THE ROLE OF INSTITUTIONAL INVESTORS IN CORPORATE GOVERNANCE

This article is written by Dadhirao Prerana of B.A.LL.B. of PRRLC, Osmania University, Hyderabad, an intern under Legal Vidhiya.

ABSTRACT

Institutional investors play an important role in the financial markets, and have  immense influence due to their large-scale investments. Representing organisations such as mutual funds, insurance companies, pension funds, these financial investors manage funds on behalf of clients and navigate the complexities of the market with their knowledge and resources. Institutional investors  handle various aspects in the world of finance like the buying, selling, and management of a range of investment securities on behalf of clients, customers, or even shareholders.

The institutional investors are the backbone of the company. They play a major role in providing capital to publicly traded companies. With specialized market knowledge, access to analytical resources, institutional investors can mitigate risk for their clients, contributing to the overall stability of financial markets. It encompasses the financial organisations and contribute to financial markets with productivity.

Institutional investors are the large market actors such as banks, mutual funds, pensions, and insurance companies. They also have the advantage of professional research, traders, and portfolio managers guiding their decisions. For Example, In the year 2021, gross revenues for FINRA-registered brokers and dealers were $398.6 billion, up 10.1%,a year ago.^[1]Institutional investors in India, such as the State Bank of India [SBI], Life Insurance Corporation of India [LIC]  play a significant role in the country’s financial markets.

KEYWORDS

Institutional Investors, Corporate Governance, Financial Institutions, Securities and Exchange Board of India [SEBI]

INTRODUCTION

This article focuses on the corporate world and institutional investors. Corporate Governance means set of rules and regulations, policies and strategies that are useful to regulate the behaviour of a system, an authority or a large number of people. It is the system of rules, practices and processes by which a company is directed and controlled. The corporate governance fosters  in balancing the interest of a company’s stakeholders, senior management, shareholders, suppliers customers, lenders, the community and the government. In the world of corporate governance, the set of rules is treated as the manual that controls the company with their established policies and aims for better resolutions in the company. Proper corporate governance is the key factor for the successful company. For instance, Apple Inc.’s investors maintain good relations and maintain site profiles with corporate leadership that provides information on its committee charters through bylaws, stocks, ownership guidelines etc.^[2]

It is important to know the history and the origin of corporate governance because it has shaped the business world of the present era. In the 1970s, corporate governance began to come into the limelight through official reforms relating to the Securities and Exchange Commission [SEC]. As the years passed by, it promoted New York Stock Exchange [NYSE] comprising of Audit Committee, Board of Directors, and a Nomination Committee. The ‘Deal Decade’ refers to the 1980s has managed to grab control over shares of institutional shareholders. The Institutional Shareholder Services (ISS) came into existence during this period. From the 2010s till the pandemic it demonstrated corporate citizenship leading to environmental awareness and better ethical behaviour in business scenarios. Post-pandemic, companies all over the world aims for better enterprising management.^[3]

INSTITUTIONAL INVESTORS

Meaning

Institutional investors means the funds that are invested on behalf of others and invest those funds in a variety of different financial instruments and asset classes. They can include investment funds like mutual funds and Exchange Traded Funds[ETFs],banks, credit unions, insurance funds, pension plans, venture capital funds, hedge funds and so forth. Institutional investors also have the benefits of traders, professional research, and portfolio managers guiding their decisions. These institutional investors play vital role in shaping the management in the corporate world. They control a significant amount of all financial assets and exert considerable influence in all markets. This influence is examining the concentration of ownership by them in the equity of publicly traded corporations.^[4]

Overview

The concept of institutional investors remains a controversial topic. Few business personalities believe that the institutional investors should interfere in corporate governance system in a company. While, other section of business personalities group opine that the institutional investors must restrict there funds to only their objectivity and productivity and not interfere in the matters of the management. There will a difficulty in corporate governance if these institutional investors lack the skill and experience in selecting board of directors, mismanagement in investment of funds, misuse of accumulated funds from people’s money.^[5]

The main function of any company  is to maximize the wealth of its shareholders. While judging the performance of any institutional investor, we do not need to look at the corporate governance record of the companies in which the institutional investor has invested. We should rather look at the returns that the institutional investor has generated for its investors. If the institutional investors and corporate governance have cordial relationship with each other, it reflects on the entity optimistically. These investors earn asset management fees charged for managing investments, in a way, the investments made by them do not go directly. They take a share of profits in  investments that exceed a predetermined performance target.

Types

1. Hedge Funds: These kinds of funds are prominent in nature. Few famous funds are Bridgewater Associate, Farallon Capital, AQR Capital Management, Blackrock and so forth. It aims at risk management strategy offered to investments made in assets and in overall stock market. This is  done by taking both long and short positions on various securities. These kinds of funds are not open to retail investors. One must be accredited investors in order to invest in hedge funds.
2. Mutual Funds: Mutual fund may include stocks, bonds, funds, or other securities. Majority of mutual funds invest in liquid securities that are traded in the stock market. JP Morgan Vanguard and Fidelity Investments are some of the most famous mutual fund managers. Most mutual funds  are open for subscription to individual or retail investors with a small minimum investment.
3. Endowment Funds: Endowment funds are established by universities, hospitals, charitable foundations, or other non-profit organisations to manage their money, which come from donations. The income generated from investment activities is used to finance the beneficiaries’ activities, such as to provide scholarships or fund charitable events. For Example, In the 2017, institutions like Harvard, Princeton, University of Texas, and Stanford held endowment funds exceeding $25 million.^[6]
4. Pension Funds: Pension funds are funds established using monetary contributions from pension plans. The accumulated capital is generally allocated to income-generating and stable investments, as the primary purpose of pension funds is to provide steady financial income for pensioners upon retirement. Some well-known examples of pension funds are Central Provident Fund (CPF) in Singapore, California State Teachers Retirement System and Government Pension Fund of Norway.
5. Insurance company: An insurance company collects premiums from its policyholders which are generally divided into life and non-life insurance policies. A part of the premiums collected is deployed into long-term investments to generate returns and cover claim payouts. Some of the world’s largest insurance companies include Prudential PLC, Axa S.A. Insurance and Allianz SE.

ROLE OF INSTITUTIONAL INVESTORS

1. Proxy Voting: Institutional investors have the power to vote and contribute to the decisions made by the management in relating to board appointments, merger and acquisition, executive compensation, and other governing matters in the company. The voting confers to form a voting bloc that can exercise influence in deliberations or negotiations. Proxy voting is a particularly important practice with respect to corporations, investment advisers often vote proxies on behalf of their client accounts.
2. Stewardship Code: The Stewardship Code is introduced by Security and Exchange Board of India [SEBI].This code aims to make rules and regulations regarding transparency and responsibility to be performed by institutional investors. Through this code, the SEBI aims to create inclusive principles and policies that address in training the staff responsible for putting the stewardship code’s principles into practice, keeping track of investee companies, conflict management, interfering in investee companies and so forth.^[7]
3. Regulatory Compliance: Institutional investors follow the provisions prescribed in Security and Exchange Board of India [SEBI].The regulations may include disclosure requirements, voting policies, engagement processes and so forth. They face fewer protective regulations compared to average investors as it is assumed that  institutional investors are more knowledgeable and wise.
4. Institutional Investor Associations: Organizations like the Institutional Investor Advisory Services (IiAS) and Association of Mutual Funds in India (AMFI) gives recommendations and guidance to institutional investors regarding their role in corporate governance. Indian Investors Federation (IIF) strengthens the investment ecosystem. It provides a collective voice and represent the investor’s community to the highest levels in financial institutions in India and globally.^[8]
5. Activism and Shareholder Activists: Few institutional investors engage in shareholder activism, take initiatives in public positions on certain issues to address corporate behavior. For instance, for improved corporate governance, changes in strategic direction, or enhanced sustainability efforts is required for initiation. They believe that it improves corporate governance due to monitoring benefits all shareholders.^[9]

IMPACT

Institutional investors have a significant impact in the financial market. They exert a large influence over the price dynamics of certain securities. According to Harvard Business Review, they own around 80% of all stocks in the S&P 500 index. In addition, financial institutions, such as BlackRock, State Street and Vanguard are one of the largest owners of most DOW 30 companies. For example, between the years 2013 and 2015, seven shareholders controlled 60% of United Airlines also handled  28% , 27% ,and 23% of Delta, JetBlue and Southwest respectively. These airlines have over half of domestic market share.^[10]They provide capital to businesses and create liquidity for the financial securities where they trade in. They also help to improve management accountability and price discovery which results in market efficiency. They have greater incentives to develop expertise in tracking and monitoring the  investment made in large monetary commitments when compared to retail investors. This practice has benefitted firms to adhere to the principles of better corporate governance for their operations.^[11]By participation in large portion of shares and voting rights in the company, they are able to make constructive adjustments in the company’s composition. Therefore, they provide funds as well as practical recommendations, networks, and support, which can be valuable to the companies where they trade.

ADVANTAGES

1. Increase in Liquidity: Institutional investors bring in capital to local securities markets, which can help to improvise in liquidity and make it easier for companies to raise capital. They exert an impact on stock liquidity. Investors turn around the portfolios frequently so that the transaction costs are reduced, which further increases stock liquidity.
2. Market Efficiency: Institutional investors can help to improve market efficiency by providing a more accurate pricing mechanism for securities. If markets are efficient, then all information is already incorporated into prices, so there will be  no undervalued or overvalued securities available.^[12]
3. Diversification: Institutional investors can help to diversify the investor base in securities markets, which can help to reduce risk and make the markets more resilient to external shocks. An Institutional investor provides the required capital to publicly traded companies, fueling growth and innovation. They offer individuals a means to invest their money efficiently, diversifying risk through the funds.

DISADVANTAGES

1. Volatility: This can be a source of volatility in local securities markets, particularly if they enter or exit positions rapidly. The change in price of security over a given period of time leads to fluctuations in the market. If the price stays stable, the security has low volatility. An increased security affects the market and can experience rapid increases and dramatic falls as well.
2. Currency risk: They may be exposed to currency risk, if they invest in securities denominated in a foreign currency. It is the pressure faced by investors to operate across the countries, because of changes in the value of one currency in relation to another currency.
3. Market manipulation: The institutional investors may engage in market manipulation, especially in smaller or less developed securities markets. It is the practice of intentional deception in an attempt to misrepresent market prices. It is manipulated to capitalize on favorable market prices and make profits.^[13]

CASE LAWS

1. Satya Narayan Banik & Ors vs Union Of India & Ors^[14]:The writ petitioners who were the aggrieved parties were affected by the cessation of office as directors of one M/s. Hahnemann International Pvt. Ltd. The disqualification happened by operation of Section 164 (2) for the reason of not filing balance sheets and annual returns for a continuous period of three years from the year 2014-15.
2. Tata Consultancy Services Limited vs Cyrus Investments Pvt Ltd^[15]:It dealt with if the approval of minority shareholders was required for a scheme of arrangement between Tata Sons and Tata Consultancy Services, as per Section 230 of the Companies Act, 2013.
3. Arun Kumar Jagatramka vs Jindal Steel And Power Ltd.^[16]:The  Supreme Court opines that   the disqualifications placed under Section 29A of the Insolvency and Bankruptcy Code of India 2016 (IBC) is applicable to the scheme of compromise or arrangement under Section 230 of the Companies Act 2013 (Companies Act) when the company is at the stage of liquidation.

CONCLUSION

Good governance system can progress to excess returns for their shareholders with higher probability. The companies that create shareholders’ wealth with poor corporate governance practices, then they cannot blame the institutional investors for having invested in the companies. The fund manager will be evaluated on the basis of stock returns that is created for the unit holders to invest the money. If the company has got a good governance system, then it will reflect in the outcome. The errors and mismanagement is not the mistake of institutional investors. The institutional investors comply with rigid structure of duties that they contribute to the company. Every institutional investor’s primary object is to concentrate on how to maximize its own shareholders’ wealth. The financial institutions have given loans to companies with good governance records. This shows that having good corporate governance is important in the company to allure the institutional investors and  can invest in the company with utmost trust.

The institutional investors exert large influence over the price dynamics of traded securities. They are crucial to financial markets as they provide capital to businesses and provide liquidity to the financial securities they trade in the market. Due to large monetary commitments, they develop expertise in monitoring investments. Institutional investors are vital to capital markets and good corporate governance as well. The institutional investors adversely influence and have impact on assets and markets.

Institutional investors should make wise voting decisions at investee companies, diligence and judgment. Institutional investors should engage in the constant development in relevant public policy and strive to advance beneficiary or client interests.

REFERENCES

1. PritishGandhi,https://www.linkedin.com/pulse/institutional-investors-role-corporate-governance-pritish-gandhi-1rgwf?utm_source=share&utm_medium=member_android&utm_campaign=share_via  [last visited on 18 April 2024]
2. 5paisaResearchTeamhttps://www.5paisa.com/stock-market-guide/generic/institutional-investor [last visited on 18 April 2024]
3. https://www.realvantage.co/insights/an-overview-of-institutional-investors/ [last visited on 18 April 2024]
4. https://www.readcube.com/articles/10.2139/ssrn.353820 [last visited on 18 April 2024]
5. KatieKolchin,CapitalMarketsFactBook,2023,SIFMAResearchhttps://www.sifma.org/resources/research/fact-book/ [last visited on 18 April,2024]
6. BobHaegele,https://www.bankrate.com/investing/institutional-investors/#:~:text=Institutional%20investors%20tend%20to%20have%20a%20significant%20advantage%20over%20individual,make%20more%20informed%20investment%20decisions [last visited on 18 April 2024]

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^[1]KatieKolchin, CapitalMarketsFactBook,2023, SIFMAResearch,https://www.sifma.org/resources/research/fact-book/  [last visited on 18 April,2024]

^[2]JamesChen,CorporateGovernancehttps://www.investopedia.com/terms/c/corporategovernance.asp#:~:text=Corporate%20governance%20is%20the%20structure,company’s%20operations%20and%20ultimate%20profitability  [last visited on 18 April,2024]

^[3]DiligentTeam-historyofcorporategovernancehttps://www.diligent.com/resources/blog/what-is-the-history-of-corporate-governance-and-how-has-it-changed  [last visited on 18 April 2024]

^[4]BarclayPalmer, InstitutionalInvestinghttps://www.investopedia.com/articles/financial-theory/11/introduction-institutional-investing.asp [last visited on 18 April 2024]

^[5] “The Fight for Good Governance”, Harvard Business Review,1993

^[6] https://www.5paisa.com/stock-market-guide/generic/endowment-fund [last visited on 18 April 2024]

^[7]SumitKocharandShivamGera,Ahlawat&Associateshttps://www.mondaq.com/india/shareholders/1264574/stewardship-code-for-institutional-investors [last visited on 18 April 2024]

^[8] https://www.indianinvestorsfederation.com/ [last visited on 18 April 2024]

^[9] https://www.oecd.org/finance/financial-markets/19388822.pdf [last opened on 18 April 2024]

^[10]JacobGreenspon,HarvardBusinessReviewhttps://hbr.org/2019/02/how-big-a-problem-is-it-that-a-few-shareholders-own-stock-in-so-many-competing-companies#:~:text=Overall%2C%20institutional%20investors%20 [last visited on 18 April,2024]

^[11] Stephen Bainbridge, Research Paper, Professor of Business Law at UCLA

^[12]XiaoqiongWang, FinancialAnalysis,https://www.sciencedirect.com/science/article/abs/pii/S1057521920302891#:~:text=4,which%20further%20increases%20stock%20liquidity. [last visited on 18 April 2024]

^[13]MargERPLtd https://margcompusoft.com [last visited on 18 April 2024]

^[14] Satya Narayan Banik & Ors vs Union Of India & Ors LAWS(CAL)-2022-2-28,Case No.11 of 2019

^[15] Tata Consultancy Services Limited vs Cyrus Investments Pvt Ltd, AIRONLINE 2021 SC 179 CIVIL APPEAL NOs.440­441 0F 2020

^[16] Arun Kumar Jagatramka vs Jindal Steel And Power Ltd. AIRONLINE 2021 SC 136 Civil Appeal No. 9664 of 2019

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