Understanding Institutional Shareholder Activism

A Comparative Study of the UK and China

Bo Gong

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136015762
• Edition: 1
• Topic: Derecho
• Subtopic: Derecho de sociedades

Institutional shareholder participation has long been considered as vital to good corporate governance yet its potential does not seem to have been realized. The recent banking crisis exposed the passivity of some institutional shareholders, many of whom appear to have chosen to sell their stakes in the banks rather than intervene or challenge the board when they realized the strategies followed by the banks were excessively risky. Institutional shareholders' role to scrutinize and monitor the decisions of boards and executive management in the banking sector in the UK is considered by many to be a failure, resulting in the phenomenon of 'ownerless corporations', as described by Lord Myners. In China, despite the fast rising of institutional investment in the securities market, institutional shareholders have not yet played a contributory role in monitoring corporate managers in listed companies.

Drawing on empirical evidence this book seeks to systematically analyses institutional shareholders' incentives to activism to explain when and why shareholder activism will occur. The book puts forward a model which explains the factors that determine institutional shareholders' propensity for activism. The model both elaborates the collective benefits of activism as a means of achieving managerial accountability asks whether and when shareholder activism is rational for any individual shareholder. The book then goes to on to apply these finding to both the UK and China in order to explain the varying levels of shareholder activism in each jurisdiction. The book is the first to take an in-depth look at institutional share-holder activism in China providing prescriptions to promote greater shareholder engagement and exploring the potential it holds for improving corporate governance in the region.

Part I

A model for shareholder activism

An outline

1 A theoretical framework for shareholder activism

This chapter addresses what is really the most fundamental, core, question in the book: is activism by shareholders rational? I wish (unsurprisingly) to answer this affirmatively. And to develop this positive assessment of shareholder activism, I need to move in two stages. The first stage seeks to show that shareholder activism is collectively beneficial: it is part of a good corporate governance system that generates greater collective benefits than the (collective) costs it creates. The second stage switches from the collective to the individual level of analysis. I wish to show the circumstances in which it is now, and could (with an appropriate regulatory framework) even more often be, in the individual interest of (at least many) individual institutional shareholders to engage in activism.

1.1 Is collective action by shareholders beneficial?

Is, then, shareholder activism collectively beneficial; are the collective benefits of some bouts of activism likely to be greater than the collective costs? Or is the management of companies best left to managers, with minimal interference by shareholders? This clearly goes to the heart of the question of whether shareholder activism is something to be encouraged and celebrated. In this section, I shall attempt to argue that activism can be beneficial to companies and therefore to their shareholders. I shall do so by confronting the arguments of those who criticize shareholder activism.

The starting point suggesting that shareholder activism can be beneficial is the agency problem, stemming from a divergence between the interests of shareholders and managers inherent in the corporate form of firm organization. This problem is well explained by Fischel:

As residual claimants on the firm’s income stream, shareholders want their agents – the firm’s managers – to maximize wealth. Because managers cannot capture all of the gains if they are successful, and will not suffer all of the losses should the venture flop, they have less incentives to maximize wealth than if they themselves were the principals. Rather, managers have an incentive to consume excess leisure, perquisites and in general be less dedicated to the goal of wealth maximization than they would be if they were not simply agents.¹

The agency problem imposes, in economic terms, ‘agency costs’ on shareholders.² Kershaw suggests that agency costs comprise of ‘direct transfers of value’, such as self-dealing and senior management remuneration, and ‘indirect agency costs’ including shirking and incompetence.³ Shareholder activism is collectively beneficial, then, in so far as it reduces agency costs by monitoring the agent’s actions to ensure that he does not misbehave and to sanction him if he does, in both the UK and China.

In addition, institutional shareholder activism in Chinese listed companies provides a source of discipline on the controlling shareholders, ensuring that they are acting in the best interests of the minority shareholders. As one will see in following chapters, in contrast to the UK’s ‘outsider/arm’s-length’ system,⁴ China has a ‘insider/control-oriented’ system of ownership and control, where listed companies typically have a ‘block holder’ – the State, which owns a sufficiently sizeable fraction of the voting shares to exercise considerable control over management.⁵ As a result, apart from contributing towards managerial accountability, institutional shareholder activism can also achieve the benefit of reducing the majority–minority agency costs.

1.1.1 A controversial question side-stepped

Having introduced the fundamental issue of agency costs, I must now note, but leave aside, one argument against the benefits of activism. This argument is put forward by some proponents of what is variously termed ‘stakeholding’, or ‘corporate social responsibility’.⁶ For these critics of shareholder activism, the objective of the company should not be understood in terms of single-minded loyalty to the interests of shareholders (by maximizing the profits available for distribution to shareholders, maximizing the wealth of shareholders, and so on). Rather, the very objective of the company is to be understood as involving some balancing of the interests of shareholders with the interests of a company’s other stakeholders, or with the company’s obligations to operate in a socially responsible way. And in this view of a company’s objectives, the disadvantage of collective shareholder action is not that it may harm the interests of shareholders but rather, it may sadly be all too effective in improving the position of shareholders. It is likely to harm the position of the company’s stakeholders, or to undermine the prospects of a company acting in a sufficiently socially responsible manner.

In this book, I am, however, assuming that the objective of those running companies is indeed to ‘promote the success of the company for the benefit of its members’ (as section 172 of the Companies Act 2006 puts it).⁷ I accept that this view is not, as the previous paragraph acknowledges, universally held. However, due to constraints of space I shall not endeavour here to defend this (orthodox) view of the company, but will take it simply as an assumption for the arguments that I do wish to deal with.

So, what arguments against shareholder activism are put forward by its critics who nevertheless share my assumption that the purpose of companies is indeed to promote the interests of the company’s members?

1.1.2 Objections to shareholder activism

Among other things, I shall consider claims that shareholder activism is detrimental to corporate value because of undermining board authority, information asymmetry and shareholders’ lack of expertise, shareholder short-termism and the special interests by which shareholders might be motivated; that other corporate governance mechanisms provide sufficient accountability; and that there is not sufficient empirical evidence supporting shareholder activism. After reviewing all these claims, I conclude that they do not, individually or collectively, form a sound basis against institutional shareholder activism.

1.1.2.1 Adverse effects on shareholder value (damaging the effectiveness of central board system)

1.1.2.1.1 DIRECTOR PRIMACY MODEL

In a series of articles e.g., Director Primacy: the Means and Ends of Corporate Governance,⁸ and one recent challenging monograph, The New Corporate Governance in Theory and Practice,⁹ Bainbridge applies Arrow’s theory from his book T he Limits of Organization¹⁰ to argue the necessity of a centre of power capable of exercising fiat within the corporation. A central authority is often the only way to process information and to make collective decisions for many thousands of members within a large organization.¹¹ Bainbridge therefore contends that the decision-making authority of a corporation shall be vested in a single, central organ – the board.¹² Bainbridge also agrees with Arrow that there is a need to maintain a trade-off between authority and accountability in an effective organization.¹³ However, while he proposes a variety of mechanisms, including self-regulation, board internal dynamics and the use of market mechanism, as means of ensuring managerial accountability, he rejects the idea that shareholder activism should play a role.¹⁴

Bainbridge views shareholder activism as being detrimental to the board’s authority. Encouraging shareholders to ‘review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel’ will ‘shift some portion of the board’s authority to them’ and ultimately undermine the optimality of the ‘director primacy model’.¹⁵

Might shareholder activism damage board authority as Bainbridge fears? No. Shareholders do, and indeed should, have some ability to intervene in corporate management. The scope of power they have, however, is limited. As argued by McDonnell when he considers Bainbridge’s director primacy model, shareholders would, as a matter of law, have restrained power to interrupt board authority.¹⁶ Most of them only get one chance a year to question the board at the annual shareholders’ meeting, and the agenda of that meeting is usually controlled by the board. It is beyond the shareholders’ legal power to intervene on most particular business decisions, and that will continue to be so even though shareholders are more actively participating in activism.¹⁷ Instead, the board, if they want, can step in to make every decision within the corporation. Hence, shareholder activism does help to achieve board accountability but does not result in the board losing a substantial amount of its authority as Bainbridge fears. It therefore fits quite well with Arrow’s position.

One way of examining the objections covered in the following sections is that, if they were correct, it would not be necessary for shares to be attached to votes at all. People who agree that it is important to let shareholders have a say on their own assets are unlikely to accept Bainbridge’s objections set out above.

In addition to retaining authority, Bainbridge has two other subsidiary (and, I would suggest, less original) reasons to support his objections to shareholder activism. He claims that some investors may misuse their power to advance their private interests which conflict with those of other shareholders. And he also argues that a variety of other mechanisms (instead of shareholder activism) will sufficiently hold the board accountable. These two points will be discussed separately in sections 1.1.2.1.4 and 1.1.2.2.

The following section will first deal with a common argument against shareholder activism: information asymmetry and lack of expertise.

1.1.2.1.2 INFORMATION ASYMMETRY AND LACK OF EXPERTISE

A main objection to shareholder activism is grounded on the informational and competence disadvantages that shareholders are likely to have vis-à-vis management.¹⁸ Opponents contend that, firstly, unlike managers, shareholders neither have time to gather information nor have full access to inside information of a corporation or business; and secondly, if they gained information, they do not specialize in making ‘sound decisions on either operational or policy questions’.¹⁹ The argument goes, by virtue of those constraints, shareholder could make poor and wrong choices that might be detrimental to the interests of the company.²⁰ However, as the following counterarguments suggest, this viewpoint does not obviate the strong need for institutional shareholder engagement.

Firstly, whether information is sufficient for a shareholder should be judged by the way he intends to use it. It is essential to bear in mind the objective or form that activism might take. Much activism will be concerned not with management of the company but with its internal governance arrangement. Making a decision as to whether a governance arrangement is problematic commonly does not turn on company-specific, inside information or professional ability. Consider, for example, the decision whether to separate the role of CEO from the chairman in a board structure. For UK investors, it is already a recommendation set out in the UK Corporate Governance Code.²¹ Any company that does not adopt such a practice will be easily viewed as not-in-compliance with the Code. If the company offers an explanation, shareholders will determine whether the reasons given by the board of directors are acceptable and such decisions are unlikely to rely on inside information that corporate managers have but shareholders lack.

Even if shareholders gather relevant information they need, the second argument mentioned above contends tha...

Table of contents

• Cover Page
• Half Title page
• Series page
• Title Page
• Copyright Page
• Contents
• Acknowledgements
• Abbreviations
• Introduction
• Part I A model for shareholder activism An outline
• Part II The framework of corporate governance in the UK and China
• Part III Institutional investment in the UK and China
• Part IV Developing and applying the model for institutional investor activism in the UK and China
• Part V Comparisons and (modest) prescriptions for reform
• Bibliography
• Index