Capital Gains Lock-In and Governance Choices

Scott Weisbenner is the William G. Karnes Professor of Finance at the University of Illinois. This post is based on a recent paper authored by Professor Weisbenner; Stephen G. Dimmock, Associate Professor of Finance at Nanyang Technological University; William Christopher Gerken, Assistant Professor of Finance at University of Kentucky Gatton College of Business and Economics; and Zoran Ivkovich, Professor of Finance at the Michigan State Eli Broad College of Business.

Does liquidity—the ability of shareholders to sell their shares easily—improve or harm corporate governance? Coffee (1991) and Bhide (1993) argue that liquidity is harmful for corporate governance because investors can more readily take the “Wall Street Walk” by selling their shares and thus avoid engaging in costly governance activities. In contrast, others have argued (see the review by Edmans (2014)) that liquidity can improve corporate governance because the threat of exit constrains management, and this threat is more credible when shares are liquid.

The debate about the relation between liquidity and corporate governance remains unresolved because it is difficult to test empirically. Both liquidity and shareholder governance choices are affected by many of the same factors, and these factors are often not directly observable. For example, takeover rumors could affect both the liquidity of a company’s shares and the governance choices of investors. Empirically testing the relation between liquidity and governance requires some way to remove the effect of such factors.

In our recent study, Dimmock, Gerken, Ivković, and Weisbenner (2018), we test how capital gains tax lock-in affects mutual funds’ proxy voting decisions on contentious proposals (we define contentious proposals as those for which the proxy advisory firm Institutional Shareholder Services recommends that shareholders vote against management’s recommendation). Capital gains tax lock-in occurs when a mutual fund with a largely taxable clientele holds a position with an unrealized capital gain. In this case, selling the stock and realizing the capital gain triggers a costly tax liability for fund investors. Because of this lock-in effect, the cost of exiting a position (a measure of liquidity) will differ across mutual funds even for the same stock at any given time, depending on the tax status of the funds’ investors and the size of the accrued gain (or loss) in that stock.

Mutual funds face a dilemma when voting on contentious proposals for which they believe that opposing management will increase shareholder value. Upon anticipating an imminent conflict with a company’s management, a fund generally prefers to exit a position rather than engage with a costly fight with management (see e.g., McCahery, Sautner, and Starks (2016)). There are two related reasons why a mutual fund locked-in to a position for tax reasons may be more likely to oppose management because of the tax incentive to continue holding that position even if the fund disagrees with the firm’s management on a particular vote. First, because realizing a capital gain is more costly for funds with tax-sensitive investors, the fund has a longer investment horizon and can benefit from the long-term value created by their voting. Second, funds that are not locked-in and that continue to hold the position are more likely aligned with management. In contrast, funds with a larger accrued gain in a stock and with tax-sensitive clientele may be more likely to oppose management on contentious votes because the capital gains lock-in effect, rather than an affinity for management, causes them to continue holding the stock. For funds locked into a holding for tax reasons, a pragmatic alternative to sale is to monitor the firm actively.

Because both our measure of liquidity and our measure of governance activity vary across mutual funds holding the same stock at the same point in time, we can focus our analyses to comparing only the variation in decisions made across funds for a specific vote. This allows us to hold constant all features of the company at that point in time (e.g., its past stock returns, current governance structure, and a number of other features) and thereby remove the confounding factors that have hampered empirical tests of the relation between liquidity and governance. Moreover, because funds cast hundreds of votes each quarter, we can similarly control for a fund’s overall willingness to support management, and therefore examine how the presence of a capital gain in a stock influences a fund’s support or opposition for management controlling for a fund’s baseline likelihood of doing so.

We find that there is a strong relation between governance choice (i.e., opposing management on contentious proposals) and capital gains tax lock-in. Funds that have large unrealized capital gains are less likely to sell a stock before a contentious vote and more likely to vote against management. Consistent with tax motivation, these findings are concentrated among funds with tax-sensitive investors (i.e., funds that have few defined contribution retirement plan investors). To provide a sense of the magnitude of the results, a one standard deviation increase in the accrued capital gain of a fund’s stock holding (approximately 68% in our sample) is associated with a 1.2 percentage-point increase in the likelihood that a fund votes against management. If the fund has primarily tax-sensitive investors, the size of the effect rises to 5.1 percentage points. Given mutual funds in our sample vote against management on contentious proposals 53% of the time, the magnitude of this effect is large.

When we aggregate across individual funds’ voting behavior, we find that liquidity meaningfully affects governance outcomes for firms. In our sample of votes on contentious proposals, management loses 24% of the time. When the aggregate capital gains held by mutual funds are large (relative to a company’s market capitalization), management is significantly more likely to lose a contentious vote. A one standard deviation increase in the fraction of the company’s market capitalization comprised of accrued capital gains held by mutual funds is associated with a 2.7 percentage-point increase in the likelihood that management loses a contentious vote (thus representing an increase of more than 10% in the likelihood of management losing a vote relative to the baseline). As predicted, the effect is even larger if the accrued capital gains are held primarily by tax-sensitive mutual funds.

We also find that the capital gains lock-in effect is associated with fewer contentious proposals occurring in the first place. In 39% of the shareholder meetings in our sample, the agenda includes a contentious vote. These contentious votes are significantly less likely to occur if the aggregate accrued gains held by mutual funds are high (but only if those gains are held by funds with tax-sensitive clientele). Thus, consistent with locked-in mutual funds helping prevent agency issues at the firm from even arising, the capital gains lock-in effect influences not only individual fund voting decisions and actual vote outcomes for firms, but also the presence of contentious proposals on the meeting agenda.

Our results provide important insights into the debate about the effects of liquidity on corporate governance. We show that mutual funds are more likely to vote against management when exit is costlier and that this affects vote outcomes and even the proposals that appear on the meeting agenda. As mutual funds continue to own an increasingly larger fraction of total U.S. equities, their voting decisions will be an increasingly important component of corporate governance, with one determinant of this corporate governance by mutual funds operating through a tax-induced capital gains lock-in channel.

The complete paper is available here.

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