Role and responsibilities of institutional investors Professor Laura

Role and responsibilities of institutional investors Professor Laura T. Starks Presentation to the International Symposium on Corporate Governance Reform in Korea December 5, 2008

Outline Ø Size, growth and influence of institutional investors in equity markets Ø Role and responsibilities of institutional investors in monitoring and corporate governance issues Ø Focus on union pension funds, mutual funds, and hedge funds Ø Role and responsibilities of institutional investors in monitoring and social and environmental issues

Growth in mutual fund assets worldwide In trillions of USD, from Investment Company Institute

Growth in mutual fund assets worldwide ? In trillions of USD, from Investment Company Institute

Growth in assets under management in mutual funds in Asia and Pacific markets (in millions of USD)

Growth in institutional equity investment in the United States 19 90 Source: Federal Reserve (in millions of USD) ’s

Percentage of U. S. corporate equities owned by institutional investors Source: Federal Reserve

How institutional investors can affect stock prices through their actions Institutional Investors Trading Monitoring

Role of institutional investors Ø Institutional investors are now the dominant shareholders in the stock market Ø Institutional investors affect firms’ management through their trading of their securities. Ø The institutional investors are individually large investors with strong ability to monitor firm management Ø Institutional “voice” can add value because of greater monitoring. This voice can come in part from more concentrated holdings and coordinated actions.

One aside on trading

Recent market movements in the Dow Jones Industrial Average

Volume at the end of the day!

Institutional investors and monitoring Institutional Investors Boards of Directors Large Blockhldrs Lenders Stock market Mechanisms to mitigate agency problems Labor Legal and competitive environments

Limiting factors for institutional monitoring Ø Fiduciary duties Ø Costs of monitoring • Concerns about the liquidity of their portfolios • Loss of potential business relations with firm • Free-rider problem

Can fiduciary duties of the institutional investors have negative effects on markets? Reserve Primary Fund situation in September 2008 • Being an institutional money market fund the Fund’s holdings were transparent. The institutions knew that the $62 billion Reserve Fund had an investment of $785 million in Lehman securities. • When Lehman went bankrupt, the institutional investors had a fiduciary duty to exit the Reserve Fund and preserve the capital of their beneficiaries, participants or shareholders. • There was consequently a run on the fund. This had negative effects for the remaining investors.

When unhappy with a company, what choices do institutional investors have? Ø Vote with their feet (Sell their shares) Ø Exercise voice (Hold shares and try to influence management decisions) Termed “shareholder activism” or “engagement” Ø Hold shares and do nothing

Voting with their feet Ø Also called Wall Street Rule or Wall Street Walk Ø Why should management care whether any of their institutional investors sell their shares?

Management cares about the composition of their shareholder base Ø Want institutions that provide them with more credibility Ø Want institutions that are more likely to vote with management Ø Want institutions with a longer-term focus

But does the institutional selling affect stock prices?

Evidence suggests yes Ø Institutions’ selling or avoidance of shares can have price effects • Heavy selling by institutional investors can put downward pressure on stock price. • Evidence shows that changes in institutional investor ownership is associated with changes in returns

How do institutional investors monitor corporate managers? Private monitoring (behind the scenes) • Direct negotiations with management • Direct contact to directors Public monitoring • Submission of shareholder proxy proposals • Publicly targeting firms

What strategies would institutional investors be most likely to pursue? From Mc. Cahery, Sautner, and Starks, 2008

Evidence on private institutional investor activism From a study of TIAA-CREF’s activities Ø Institutional investor reached agreement with targeted firm over 95% of the time Ø In at least 87% of these cases, the targeted firm took actions to comply with the agreement

Example of private activism taken public In 2007 Fidelity publicly announced that they would vote against the buyout of one of their portfolio companies. Fidelity owned 9% of the firm. The Tweedy Browne Funds helped unseat Conrad M. Black from Canada's Hollinger in 2003 and successfully fought German automaker Volkswagen to push one of the Porsche family members off VW's supervisory board.

Evidence that institutional investors care about corporate governance Ø Surveys Ø Creation of governance indexes • To assess country environments • To assess corporation’s practices • To serve as the basis of index funds Ø Investors’ reactions to corporate governance-related activities – stock prices change on announcements

2007 survey on importance of specific mechanisms Equity ownership by managers 87% Use of equity-based compensation 86% Independence of the board 86% Transparency about holdings of large shareholders 85% High free float of shares 85% Ownership concentration 80% From Mc. Cahery, Sautner, and Starks, 2008

Public activism: Which firms get targeted? Poorly performing firms Ø With high institutional ownership Ø With poor corporate governance Ø Low inside ownership

Public activism: Does it work? Metrics: • • Short-term market reactions Long-term performance Voting outcomes on shareholder proposals Other effects These metrics lead to mixed conclusions on whether public activism is effective.

Increasing interest in proxy proposals Ø According to the IRRC, 8, 600 shareholder proposals were put on proxies between 1973 -2004 Ø Less than 10% won majority support Ø But more than half of these majority votes occurred in the last four years of the period

Changes in proposal issues over time

Changes in percentage votes on proposals over time

Changes in sponsorship of proposals over time

Mutual fund voting records on 2007 corporate governance proposals

New shareholder proposals for 2008 Ø Proposals to create compliance committees to oversee boards’ roles in managing risk Ø Requests to improve how companies manage risk Ø Enhanced disclosures of lending practices • Financial institutions • Home builders (due to concerns about their mortgage lending arms' dealings in high-risk loans) Ø Moody’s and Mc. Graw Hill received proposals that called for the board to adopt policies to bar the employment of any individual who worked for a client within the past year.

New kids on the block: Hedge fund activism Forms of hedge fund activism – all seeking changes in the firms’ strategy • Publicly targeting the firm • Privately targeting the firm • Getting representation on board of directors • Litigation • Targeting firm for change in control

Growth in hedge funds In millions of USD

Why have hedge funds turned to activism? Avg returns: 1990 -1999: 19% Merger arb 14% 2000 -2005: 9% 5%

Study finds that hedge funds only made above average returns on targeted firms that were acquired

Ø Other studies have concluded that hedge funds have been able to make a difference

Effects of institutional investor activism Ø Some evidence that public activism works Ø Much evidence that private activism works

Role of institutional investors in firm corporate governance Preponderance of evidence suggests that: Ø Institutional investors have substantial influence on firms’ corporate governance Ø This influence has generally positive consequences

Role and responsibility of institutional investors in corporate social responsibility issues

New acronym

Who are the social activist shareholders in the U. S. ? Ø Religious organizations, e. g. , Interfaith Center on Corporate Responsibility (ICCR) Ø Individuals Ø Socially Responsible Investing (SRI) funds Ø Social organizations, e. g. , Noyes Foundation, PETA Ø Labor unions

Example of 2008 global warming resolution at Exxon. Mobil Global Warming Emissions Reduction - Oil & Gas Companies Exxon Mobil Corporation (Similar resolutions filed at a number of U. S. companies in the oil & gas, utility, home building, and automotive industries) After the whereas: Ø THEREFORE, BE IT RESOLVED: shareholders request that the Board of Directors adopt quantitative goals, based on current technologies, for reducing total greenhouse gas emissions from the Company's products and operations; and that the Company report to shareholders by September 30, 2008, on its plans to achieve these goals. Such a report will omit proprietary information and be prepared at reasonable cost.

Changes in rationale for corporate social responsibility shareholder proposals Ø Previous rationale: • CSR factors are important for ethical/moral/social reasons Ø Recently added rationale: • CSR factors are important because they can affect company performance.

Shareholder proposals Who gets targeted? Corporations with largest number of social responsibility proposals (1992 -2002): • • General Electric Chevron/Texaco Exxon/Exxon Mobil Phillip Morris AT&T General Motors JP Morgan Chase 86 64 60 54 46 42 38 From Tkac, 2006

Survey: Importance of ESG factors to mainstream investment considerations (economic risk/return) Mercer Consulting 2006

What do investors do? Ø Market reactions to announcements of proposals • Little evidence Ø Institutional investor monitoring • Little evidence except for union funds and religious funds and more recently SRI mutual funds

Votes on CSR shareholder proposals Ø Low proportion of votes in favor Ø Tkac (2006) finds average yes vote over 1992 -2002 period is 8. 2% Ø But, this has been changing…

How do mutual funds react? % votes in favor of CSR proposals 2004 2005 2006 10 Mainstream Mutual Funds 5. 8% 7. 2% 11. 3% 7 SRI Mutual Funds 70. 5% 65. 8% 74. 9%

But even variation within mainstream funds (2006 votes) Abstain Against For American 108 3 Fidelity 124 1 TIAA-CREF 42 70 87 Vanguard 164 7 4

Voting in 2008 proxy season Ø Votes in favor of CSR proposals this year have increased to 14. 7% Ø About 30% of the issues voted on received more than 20% support Ø 129 proposals were withdrawn

Major social issues arising in the 2008 proxy season I. Climate change II. Sudan and Darfur conflict III. Political contributions IV. Health care proposals

2008 major social issues on proxies Climate change Ø Major issue: greenhouse gas emissions Ø Is there an economic effect? • Possibly – future carbon emissions may have a price • Possibly – if a company can have a competitive edge from a position on climate change • Probably – companies face increased risk because of the regulatory changes that will occur from concerns about climate change

2008 major social issues on proxies Climate change Ø Example that underscores the possible economic effect Ø 11 multinational corporations have formed the Supply Chain Leadership Collaboration to work with their suppliers to reduce greenhouse gas emissions • Dell, HP, Pepsico, Proctor & Gamble, Unilever, L’Oreal, Reckitt Benckiser, Cadbury Schweppes, Nestle, Tetco

2008 major social issues on proxies Climate change: Shareholder positions Ø Shareholder proposals on climate change • Most address greenhouse gas emissions • Request for a policy of increasing global renewable energy sources Ø Joint institutional investor initiatives • Carbon Disclosure Project • 385 institutional investors representing $57 trillion in assets under management • On their behalf it seeks information on the business risks and opportunities presented by climate change and greenhouse gas emissions data from the world's largest companies: 3, 000 in 2008

2008 major social issues on proxies How much attention are investors paying? Ø Goldman Sachs’ view: “Environmental and social issues count … in an increasingly complex world, we believe such issues are part of the relative quality of overall management performance needed to compete successfully. ” Ø TIAA-CREF’s view: “Will generally support reasonable shareholder resolutions seeking disclosure of greenhouse gas emissions and the impact of climate change on a company’s business activities.

2008 major social issues on proxies Sudan Ø Divestment • Pros • Puts pressure on Sudanese government to end the Darfur conflict • Cons • Shareholder engagement may be more effective than divestment – studies show that South African divestment had no discernible effect • Many institutions have a fiduciary duty to make decisions solely on the basis of economic returns

2008 major social issues on proxies U. S. Department of Labor’s View Interpretation of ERISA and SRI ‘‘A fiduciary must ordinarily consider only factors relating to the interests of plan participants and beneficiaries in their retirement income. ” “A decision … may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments. ” Reason for new legislation and presidential orders

2008 major social issues on proxies Ø Sudan Divestment Accountability Act of 2007 • Provides safe harbor to states and fund managers who divest Sudan-related companies from their portfolios • Prohibits companies with operations in the military or energy sector of Sudan from receiving federal contracts

2008 major social issues on proxies Proposals at mutual funds Ø Mutual Funds Divestment Campaign • Investors against Genocide (formerly called Fidelity out of Sudan) • Have filed proposals at 28 Fidelity funds, 24 Vanguard funds and other funds at Barclays, Franklin Templeton, and T. Rowe Price

2008 major social issues on proxies Sudan: Shareholder positions Ø Proposals Ø Investor coalitions • Socially responsible investment firms have submitted proposals at financial services firms: Merrill Lynch, Morgan Stanley, T. Rowe Price asking their boards to report to shareholders on how investment policies, including shareholder engagement, “addresses or could address human rights issues” (with specific reference to Sudan)

2008 major social issues on proxies Political contributions Ø Activists have concerns that firms may say one thing publicly and then fund a trade association that lobbies for the opposite. Ø Shareholder proposals calling for disclosure of contributions to trade associations Ø Support averaged 26. 1% in 17 votes on the issue.

2008 major social issues on proxies Health care proposals Ø Proposals ask companies to support universal healthcare. Ø Opponents believe this is not an appropriate use of shareholder proposals as it is asking corporations to campaign for public policy issues. Ø Voting results in 2008 • Support averaged 4. 35% in 8 votes on the issue. • 13 of the 27 total proposals filed were withdrawn. • 3 health care companies were allowed to exclude the resolutions because they related to those firms’ “ordinary business. ”

Other types of social proposals in 2008 Ø Stop predatory lending practices Ø Prepare report on operations in Burma (Myanmar) Ø Prepare report on company activities affecting indigenous peoples’ rights Ø Tobacco related proposals Ø Prepare reports on outsourcing Ø Prepare reports on connections to pornography Ø Ethical criteria for military contracts

But some pushback from other investors as well Free Enterprise Action Fund (FEAF) submitted proposals asking companies to report on the effect of sustainability efforts on their operations. The Free Enterprise Action Fund is a shareholder activist mutual fund that seeks long-term capital appreciation while aggressively challenging CEOs who use shareholder assets to advance the liberal political agenda which threatens longterm shareholder value, the free enterprise system and individual liberty.

So…what should institutional investors consider? Ø Do social responsibility issues affect firms’ risk? • Potential risk factors • • • Regulatory risk from future regulations Supply chain risk Product and technology risk Litigation risk Reputational risk Physical risk Ø Is this risk priced?

Bottom line on social responsibility shareholder proposals Ø According to surveys, a minority of investors believe social responsibility issues, in general, have important effects on a firm’s actions and value. Ø Traditionally only specialized institutional investors (primarily union funds and religious funds) have been both interested in and tried to affect firms’ actions with regard to social responsibility issues. They have generally not been very successful in changing firms’ actions. Ø Recently more institutional investors and individual investors have become interested, but others have actively fought against such efforts. Ø BOTTOM LINE: The effects of CSR issues on corporations needs to be better understood.

Conclusions Ø Institutional investors have important roles and responsibilities in the financial markets. Ø Through their trading and monitoring they have substantial effects on firm’s stock prices and on their actions. Ø This monitoring affects both firms’ corporate governance and may affect firms’ treatment of their environmental and social issues as well.