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Academic study supporting insider director communications for better informed mutual fund proxy voting



Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, December 18, 2018 posting

Mutual Fund Board Connections and Proxy Voting

Posted by Paul Calluzzo (Queen's University) and Simi Kedia (Rutgers Business School), on Tuesday, December 18, 2018

Editor’s Note: Paul Calluzzo is assistant professor of finance at Queen’s University Smith School of Business and Simi Kedia is the Albert R. Gamper Chair in Business at Rutgers Business School. This post is based on their recent article, forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum 28, 2018, ).

Mutual funds own 24 percent of the U.S equity market and are dominant players in proxy voting. If mutual funds were to vote their proxies to maximize firm value, they would play an important role in corporate governance. However, many funds may not find it optimal to invest resources to get informed about specific votes. Proxy advisory firms like Institutional Shareholder Services (ISS) fill this gap by gathering information across firms to guide mutual funds in their voting decisions.

ISS recommendations have an important impact on voting patterns and a negative ISS recommendation will significantly reduce the aggregate support for management. Even if management wins the vote, low management support has consequences. The proxy vote has increasingly become a referendum on a firm’s performance with investors using their vote to express concerns about firm policies or stewardship.

As management is affected by vote outcomes that show low support, they have an incentive to have their own lines of communication and influence with mutual funds. Firms’ incentives to communicate with mutual funds could arise from two non-mutually exclusive sources: to pursue private interests or to facilitate information flow. Specifically, private interests may motivate firm managers to approach mutual funds to garner their support, especially in difficult and contentious voting situations. By influencing mutual funds to vote in management’s favor, firms mitigate the pressure from shareholders to address agency problems and bring about value enhancing change. However, not all pressure from shareholder voice is value maximizing and ISS has been criticized for employing “one size fits all” positions on issues that may lead them to make recommendations on individual firms that are not value enhancing. Therefore, firm management may approach mutual funds to counteract the influence of these “one size fits all” ISS recommendations by facilitating mutual funds in their information gathering.

Our research examines fund firm connections that arise when firm directors and executives are also simultaneously directors of mutual funds and the potential effect of these connections on mutual fund voting. As these fund directors are simultaneously employed by a firm, they may be informed about firm practices and supportive of firm management. During proxy voting season, funds may reach out to firms seeking information about upcoming votes, or vice versa (MFDF Report 2012). Such contact between fund family and firms may be through the connected director, especially in difficult voting situations. The presence of the connected director may increase the likelihood of interaction between fund and firm, and might also improve the quality of information flow.

We hand collect the names of mutual fund directors from their N-CSR filings with the SEC, and match them with the names of the top five executives and firm directors in S&P 1500 firms. About 66% of mutual funds and 20% of sample firms have at least one connection over the period from 2004 to 2015. Director Connections, formed when firm directors are also simultaneously fund directors, are more common relative to Executive Connections, that are formed when executives of firms sit on fund boards. We find significantly higher support for management by connected funds in proposals that have a negative ISS recommendation. The results are robust to including a rich set of saturated fixed effects that control for time, fund, firm, and proposal specific effects. The results also hold in a sample of firms that have at least one connection, and for proposals that garner low support for management.

We also collect data on the formation, as well as, termination of these fund firm connections over the sample period. We examine and find no evidence of greater support for management in the years prior to the formation of the connection nor in the years after its termination, while observing significant support during the connected period. We also use director retirements and deaths to proxy for exogenous connection terminations and continue to find no evidence of higher management support in conflict situations after the connection is terminated. These findings suggest that the higher support for management in conflict situations is likely due to the active connection and unlikely to be due to omitted variables.

The stronger support for management displayed by connected funds in contentious voting is consistent with both informed voting and conflicts of interest. We perform several tests to understand the importance of these explanations for our results. We find that connected directors associated with greater management support in conflict situations have characteristics, like senior executive experience and being less busy, that facilitate information gathering. Connected funds voting patterns also display independence from ISS recommendations suggesting that they are more likely to be informed voters. Finally, successful connected voting—that is when the vote outcome is in line with the connected vote—is associated with significant cumulative abnormal returns pointing to it being value enhancing. Overall, the evidence suggests that information advantages, rather than conflicts of interest, are more likely to account for connected fund support of management in contentious voting situations.

As these fund firm connections are advantageous to firms, we also examine the characteristics of fund families that firm’s seek to form connections with. The evidence shows that fund families that hold a higher percentage of the firm, and those that are geographically proximate are more likely to form a connection. Finally, consistent with the role of fund-firm connections in voting support, we find that fund families that tend to vote with ISS are less likely to form a connection.

Our results suggest a potential use of fund-firm connections to reduce information asymmetry around contentious voting situations. As shareholder voice and activism become important agents for corporate governance, firms may use fund-firm connections as channels of information and influence to build support among institutional shareholders. As firms use fund-firm connections to counter the effect of “one size fits all” recommendations from ISS, the results have implications for the policy debate on the power of the proxy advisory firms.

The complete article is available for download here.


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