mutual funds, pension funds, insurance companies and hedge funds, has increased significantly in recent years, and many such assets are now managed by specialized asset managers. A broad consensus has now emerged that involving these professional institutional investors can be an effective mechanism to improve firm governance. Long-term institutional investor engagement is seen as a means to optimize firm performance and foster economic growth.

As a result of these trends, there is now widespread interest in understanding how institutional investors can be engaged through regulatory action. More generally, the question is whether and which regulatory measures can assist in creating a “stewardship culture” in which institutional investors actively participate in the governance of “their” companies.

Our new paper Institutional Investor Engagement: How to Create a “Stewardship Culture” considers these questions and argues that regulation does matter, but perhaps not in the ways that are traditionally assumed, either by policy-makers or other commentators.

Looked at in isolation, the impact of regulatory initiatives aiming to mobilize institutional investors can often seem underwhelming in their effects and can easily be perceived as failing. In general, regulatory interventions don’t seem to have an immediate or significant impact on the incentives and actions of investors.

Nevertheless, the process of designing and then implementing regulatory measures can play a crucial role in triggering interest in, and discussion around, the need for a more engaged relationship between institutional investors and the companies that they own. It is in this less formal mode—via a process of “spotlighting”—that regulation can play a useful role in fostering a corporate culture in which all of the stakeholders in a company become more engaged with senior management.

Regulatory initiatives aimed at promoting shareholder engagement therefore need to be examined in the broader context of efforts—both regulatory and business—to build a new more engaged corporate culture and a more open and inclusive organizations. Otherwise, the value and impact of such regulatory initiatives can be under-appreciated.

As such, the paper carries out a regulatory impact assessment of recent policy and regulatory efforts to encourage more active forms of “long-term” investments as a means of increasing the efficiency of companies.

In order to analyze recent developments in this field and to develop a conceptual framework for understanding this issue, we make a distinction between four types of regulatory measure that are relevant to the issue of shareholder engagement. These regulatory measures aim to increase the capacity and incentives of institutional investors to adopt a more stewardship-oriented form of engagement.

The four types of measure that we examined are as follows:

  • Regulatory measures that “enable” institutional investor engagement. In order to engage with management and become involved in firm strategy and governance, investors need—as an absolute minimum—to have various formal shareholder rights. Most fundamentally, these would include the right to attend, speak and vote at the general meetings of shareholders. Moreover, in most jurisdictions if you hold above a certain percentage of shares, then such rights are extended to include convening shareholders meetings or putting items on the meetings’ agenda.
  • Regulatory measures that “support” institutional investor engagement. Any form of engagement is also contingent on investors having access to reliable and up-to-date information about the company’s ownership and control structure (including “beneficial” ownership). Rules that enable institutional investors to have access to such information not only facilitates meaningful engagement, but also allows them to find potential partners (other investors/shareholders) that are willing to support their involvement.
  • Regulatory measures that “require” institutional investor engagement. A third type of regulatory measure attempts to pressure shareholders into more active involvement in firm governance by obliging, or otherwise compelling or encouraging, them to engage in specific activities on a regular basis. Examples of this are rules that require or allow minority shareholders to appoint one or more directors, or require shareholders to approve directors and executive remuneration policies and their implementation.
  • Regulatory measures that “activate” institutional investors. The first three types of measure are all linked to the governance of the company. In contrast to such company-oriented governance measures, there is a recent trend to implement measures that directly target the institutional investors and their governance structures and practices. These regulatory measures attempt to pressure institutional investors to be more actively engaged with firm strategy, performance and governance. Industry guidelines and the more recent stewardship codes are examples of such measures.

This typology of four types of regulatory measure allows us to develop a more nuanced framework for understanding this issue. For a start, it will allow us to classify countries according to the combination of the above types of regulatory measures that they have adopted. The paper conducts an empirical review of recent developments in sixteen jurisdictions. Crucially, this allows us to identify which combination of regulatory measures creates the kind of environment for mobilizing institutional investors, and encouraging them to become stewards and more engaged with firm strategy, performance and corporate governance.

The conclusion of our analysis is that “regulation matters”. But, policymakers and regulators should not become over-excited about the potential impact of new regulation. For instance, general and special shareholder rights are important and enable investor engagement, but there is little evidence of a resulting change in the behavior of investors. The same goes for the “supportive” transparency rules and regulations. However, regulatory measures that allow and enable investors to coordinate their actions do have an impact on the level of engagement.

Requiring shareholders to be more involved in the decision-making process regarding the composition of boards and remuneration matters also increases the level of engagement. Clearly, investors that are obliged to vote and disclose their voting policy also tend to become more engaged. Yet, regulators should realize that the effect is often “reactive” in nature.

The introduction of stewardship codes appears to offer the most potential in this context. But here it is also important to note that the impact is usually not directly or immediately visible. In particular, domestic institutional investors may not be willing to instantly comply with the regulations or best practices. And if they do comply, they often appear to adopt a grudging style of compliance.

Why then is an optimistic view of stewardship codes justified? First, an enabling regulatory environment (both at the company as well as the investor level) appears to attract and “activate” foreign institutional investors. The expectation is that such a development could lead to reactive, corrective or supportive action on the part of domestic investors.

Second, corporate governance advisors usually respond by encouraging compliance with the new regulatory directions thereby creating a more investor friendly environment.

Third, corporate boards, particularly the ones that operate at an international level, often induce companies to enter into a pro-active dialogue with investors. This arguably also “nudges” investors to embrace a more engaged, involved and active attitude.

As institutional investors continue to become more significant, the issue of promoting shareholder engagement seems likely to remain high on the agenda. As such, it seems important to continue to deepen our understanding of whether and how we might achieve this objective.

The complete paper is available for download here.

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