Institutional Investing When Shareholders Are Not Supreme

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Institutional Investing When Shareholders Are Not Supreme by SSRN

Christopher Geczy

University of Pennsylvania – The Wharton School, Finance Department

Jessica S Jeffers

University of Pennsylvania – The Wharton School

David K. Musto

University of Pennsylvania – Finance Department

Anne M. Tucker

Georgia State University College of Law

March 24, 2015

Harvard Business Law Review, Vol. 5, 2015

Georgia State University College of Law, Legal Studies Research Paper No. 2015-08


Institutional investors, with trillions in assets under management, hold increasingly important stakes in public companies and fund individual retirement for many Americans, making institutional investors’ behaviors and preferences paramount determinants of capital allocations and the economy. In this paper, we examine high fiduciary duty institutions’ (HFDIs’) response to decreased profit maximization pressure as measured by the effect of constituency statutes on HFDI investment. We ask this question, in part, to anticipate HFDIs’ response to alternative purpose firms, like benefit corporations. Only with access to institutional investors’ capital can alternative purpose firms gain economic significance to rival the purely for-profit corporation.

In our empirical study, we ask whether decreased profit maximization pressure, as evidenced by expanded director discretion to pursue non-shareholder interests, affected HFDIs’ decision to invest (or remain invested) in firms incorporated in constituency statute states (constituency firms) because of a conflict, or perceived conflict, of fiduciary duties owed to beneficiaries and shareholders. HFDIs, as agency investors for their shareholders and beneficiaries, are subject to strict fiduciary duties, which among other things explicitly disallow, everything else equal, sacrificing monetary returns for other goals. We focus on HFDIs for our statistical analysis under the theory that any impact of fiduciary duties on investment behavior would be strongest among those subject to the strictest duties. In other words, if we were to see an effect at all between expanded duties and investment behavior, it would be most easily observable in HDFI.

Constituency statutes expand directors’ ability to consider non-profit maximizing goals similar to, although smaller than, the expansion of director prerogatives under alternative purpose firm legislation. Moreover, constituency statutes are particularly well-suited to an empirical study because 1) institutional holdings of public firms are public and easily observable unlike investment levels in alternative purpose firms, which are all private; 2) the sample is large, as it comprises all public firms in all states; and 3) the timespan over which states passed constituency statutes, three decades, makes it unlikely that any effect observed would be confounded empirically by some other concurrent event. Before testing changes in HFDI investment, we review 30 years of court decisions to verify that constituency statutes, once enacted, were enforced by courts and therefore changed directors’ duties in practice.

Our findings answer questions raised in early constituency statute scholarship regarding the scope and impact of constituency statutes. Our findings also connect constituency statutes to the current academic debate on alternative purpose firms by identifying potential litigants and theories of recovery under the new statutes. Finally, as to our empirical inquiry, we observe that HDFIs did not meaningfully change investment behavior in response to constituency statutes’ expansion of director duties. Extrapolating our empirical observation to the current question of alternative purpose firms, we do not foresee expanded director duties under these new hybrid entities to, by itself, be a barrier to HFDI investment.

Institutional Investing When Shareholders Are Not Supreme – Introduction

According to the shareholder primacy view of U.S. corporations, a corporate board’s duty is to maximize shareholder value. Although debated,1 it is a popular and influential view supported de jure through case law and de facto through the assignment of votes exclusively to shareholders. Recently, however, entrepreneurs, legislators, and investors have contemplated variations of this duty. Pressure on the shareholder wealth maximization rationale is evidenced by trends such as social and impact investing, the emergence of benefit corporations, and even the actions of some of the most notable corporations. A recent episode involving the largest U.S. corporation by market capitalization, Apple, Inc. (Apple), illustrates the resulting tension. In a March 2014 debate over Apple’s environmental policies, including a plan to power its new facilities using “100% green energy,” CEO Tim Cook advised, “If you want me to do things only for ROI [Return on Investment] reasons, you should get out of this stock.”

Whether an investor who wants Apple to focus on return on investment can, in fact, get out of the stock depends on whether the investor has delegated investment discretion to someone else. An investor who has retained discretion can heed the advice and exit the individual stock.3 But if investment discretion has been delegated to an institution, like a mutual fund or a pension plan, then the investor cannot simply exit the stock. Thus, many investors rely on investment agents to decide whether nonmonetary goals, such as Apple’s, are appropriate.

Reliance on investment agents is widespread. Institutional investors own a majority of Apple stock,4 which is consistent with stock ownership trends for public companies generally, according to the Federal Board Flow of Funds. Absent certain external restrictions, such as those imposed by index funds, institutions wield investment discretion, deciding which stocks to hold and which to sell. With this discretion comes responsibility in the form of fiduciary duties owed to the institutions’ principals (for example, shareholders and other beneficiaries). These duties, if breached, expose institutions to liability. How then do institutions reconcile fiduciary duties to their investors with the discretion to invest in companies, some of which may pursue non-monetary corporate goals?

Institutional Investing

Institutional Investing

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