A corporation’s governance structure does not exist in a vacuum: It can impose externalities on other firms. The existing literature has argued that those externalities can arise because companies interact with each other through various types of relationships. For example, according to Acharya and Volpin (2010), firms compete against each other in the managerial labor market. When a firm’s competitors adopt a low level of governance (e.g., by appointing a weak board of directors) and thus allow their managers to extract large benefits for themselves, the firm’s managers have an incentive to join those competitors, which in turn forces the firm to choose a lower level of governance to retain the managers. Since firms, as independent decision-makers, do not fully take into account the cost to rivals of this behavior – they do not, in other words, internalize this externality – Acharya and Volpin (2010) predict that, in equilibrium, the level of governance in the economy is inefficiently low. In our recent paper, Internalizing Governance Externalities: The Role of Institutional Cross-ownership, we examine the role of a market-based mechanism for internalizing governance externalities that has not been explored in the literature, namely, cross-ownership by institutional investors.
Cross-ownership, also referred to as common-ownership, is becoming increasingly prevalent among public firms (for recent published work on this topic, see Matvos and Ostrovsky, 2008; Harford, Jenter, and Li, 2011; He and Huang, 2016). The objective of cross-holding shareholders is to maximize the combined value of their portfolio companies. Therefore, relative to stand-alone institutions that only invest in one of these firms, cross-owners have a stronger incentive to internalize corporate governance externalities among their portfolio companies, because for them the same marginal cost of improving governance in one company would yield a higher marginal benefit. Specifically, for each additional unit of monitoring effort exerted on a firm, the cross-owner can benefit not only from an improvement in governance in the company itself, but also from the ensuing improvement in governance in the company’s peers that are in its portfolio. Thus, relative to non-cross-holding shareholders, cross-holders should play a stronger governance role, particularly when the potential for governance externalities is high.
Anecdotal evidence suggests that institutional investors take governance externalities into consideration when exerting their influence. For example, commenting on passive institutions’ role in corporate governance, a Financial Times (2014) article argues that because such institutions “are invested across the entire market, [they] have an interest in raising standards everywhere, not just in individual companies.”
We analyze the governance role of cross-holding institutions by examining their voting behavior in governance-related proposals. One unique advantage of the proxy-voting setting is that it allows us to directly observe one of the most important monitoring actions taken by institutional investors. We focus on the relation between cross-ownership and institutions’ tendency to vote against management on shareholder-sponsored governance proposals, the passage of which increases firm value (Cunat, Gine, and Guadalupe, 2012). Voting against management is widely recognized as one of the most important and commonly used channels through which institutional investors exert their influence. If cross-holdings induce an institution to play a stronger governance role, we should expect that larger cross-holdings would be associated with a greater likelihood that the institution votes against management when the interests of shareholders and managers are in conflict.
To test the above prediction, we use a sample of 169,000 votes on shareholder-sponsored governance proposals cast by institutional investors from 2003 through 2012. We find that institutional shareholders of a focal firm that have larger ownership stakes in the peers of the focal firm (peer firms defined as same-industry firms with similar size) are more likely to vote against management in shareholder-sponsored governance proposals at the focal firm. This result is obtained after controlling for a large set of fixed effects as well as the institution’s holdings in the focal firm itself. The economic magnitude is large as well. For example, according to the most stringent specification, a one-standard-deviation increase in the continuous measure of cross-holdings in peer firms is associated with an increase of 2 percentage points in the likelihood of voting against management. Also, the likelihood of voting against management increases by 7 percentage points when an institution holds a block (i.e., equity holding that exceeds 5 percent of the outstanding shares) in the peers of the focal firm than when the same institution does not. These magnitudes are economically meaningful given that the standard deviation of the likelihood of voting against management is 46.5 percentage points. Since shareholder-sponsored governance proposals, which management almost always opposes, are intended to reduce managerial rents and improve shareholder value (e.g., Cunat, Gine, and Guadalupe, 2012), our results suggest that cross-ownership induces institutions to play a valuable monitoring role.
The results on the voting behavior at the institution level raise a natural question: Do cross-holding institutions have aggregate effects on actual vote outcomes? The answer is yes. We find that institutional cross-ownership positively predicts that management loses to shareholders in a proxy vote. The economic magnitude is large as well. For example, a one-standard-deviation increase in firm-level cross-ownership is associated with an increase of 6.2 percentage points in the likelihood that management loses a vote. This result provides suggestive evidence that institution-level voting behavior we observe above has aggregate effects on governance outcomes.
The main contribution of our paper is two-fold. First, to the best of our knowledge, this is the first study to examine the role of institutional cross-holders in internalizing corporate governance externalities. Our results highlight the importance of a market-based mechanism, i.e., institutional cross-ownership, in reducing the inefficiency induced by governance externalities. The finding that cross-ownership is associated with a stronger disciplining role played by institutional investors in proxy voting indicates that firms choose an inefficiently low level of corporate governance in the absence of cross-holding shareholders, which is consistent with the equilibrium depicted in recent theoretical studies (e.g., Acharya and Volpin, 2010; Dicks, 2012). Second, while much of the existing literature on cross-ownership focuses on various outcomes at the portfolio firms (such as their product market behavior), it is still largely unknown how institutional cross-holders exert influence on corporate decision-making. By investigating the voting behavior of institutional cross-owners, our study sheds light on a specific channel through which these investors affect corporate policies. Our approach enables us to provide direct tests of the influence of cross-ownership on institutional investors’ monitoring behavior.
Our study has important policy implications. The finding that cross-ownership induces institutional investors to play a stronger governance role suggests a bright side of cross-ownership, which provides an important alternative perspective to the current policy debate that centers on the potential anticompetitive effects of cross-owners (e.g., New York Times, 2016). Our results also have implications for regulatory policies that seek to address corporate governance externalities. One motivation for corporate governance regulations such as the Sarbanes-Oxley Act of 2002 is to reduce negative externalities (Acharya and Volpin, 2010; Dicks, 2012). Given that cross-holding institutional investors are likely better positioned to collect and produce information about firms and more motivated to internalize governance externalities, cross-ownership, as a market-based solution, may be more effective than government regulations in addressing governance externalities.
Acharya, Viral, and Paolo F. Volpin, 2010, Corporate governance externalities, Review of Finance 14, 1–33.
Cunat, Vicente, Mireia Gine, and Maria Guadalupe, 2012, The vote is cast: The effect of corporate governance on shareholder value, Journal of Finance 67, 1943–1977.
Dicks, David L., 2012, Executive compensation and the role for corporate governance regulation, Review of Financial Studies 25, 1971–2004.
Financial Times, 2014, Passive investment, active ownership, April 6.
Harford, Jarrad, Dirk Jenter, and Kai Li, 2011, Institutional cross-holdings and their effect on acquisition decisions, Journal of Financial Economics 99, 27–39.
He, Jie, and Jiekun Huang, 2016, Product market competition in a world of cross-ownership: Evidence from institutional blockholdings, Review of Financial Studies, forthcoming.
Matvos, Gregor, and Michael Ostrovsky, 2010, Heterogeneity and peer effects in mutual fund proxy voting, Journal of Financial Economics 98, 90-112.
New York Times, 2016, A monopoly Donald Trump can pop, December 7.
This post comes to us from Professor Jie (Jack) He of the University of Georgia, Professor Jiekun Huang of the University of Illinois at Urbana/Champagne, and Professor Shan Zhao of the Grenoble Ecole de Management. It is based on their recent paper, “Internalizing Governance Externalities: The Role of Institutional Cross-ownership,” available here.