Role of Institutional Investors in Corporate Governance

Role of Institutional Investors in incorporate GovernanceCHAPTER IIREVIEW OF belles-lettresCorporate organisation paradigm is based on the argument of Berle and Means (1932) that separation of ownership and curtail leads to the problems associated with agency theory so that the managers of a corporation whitethorn not act in the best interest of owners. Through come out of the closet the twentieth century, the pattern of ownership continued to change from declining individual ownership to change magnitude institutional ownership. So, it is not surprising that institutional investors argon increasingly looking to a greater extent than cargonfully at the bodied plaque of companies because good governance goes go past in hand with increased transp arncy and account aptitude. M all studies create been conducted to see the move of institutional holdings on unified governance. Some researchers contend that substantial holdings by institutional investors and corporate governan ce are significantly cor link while otherwises argue the absence of such(prenominal) a relationship.Evidences are also inconclusive on whether institutional investors invest in good governed companies or their holdings improve the governance practices. The piece of institutional investors is visualized in two perspectives, the corporate governance and the immobile mathematical process. The present chapter covers the empirical studies on the above issues as institutional holdings and corporate governance, institutional holdings and tight transaction, corporate governance and substantial public presentation with special wildness on the studies conducted in India on the above aspects. The present submission seeks to evaluate the impact of institutional holdings over corporate governance and firm performance by constructing governance score and taking various measures for firm performance. Various studies withstand focused on different aspects/levels of ownership and their set up on firm performance.As a result, various arguments have been put forward both in support and against the notion of the effects of ownership structure on the firm performance. sequence some researchers denied the direct correlation amidst ownership structure and firms economic performance while the others argued that on that point exists such a relationship for certain. Amongst those who establish such causality, some provide license that there is a ostracisely charged relationship, while others plead a overbearing relationship betwixt the two. Studies have also been carried to limit a link between varied aspects of corporate governance and firm performance evidence in this regard too appears fairly mixed. There has been bulky literature to document a absolute relationship between the two, based on identified individual aspects of corporate governance and firm performance whereas others do not demote any conclusive evidence in this regard. Prepositions put forwarde d by the researchers in this context are being reviewed here as under(a) in the perspectives identified above2.1 Institutional Holdings and Corporate GovernanceCoombes and Watson (2000)1 on the basis of a survey of to a greater extent than 200 institutional investors with coronations across the military personnel showed that governance is a significant factor in their investment decision. Three-quarters of the investors say that board practices are at least as important as fiscal performance. In fact, over 80% of the investors in the survey positd that they would pay more for the shares of a well-governed firm than a poorly governed firm with comparable pecuniary performance. The survey indicated that the premium these institutional investors would be willing to pay varied by country, with premiums being higher(prenominal) in Asia and Latin America (where financial account is less reliable) than in Europe or the U.S.Bradshaw, Bushee and Miller (2004)2 indicated that firms who se accounting methods conform to U.S. Generally Accepted Accounting Principles have a greater level of investment by U.S. institutional investors. They form further that increases in conformity with U.S. GAAP are positively associated with future increases in U.S. institutional investment, only when that the reverse does not hold (i.e., increases in U.S. institutional ownership are not associated with later changes in accounting methods). The authors attributed this relation to home bias or else than better transparency (and corporate governance) however their results are also undifferentiated with the latter interpretation. Chung, Firth, and Kim (2002)3 hypothesized that there will be less opportunistic earnings solicitude in firms with more institutional investor ownership because the institutions will either put blackjack on the firms to adopt better accounting policies or they will be able to function the earnings management rule so it will not benefit the managers. They found that when institutional investors own a hulking percentage of a firms owing(p) shares, there is less opportunistic earnings management (i.e., less use of discretionary accruals).Hartzell and Starks (2003)4 provided empirical evidence suggesting institutional investors serve a monitoring role with regard to executive compensation contracts. First, they found a positive association between institutional ownership concentration and the pay-for-performance sensitivity of a firms executive compensation. Second, they report a negative association between institutional ownership concentration and excess salary. One implication of these results, consistent with the theoretical literature regarding the role of the large shareholder, is that institutions have greater fix when they have larger proportional stakes in firms.Parrino, Sias and Starks (2003)5 indicated that those firms that fired their top executives had a significantly greater decline in institutional ownership in the ye ar prior to the CEO turnover than firms experiencing voluntary CEO turnover (even after supreme for differences in performance). These results support the supposition that institutional wandering influences decisions by the board of directors-increasing the likelihood a CEO is forced from office. This implies that boards care about institutional trading and ownership activity in their firms. Further, the authors found that larger decreases in institutional ownership are associated with a higher probability of an outsider being appointed to succeed the CEO. This result suggests that directors are more willing to break with the current corporate management and institute change.They also noted that there are several potential effects when institutions sell shares. First, heavy institutional selling can put downward pressure on the hold price. Alternatively, institutional selling office be interpreted as giving in the raws, thus triggering sales by other investors and further dep ressing the billet price. Finally, the composition of shareholder base might change, for example, from institutional investors with a long focus to investors with a more myopic view. This last effect might be important to directors if the showcases of institutions holding the stock affect share value or the management of the company.Cremers and Nair (2005)6 stated that the interaction between shareholder activism on behalf of institutional investors and the market for corporate control is important in explaining developments in abnormal justice returns and accounting measures of profitability. Davis and Kim (2007)7 found that mutual coin with conflicts of interest (based on management of pension assets) more often vote with management in general. On the other hand, mutual funds have more incentive and power to oppose management in firms in which they have a larger stake.McCahery, Sautner and Starks (2008)8 have relied on the survey data to investigate governance preference of 1 18 institutional investors in U.S. and Netherlands. The study found that the majority of institutions that responded to the survey take into account firm governance in portfolio weighting decisions and are willing to engage in activities that can improve the governance of their portfolio firms.Brickley, Lease and Smith (1988)9 found evidence supporting the possible action that firms with greater holdings by pressure-sensitive shareholders (banks and insurance companies) have more proxy votes cast in favor of managements recommendations. Moreover, firms with greater holdings by pressure-insensitive shareholders (pension funds and mutual funds) have more proxy votes against managements recommendations. The authors differentiated between the different types of institutional investors, noting the difference between pressure-sensitive and pressure-insensitive institutional shareholders and arguing that pressure-sensitive institutions are more likely to go along with management decisions . The rationale is that pressure-sensitive investors might have current or potential occupation relations with the firm that they do not want to jeopardize.Maug (1998)10 noted that institutions use their ability to influence corporate decisions are partially a function of the size of their shareholdings. If institutional investor shareholdings are high, shares are less marketable and are thus held for interminable periods. In this case, there is greater incentive to monitor a firms management. However, when institutional investors hold relatively few shares in a firm, they can easily drop their investments if the firm performs poorly, and therefore have less incentive to monitor firm performance.Almazan, Hartzell and Starks (2003)11 provided evidence both theoretical and empirical that the monitoring influence of institutional investors on executive compensation can depend on the current or prospective business relation between theinstitution and the corporation. They concluded t hat the monitoring influence of institutions is associated more with potentially active institutions (investment companies and pension fund managers who would be less sensitive to pressure from corporate management due to lack of potential business relations) than with potentially passive institutions (banks and insurance companies who would be more pressure-sensitive).Marsh (1997)12 has argued that short-term performance measurement does work against the active monitoring by institutional investors. The performance of fund managers is evaluated over a shorter time period. Hence, they act under tremendous pressure to beat some index. So, when they find a case of bad governance, they find it economical to sell the stock or else than interfere in the functioning of the company and incur monitoring costs.Denis and Denis (1994)13 found no evidence to suggest that there is any relationship between institutional holdings and corporate governance. They stated that if companies that create shareholders wealth are the ones with poor corporate governance practices, and then one sincerely cannot blame the institutional investors for having invested in such companies. For, after all, a fund manager will be evaluated on the basis of stock returns he creates for the social unit holders and not on the basis of the corporate governance records of the company he invests the money in. If however, one finds that companies with poor corporate governance practices are the ones, which have consistently destroyed shareholders wealth, then the contention that the institutional investors need not look at corporate governance records cannot be justified.David and Kochhar (1996)14, provided empirical evidence regarding impact of institutional investors on firm behaviour and performance is mixed and that no definiteconclusions can be drawn. They argued that various institutional obstacles, such as barriers stemming from business relationships, the restrictive environment and cultiva tion processing limitations, might prevent institutional investors from effectively exercising their corporate governance function. Agrawal and Knoeber (1996)15 found little evidence of an association between total institutional ownership and other possible control mechanisms (e.g., insider ownership, block holders, outside directors, CEO human capital, and leverage).Payne, Millar, and Glezen (1996)16 focussed on banks as one type of institutional investor that would be expected to have business relations with the firms in which they invest. They examined interlocking directorships and income- connect relationships, and noticed that when such relations exist banks tend to vote in favor of management anti-takeover amendment proposals. When such relations dont exist, banks tend to vote against the management proposals.Leech (2002)17 is of the view that many institutional shareholders do not seek control of a company for a variety of reasons, which include the fear of obtaining price s ensitive information, and that it is more likely that institutional investors seek only influence rather than complete control. Moreover, it has also been argued, in line with the passive monitoring view, that institutional investors may not be keen to exit on their investments i.e. sell their rightfulness stakes when the firm is not performing optimally, mainly because they hold large investments and thus selling may lower the price and further increase any potential loss. Woidtke (2002)18 concluded by comparing the relative value of firms held for public versus semiprivate pension fund that relative firm value ispositively related to private pension fund ownership and negatively related to ( activist) public pension fund ownership. These results supported the view that the actions of public pension fund managers might be motivated more by political or social influences than by firm performance.Ashraf and Jayaman (2007)19 examined mutual funds trading behavior after the emancipa te of voting records. The study found that funds that support shareholder proposals reduce holdings after the release of voting records. Since the time of releasing voting records could be genuinely far from the shareholder group meeting date, mutual funds trading behavior after the release of voting records may be unrelated to the votes cast in the meeting.Dahlquist et al. (2003)20 analyzed foreign ownership and firm characteristics for the Swedish market. The study found that foreigners have greater presence in large firms, firms paying low dividends and in firms with large cash holdings and explained that firm size is driven by liquidity. It reiterated that foreigners tend to underweight the firms with a dominant owner. Leuz, Nanda and Wysocki (2003)21 evokeed that the information problems cause foreigners to hold less assets in firms. Firm level characteristics can be expected to contribute to the information asymmetry problems. Concentrated family control makes it more like ly that information is communicated via private channels. Informative insiders have incentives to hide the benefits from outside investors by providing opaque financial statements and managing earnings.Haw, Hu, Hwang and Wu (2004)22 found that firm level factors cause information asymmetry problems to FII. It found evidence that US investment is lower in firms where managers do not have effective control. Foreign investment in firms that appear to engagein more earnings management is lower in countries with poor information framework. Choe, Kho, Stulz (2005)23 found that US investors do indeed hold fewer shares in firms with ownership structures that are more conducive to expropriation by controlling insiders. In companies where insiders are dominating information access and availability to the shareholders will be limited. With less information, foreign investors appear an adverse selection problem. So they under invest in such stocks.Covirg et al. (2008)24 concluded that foreign fund managers have less information about the house servant stocks than the domestic fund managers. They found that ownership by foreign funds is related to size of foreign sales, index memberships and stocks with foreign listing. Leuz, Lins, and Warnock (2009)25 found that foreign institutional investors prefer to invest in firms with better governance practices. This literature assumes that firm level corporate governance mechanisms substitute for weak country level profound protections of minority shareholders. Aggarwal, Klapper and Wysocki (2005)26 found that U.S. mutual funds tend to invest greater amounts in countries with stronger shareholder rights and legal frameworks (controlling for the countrys economic development). In addition, within the countries, the mutual funds also discriminate on the basis of governance in that they allocate more of their assets to firms with better corporate governance structures.ResumeAfter reviewing the literature on the above sub-section, i t is concluded that the results are inconclusive regarding the association between institutional holdings and corporate governance as some studies invariably support the hypothesis that institutional holdings and corporate governance are significantly related while the others reject it. But the results are uniform on one issue that there is positive relation between the foreigninstitutional holdings and corporate governance as foreign institutional investors are relatively more concerned about the governance practices of companies and countries as well. They prefer to invest more in the countries with stronger shareholder rights and legal frameworks. Similarly, they do invest in the companies with good disclosure and transparency measures.A theme of studies contend that institutional investors consider governance practices of companies as an important consideration for investment decision. They not only care for financial performance of brand companies, but also put great emphasi s on the board practices. They are ready to pay premium for good governance. Institutional investors can put pressure on firms improve their governance practices if they have substantial stake in the target companies and do not have business relations with them. Moreover, if they dont involve themselves actively in governance but only vote with their feet it serves as a deterrent for the management in practicing bad governance. As it will send bad signal to the stock market leading to further decline in the stock prices and may be changing the shareholder base from dynamic institutional investors with long-term focus to myopic investors.Whereas in other studies, it has been detect that institutional investors prefer to remain passive and concentrate on their own business objectives, rather than look into the governance practices of companies. They do not involve themselves actively in the governance of firms for variety of reasons as short-term performance measurement, business rel ationships, regulatory environment, information processing limitations, free-rider problem etc. Moreover, they may not be interested in selling the shares of poor firms as they have large holdings and selling may aggravate their potential loss.2.2 Institutional Holdings and Firm PerformancePound (1988)27 explored the influence of institutional ownerships on firm performance and proposed three hypotheses on the relation between institutional shareholders and firm performance efficient-monitoring hypothesis, conflict-of-interest hypothesis, and strategic-alignment hypothesis. The efficient-monitoring hypothesis says that institutional investors have greater expertise and can monitor management at lower cost than the subaltern atomistic shareholders. Consequently, this argument predicts a positive relationship between institutional shareholding and firm performance. The conflict-of-interest proposition suggests that in view of other profitable business relationships with the firm, ins titutional investors are coerced into voting their shares with management. The strategic-alignment hypothesis states that institutional owners and managers find it mutually advantageous to cooperate.Holderness and Sheehan (1988)28 found that for a sample of 114 US firms controlled by a majority shareholder with more than 50% of shares, both Tobins Q and accounting profits are significantly lower for firms with individual majority owners than for firms with corporate majority owners. Hermalin and Weisbach (1988)29 further stated that the managerial ownership is positively related to performance between 0-1% of managerial ownership, negatively related thereafter up to 5%, and again positively related from 5-20% and negatively related thereafter.Boardman and Vining (1989)30 compared the performance of state owned enterprises, joint enterprises, and private corporations among the 500 largest non-US industrial firms, and found that mixed enterprises and state owned enterprises perform su bstantially worse than similar private enterprises. McConnell and Servaes (1990)31found a strong positive relationship between the value of the firm and the fraction of shares held by institutional investors. They found that performance increases significantly with institutional ownership.Han and Suk (1998)32 found (for a sample of US firms) that stock returns are positively related to ownership by institutional investors, thus implying that these corporate owners are actively involved in the monitoring of incumbent management. They also found that alignment effect dominates if the managers own up to 41.8% of the share capital. They further evidence that beyond the limit of 41.8%, the mangers are able to control the Board of directors and so the entrenchment effect dominates the alignment effect.Majumdar and Nagarajan (1994)33 found that levels of institutional investment are positively related to the current performance levels of firms. However, a less-stronger, though positive, effect is established between changes in performance levels and changes in institutional ownership. The results are based on a study investigating U.S. institutional investors investment strategy. Bethel et al. (1998)34 consistent with the view that market for partial corporate control identifies and rectifies problems of poor corporate performance, found that activist investors typically target poorly performing and diversified firms for block share purchases, and thereby assert disciplinary effect on target companies plans in mergers and acquisitions.Douma, Rejie and Kabir (2006)35 investigated the impact of foreign institutional investment on the performance of emerging market firms and found that there is positive effect of foreign ownership on firm performance. They also found impact of foreigninvestment on the business group affiliation of firms. Investor protection is poor in case of firms with controlling shareholders who have ability to expropriate assets. The block shareho lders affect the value of the firm and influence the private benefits they receive from the firm. Companies with such shareholders find it expensive to raise external funds.Bhattacharya and graham (2007)36 investigated the relationship between different classes of institutional investors (pressure-sensitive and pressure-resistant) and firm performance in Finland. It documented evidence that these institutional owners own stakes in multiple firms across industries, leading to a possible two-way causality or endogenous problem between firm performance and ownership structure. It was also evidenced that institutional investors with likely investment and business ties with firms have negative effect on firm performance and the impact is very significant in comparison to the negative effect of firm performance on institutional ownership.Wiwattanakantang (2001)37 investigated the effects of controlling shareholders on corporate performance and found that presence of controlling sharehold ers is associated with higher performance, when measured by accounting measures such as return on assets and the sales-asset ratio. However, the controlling shareholders involvement in management has a negative effect on the performance and it is more pronounced when the controlling shareholder and managers ownership is at the 25-50 percent. The evidence also revealed that family controlled firms display significantly higher performance. Foreign controlled firms as well as firms with more than one controlling shareholder also have higher return on assets, relative to firms with no controlling shareholder.Abdul Wahab et al. (2007)38 examined the relationship between corporate governance structures, institutional ownership and firm performance for 440 Bursa Malaysia listed firms from 1999 to 2002 and found that institutional investors have a positive impact on firms corporate governance practices.Qiet et al. (2000)39 found that firm performance is positively related to the proportion of shares owned by the state. In addition, they found little evidence in support of a positive correlation between corporate performance and the proportion of tradable shares owned by either domestic or foreign investors. Wahal (1996)40 observed that although institutional investors, particularly, activist institutions, have been successful in their efforts to affect the governance of targeted firms, these same firms have not demonstrated performance improvements.Studies examining the relationship between institutional holdings and firm performance in different countries (mainly OECD countries) have produced mixed results. Chaganti and Damanpour (1991)41 and Lowenstein (1991)42, for instance, find little evidence that institutional ownership is correlated with firm performance. Seifert, Gonenc and Wright (2005)43 study does not find a consistent relationship across countries. They conclude that their inconsistent results may reflect the fact that the influence of institutional inve stors on firm performance is location specific. The above studies primarily consider institutional investors as a monolithic group. However, Shleifer and Vishnys (1997)44 as well as Pounds (1988)45 theorizations and later empirical examinations by McConnell and Servaes (1990)46 suggest that shareholders are differentiable and plight different agendas. Jensen and Merkling (1976)47 also show that equity ownerships by different groups have different effects on the firm performance. Agrawal and Knoeber (1996)48, Duggal and Miller (1999)49 find no such significant relation between institutional holdings and firm performance.ResumeVarious studies on relationship between institutional holdings and firm performance have been reviewed in the above sub-section and the results are mixed. Different researchers have taken different performance measures as some of them have considered accounting measures but others have taken stock market indicators.Some of the observations contend that institu tional investors are more expert in monitoring the affairs of companies as compared to individual investors their holdings improve the financial performance of target companies. The results are more significant, where managers also have some ownership stake so as to have alignment effect. Moreover, if their stake is substantial, they can also assert disciplinary action against the poorly performing firms. Similarly, foreign institutional investors have also positive impact on the firm performance.But the results of other observations state otherwise. They state that if institutional investors have business ties with the firms, they would go along with the management and it may have negative impact on the firm performance. The studies have revealed out an interesting observation that Institutional holdings have positive effect on firm performance but their active involvement in management has negative effect. Some of the observations state that institutional investors may have signif icant impact on the governance practices of companies but do not improve financial performance.2.3 Corporate Governance and Firm PerformanceLipton and Lorsch (1992)50 found that limiting board size improves firm performance because the benefits by larger boards of increased monitoring are outweighed by the poorer communication and decision-making of larger groups. Millstein and MacAvoy (1998)51 studied 154 large publicly traded US corporations over a five-year period and found that corporations with active and independent boards appear to have performed much better in the 1990s than those with passive, non-independent boards.Eisenberg et al. (1998)52 found negative correlation between board size and profitability when using sample of small and midsize Finnish firms, which suggests that board-size effects can exist even when there is less separation of ownership and control in these smaller firms. Vafeas (1999)53 found that the annual number of board meeting increases following shar e price declines and operating performance of firms improves following years of increased board meetings. This suggests meeting frequency is an important dimension of an effective board.Core, Holthausen and Larcker (1999)54 observed that CEO compensation is lower when the CEO and board chair positions are separate. It is further shown that firms are more valuable when the CEO and board chair positions are separate. Botosan and Plumlee (2001)55 found a material effect of expensing stock options on return on assets. They used endangerments list of the 100 fastest growing companies and obtained the effect of expensing stock options on firms operating performance. Morgan and Poulsen (2001)56 found that pay-for-performance plan generally helps to reduce agency problems in the firm as the votes approving the plan are positively related to firms that have high investment or high growth opportunities. On the other hand, votes approving the plan are inversely related to negative features in some of the plans such as dilution of shareholder stakes.Mitton (2002)57 examined the stock performance of a sample of listed companies from Indonesia, Korea, Malaysia, the Philippines and Thailand. It reported that performance is better in firms with higher accounting disclosure quality (proxied by the use of Big Six auditors) and higher outside ownership concentration. This provides firm-level evidence consistent with the view that corporate governance helps explain firm performance during a financial crisis.Claessens et al. (2002b)58 observed that firm value increases with the cash-flow ownership (right to receive dividends) of the largest and controlling shareholder, consistent with incentive effects. But when the control rights (arising from pyramid structure, cross-holding and dual-class shares) of the controlling shareholder exceed its cash-flow rights, firm value falls, which is consistent with entrenchment effects. Deutsche Bank AG (2004a and 2004b)59 explored the implicat ions of corporate governance for portfolio management and concluded that corporate governance standards are an important component of equity risk. Their analysis also showed that for South Africa, Eastern Europe, and the Middle East, the performance differential favored those companies with stronger corporate governance. Fich and Shivdasani (2004)60 based on Fortune 1000 firms, asserted that firms with director stock option plans have higher market to book ratios, higher profitability (as proxied by operating return on assets, return on sales and asset turnover), and they document a positive stock market reaction when firms announce stock option plans for their directors.Gompers et al. (2003)61 examined the ways in which shareholder rights vary across firms. They constructed a Governance Index to proxy for the level of shareholder rights in approximately 1500 large firms during the 1990s. An investment strategy that bought firms in the lowest decile of the index (strongest rights) a nd sold firms in the highest decile of the index (weakest rights) would have earned abnormal returns of 8.5% per year during the sample period. They found that firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions.Brown, Robinson and Caylor (2004)62 created a broad measure of corporate governance, Gov-Score, based on a new dataset provided by Institutional Shareholder Services. Gov-Score is a composite meas