Institutional Investors’ Appetite for Alternatives

The emergence of alternative business entities[1] like benefit corporations, which facilitate pursuit of profit and purpose in the same endeavor, challenges the strict dichotomy between for-profit and non-profit corporations. Most alternative entities, including well-known brands like Warby Parker and Etsy—both certified B corps—have been privately-owned and thus untested in financial markets,[2] until now. Last month, the online consortium of unique and hand-made goods known as Etsy, made headlines announcing its SEC filing initiating an IPO to raise up to $300 million.

If Etsy retains its B corp certification or elects to reincorporate as a Delaware benefit corporation, it will become a test case for how the public stock market reacts to alternative entities. The inability to control who owns stock in a public company and thus has standing to sue poses a litigation threat to typical corporations that have non-profit maximizing pursuits. Even as a Delaware benefit corporation, Etsy will test the strength of the statutory protections granted to alternative firms[3] and the public’s appetite for alternatives. Perhaps even more crucial to the success of alternative firms will be acceptance by institutional investors, which include funds with trillions in assets under management. Importantly, institutional investors invest the money of other, often individual, investors and do so subject to their own fiduciary duties to serve the investment interests of their investors, independent of the duties imposed by law upon corporate boards. What is institutional investors’ and the public’s appetite for these alternatives? We don’t know, but this very question prompted our recent research, Institutional Investing When Shareholders Are Not Supreme,[4] examining institutional investors’ response to decreased profit maximization pressure as measured by the effect of constituency statutes on institutional investment.

Without existing examples of public, hybrid firms, we identified constituency statutes as the most suitable proxy for studying institutional investors’ acceptance of legal changes expanding directors’ discretion to pursue goals outside of maximizing shareholder profit.[5] Constituency statutes, first passed as part of anti-takeover defenses in the 1980’s, explicitly extended directors’ discretion to consider non-shareholder interests in takeover, and sometimes other, circumstances. We limited our empirical review to institutional investors with high fiduciary duties (we call them HFDIs) including public and private pension funds, as well as endowments. HFDIs’ fiduciary duties owed to investors explicitly forbid sacrificing monetary returns for other goals. Our hypothesis was that if institutional investors were incapable of reconciling their unique fiduciary duties to their investors with the limited latitude of some companies to pursue nonmonetary corporate goals, we would see this effect most clearly on HFDIs. And if we saw a flight of HFDI investment in response to constituency statutes, an admittedly weaker version of profit de-maximization pressure, then we could make an informed prediction that institutional investors would have little appetite for new alternative firms, like benefit corporations. But that isn’t what our results demonstrated. The main empirical result of our article is that HFDIs did not significantly decrease their investment participation in response to the passage of constituency statutes. Expanding a corporation’s latitude to pursue nonmonetary goals does not constitute an automatic roadblock to institutional investment from HFDIs.

To help explain our results and the suitability of our test, we first verified that constituency statutes, once enacted, were enforced and therefore changed directors’ duties in practice. We analyzed case citations to constituency statutes and determined that the statutes, as enforced, expanded boards’ rights to serve nonshareholder interests as opposed to maintaining the status quo.[6] In other words, constituency statutes brought about legal change, even if limited in scope compared to the benefit corporation statutes seen today. Having verified the strength of constituency statutes as a source of profit de-maximization pressure, we were able to empirically test our hypothesis.

We employed a “difference-in-differences” methodology to measure the change in HFDI investment in public firms after the state of incorporation passed a constituency statute, and then contrasted that change to the change in HFDI investment in firms incorporated in states that did not pass such a statute.[7]

An example helps to illustrate our approach. New York passed a constituency law in 1989, whereas Delaware has not passed such a law to this date. To estimate the effect of the New York law, we could compare HFDI investment after the law to HFDI investment before the law in New York-incorporated firms. This difference would be one estimate of the effect of the New York law. However, something else could have happened in 1989 that affected institutional investment, such as the savings and loans crisis. To control for that, we could look at institutional investment in Delaware and see what change they experienced after 1989 compared to before 1989. Comparing the change in New York to the change in Delaware, or taking the difference in differences, should yield a better estimate of the New York law’s impact because it accounts for effects unrelated to the passage of a constituency statute. Our empirical study applies this approach to a panel with different states passing laws at different times.

We measured both the number of HFDI investors (participation) and the percent of shares held by HFDIs (exposure) to test both flight of HFDIs and dilution of their holdings in constituency statute corporations. As to both variables the test results did not establish an economically significant negative reaction by HFDIs to constituency statutes. Our empirical test stands out from existing event studies for three reasons: (1) institutional holdings of public firms are easily observable due to the disclosure requirements specific to public firms; (2) the sample is large, as it comprises all public firms in all states; and (3) the timespan over which states passed these statutes—three decades—makes it unlikely that any effect observed across the statutes’ passages dates would be confounded empirically by some other concurrent event.

While we cannot rule out that constituency statutes had some effect on HFDI investment, we can rule out that these investors significantly altered investment behavior after the passage of constituency statutes, as one might expect if these institutions perceived material conflicts with their fiduciary duties. Overall, however, we consider our findings promising for alternative corporate entities entering public markets. The absence of a clear road block from constituency statutes should not be considered an unqualified green light for alternative entities because constituency laws did not expand director duties (just discretion) and did not increase litigation rights, which may, together, tip the balance for institutional investors concerned about their fiduciary duties, reducing the pool of capital available for newly minted alternative purpose firms.


[1] For example, corporations in 27 states can organize as Benefit Corporations, entities can form as low-profit limited liability companies or L3Cs in 8 states, and corporations in any state can voluntarily label themselves as a “B corp” after obtaining B Lab certification for meeting “rigorous standards of social and environmental performance, accountability, and transparency.”

[2] Rally Software, a B corp, raised 84 million in a 2013 IPO and trades on Nasdaq as RALY.

[3] Delaware’s Public Benefit Corporation Act specifically grants rights in stockholder of 2% or more of the company’s stock to bring derivative suits enforcing a director’s obligations to “manage or direct the business and affairs of the public benefit corporation in a manner that balances the pecuniary interests of the stockholders, the best interests of those materially affected by the corporation’s conduct, and the specific public benefit or public benefits identified in its certificate of incorporation.” 79 Del. Laws, c. 122, § 8.

[4] 5 Harv. Bus. L.Rev. 73 (2015).

[5] Common features of benefit corporation legislation include the creation of a corporate purpose outside of profit, a mandate that directors shall consider nonshareholder constituents, limited director liability for pursuit of alternative purposes, a named benefit officer or named benefit director, an annual benefit report, and a benefit enforcement proceeding. Constituency statutes, like benefit corporation statutes, focus on expanding directors’ ability to consider nonshareholder constituencies utilizing similar language, but do not build in the additional features described above.

[6] For a full discussion of our case review and results, please see Section V (pp. 105-118) of our paper, Institutional Investing When Shareholders Are Not Supreme, 5 Harv. Bus. L.Rev. 73 (2015).

[7] For a full discussion of our data and methodology please see Section VI (pp. 118-128) of our paper, Institutional Investing When Shareholders Are Not Supreme, 5 Harv. Bus. L.Rev. 73 (2015).

The preceding post comes to us from Christopher Geczy, Adjunct Professor of Finance at The Wharton School at the University of Pennsylvania, Academic Director of the Wharton Wealth Management Initiative, and Academic Director of the Jacobs Levy Equity Management Center for Quantitative Financial Research, Jessica S Jeffers, PhD student at The Wharton School at the University of Pennsylvania, David K. Musto, the Ronald O. Perelman Professor in Finance at The Wharton School at the University of Pennsylvania, and Anne M. Tucker, Associate Professor of Law at Georgia State University College of Law. It is based on their recent article “Institutional Investing When Shareholders Are Not Supreme”, which is available here.