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Institutional Investors’ Tools of Engagement

The worldwide growth of institutional investment practices has provided investors with a

comparative advantage by granting them the opportunity to act as good monitors of their

25 Globally, sovereign wealth funds account for more than $6 trillion (Tricker, 2015).

26 The group consisted of 26 countries and met three times to formulate the Santiago Principles and Practices

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investee firms (Gillan and Starks, 2003; Ferreira and Matos, 2008). Institutional investors face

continuous pressure to improve their governance practices; this pressure comes from many

sources, including government agencies, stock markets and the investors’ ultimate

beneficiaries (Mallin, 2016). According to Hirschman’s (1970) framework, institutional

investors may pursue one of two options if and when they become dissatisfied with the

governance practices of their investee firms. They can choose to exercise their voting rights in

order to promote change, or they can elect to leave the company by selling their shares; this is

known as the ‘Vote or Exit Concept’. Since the selling option may not be viable, as it is often considered costly, most institutional investors opt to engage with their investee firms in an

attempt to alter any unfavourable governance structures (Jin, 2006; McCahery et al., 2016).

Institutional investors can adopt many tools in order to facilitate a dialogue with their investee

firms, such as one-to-one meetings, voting, shareholder proposals and resolutions, focus lists

and corporate governance rating systems (Martin et al., 2007; Goranova and Ryan, 2014;

Mallin, 2016). Behind-the-scenes engagement is also considered important, as private

negotiation is a favoured tactic of many institutional investors (McCahery et al., 2016). All of

these tools are discussed below.

4.3.1. One-to-One Meetings

Meetings between institutional investors and their investee firms are considered an essential

means of communication (Mallin, 2016). As such, the Cadbury Report emphasised that

institutional investors should hold regular one-to-one meetings with the corporate boards of

their investee firms (Solomon, 2013). According to the Cadbury Report, ‘institutional investors should encourage regular, systematic contact at [the] senior executive level to exchange views

and information on strategy, performance, board membership [and] quality of management’ (Solomon, 2013). This type of meeting is considered to be an advantage for the institutional

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institutional investors who hold larger stakes in the company (Mallin, 2016). In the context of

the UK, firms usually arrange to meet with large-scale institutional investors on a one-to-one

basis over the course of a year; such meetings typically involve key members of the corporate

board. In these meetings, the targeted audience of institutional investors includes large-scale

shareholders, brokers’ analysts and any significant investors who are seeking to underwrite or sell their shares. Furthermore, investee firms typically reach out to those institutional investors

who have been absent for longer than one year, and any institutional investors who attend these

meetings are contacted to ensure that all concerns have been discussed (Mallin, 2016).

Marston (2008) conducted a comparison study of investor relations meetings held by the top

500 UK firms between 1991 and 2002. He reported that the one-to-one meeting was the most

important communication tool that existed between institutional investors and their investee

firms; he also noted that the demands of institutional investors for this type of communication

increased during the period under study (Marston, 2008). Furthermore, he pointed out that a

higher number of meetings was associated with the number of institutional investors and

analysts present (Marston, 2008). Moreover, the results revealed that companies kept records

of previous meetings in order to better prepare for future meetings, which reveals the

importance of these meetings (Marston, 2008).

Additionally, companies sometimes initiate new investor relations programs whereby they may

increase the number of meetings with investors in an attempt to attract institutional

investments. Using a sample of small and mid-cap firms that were either listed in the Nasdaq

or that operated over the counter (OTC) between 1998 and 2004, Bushee and Miller (2012)

reported that companies that initiated investor relations programs that included face-to-face

meetings with investors were found to attract more institutional investments and greater analyst

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relations programs and encourage one-to-one meetings. The introduction of such activities by

a company was also found to attract media coverage and increase market value.

It is also important to note that institutional investors may engage with their investee firms

through private negotiations, ‘widely known as behind the scene[s] engagement’ (McCahery et al., 2016). This type of intervention is seen as an effective tool that can encourage efficient

corrective actions within an investee firm. Carleton et al. (1998) investigated the extent to

which the TIAA-CREF27, using behind-the-scenes tactics, influenced governance issues within

its 45 investee firms between 1992 and 1996. Their results suggested that the TIAA-CREF

facilitated agreement with investee firms on several governance issues more than 95% of the

time (Carleton et al., 1998). Furthermore, it was found that in 70% of these cases, agreement

was reached through private negotiations, thus indicating the effectiveness of this tool in

altering the governance practices of a particular investee firm (Carleton et al., 1998).

More recently, McCahery et al. (2016) conducted a study to examine the extent to which

institutional investors exercise behind-the-scenes engagement; to this end, he distributed a

survey to ICGN members for two subsequent years, 2012 and 2013. The study surveyed the

143 largest institutional investors in the world, 36% being from continental Europe, 24% from

the United States, 16% from the United Kingdom, and the remainder from other parts of the

world. The results of this study revealed that behind-the-scenes engagement is considered to

be a common channel that exists between institutional investors and their investee firms

(McCahery et al., 2016). For example, they found that 63% of respondents engaged in direct

discussions with the management team in the preceding five years, whilst 45% had private

discussions with a company’s board without the attendance of the management team.

27TIAA-CREF is one of the largest pension funds in the US, and it holds approximately 1% of the total US equity market

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McCahery et al. (2016) also reported that the investor’s horizon (long-term versus short-term) had an impact on the intervention. For instance, long-term institutional investors intervened

more intensively than their short-term counterparts, discussing issues such as corporate

governance structure and firm strategy. The institutional investors involved in the study

emphasised that the exit option could be a viable strategy, 49% of respondents stating that they

had chosen the exit option as a result of performance dissatisfaction. Another 39% of

respondents reported that the exit was due to dissatisfaction with governance structure. The

investors emphasised that they considered the exit option complementary to, rather than a

substitute for, the voice, as institutional investors typically engaged with their investee firms

prior to the potential exit.

McCahery et al. (2016) further illustrated that institutional investors face multiple hurdles, the

major difficulty being the free rider problem. In addition, the study demonstrated that 63% of

the respondents used proxy advisors, about half of them using the services of more than one

proxy advisor. Furthermore, institutional investors using proxy advisors indicated that they

engaged more intensively with their investee firms rather than substituting proxy advice for

their own voice, which indicates that the presence of proxy advisors does not necessarily mean

that institutional investors take a passive governance role.

McCahery et al. (2016) also found that institutional investors who hold more liquid stocks

report more engagement with their investee firms, as they might find the exit is the most viable

option in these firms. This finding is consistent with Edmans et al. (2013), who argued that

stock liquidity determines whether institutional investors choose to voice or exit. Examining

the activist hedge funds that engaged in block acquisitions between 1995 and 2010, Edmans et

al. (2013) reported that liquidity attracted hedge funds to acquire a block, especially in firms with high managerial incentives. Once the block was formed, the blockholder was more likely

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investment (filing Schedule 13D) than passive investment (filing Schedule 13G). The results also indicate that 13D filing is associated with positive announcement returns and

improvements in operating performance, especially in liquid firms.

4.3.2. Voting

The right to vote is considered to be an influential tool used by institutional investors to weigh

in on all issues raised during the annual general meeting (Mallin, 2016). In an effort to enhance

the activism of institutional investors, the Cadbury Report (1992) encouraged institutional

investors to make positive use of their voting rights. Furthermore, there have been clear

statements from various international organisations regarding voting rights and the

responsibilities of share-owners. For instance, OECD has dedicated one of its six principles to

the rights of shareholders and key ownership functions. This principle stated that ‘shareholders should be able to vote in person or in absentia, and equal effect should be given to votes whether

cast in person or in absentia’ (OECD, 2004). Furthermore, in its global corporate governance

principles, which were revised in 2009, the International Corporate Governance Network

(ICGN) stated that ‘shareholders should actively vote at annual and extraordinary general meetings, and votes should always be cast in a considered manner’ (ICGN, 2009).

In the context of institutional investor voting in the UK, institutional investors used to register

their views of a vote by using the postal service; however, nowadays this process can be

completed electronically where such a service is available (Mallin, 2016). Generally,

institutional investors attempt to sort out any conflicting views prior to a vote date, even

pursuing private negotiations with the management in an effort to do so. However, if these

private negotiations fail, institutional investors may abstain or vote against a particular

resolution (Mallin, 2016). The dissatisfaction of shareholders is taken into consideration by a

corporate board during attempts to alter the governance structure of a firm. It is also important

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support the casting of meaningful votes. Examining the activism of US institutional investors

by investigating their vote casting in 43 countries outside of the US between 2003 and 2009,

Iliev et al. (2015) found that the laws and regulations governing shareholder voting in non-US

countries allowed for meaningful votes to be cast. In addition, the study revealed that voter

dissent was more frequently reported when the institutional investors feared expropriations. In

addition, greater voter dissent was associated with higher director turnover and increased

mergers and acquisitions.

Del Guercio et al. (2008) studied the extent to which a campaign of ‘just vote no’ could influence a corporate board’s decision to improve corporate governance structures; to this end, the team examined 112 US-listed companies in operation between 1999 and 2003. They found

that activist institutional investors often convinced their fellow investors to also withhold their

votes when it came time to elect directors during a general meeting, which frequently led to

the embarrassment of the corporate board (Del Guercio et al., 2008). As a result of such

campaigns, several improvements were noted in terms of governance structure and the

performance of investee firms, including abnormal discipline related to CEO turnover and the

improved performance of the firm. More recently, Aggarwal et al. (2015) examined the US

securities lending market in an attempt to investigate the behaviours and attitudes of

institutional investors towards any shares that were on loan prior to the record date. In the

securities lending market, shares cannot be voted upon if they are on loan on the day of voting.

This study emphasised that the supply of lendable shares was very low prior to the proxy record

date, as institutional investors began to recall their loaned shares before the voting date

(Aggarwal et al., 2015). The study also showed that the corporate governance practices of

investee firms was one of the major reasons behind the recalling of shares, as institutional

investors recalled shares from weak governance firms (Aggarwal et al., 2015). More

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to be recalled; additionally, the level of recalled shares was noted to be high when antitakeover

or compensation proposals were listed in the voting agenda (Aggarwal et al., 2015).

4.3.3. Shareholder Proposals/Resolutions

Shareholder proposals, or shareholder resolutions, are quite common in the US as compared to

the UK (Mallin, 2016). On average, between 800 and 900 shareholder proposals are introduced

in the US per year, most of which are related to the social environment and ethical issues; there

is an expectation that this number will increase in the future due to widespread dissatisfaction

with regard to executive remuneration packages (Mallin, 2016). In the UK, however, the

relatively low number of shareholder proposals presented in the AGM is the result of a process

in which a resolution must be requested by (i) members who own at least 5% of the company’s voting power, or (ii) 100 or more shareholders whose paid-up capital averages at least £100

each. Given the difficulty of meeting these two conditions, the number of shareholder proposals

tends to be low in the UK, normally not exceeding 10 per year (Mallin, 2016). Although, the

number increased following the financial crisis.

As far as the US is considered, private negotiations between institutional investors and their

investee firms may cause many shareholder proposals to be withdrawn prior to the AGM date.

For instance, Bauer et al. (2015) examined the determinants of proposal withdrawals by

considering 1,200 proposals filed by institutional investors in S&P1500 firms between 1997

and 2009. The results demonstrated that shareholder proposals were often withdrawn prior to

the AGM because institutional investors were able to reach an agreement with their investee

firms through private dialogues (Bauer et al., 2015). Their results also showed that the

withdrawal cases were mainly initiated by influential institutional investors rather than their

private investor counterparts (Bauer et al., 2015). Furthermore, long-term and passively

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was initiated by institutional investors; however, negative relationships between CEO

ownership and withdrawal cases were documented (Bauer et al., 2015).

4.3.4. Focus Lists

A number of institutional investors have established ‘focus lists’ with regard to underperforming companies (Mallin, 2016). These types of indices also identify those firms

that do not respond to the queries of institutional investors. Examining a sample of 93 firms

appearing on the focus list of the Council of Institutional Investors from 2000 to 2005, Ward

et al. (2009), reported that institutional investors reduced their holdings in firms that appeared

on the focus list; this was seen as a signal for underperforming firms to improve their

performance. However, this relationship was moderated by the composition of a corporate

board. In particular, a board’s level of independence was found to mediate the reduction of institutional holdings in these types of firms, thus indicating that institutional investors pay

particular attention to the composition of corporate boards within these firms (Ward et al.,

2009). The study also reported that firms with higher levels of independence tend to be more

responsive to institutional concerns than their counterparts; consequently, these firms adopt

various reactive measures, such as scrutinising the incentives given to the company’s CEO (Ward et al., 2009).

4.3.5. Corporate Governance Rating Systems

For several years, many parties around the world have assessed and scored governance quality

at the firm and country levels. According to Mallin (2016), the most well-known firms to have

initiated corporate governance rating systems are Deminor, Standard and Poor’s (S&P), and

Governance Metrics International (GMI). Deminor focuses on European countries, while S&P

concentrates on other countries including Russia. The GMI rating covers a range of countries

and regions, including the US, Europe and various countries in Asia-Pacific (Mallin, 2016).

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quality of corporate governance. However, corporate board structures and processes are of the

main categories involved in most corporate governance rating systems (Van den Berghe and

Levrau, 2004).

Corporate governance rating systems are beneficial for the investor as well as for the country.

For instance, such systems enable investors to assess the governance quality of their investee

firms and of the companies in which they intend to invest in the future. Additionally, such

systems allow governments to assess their governance quality in comparison to that of other

countries; thus, they may be able to enhance the overall governance structure of their country

in order to attract foreign investors (Mallin, 2016).

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