Institutional Investors, Shareholder Activism and Corporate Governance - Essay Example

Institutional investors - discuss the prevalence and impact of shareholder activism and its role of corporate governance. Task Course name: Course code: Date Institutional investors - discuss the prevalence and impact of shareholder activism and its role of corporate governance. Introduction Before the 2002 WorldCom scandal, the Enron scandal of October 2001 was the greatest white collar crime in the history of the United States of America. The case that saw the biggest energy company in the united states of America come crushing down, also caused the indefinite dissolution of Arthur Andersen, one of the big five audit and accounting consultants firms in the entire world. A white collar crime is a non-violence type of crime committed by those people that wear suit and tie to work. Currently, the WorldCom scandal is considered the largest white collar crime in the United States of America (Brav, A., Jiang, W., Partnoy, F. and Thomas, R., 2008). Even so, the Enron scandal is well known since it was the first white collar crime with such a globally felt magnitude. These two white collar evils are the key causes of the prominence that corporate governance is enjoying is the contemporary business world. This paper seeks to explain the role and impact of investor activism on the corporate governance of corporations in light of the institutional investors. Difference between active investors, value-type investors and individual investors Investment approach entails the continuing buying and selling actions by the investor. Active investors refer to the kind of investors who seek to spot market inefficiencies and exploit profitable conditions (Erickson, Jessica, 2010).Active investors will purchase investments and closely monitor the market activity with intention to outperform yardstick indices or lower return volatility as they hunt for quick-fix profits. Whereas value-type investors seek for investments that trade with less value that weigh against their intrinsic values. They believe in investing in stocks that market has undervalued, whose present value does not correspond to real value with aim of gaining long-term profit. On the other hand, individual investors entail personalized investment compared to a group or institutional one. An individual investor purchases a given stock or securities for himself as opposed to a group. Difference between Hedge fund, mutual fund and pension fund A mutual fund refers to an accumulated pool of funds from scores of investors with intention of investing in securities. Both hedge funds and mutual funds are managed portfolios; hedge funds are managed more assertively compared to mutual funds. This makes it easy in speculating value positions in derivative securities thus ability to short sell stocks at the market. While pension fund is set up by an employer to facilitate the investment of employees retirement benefits contributed by both of them Păcală, Anca.(2012). Mutual funds are managed by fund managers who invest the funds appropriately and generate gains and income for the investors, whereas pension fund is meant to create stable growth of funds over a long period and later availed to employees as pensions at the end of their working period. A number of investors may resort to hedge funds to gain benefits when the stock is falling on securities market. The accountability of executives and directors to the shareholder needs in light of the presence of institutional investors. The board of directors of any organization truly represents the shareholders who appoint them and the board should therefore negotiate with executives a better compensation package that benefits shareholders. Even as payment for some executives may be higher sometimes, most of the payment is tied directly to the performance of the company and investors intended results. Mostly, executives will only be well remunerated when shareholders are well remunerated. Sometimes, the executives may influence board members, for the reason that not all board members are truly independent. For instance, they may be obligated to CEO for the work that he/she provides to institutional investors. In regards to Becht, M., Franks, J., Mayer, C. and Rossi, S. (2008).Fundamentally, the shareholders are the owners of the company. This is because they are the providers of funds that act as the capital base of the company. Additionally, it is for their wealth maximization that the organization exists. It is for this reason that the shareholders are the chief decision makers of the organization. They make decisions regarding the long term direction of the company through a democratic voting process that takes place on a yearly basis. This yearly meetings held by the owners of the entity are known as the annual general meetings. It is at these meetings that the audited books of accounts are made public (Tan, W. and Keeper, T. 2008).The books of accounts are accompanied by a report done a competent and professionally qualified auditor. The auditor will be held liable for any material misrepresentation in the books of accounts and the audit report. According to Păcală, Anca.(2012). Material misrepresentation aimed at concealing. Scandalous and fraudulent activity taking place in the company was the sole reason for the bankruptcy of the Enron Corporation. The share price of the company had drastically dropped within a single accounting period. These changes were covered by the auditor’s report. According to the American Supreme Court, the act by the auditor in the case of Enron was immoral and amounted to interference to public information. The auditors’ partnership was immediately dissolved Erickson, Jessica. (2010).It is from this case that most companies learnt the importance of corporate governance. Investor activism is a practice through which the shareholders of the organization use their power as the owners of the company, to demand transparency and accountability from their stewards, the management. In the company setting there is an agency relationship in which the shareholders are the principals whereas the management is the agent. The auditors are as well agents of the shareholders and the failure of the auditor to give accurate information to the shareholders amounts to breach of trust. Institutional investors are a class of investors that are made up of a group of individuals that pool resources and invest collectively. The rationale behind investing as an institution is to gain a strong bargaining front and gain preferential treatment by the company Erickson, Jessica. (2010). the basic examples of the institutional investors include the insurance firms well as such financial institutions as banks. Such investors are given preferential treatment since they have more voting rights than the individual investors. Institutional investors control a bigger block of the project compared to the individual that invests as a lone ranger. The institutional investors can demand explanations from the management of the organization. Before understanding the role of the activism of the institutional investors on corporate governance, it is imperative that we understand the concept and components of corporate governance. Corporate governance has been described as the structures through which the organizations are led and directed Choi, Sunho. (2010).Corporate governance is fundamentally the connections between the organizations itself, the managers, as well as other stakeholders. Such stakeholders can be broken down into two, the external and the internal stakeholders. Usually, the internal stakeholders include the directors’ boards, the various managerial executives as well as the various classes of employees within the organization. The external shareholders are usually: the members of the community within which the organization operates the consumers of the organization’s products. The major reason why the institutional investors are likely to affect the corporate governance is because the institutional investors have the capacity to access the information of the company to the extent that the individual investors cannot easily manage. The institutional investors can demand access to the records of the company citing various reasons that the single handed individual investor. Another major reason why the voice of the institutional shareholders is louder than that of the individual is because the institutional is because they have enough resources that can be used to sue for their rights and claims in legal proceedings. Erickson, Jessica. (2010). the institutional shareholders have stronger bargaining power since they are better informed and control a substantial part of the company. The consolidated voting rights of the institutional shareholders are the key players when it comes to shareholder activism. It is however worth mentioning that shareholder activism is one of the most justified ideas since the shareholders are the owners of the company. They have every right to protect their interest in the company. Even so, activist activities by the shareholders are not a solution to the agency relationship but rather a way of shifting the problem to a different locus. In fact the gurus in management and finance argue that shareholders activism have negative impacts on the effectiveness of corporate governance Finseth, Eric john. (2011).This is because activist activities tend to undermine the powers of the directors board of a company. The directors board is the key decision making body in any organization and once it is undermined, its effectiveness in determining the direction and functions of corporate governance becomes compromised. Activism is beneficial to the shareholder as it is intended to protect his or her interests. When the shareholders are planning activist activities, they do not consider their influences on corporate political expenditures but rather focus on the interests of the shareholders as individuals or institutions. The effects of the activism on the share prices and net worth of the firm is a topic that can be understood from different viewpoints and financial theories. The extent to which the activism of the shareholders affects prices of shares and the net value of the organization depends to a great extent on the size of the firm, the prevailing market price as well as the portion of the investments controlled by the institutional shareholder. It is of essence to mention the observation that the shareholders are not homogeneous. Homogeneity is a quality that makes two or more objects possesses identical features. When determining whether or not the shareholders are homogeneous, we usually look at the risk attitudes of the particular shareholders Clarkl, Gordon L.; Salo, James; Hebb, Tessa. (2008). Naturally, people view things differently. For instance, we have a pessimist and an optimist. These two are extreme characters and view things as either extremely negative or extremely positive respectively. It is for this reason that the shareholders hold different attitudes towards risk. Investments are generally risk inherent. The risky projects are associated with high returns whereas the low-risk projects are associated with low returns that are I most cases guaranteed. A good example of the low risk investments is investing funds in real estate. Real estate is one of the most popular investments as it is not usually affected by the volatility of the market forces. The permanency associated with real estate gives the investors the confidence that there is a source of guaranteed revenue (Walker Review, 2009). It is one form of passive investment. On the other hand a good illustration of the high risk investment is the commitment of funds to financial markets. Financial markets are subject to such economic variables as inflation and changes in the interest rates. The investors that are willing to commit fund to the high risk projects are said to be risk takers. Those that are cautious enough to commit funds to the low risk projects are termed as being risk averse. There is another intermediate class of investors that are unconcerned about the risk profile of the projects. These are said to be risk neutral investors. In the light of these attitudes, there are three types of shareholders, namely: the risk taker, the risk averse and the risk neutral classes. On the basis of ownership and control, we have the preference shareholders and the ordinary shareholders. The ordinary shareholders are the owners off equity. Unlike the preference shareholders, the ordinary shareholders have voting rights. They participate in making of decisions at the annual general meeting. Even so, it is the preference shareholders that are given priority in the event of dissolution (Taub, J.S., 2007). The preference shareholders are seen as creditors to the company since theirs is a fixed return investment. This is one of the best ways of investing in the event that one is a risk adverse investor. Conclusion In conclusion, it is worth noting that the role of investor activism in corporate governance is quite a significant one. It is as well noteworthy that the activism of the investors impacts negatively on the concept of corporate governance. Activism weakens the power of the board of directors, which is the decision making body of the company. This may translate to poor and unnecessary political spending by the company. The homogeneity of the shareholders is founded in their different attitudes towards risk. Worth mentioning is the fact that institutional shareholders are very strong forces within any organization and have the capacity to bargain better following their possession of voting rights. Such rights are consolidated. the concept corporate governance is vital and can prevent such cases of fraudulent scandals that make a company bankrupt as was the case with Enron and WorldCom. Corporate governance coupled with activism yields transparency and accountability. 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