Intermediated Corporate Governance

In the research programme outlined in this grant proposal, we shall study corporate governance in economies with intermediated equity ownership.

When public corporations are characterised by dispersed equity ownership, blockholders - holders of non-trivial percentages of a company's shares - are key to good governance. In contrast to small shareholders, who have neither the incentive nor the capacity to effectively monitor management, blockholders are able to govern firms to the benefit of all.

The governance role of blockholders must be viewed in the backdrop of the large-scale intermediation of equity ownership in recent decades. Fifty years ago households directly owned around 70% (55%) of US (UK) equity. Today direct ownership accounts for only around 20% (10%) of US (UK) equity. The rest is indirectly owned via institutional investors such as pension funds, mutual funds, and hedge funds. Thus, a majority of blockholders in public corporations in the US and the UK today are money managers. In other words, modern-day corporate governance is intermediated: Funds that manage other people's money must monitor company executives who make business choices funded by external investors, a case of agents watching agents.

Several questions arise immediately. What are the consequences of myopia induced by asset management contracts on the nature of governance? Intermediation of equity ownership increases the distance between ultimate owners and ultimate decision makers while ownership chains also fragment equity holdings: how does this affect coordinated shareholder engagement and corporate decision making? Are there systemic stability concerns that arise from the predominance of asset managers as monitors of firms? In the aftermath of the financial crisis, prominent policy reviews have highlighted several such questions. Yet, the academic literature is yet to engage comprehensively with these issues.

We propose to fill this gap. By a combination of theoretical and empirical methods, we shall develop a comprehensive analysis of several key facets of intermediated corporate governance that are of interest to policy makers. The work will be carried out via seven, interrelated, projects. The emphasis throughout will be on the incentives of asset managers and how these impact the nature of corporate governance in firms in which they hold blocks. We shall document the landscape and legal environment of intermediated ownership around the world, delineating how incentives vary along the ownership chain (Project 1). We shall examine theoretically and empirically how such incentives affect the nature of coordinated engagement in settings with multiple small blockholders (Projects 2 and 3), engender long ownership chains (Project 4), and provide commitment mechanisms for monitoring (Project 5). We shall also examine whether the ways in which such incentives induce asset managers to govern firms foster new channels for systemic risk (Projects 6 and 7).

Our research approach will be positive: in other words, the projects will develop conceptual frameworks backed up by empirical analysis to provide a basis for understanding intermediated governance as it exists today. It is only by gaining such understanding that we can carefully evaluate the normative proposals in the policy reviews for what intermediated governance should be.

We shall facilitate knowledge exchange between the academic and policy communities. By engaging carefully with issues highlighted by policy reviews, we shall enhance awareness of policy-relevant questions amongst academic researchers. By providing thorough theoretical and empirical analyses of issues of direct interest to policy makers, we shall facilitate the development of informed and effective policy to regulate the role of institutional investors in corporate governance.

The main (non-academic) beneficiaries of this research are policy makers and regulators. Our research will provide guidance for enrichment of policy in regulating the role of institutional investors in corporate governance. Policy in this area is typically governed by national "stewardship codes." Such codes are usually less than a decade old, galvanized by the financial crisis. The UK was an early adopter of a formal stewardship code in 2010. The most significant recent development in this area is the EU's adoption of the 2017 Shareholder Rights Directive (Directive 2017/828, henceforth SRD). The SRD represents a major enrichment of existing code, attempting to tackle issues highlighted in the policy literature (see the Case for Support) such as fragmentation of shareholding, ownership chains, shareholder coordination, and conflicts of interest. Yet, many of the aspects of the SRD represent only first steps. We outline the anticipated impact of our projects in the context of the SRD.

Project 1 will establish the first comprehensive empirical characterization of the institutional ownership landscape along with a characterization of incentives along the chain. A full appreciation of this landscape and of incentives is an essential starting point for enriching policy on the institutional stewardship.

Project 2 will help refine policy to coordinate shareholder voice. It shows that flow motivations can form a basis for overcoming free riding in engagement within visible activism events. This suggests that policy aimed at coordinating voice should be targeted towards aiding "hidden" shareholder engagement that occurs "behind the scenes". Project 3 in turn will help to formulate policy to coordinate governance via trade. Preliminary findings indicate that - in the context of the exit governance mechanism - there are unexpected benefits to the presence of flow-motivated shareholders (e.g. mutual funds). They correlate exits with those of an engaged blockholder, enhancing the ex ante threat of the engaged blockholder's exit. Thus, in terms of stewardship, the full composition of the blockholder base matters, and policy must account for such subtlety. While the SRD proposes concrete steps for the identification of the shareholder base to company management, Projects 2 and 3 suggest that it may be helpful to make shareholders aware of each other's identities.

Long ownership chains are problematic and policies are proposed to cull them: e.g., the 2012 Kay Review (KR) proposes (6.13, p. 46) that "the chain of intermediation should be shortened." The SRD emphasizes ownership chains, and proposes that incentives along the chain are reported and revealed. While transparency is desirable, it is no panacea. It is only by understanding why ownership chains form that they can be effectively regulated. This is what Project 4 will do. The KR proposes - as part of a solution - that punishments on asset managers who do not deliver be increased: those who fail "should not expect to be employed" (6.19, p. 47). Our preliminary analysis provides a cautionary note: our conceptualization of the underlying forces suggests that any increase in downside risk to managerial labour income is likely to increase the incentives to delegate.

Projects 6 and 7 deal with an even more nascent area of policy. Following the deleveraging of banks after the financial crisis, policy-makers have very recently become concerned about other sources of systemic risk, e.g., arising from the asset management sector (e.g. 2015 IMF Global Financial Stability Review). In order to regulate and mitigate such new forms of systemic risk, it is key to formally characterize how such risks can arise. By modeling and documenting specific mechanisms by which asset managers foster systemic risk in the real economy (Project 6) and in financial firms (Project 7), these projects will enable better monitoring of systemic risk and provide foundations for policy in this area.