Institutional shareholders’ role in corporate governance and their effect on firm value have been explored, both theoretically and empirically, mainly in the context of dispersed-ownership environments like the United States or the United Kingdom. In these common law countries, institutional investors play an active role, initiating proposals of their own regarding compensation [1] and appointment of board members. [2] In other countries, however, where corporate ownership is more concentrated and controlling shareholders are more prevalent, institutional investors are expected to fulfill a different function, namely, to protect minority shareholders in their conflict with controlling shareholders by, for example, voting against unfair related-party transactions proposed by management. Research suggests that certain voting processes could serve as an efficient form of activism in firms across the U.S. [3] as well as in other countries. [4] It is important to keep in mind, however, that minority shareholders’ ability to effectively oppose and prevent unfair transactions in controlling-shareholder environments is contingent on the existence of a regulation that gives them special power beyond their relative voting rights.

In line with this rationale, several countries have implemented advance minority approval of related party transactions. [5] This has opened up the possibility of investigating the effect of shareholders’ voting power on voting by institutional shareholders.  The term “voting power” is used here to mean a voter’s ability to influence voting results by either forming a coalition with other voters or withdrawing from one. A shareholder’s a priori voting power under a given majority rule is the potential influence that this rule assigns to that shareholder.[6] This variable can be measured using two different power indices, both widely used in scholarship: the Shapley-Shubik index (1954) and the Banzhaf index (1965). Both these measures are a function of three parameters: the number of players in a voting game, each player’s relative voting rights, and the majority rule for a winning coalition.

Inasmuch as the above two power indices take into account possible coalitions, they enable a more accurate measurement of an investor’s potential influence than his or her relative voting rights or equity-stakes. Consider, for example, a company that has only three shareholders, holding 49 percent, 49 percent, and 2 percent of the outstanding equity, respectively. The voting rights measure would predict significantly lower ability to influence any vote for the third, small shareholder. By contrast, the power indices would assign equal power to all three shareholders, as each is pivotal in one-third of possible coalitions. In this framework, a change in the required majority (like one implemented in 2011 by the Israeli regulator, for example) affects the shareholders’ power indices. The effectiveness of such a regulation can be better understood and evaluated through an analysis of the voting power of institutional shareholders and of their voting behavior on proposals involving self-interested transactions that require a special majority for approval.

Consistent with the literature on voting, [7] my analysis of the distribution of voting power and of the votes cast by institutional shareholders has shown that the strongest minority shareholders tend to vote in favor of management-sponsored proposals. In other words, a positive correlation was demonstrated between voting power and management friendliness.

What may account for this pattern? One possibility is that large shareholders’ voting decisions are swayed by conflicts of interest; they may, for example, have some other business dealings with firm management, or possibly management may even be “buying” their votes directly. Let us dub both these possibilities “the bad story.” An alternative scenario could be that, as strong institutional investors, large shareholders negotiate the conditions of a transaction with management before the vote and use their power to achieve better terms, thereby benefiting minority shareholders. This explanation can be labeled “the good story.”

Since behind-the-scenes negotiations are, by definition, not open to outsiders, in order to distinguish between the above two accounts, it is first necessary to identify the cases in which a negotiation took place between management and shareholders over the conditions of a transaction prior to the vote. An indication of such a negotiation could be a delay in a vote, announced shortly before the originally scheduled meeting, likely on account of disagreements. Such information was used in my study as a proxy for negotiations, and the analyses targeted subsequent votes of smaller shareholders with no conflicts of interest – specifically, if they had voted in favor of or against the proposed transaction, in line with the good and the bad story, respectively. My study shows that, when pre-vote negotiations regarding self-dealing transactions take place, small institutional shareholders are more likely to dissent, whereas the largest, and strongest, among minority shareholders are more likely to vote with management. This finding is consistent with the bad story, in the sense that large (and strong) minority shareholders vote with management even though the proposal does not necessarily maximize value. Furthermore, the data show that, in their voting behavior, institutional investors display consistent patterns such that their voting history is significant in predicting their next vote. The voting behavior of the largest and strongest investors tends to be management friendly, whereas small employee-owned funds tend to vote in opposition to management. Two possible interpretations for this observation are broached, neither of which bodes well for minority shareholders.

The first is that institutional shareholders develop a general voting strategy and apply it regardless of the specific details of the proposal voted on because of their limited interest in the voting process in general. [8] The second interpretation applies in cases where voting with management is the prevalent pattern. Here, a conflict of interest could be at play, as already elaborated in the literature. [9]

Overall, it appears that raising the required majority in an attempt to empower minority shareholders in a concentrated-ownership environment is likely to exacerbate inequalities in the distribution of voting power by bestowing even more power on shareholders that were powerful to begin with. Large institutions thus empowered tend to be management friendly and vote mostly in favor of management-sponsored proposals. It is therefore not at all clear that such a move can be effective in preventing minority shareholder expropriation by controlling shareholders and in improving corporate governance.

Implications from the Israeli case I investigated can be drawn to improve corporate governance in general. To achieve this objective, strengthening minority shareholders appears to be a necessary but not sufficient condition. An efficient regulation should ensure that institutions that represent minority shareholders do not operate under conflicts of interest. It is also essential that such a regulation increase these institutions’ motivation to consolidate a viewpoint on every proposal and utilize their position of power to benefit minority shareholders.

ENDNOTES

[1] See detailed review in Yermack, D. (2010). Shareholder Voting and Corporate Governance. Annual Review of Financial Economics, 2(1), 2.1-2.23.

[2] Cai, J., Garner, J., & Walkling, R. (2010). Shareholder Access to the Boardroom : A Survey of Recent Evidence. Journal of Applied Finance, 20(2), 15–26.

[3] Cai, J., Garner, J., & Walkling, R. (2009). Electing Directors. The Journal of Finance, 64(5), 2389–2421., Fischer, P. E., Gramlich, J. D., Miller, B. P., & White, H. D. (2009). Investor perceptions of board performance : Evidence from uncontested director elections. Journal of Accounting and Economics, 48(2–3), 172–189, and papers surveyed in Yermack 2010.

[4] Iliev, P., Lins, K. V., Miller, D. P., and Roth, L. (2015). Shareholder Voting and Corporate Governance Around the World. Review of Financial Studies, 28(8), 1–59.

[5] Canada, Australia, Hong Kong, Indonesia, Mexico and Israel (Fried, Jesse M., Kamar, Ehud and Yafeh, Yishay (2018), The Effect of Minority Veto Rights on Controller Tunneling. CEPR Discussion Paper No. DP12697. Available at SSRN: https://ssrn.com/abstract=3122359). This post is based on an analysis of voting data from Israel.

[6] Felsenthal, D. S., and Machover, M. (2004). A priori voting power : what is it all about ? Political Studies Review, 2(1), 1–23.

[7] Matvos, G., & Ostrovsky, M. (2010). Heterogeneity and peer effects in mutual fund proxy voting. Journal of Financial Economics, 98(1), 90–112. As well as Hamdani, A., and Yafeh, Y. (2013). Institutional Investors as Minority Shareholders. Review of Finance, 17(2), 691–725

[8] See, for example, Lund (2018), arguing that passive investors have no incentive to acquire information on every proposal in every firm in their portfolio, therefore will follow a passive vote strategy

[9] Hamdani and Yafeh, 2013. As well as Cvijanovi, D., Dasgupta, A., and Zachariadis, K. E. (2016). Ties that Bind : How business connections affect mutual fund activism. Journal of Finance, 71(6), 2933–2966.

This post comes to us from Efrat Dressler, a visiting scholar at The Wharton School, University of Pennsylvania. It is based on her recent article, “Institutional Investors, Voting Power, and Voting Patterns: An Empirical Analysis,” available here.