Corporate Governance, Institutional Investors and Conflicts of Interest

• Author: C. B. Ingley,N. T. Van Der Walt
• Date: 01 October 2004
• DOI: http://doi.org/10.1111/j.1467-8683.2004.00392.x
• Published date: 01 October 2004

534 CORPORATE GOVERNANCE

Introduction

Large institutional investors are urged by

academics, shareholder activists and

others to adopt a greater role in monitoring,

enforcing governance standards and inf‌luenc-

ing the corporations in which they invest. Two

main streams of thought are represented in

support of their argument: an economic per-

spective that focuses on agency costs, and a

stakeholder approach highlighting issues of

corporate democracy. As owner-shareholders,

large institutional investors have the incentive

to exercise closer oversight and control of

management and corporate decision-making

in order to reduce agency costs and protect

shareholder wealth. Institutional investors are

encouraged to take up their democratic rights,

the most important of which are their voting

rights, in order to redress the power imbalance

arising from the separation of ownership and

control.

An increasingly concentrated ownership –

represented by the large institutional share-

holders – while now more powerful and voci-

ferous in protecting their interests, is not,

however, without its costs in agency terms.

Institutional investors play a dual role as both

principals and as agents with a f‌iduciary

responsibility to their benef‌iciaries and are

thus conf‌licted in serving the interests of these

roles as both owner-shareholders and inter-

mediaries. The associated governance issue

occurs because most fund managers are short-

term speculators, not long-term owners, and

because of the conf‌licts of interest they incur

when fund managers’ largest clients are f‌irms

that comprise the corporate investment pool

(Gunther, 2002). Monks (2002c) characterises

the fund industry as a “web of mutually self-

supporting interests” and highlights “the con-

f‌licts of interest that envelop the institutional

ownership world” (p. 119), while Kirby (1996)

notes that often the goals of institutions are

short-run and opportunistic and may be in

direct conf‌lict with the long-term health of the

business.

The commentary that follows outlines the

problems of conf‌licts of interest for f‌iduciary

shareholders and considers from the literature

various approaches proposed to address these

problems. The questions of whether f‌iduciary

problems are the result of a vacuum of own-

ership and an imbalance of power, and the

extent to which regulatory reform and share-

holder activism can resolve these problems,

© Blackwell Publishing Ltd 2004. 9600 Garsington Road, Oxford,

OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

Volume 12 Number 4 October 2004

Corporate Governance, Institutional

Investors and Conf‌licts of Interest*

C. B. Ingley** and N. T. van der Walt

The paper outlines the problems of conf‌licts of interest for f‌iduciary shareholders with respect

to the stock of publicly owned companies in their portfolios and considers various approaches

proposed to address these problems. The questions of whether f‌iduciary problems are the

result of a vacuum of ownership and an imbalance of power, and the extent to which regula-

tory reform and shareholder activism can resolve these problems, are examined. From this

analysis a framework is developed that describes the sources, outcomes and factors con-

tributing to the effectiveness of conf‌lict management in the context of the current investment

environment. A series of recommendations for mediating conf‌licts of interest by changing

board architectures are presented. These recommendations apply principles of participative

corporate democracy to the overall governance system.

Keywords: Fiduciary standards, stakeholders, agency problem, mediating hierarch, share-

holder power, board architecture

*This paper was presented at

the 6th International Confer-

ence on Corporate Governance

and Board Leadership, 6–8

October 2003 at the Centre for

Board Effectiveness, Henley

Management College.

** Address for correspondence:

Massey University, Private Bag

102 904, North Shore MSC,

Auckland, New Zealand.

Tel: +64+9+414-0800; Fax:

+64+9+441-8109; E-mail: c.b.

ingley@massey.ac.nz

CORPORATE GOVERNANCE, INSTITUTIONAL INVESTORS AND CONFLICTS OF INTEREST 535

are examined. From this analysis a framework

is developed that describes the sources, out-

comes and factors contributing to the effec-

tiveness of conf‌lict management in the context

of the current investment environment. A

series of recommendations for mediating con-

f‌licts of interest by changing board architec-

tures is presented. These recommendations

apply principles of participative corporate

democracy to the overall governance system.

Commentary

Amajor focus in the current debate in corpo-

rate governance concerns the alignment of

corporate direction with shareholder interests

and is about the principles of stewardship and

wealth creation (Healy, 2003). Healy argues

that the purpose of modern corporate gover-

nance is to increase shareholder and economic

wealth in a sustainable way, to align the inter-

ests of boards, management, shareholders and

to provide timely and accurate information to

facilitate accountability to shareholders and

other stakeholders.

In essence, this debate deals with the agency

problem and the current issue of lack of public

trust in the equity market system, following

massive destruction of shareholder value

around the world in the wake of recent

high-prof‌ile corporate collapses. The agency

problem is central to the debate in corporate

governance and highlights conf‌licts of interest

among various corporate stakeholder groups

(Kose and Senbet, 1998). The most funda-

mental are the conf‌licting interests of outside

owners and inside management, arising from

the separation of ownership and control

(Paris, 2001; Kostant, 1999; Brown Jr, 1998;

Kose and Senbet, 1998; Shleifer and Vishny,

1997).

Much recent media attention has been

directed at the role of “absent owners” in cor-

porate underperformance and loss of share-

holder wealth. While boards and senior

management have been held primarily cul-

pable for corporate failure and poor perfor-

mance, shareholders are also implicated in the

pathology that has accompanied each wave of

corporate crisis. Separation of ownership and

control has resulted in managerial dominance

and concentration of power among corpo-

rate elites. Contributing to this asymmetry of

power and control is the abdication by share-

holders of their responsibility as owners

through passivity and absence of voice in the

affairs of the corporations in which they invest

(Gunther, 2002; Monks, 2002c; Kostant, 1999).

The publicity surrounding this issue has

resulted in calls for shareholders to act more

like owners and exercise their rights by voting

their proxies, thereby taking greater control

over corporate direction than they have in the

past and holding management and directors

to greater account for corporate performance

(Monks, 2002c).

Shareholder activism has emerged over the

past two decades as a growing force to be

reckoned with by management and boards

of corporations. Greater participation by share-

holders in corporate oversight is promoted

as a democratic right and obligation (Kostant,

1999; Brown Jr, 1998). The focus of current

activism is seeking to establish a stronger

link between governance and improved cor-

porate performance, and to achieve greater

shareholder democracy (Garten, 2002). Beyond

voting proxies, shareholders – notably the

large institutions – have been urged to ex-

ercise more direct control through a greater

presence on corporate boards (Emmott, 2003;

Monks, 2002a). The argument for shareholder

democracy is well known: capitalism works

best when owners look after their own inter-

ests, which are often not the same as those of

corporate management (Garten, 2003).

Monks (2002a) states that corporate gover-

nance is a process of effective accountability of

managements to informed and active owners.

Yet various agents of shareholder-owners,

namely senior managements, boards and insti-

tutional intermediaries, through inappropriate

powers under the present system of corporate

governance, have prospered while neglecting

shareholders’ best longer-term interests.

Monks notes that most mutual funds have

failed to act on behalf of their investors

because they want to manage corporate

pension money for large companies (cited in

Gunther, 2002).

Shareholder value creation and crisis

of conf‌idence

The governance problems that have come to

light in the recent past have thrust the quality

of accounting standards, the professionalism

of auditors and governance practices of major

companies into the limelight. These issues

have triggered a spate of regulatory reforms in

the United States (Bies, 2003), and the mass of

publicity generated from governance failures

around the world has been articulated in con-

cerns over loss of public trust in the equity

markets. Monks (2002a), for instance, states

that the United States is suffering from the

aftermath of hubris, the enthusiasm of the last

decade around the merits of GAAP, gover-

nance and competitive performance having

dissipated out of concern that trust in the

© Blackwell Publishing Ltd 2004 Volume 12 Number 4 October 2004