How Institutional Investors Hinder Companies and the Economy - Essay Example

It is often claimed that al investors are prone towards short-termism, and that such short-termism ultimately harms companies and the economy as a whole. Critically evaluate the extent to which institutional investors hinder companies and the economy as a whole. By Student Name Course University Date Introduction Short termism or the short-term theory assumes that institutional investors are more prone to respond to the short term returns on their investments.1The difficulty with institutional investors’ propensity toward short termism is that what is good for the firm and the economy in the long term is often not good for the short term.2 In the UK, institutional investors hold approximately 40% of equity in UK companies.3 It has also been claimed that 70% of equity in public companies in the UK are owned by institutional investors.4 Corporate ownership by institutional investors would not ordinarily cause concern about short-termism and its incompatibility with the company’s long-term goals. This is because ownership and management is separated in corporate governance.5 However, since the global financial crisis of 2007 policy-makers have called for a greater role of shareholders in corporate governance as a means of minimizing the risks associated with the cause of global financial crisis.6 Criticism in the literature therefore alleges that given institutional investors’ large ownership of companies and their propensity for short-termism, institutional investors are behind the short-termism that weakens capital markets and can compromise corporate governance and an unprecedented rate of ‘takeover activity’ in the UK.7 This research paper investigates whether or not the short-termism associated with institutional investors has a negative impact on companies and the economy as a whole. The following research questions are investigated: Are institutional investors more predisposed to short-termism? Are the short-termism activities of institutional investors bad for corporate and economic performance? In answering the research questions this paper is divided into three main parts. The first part of this paper defines and describes short-termism and theoretical perspectives. The second part of this paper analyses the literature on the link between institutional investors and short-termism. The final part of this paper analyses the effect of institutional investors’ predisposition for short-termism on companies and the economy. Short-Termism Short-termism contemplates scenarios in which ‘corporate stakeholders’ including management, employees, board member, investors’ prefer strategizing in favour of ‘an earlier payoff’ as opposed to ‘strategies that would add more value but have a later payoff’.8 Short-termism is not necessarily a bad thing as in many cases a company’s ‘survival’ will often depend on achieving a short-term gain which should be beneficial to the company in the long term.9 The problem however, is that quite often a short-term gain is not always consistent with long-term gains.10 For example, a company may wish to rescue the company from a specific debt or wish to take advantage of a new investment opportunity and in doing so, might obtain a loan. While this new debt might bring short-term gains, it could put the company into unmanageable debt in the long-term. Short-termism is best understood by reference to myopia theories which argue that investment decisions are driven by a failure to invest ‘due to concerns with the firm’s short-term stock price’.11 Essentially, myopia theories claim that short-termism is characterized by impatience associated with a ‘tendency to’ focus on the firm’s ‘newly announced financial results and then hurry to buy or sell shares accordingly’.12 According to Bair, short-termism is responsible for the distorted allocation of assets and resources and therefore played an important role in the recent global financial crisis.13 Short-termism theory and the theory of myopia therefore assume that business planning is short-term and is characterized by a lack of long-term planning. This paper will now analyse the literature on the link between short-termism and institutional investors. Short-termism and Institutional Investors According to Bushee institutional investors are typically ‘transient’ in nature.14 Transient institutional investors are characterized by a tendency to move from one company to another and as such to follow immediate stock values. This class of institutional investors rely on current stock values and do not usually conduct long-term value analysis. There is a tendency on the part of institutional investors to ‘over-weight’ a firm’s ‘short-term earnings potential’ and ‘underweight’ the firm’s ‘long-term earnings potential’.15 The link between short-termism and institutional investors is traced back to the 1970s when a number of systematic changes impacted the accumulation of wealth. One change was the creation of pension funds which changed capital markets with institutional holdings of pension funds. Since pension funds are tax-free, institutional holdings of pension funds were more predisposed to trading pension funds for short-term gains. Moreover, capital gains taxes changed during the 1970s so that taxes were higher on long-term capital gains than on short-term capital gains. This led to a restructuring of stock markets. Aware of the tax consequences of long-term capital gains, stock markets began paying a higher commission premium for sales’ analysis. This led to a focus on short-term gains as capital gains taxes were lower on earnings over a year or less.16 In addition institutional investors are said to be more inclined toward short-termism as a result of the scandals associated with firm misconduct during the 1990s. These scandals such as Enron and WorldCom revealed fraudulent activities, excessive compensation, a lack of transparency and insider dealing and so on. This obviously led to institutional investors thinking only in the short-term with no intention of remaining with a company over the long-term. Another factor influencing institutional investors’ proclivity for short-termism is said to be the lack of acceptable analysis of a firm’s long-term investment prospects. It is also claimed that institutional investors are highly speculative and have a tendency to ‘jump in and out of the market’.17 A review of literature therefore demonstrates that institutional investors are motivated by market structure, commission incentives, taxing process and their own propensity toward speculative behaviour to engage in short-termism. In other words, it is reported in the literature that institutional investors do engage in short-termism for a variety of reasons. The next section of this paper analysis how and to what extent, institutional investors’ proclivity for short-termism impacts companies and the economy in general. The Impact of Institutional Investors’ Preference for Short-Termism on Companies and the Economy Institutional Investors, Short-Termism and Corporate Performance The problem with short-termism is framed as one in which, institutional investors focus on short-term returns on their investments and as a result, corporate management focus on satisfying institutional investors’ desires.18 This chain reaction is enabled by company law which has since 1948 imposed a fiduciary duty on corporate directors to take account of the interests of stakeholders. Moreover, the theory of shareholder primacy which forms the basis of the Anglo-American business model is reflected in UK company law. The shareholder primacy theory insists that the purpose of any business is to maximize profits and in the case of companies, the company is intended to maximize the profits of shareholders.19 Indeed Section 172(1) of the Companies Act 2006 instructs company directors to: …act in the way he considers in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.20 This duty is also qualified by the directors’ duty to take account of the interests an enlightened class of stakeholder including employees, the community and the environment in which the company operates.21 Although the duty to look after a variety of enlightened shareholders tend to suggest that shareholder primacy is not possible, a closer look at the Companies Act 2006 confirms otherwise. For example Section 168 of the Companies Act confers upon shareholders a right to remove directors by virtue of a simple majority vote for any reason and irrespective of any pre-existing agreement between the company and the director.22 It therefore follows that company directors are under pressure, for fear of removal to ensure that shareholders are satisfied. Given that a large number of shareholders in UK companies are institutional investors, directors are likely to engage in short-termism to keep their institutional investors satisfied. Even if institutional investors is a minority shareholder in a company, it can still hold considerable power over the manner in which the corporate directors manage the affairs of the company. Minority protection under the Companies Act 2006 permits minority shareholders to petition the court for a winding up order if they are dissatisfied with the way the company is conducting its business.23 This is known as derivative claims and can be brought by minority shareholders on the grounds of negligence, default, breach of duty or breach of trust.24 The action is brought in the company’s name and for the benefit of all shareholders.25 Regardless, the mere threat of removal by shareholders in light of the fiduciary duty toward shareholders, exerts significant pressure on corporate directors to ensure that shareholders are satisfied with their returns on investments. The fiduciary duty is both a common law and statutory duty. The statutory duty is captured by Sections 172-177 of the Companies Act 2006 and includes as previously mentioned the duty to take act in good faith for the success of the company and for the benefit of the company’s shareholder while taking account of a wider class of stakeholders. In addition, directors are required to avoid conflicts of interest, obtaining an undisclosed personal profit and must use professional and diligent skill, care and judgment in carrying out the day-to-day activities of the company.26 What is ultimately required of directors is a duty of loyalty to its shareholders and a failure to comply could lead to removal and/or in some circumstances an accounting of profits.27 In other words, the stakes are too high for directors who do not conduct activities that are consistent with the investment intentions of shareholders and this holds true for institutional investors who are more inclined to prefer short-termism. The fiduciary duty assigned to directors ensures that directors comply with the investment intentions of their shareholders and this includes institutional investors. For example a fiduciary is defined as a party who is required to act as an agent of another in specific scenarios which is characterized by trust.28 The characterization of the directors’ relationship to shareholders is important because it favours investors and puts pressure on directors to satisfy shareholders’ investment preferences.29 The main reason it is assumed that the characterization of directors’ relationship with shareholders as fiduciary in nature is that is provides shareholders with ‘more elastic’ remedies in respect of a breach of fiduciary duties.30 For example, under Section 21 of the Limitation Act 1980 the limitation period for commencing an action is waived in cases where there is a claim of a fraud or a fraudulent breach of trust or for the recovery of property subject to the fiduciary relationship.31 Thus the limitation period may be waived where there is a claim by a shareholder against a director or directors for a breach of a fiduciary duty.32 Profits may also be claimed against a director as a fiduciary in instances where the director made a profit via his position in the company despite the fact that the company would have not profited from the transaction.33 Moreover, if a loss to the company is demonstratively caused by a breach of fiduciary duty, the duty to make good on those losses are more extravagantly applied than other losses.34 Putting further pressure on directors, a breach of fiduciary duty also incurs personal liability.35 Essentially, by describing directors as having a fiduciary duty in relation to shareholders and the company as a whole, companies do not really benefit from the corporate governance structure that divorces management from ownership. As Lindley LJ stated, directors may not be trustees in a strict sense, but: …they have always been considered and treated as trustees of money which comes to their hands or which is actually under their control; and ever since joint stock companies were invented directors have been liable to make good moneys which they have misapplied upon the same footing as if they were trustees.36 It therefore follows that corporate directors walk a thin line with respect to their obligations toward shareholders. It is therefore hardly surprising that there are concerns that institutional investors’ tendency to prefer short-termism is bad for a company’s successful performance. The reality is that institutional investors are particularly ‘powerful’ and contribute to or influence ‘short-term corporate behaviour’.37 Indeed, the Hampel Report noted that those who manage funds are under pressure to ‘maximise short-term investment returns’ or to ‘maximise dividend income at the expense’ of long-term gains for the company.38 As a result, institutional investors will ensure that proposals that are put before the board of directors are not supported unless they are consistent with short-term goals. The Hampel reports goes on to state however, that while there is no direct evidence of this practice, long-term goals are the best corporate governance models.39 It can therefore be argued that short-termism is not conducive to long-term corporate success. Therefore if perceptions that institutional investors are indeed vulnerable to short-termism and have significant influence on managerial and director decisions, institutional investors are bad for company performance and especially long-term corporate governance strategies. Solomon argues however, that while it is certainly true that short-termism is particularly obstructive to long-term planning which is the best way forward for sound corporate governance, there is a lack of empirical evidence supporting the contention that institutional investors prefer short-termism. According to Solomon, the contention that institutional investors are more inclined toward short-termism is anecdotal and built round the theory of myopic institutions. The theory of myopic institutions assumes that ‘institutional shareholders are more short-sighted in their investment decisions than individual investors’.40 However, Solomon argues that the myopic institutions theory has not gained currency and has ‘little support’.41 Engelen and van Essen did provide empirical evidence of institutional investor’s proclivity toward short-termism. Engelen and van Essen conducted a study on 411 companies across 16 countries in Europe. The purpose of the study was to examine the impact of company level corporate governance and state-level regulations on a firm’s research and development (R & D) investments during the recent global financial crisis. The study was important because R & D is regarded as a significant corporate governance indicator.42 The results of the study found that state-level regulations do not have a negative impact on R&D decisions of the firm. More significantly the results of the study conducted by Engelen and van Essen revealed that ‘the corporate governance characteristic with the strongest effects on R&D expenditures in crisis time’ is linked to the ‘largest shareholder’.43 Specifically, the study found that: …having an institutional largest block-holder significantly reduced the R&D spending of the firm during the credit crisis. This finding points toward short-termism of institutional investors to push firms to curtail R&D expenditures to realize short-term gains over long-term R&D plans.44 The results of this study however may not be altogether reliable. As Engelen and van Essen admit, the global financial crisis was a time when all firms would have made a conscious effort to cut back on spending.45It can therefore be argued that institutional investors stance against spending on R&D was just as likely influenced by the crisis as it was by a proclivity for short-termism. In other words, it is not clear that the crisis was not an explanatory variable in the study conducted by Engelen and van Essen. Nevertheless, scholar and academics insist that institutional investors are an obstacle to R&D and any long-term goal that is necessary for corporate survival and the ability to compete in a fiercely competitive market. For example, Millon argues that company management panders to the institutional shareholders’ preferences for short-term ‘stock price performance’ despite the fact that short-termism ‘is widely understood to threaten’ the company’s ‘sustainability’.46 Millon goes on to state that institutional investors are concerned about quarterly returns as opposed to long-term returns which are not reflected in published share pricing. Company management usually react to these preferences by conducting the company’s affairs by emphasizing a drive to satisfy institutional investor’s ‘quarterly earnings targets’.47 This means that the company will not pursue spending initiatives that will cut back on immediate profits and at the same time result in profits at some time in the future. The practice of attempting to satisfy the short-term goals of institutional investors also leads to avoidance of investments that are needed for the company being profitable in the long-term. This may include ‘neglected expenditures on capital assets, research and development, maintenance, advertising, employee training and customer service’. 48 A review of literature therefore reveals that short-termism hinders company sustainability in that it compromises the development of long-term goals that are necessary for competition, long-term success and performance. A review of literature also reveals that despite corporate governance initiatives and policies that segregate ownership from management, the fiduciary duty imposed upon corporate directors puts pressure on directors to pander to their shareholder’s wishes and preferences. The literature reveals that the largest group of shareholders in UK companies are institutional investors. Yet it is not clearly established in the literature that institutional investors are more inclined toward short-termism. Theoretically at least, institutional investors are inclined toward short-termism as they are usually in and out of the market and are usually representing funds such as pension funds, insurance companies and trust units.49 Because of institutional investors’ link to these funds it is usually assumed that they are competing for clients and as such, they are only interested in short-term gains. However, it is not established by satisfactory empirical evidence that institutional investors are inclined toward short-termism. Therefore the best than can be concluded is that short-termism hinders companies’ performance in the long-term and companies’ sustainability and competitiveness. Significantly, short-termism hinders a companies’ investment in R & D and as such hinders innovation and long-term goals in general, especially with respect to competing with other companies. However, it is not altogether clear whether or not institutional investors are inclined toward short-termism. Although it is widely assumed in the literature, it is not satisfactorily established as a verifiable fact. Therefore it can only be stated that if, in fact, institutional investors are prone toward short-termism, since short-termism hinders companies and companies are bound to follow the wishes and preferences of their shareholders and especially the more powerful institutional shareholders, then institutional shareholders hinders the company. Institutional Investors, Short-Termism and the Economy Short-termism dictates that where myopic investments are the preferred option, an investor would chose an investment with a current high value over an investment with a higher value over the long-term. For example if presented with a portfolio where the current net value of one investment is 49 pounds (project A) and another investment’s current net value is 55 pounds (project B), yet the long-term cash flow for project A is 140 pounds and 80 pounds for project B, short-termism would select project B for its current value.50 As Barker argues: If such decision-making myopia were endemic in an economic system, it would represent a substantial market failure. Such behaviour would tend to result in investment being too low across the economy as a whole.51 In addition, long-term projects such as developing infrastructure and improving and transferring technologies require larger initial investments. Short-termism restricts these kinds of investments and as such hinders the economy, only if it is preferred by a majority of investors.52 Dekkers argues that technological advancements and investments in technology are important for driving economic growth and development. Moreover, companies which are involved in technological development and transfer as well as the development of human capital and providing employment opportunities are significant contributors to economic growth and development.53In other words, when companies are hindered in their sustainability, the economy is likewise hindered in the provision of services, goods and developing human capital, developing and transferring technology and providing employment opportunities. Thus, if institutional investors prefer short-termism and puts pressure on companies to engage in short-termism, companies are hindered in significant ways that in turn, hinder the economy. In the meantime, independent of the impact of institutional investors’ impact on companies, institutional investors also directly hinder economic growth and development, but only if, it occurs on a large scale. Almazan, Hartzell and Starks argue however, that institutional investors are more inclined toward monitoring managers, although this is an uneven practices since ‘not all institutions are equally willing or able to serve this function’.54 Almazan, et al., argue that monitoring by institutional investors can be especially good for corporate governance and as such can contribute to economic growth and development. This is because, institutional investors are usually associated with the tendency to monitor their portfolio’s liquidity, fiduciary duties, due diligence, directors’ compensation, free-rider problems and so on.55 Callen and Fang argue however, the monitoring on the part of institutional investors is more closely connected to crash risk as it puts portfolio investors and company directors under significant pressure to achieve a return on investments.56 At the same time, Callen and Fang argued that short-termism is not positively connected to crash risk.57 The Organization for Economic Cooperation and Development (OECD) paints an entirely different picture of institutional investors and claim that institutional investors are not good and diligent monitors. Although institutional investors make significant contributions to the economy by providing a source of funding when banks are suffering from economic shocks, institutional investors are hindered by short-termism and poor monitoring systems. A major concern is that ‘investment holding periods are declining’ and are allocated to ‘less liquid, long-term assets such as infrastructure and venture capital’ and are being superseded by ‘allocations to hedge funds and other high frequency traders’.58 The OECD also claims that: Other related concerns over the behaviour of institutional investors are their herd-like mentality which may sometimes feed asset price bubbles and their tendency to being asleep at the wheel, failing to exercise a voice in corporate governance.59 Nevertheless, in the UK, it is believe that institutional investors are over analytical or monitor investments too closely. This practice is believed to be tied to management inability to operate with the kind of freedom necessary for making long-term, productive decisions relative to corporate governance and as such not only stifles corporate growth, but also forces a focus on short-termism with negative consequences for the company and the economy of the UK as a whole.60 Another way that short-termism usually associated with the behaviour of institutional investors is its stifling of long-term expenditure on research and development and employee training. This can result in a lack of innovation and human capital development. As a result, investors may relocate to other areas were innovation and human capital development is of higher value. This would of course, be detrimental to the economy of the UK.61 A review of literature therefore suggests that institutional investors’ preference for short-termism is linked to negative economic development both directly and indirectly. Either through company investment or through market investments, institutional investors are said to be inclined toward short-termism that hinders long-term economic growth and development. However, as previously noted, it is not altogether clear that institutional investors are actively engaged in short-termism although theoretically it makes sense, given the competition among institutional investors for clients. Even so, it cannot be stated with any degree of certainty that institutional investors prefer short-termism. However, if they do in fact prefer short-termism, institutional investors hinder economic growth and development since short-termism has been found to have a negative impact on economic growth and development. Conclusion This research study reveals that academics largely agree that institutional investors are predisposed toward short-termism. However, there is a paucity of empirical research in the literature that can unequivocally confirm or support these claims. Nevertheless, it certainly cannot be ruled out as a possibility. Institutional investors are usually involved in pension funds and insurance policies as well as trust units. Since there is competition for clients in trust units, insurance policies and pension funds, it is expected that institutional investors are concerned with current returns on those investments. Therefore, if it is accepted that institutional investors are short-term activists, it is certainly true that they hinder companies and economic growth and development. This is because short-termism is associated with short-term goals and is inconsistent with long-term goals which are necessary for employee development, technology transfers and development, research and development and infrastructure development. Each of these elements are entirely important for economic growth and development and company success. Monitoring on the part of institutional investors can further hinder companies and economic growth and development. Monitoring puts pressure on companies to focus on the institutional investor’s insistence on short-termism. However, the literature is mixed on the consequences of institutional investors’ monitoring practices and whether or not institutional investors are over-zealous monitors. It can therefore be concluded that institutional investors are large and powerful participants in terms of ownership in the market, industries and companies. As such, they have significant influences on how companies, the market and industries perform. Since short-termism is associated with poor long-term performance, if as claimed by short-termism theorists, that institutional investors are inclined toward short-termism, there is no doubt that institutional investors hinders companies and economic growth and development. 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