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E-MailDhruv Aggarwal is an Assistant Professor of Law at Northwestern Pritzker School of Law, Albert H. Choi is the Paul G. Kauper Professor of Law at the University of Michigan, and Yoon-Ho Alex Lee is Professor of Law and Director of the Center on Law, Business, and Economics at Northwestern Pritzker School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; How Much Do Investors Care About Social Responsibility? (discussed on the Forum here) by Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; and Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.
What role do retail shareholders play in corporate governance? Finance and legal scholars have long debated and analyzed the impact of changes in shareholder base (from retail to institutional or vice versa) on corporate governance and performance. In a recent paper, we attempt to shed light on this issue by using the sudden abolition of trading commissions by major brokerages in 2019 as a potential natural experiment. The market-wide introduction of zero-commission trading by major brokerages substantially reduced retail investors’ cost of entering the stock market and can be linked to an increase in retail ownership at certain firms. By examining the effect of zero-commission trading and subsequent changes at firms, we attempt to uncover the impact of having more retail shareholders on firm ownership and governance.
We find evidence consistent with the reduced entry cost translating to a significant increase in retail ownership (and a concomitant decrease in institutional stockholding). The effect of increased retail ownership, however, was not uniform across all firms. Rather, this effect was more pronounced in firms that were already popular with retail investors, as measured by lower institutional ownership. In an event study analysis, we find that firms with higher existing non-institutional ownership experienced greater positive abnormal returns on October 1, 2019, when the major brokerages unexpectedly announced the introduction of zero-commission trading platforms. For our empirical analysis, our treatment group consists of firms that experienced larger (more positive) abnormal returns around October 1, 2019. We define the group as such because the advent of zero-commission trading would likely reduce the cost of capital for those companies, which can plausibly be attributed to the fact that retail investors provide companies with higher liquidity. In short, firms with the highest abnormal returns around the introduction of zero-commission trading were most likely to experience the effect of retail investors on their ownership and corporate governance. Consistent with this intuition, we show that companies with higher abnormal returns on that day saw a steady rise in non-institutional ownership in the years after the advent of zero-commission trading.
As for the consequences on corporate governance, we first establish using a model that if retail shareholders are not as active (either directly or indirectly) as institutional shareholders, an influx of retail investors and an exit of institutional investors do not automatically translate to a decline in influence by remaining (including passive) institutional investors. The key driving factor is how those institutional investors that exit tended to cast their votes. The theoretical ambiguity, therefore, leaves it open for an empirical assessment. On the empirical side, we foremost find that retail investor entry led to a significant decline in shareholder participation in governance, as measured by shareholder voting. Studying proposal-level voting data, we find that these firms saw a significant jump in non-voting after the introduction of zero-commission trading. Treated firms also experienced a deterioration in environmental, social, and corporate governance (ESG) metrics after 2019. This deterioration in ESG scores is consistent with an increase in the (relative) influence of retail investors, who typically exert less pressure on corporations to prioritize ESG than institutional players. However, we find no evidence that treated firms perform any differently when we study board independence or gender diversity. Our empirical results for the effect of zero-commission trading on ownership and governance persist in a series of robustness tests.
If retail shareholders do not participate as much in shareholder meetings and do not exercise their voting rights, this could also have an implication for the companies in terms of their ability to satisfy various legal requirements (such as quorum) and to elect directors and passing proposals. To examine what impact the increase in retail ownership may have in making it more difficult for companies to hold shareholder meetings, we hand-code corporate changes to quorum requirements in the years around the abolition of commissions. Consistent with the prediction, we find that firms have generally become more likely to amend bylaws to reduce the percentage of shares required for a quorum at shareholder meetings. Moreover, the treatment group of firms that experienced the highest abnormal returns around the abolition of commissions were especially likely to decrease quorum requirements. Companies most affected by zero-commission trading thus seem to have changed their bylaws to account for the rise in retail ownership and consequent decrease in shareholder voting.
Our paper sheds light on the distinctive place of retail investors in corporate governance. As individuals with small stakes in firms run by professionals and lacking the ability to monitor managers, retail investors can be seen as rationally apathetic toward corporate affairs and issues such as ESG. Our results, showing a decrease in shareholder voting and deterioration in ESG scores at firms exposed to zero-commission trading, are consistent with retail investor apathy. This paper’s main contribution lies in establishing a causal relationship between the 2019 abolition of entry costs for retail investors and the subsequent corporate governance changes consistent with retail shareholders’ apathy toward corporate governance in general and ESG in particular.
We also help to understand the relationship between entry costs and stock market participation. Previous experimental work looking at Scandinavian lottery winners and the inheritors of large bequests has shown that a modest fixed entry cost can explain why many retail investors choose not to invest in the stock market. Our study is broadly consistent with these papers: the removal of the relatively modest trading commissions led to a significant systematic increase in retail ownership at affected firms. Unlike previous studies, however, our finding does not rely on experimental data and instead documents a relationship between entry costs and retail investor entry into a broad swathe of publicly traded U.S. companies.
Overall, our findings use the unique setting of the introduction of zero-commission trading to analyze the effect of retail investors on the ownership and governance of publicly traded corporations. The rise in retail investor influence with the increasing popularity of zero commission trading through mobile phone apps might presage a decrease in shareholder participation in corporate governance and a deterioration of corporate ESG outcomes.
The full paper is available here.
