Professor Bainbridge...on law, politics, religion, culture & food

The Passivity of Institutional Investors

Megan McArdle:

I wish someone had a better answer to the question of why large institutional investors aren’t more active in corporate governance.

I’m not entirely sure what she means by “better” answer, but there is a clear answer. I argued in Shareholder Activism and Institutional Investors that:

… institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

Specifically, I explained that:

Most institutional investors compete to attract either the savings of small investors or the patronage of large sponsors, such as corporate pension plans. In this competition, the winners generally are those with the best relative performance rates, which makes institutions highly cost-conscious.  Given that activism will only rarely produce gains, and that when such gains occur they will be dispensed upon both the active and the passive, it makes little sense for cost-conscious money managers to incur the expense entailed in shareholder activism. Instead, they will remain passive in hopes of free riding on someone else’s activism. As in other free riding situations, because everyone is subject to and likely to yield to this temptation, the probability is that the good in question—here shareholder activism—will be under-produced.

In addition, corporate managers are well-positioned to buy off most institutional investors that attempt to act as monitors. Bank trust departments are an important class of institutional investors, but are unlikely to emerge as activists because their parent banks often have or anticipate commercial lending relationships with the firms they will purportedly monitor. Similarly, insurers “as purveyors of insurance products, pension plans, and other financial services to corporations, have reason to mute their corporate governance activities and be bought off.” Mutual fund families whose business includes managing private pension funds for corporations are subject to the same concern.

This leaves us with union and state and local pension funds, which in fact generally have been the most active institutions with respect to corporate governance issues.  Unfortunately for the proponents of institutional investor activism, however, these are precisely the institutions most likely to use their position to self-deal—i.e., to take a non-pro rata share of the firms assets and earnings—or to otherwise reap private benefits not shared with other investors.

Put bluntly, passivity is inherent in the nature of the beast.