Monitoring the Monitor: Distracted Institutional Investors and Board Governance

Ronald Masulis is Scientia Professor of Finance at University of New South Wales Australian School of Business. This post is based on a recent paper, forthcoming in the Review of Financial Studies, authored by Professor Masulis; Claire Liu, Assistant Professor of Finance at the University of Technology Sydney; Angie Low, Associate Professor of Finance at Nanyang Technological University; and Le Zhang, Senior Lecturer of Finance at Australian National University. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

The board is a particularly powerful governance mechanism for monitoring firm performance in the U.S., with the power to initiate and approve major corporate decisions and to reward or discipline managers. However, director monitoring incentives do not appear to be particularly strong. Past studies show that the labour market for directors does not punish poorly performing directors sufficiently (Fahlenbrach, Low, and Stulz, 2017). Furthermore, independent directors generally have weak financial incentives to actively monitor a firm’s management on a consistent basis (Yermack, 2004). This raises some important questions. How reliable are boards of directors in representing shareholder interests? What motivates directors to monitor? Who monitors the board monitors? In our forthcoming paper in the Review of Financial Studies, we examine whether monitoring by institutional investors, a major class of shareholders, affects director behavior. We show that institutional investor monitoring on a regular basis significantly improves director incentives to expend effort in monitoring management.

The past literature has often treated board monitoring and institutional investor monitoring as substitute mechanisms for solving managerial agency problems. Yet, the board of directors is the primary mechanism that outside shareholders have to influence managers because the board serves as the “gatekeeper” of all shareholder proposals to amend the charter and the almost all major corporate decisions require board approval. In the absence of effective board monitoring, institutional investors can be exposed to severe agency problems and experience significant losses. Consistent with this conjecture, prior studies that report on “behind-the-scenes” institutional investor activities find that institutional investors often intervene in firms by engaging directors in active discussions. Thus, providing board incentives to ensure they perform their fiduciary duties should be a critical channel through which these outside investors seek to maximize the returns on their investments.

To test whether institutional investor monitoring affects board incentives, we construct measures of exogenous distractions of institutional shareholders. Distracted institutional investors are less likely to have the time or resources to engage in intensive monitoring. Following Kempf, Manconi, and Spalt (2016), we utilize variations in institutional shareholder attention caused by exogenous shocks to other unrelated portfolio firms to capture exogenously induced reductions in institutional shareholder monitoring. The following example illustrates how an exogenous distraction can occur. Suppose there are two large stockholdings in a mutual fund investor’s portfolio, namely a bank and a pharmaceutical firm. When the pharmaceutical industry is experiencing a large return shock, the mutual fund manager needs to allocate more time and effort to the pharmaceutical firm. Assuming the attention and effort of a fund manager is in limited supply, we expect the bank accordingly to receive less attention, hence reducing the monitoring intensity the mutual fund manager allocates to the bank. To the extent that shocks to a mutual fund’s portfolio firms in other industries are unrelated to the focal firm’s fundamentals, the measure captures exogenous shocks to institutional investor monitoring intensity towards the focal firm that are orthogonal to the focal firm’s fundamentals.

Generalizing on the above example, we first construct an institutional investor-level measure of the exogenous distractions experienced by an investor towards the focal firm in a given quarter. In particular, we aggregate industry shocks unrelated to the focal firm using the weights of the shocked industries in an institutional shareholder’s portfolio. Next, we construct a focal firm-level investor distraction measure by aggregating the distractions of all its institutional investors, weighting each individual institutional shareholder’s importance in the firm based on their percentage share ownership.

We begin by examining the voting behavior of institutional investors at annual director elections to investigate whether institutional investors influence board governance. Institutional shareholder voting on directors represents a primary mechanism for exerting influence over a firm’s board. While directors rarely fail to be reelected, experiencing negative disciplinary votes nevertheless can be a public embarrassment to a director and adversely affect her reputation and likelihood of being re-nominated in the future (Aggarwal, Dahiya, and Prabhala 2019). Using our investor-level measure of distraction, we find that distracted mutual fund managers are less likely to discipline directors with negative votes compared to when they are not distracted. Economically, a 1-standard-deviation rise in a mutual fund investor’s distraction level is associated with a 4.3% fall in the likelihood of a vote against a director candidate at the annual shareholder meeting. Moreover, we test whether this effect is stronger for problematic director candidates, such as those who either are busy directors or socially linked to the CEO. We find that the decline in negative votes due to investor distraction is greater for a problematic director (a 7.5% fall) than non-problematic director (a 3.9% fall) as shown in Figure 1 below. Further tests suggest that distracted institutional investors are less likely to independently evaluate the underlying issues up for vote and tend to exhibit greater reliance on ISS recommendations, especially when voting on problematic independent directors.

Next, we examine how investor distraction at the firm-level affects director voting outcomes. We find that independent directors receive significantly more favourable votes from institutional shareholders when these investors are distracted. Consistent with our mutual fund voting results, this effect is stronger for problematic director candidates. Economically, a 1-standard-deviation increase in institutional investor distraction decreases negative votes received by a problematic director by 8.8%. In addition, the sensitivities of director departures from the board and major board positions to poor election outcomes are also significantly lower when institutional shareholders are distracted, suggesting weaker subsequent disciplinary effects of shareholder voting.

Next, we examine how boards react to reduced institutional shareholders oversight measured by board monitoring activity. We find that when institutional shareholders are distracted, independent directors miss more board meetings and boards hold fewer meetings. Economically, a 1-standard-deviation increase in investor distraction level leads to a 17% rise in the probability that a director exhibits an attendance problem. Consistent with our director voting results, attendance problems are concentrated among problematic directors (a 46.5% rise) rather than non-problematic directors (a 1% rise) as shown in Figure 2 below. Moreover, we show that institutional investor distraction leads to more problematic independent directors being on the board because of an increased likelihood of both new appointments and reappointments of problematic directors.

Finally, we examine how investor distraction affects several important firm outcomes through the effects of problematic directors and ineffective boards. When institutional investors are distracted, firms are more likely to grant their CEOs higher abnormal pay and have lower pay-performance sensitivity, exhibit greater earnings management, have a higher likelihood of undertaking diversifying mergers, and in general have lower equity valuation. Importantly, the negative effect of institutional investor distraction on various firm outcomes is present only when controversial independent directors sit on the board or its key committees. Taken together, our results suggest that institutional shareholder distraction leads to significantly poorer director monitoring incentives, which in turn leads to worse governance outcomes.

Overall, we find strong evidence that distracted institutional investors cause poorer board governance through fewer disciplinary votes in director elections. This is a serious concern given that boards generally have primary responsibility for monitoring manager performance. Our study shows that these critical firm monitors also need to be monitored. In particular, institutional shareholder monitoring provides strong incentives for directors to exert more effort in monitoring managers and in performing these monitoring duties more effectively.

The complete paper is available for download here.

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