Royal Bank Column
A DOMINANT characteristic of many public companies is the involvement of institutional investors as equity holders. Although figures are not immediately available institutional investors hold a signifi
cantly large proportion of the value of stock in public companies listed on the Zimbabwe Stock Exchange (ZSE).
Institutional investors include pension funds, insurance companies, unit trusts, investment companies and other financial intermediaries such as asset management companies. Common institutional shareholders in Zimbabwean companies include the National Social Security Authority, Old Mutual, First Mutual, NRZ Pension Fund, Mining Industry Pension Fund, and the Venture Capital Company of Zimbabwe. These institutions are much sought after by companies intending to raise funds on the public market because they are cash rich and can therefore provide the necessary capital requirements.
This article pursues the argument that given their growing dominance in public companies institutional investors can play a significant role in improving the quality of corporate governance in Zimbabwe.
The traditional model of the company as presented by Berle & Means (1932) is that in which there is a separation between ownership and control whereby the management have control while the shareholders who own the stock are widely dispersed and lack control. The costs of monitoring and the free-rider problem whereby certain passive shareholders benefit from the activism of a few active monitors without contributing to the costs deterred individual shareholders form exercising their voice to control the affairs of the company. In this model shareholders were typically apathetic which meant that they did not vote and relied on the market to discipline errant managers. The use of market forces for corporate control, increase in the role of non-executive directors, introduction of audit committees, etc, are some of the measures that have been put forward as means of closing the gap between shareholders and management of the company.
The increasing dominance of institutional shareholders on the market suggests that ownership of stock is now concentrated in the hands of a small number of shareholders that control a large portion of the equity market. It is suggested that institutional shareholders could play a bigger role in reducing the gap between ownership and control since unlike non-executive directors or auditors, they have a long-standing economic incentive to ensure that they get good returns from their investment which is usually large.
Typically, shareholders can exercise control over the company in two ways: the voice or exit. The voice refers to their ability to control the company through utilisation of their voting rights, which attach to ordinary shares. The exit mechanism refers to the option whereby dissatisfied shareholders sell their shares and leave the company thereby causing a drop in the share price.
Consequently the company may become a target for takeover, threatening the position of management. Individual shareholders holding only a small portion of the company’s stock are more likely to take the exit portion but this is not an easy escape route for institutional shareholders that typically hold a large portion of the stock. The costs of exit can be huge where large stock is involved such as the downward pressure on the share price while it is being sold. For institutional investors with large stock the better option may be to work with and put pressure on companies and management that total divesting compared to the situation of the individual shareholder.
Having noted that institutional shareholders can play a huge role in good corporate governance by taking a more activist stance, it is necessary to investigate the barriers that may stand in the way of pursuing this route.
The greatest disincentive to exercising the monitoring role is the costs involved. These include money, time and effort spent in the process. This is further compounded by the free-rider problem, which entails that ultimately most shareholders become passive. This is what has traditionally deterred individual shareholders from performing this role.
However the dominance of institutional shareholders has meant that the scattered nature of shareholders is no longer a big problem. Usually the institutions that invest in public companies are few, well known and connected. Even though like individuals they spread risks through diversification of shareholdings in different companies they can more easily communicate both formally and informally among themselves and with management. Stapledon has noted that the presence of the Institutional Shareholders Committee has helped to develop statements of good practice in corporate governance for institutional shareholders (1996).
One of the key problems is that traditionally shareholders do not vote or if they do they simply engage in “box-ticking” whereby they simply endorse management proposals without scrutiny. Often management knows this passivity and routinely uses proxies to endorse their proposals. It is therefore important that institutional investors take a more active role in the voting process.
This is key because often institutional investors are merely financial intermediaries investing other people’s money. Insurance companies and pension funds typically invest funds that have been contributed by a large portion of the working population and in this way individuals still participate in the stock market, albeit in an indirect way. For this reason, institutional investors have a duty to be more responsible and accountable to their clients and they can do this by actively monitoring the companies in which they invest.
The collapse of ENG and the subsequent exposure of various insurance companies and banks in Zimbabwe show that these institutional investors were not properly exercising their monitoring role. Had they done that perhaps things could have been different.
Consequently, their clients’ contributions have been put at risk from the exposure. In addition to making it good practice that institutional shareholders should vote associations can take the lead by establishing voting information services to assist them to effectively exercise their right to vote. This could include scrutiny of notices of meetings and provision of guidance on whether matters under consideration comply with best practice.
The National Association of Pension Funds (NAPF) in the UK already plays similar roles for its members and this helps to ensure that fund managers put into practice the proposals and intentions of investors. By exercising their right to vote, institutional shareholders can help to cultivate the culture of controlling the company through the voice rather than exit. One of the handicaps to shareholder activism is the prevalence of information imbalances between management and shareholders. The management is in control of the information about the company and shareholders only get what management has filtered.
The availability and type of information from the management determine the effectiveness of the shareholders. It is also dependent on the availability of skills to interpret and act on the information provided. Usually institutional shareholders may be skilled in collecting, interpreting and acting on information necessary for investment but they lack the skills regarding management.
It is therefore necessary to first ensure that institutional shareholders develop that side of their business by recruiting or training staff on such matters and secondly to improve the flow of relevant information. One way to close the information gap is to encourage institutional shareholders to take a more active role and interest in the appointment of non-executive directors since the latter have more scope for access to management information and control of management.
This might increase the flow of information since non-executive directors will in this case be closely connected to the shareholders and not necessarily bow to the whims of management. It is also suggested that through their significant control and knowledge of the market, institutional shareholders can influence the strategic direction of the company. They can do this not only as monitors against excesses of the management and also playing a role in the affairs of the company as sounding boards for the development of new business proposals.
A similar point can be made also in respect of the non-executive directors who are not only monitors but also key to the strategic development of the company. In this way they can also help the company to be more competitive and add value.
It is clear that institutional shareholders now control a significant portion of the stock market. As financial intermediaries, institutional shareholders normally have a lot of money, which is keenly sought after by emerging companies especially those listed on the stock exchanges. For that reason they have considerable leverage over the management of companies and can play role in keeping them in check. Of course there are drawbacks such as the potential for conflict of interests, lack of technical expertise regarding aspects of corporate management.
They may also be wary of taking an overly confrontational approach against management, as they may perceive that public intervention may harm the company. In addition, collective action is based on the assumption that the interests and perceptions of institutional shareholders will be homogenous which is not always the case in practice.
These limitations may work to counter the positive role that institutional shareholders can play in corporate governance. Nonetheless there is scope for improvement and not only formal but also even informal dialogue and behind-the-scenes action that often takes place can also bring beneficial results. The only problem is that “behind-the-scenes” action does not augur well with the desire for transparency required of institutional investors in their role as financial intermediaries. That is why it is necessary to emphasise and improve the formal participation of institutional investors in corporate governance. In a nutshell, by improving their role in corporate governance, it also augurs well with an improvement in the governance regimes within the institutional investors, which are in fact major corporate entities in Zimbabwe.
* Alex Tawanda Magaisa is Baker & McKenzie Lecturer in Corporate & Commercial Law at the University of Nottingham, UK. He can be contacted at email@example.com or firstname.lastname@example.org