The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market The Journal of Finance Reena Aggarwal, Pedro A. C. Saffi, and Jason Sturgess* Abstract This paper investigates voting preferences of institutional investors using the unique setting of the securities lending market. Investors restrict lendable supply and/or recall loaned shares prior to the proxy record date to exercise voting rights. Recall is higher for investors with greater incentives to monitor, for firms with poor performance or weak governance, and for proposals where returns to governance are likely higher. At the subsequent vote, recall is associated with less support for management and more support for shareholder proposals. Our results indicate that institutions value their vote and use the proxy process to affect corporate governance. JEL: G32; G34; G38 Keywords: Proxy Voting, Securities Lending, Institutional Investors, Value of the Vote. * Aggarwal is at the McDonough School of Business, Georgetown University; Saffi is at the Judge School of Business, Cambridge University; and Sturgess is at the Driehaus College of Business, DePaul University. We thank Cam Harvey (the editor), an anonymous Associate Editor, and two anonymous referees for excellent comments. We thank Alon Brav, Susan Christoffersen, Isil Erel, Richard Evans, Slava Fos, Stuart Gillan, Mireia Giné, Denis Gromb, Steve Kaplan, Jose Liberti, Lee Pinkowitz, Gregor Matvos, David Musto, Adam Reed, David Ross, Laura Starks, Astrid Schornick and David Yermack; seminar participants at the Federal Reserve Board, U.S. Securities and Exchange Commission, 10th Cambridge - Princeton Meeting, ICGN 2014 Academic Meeting, 3rd Annual RMA - UNC Academic Forum for Securities Lending Research, American Finance Association 2013, European Finance Association 2011, Western Finance Association 2011, FMA Asia 2011, Drexel Conference on Corporate Governance 2011, DePaul University, Georgetown University, IESE, Università Cattolica del Sacro Cuore, Comisión Nacional del Mercado de Valores, London School of Economics, Temple University, University of Cambridge, Queen Mary, University of Maryland, University of Texas at Austin, Imperial College, INSEAD, University of Sydney, UNSW Australia, Singapore Management University, National University of Singapore, Nanyang Technological University and HKUST for helpful comments. Conversations with several industry participants, particularly, Les Nelson of Goldman Sachs and Judith Polzer of J.P. Morgan helped us to understand the workings of the securities lending market. Doria Xu and Jiayang Yu provided excellent research assistance. We gratefully acknowledge a grant from the Q Group. Saffi acknowledges support from the Spanish Ministry of Science and Innovation under ECO2008-05155 at the Public-Private Sector Research Center at IESE. Aggarwal acknowledges support from the Robert E. McDonough endowment at Georgetown University’s McDonough School of Business. The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market Understanding the preferences of institutional investors regarding governance is important for firms trying to attract new investors as well as for policy makers considering the regulation of different governance mechanisms. However, the mechanisms used by institutional investors to impact corporate governance tend to be private and difficult to study. One key governance mechanism through which institutional investors can exert influence is the proxy voting process. In this paper, we use the unique setting of the securities lending market to study the conditions that prompt institutional investors to influence firm-level governance and the extent to which investors use the proxy voting process to exercise their opinions. Most large pension funds, mutual funds, and other institutional investors have a lending program and consider it to be an important source of revenue, with estimates of $800 million in annual revenue for pension funds alone (Grene (2010)). Equity lending transfers voting rights to the borrower, typically hedge funds, and therefore lenders cannot vote shares that are on loan on the voting record date.1 Hence, institutions must decide whether to recall shares or make shares available for borrowing for an associated fee and the transfer of voting rights. Our study uses a comprehensive daily data set comprised of lendable supply, shares on loan, and the associated borrowing fee for the period 2007-2009. Lendable supply measures the shares made available to borrow by investors with long positions in the stock, and on loan measures borrowing demand, which is the quantity actually lent out. We find a marked reduction in the lendable supply prior to the proxy record date and an increase in borrowing demand and fees around the record date. Furthermore, lendable supply returns to normal levels immediately after the record date, consistent with institutions restricting and/or recalling their loaned shares to exercise their voting rights and resuming lending immediately after the record date. 2 We make five contributions. First, our results illustrate that institutional investors value the right to vote. Analyzing the lendable supply dynamics of the equity lending market around voting record dates reveals that institutional investors recall shares to retain voting rights.2 This finding shows that institutional investors value their vote and use the proxy process as an important channel for affecting corporate governance. In addition, we show that borrowing demand and fee increase around the record day. Second, we find that institutional investors do not all value their voting rights in the same way, with considerable heterogeneity in the preferences. Third, we show that the decision to recall shares on the voting record date also varies based on firm and proposal characteristics, which typically affect the value of control rights. Fourth, we propose a metric to quantify the value of the vote and find that lenders of shares place a higher value on their vote than borrowers. Finally, we show that share recall is associated with less support for management in the subsequent voting outcome. The heterogeneity in recall of shares shows that institutional investors systematically differ in their desire to exert governance via proxy voting. For example, Shleifer and Vishny (1986) model the blockholder’s free-rider problem and show that the willingness of a shareholder to intervene will increase with the size of their stake, the value creation stemming from such intervention, but decrease with the cost of monitoring.3 Consequently, institutional investors should not be expected to recall shares en-masse on all record dates. The recall by institutional investors should differ along several dimensions including their ownership stake, investment philosophy, investment time horizon, fiduciary responsibility, ability or incentives to engage with management, and/or invest in private information required for effective monitoring (e.g., Maug (1998), Kahn and Winton (1998) and Edmans (2009)). As an empirical example, Matvos and Ostrovsky (2010) find systematic heterogeneity in voting behavior even across mutual funds. 3 While we do not know the identity of the lenders and the borrowers, we study the heterogeneity in investors’ voting preferences by observing the differences in recall between firms that have a higher proportion of ownership by certain types of investors. We classify institutional ownership based on categories used previously in the literature (e.g., Bushee (1998, 2001), Bushee and Goodman (2007), and Chen, Harford, and Li (2007)) and examine blockholdings in aggregate, since these investors should have the greatest incentive to intervene through the proxy process (Maug (1998)), and those held by four types of investors: mutual funds, banks and insurance companies, pensions and endowments, and long-term investors. For aggregate blockholdings and each of the four categories, we find that the recall/restriction in lendable supply is significantly higher for firms with higher ownership relative to firms with low ownership. When examining borrowing demand, the difference is never statistically significant. Our results provide insights into the preferences of institutional investors, and suggest that institutional investors do not all have the same motivation to be active in corporate governance. We also examine asymmetric changes in lendable supply and borrowing demand based on underlying firm characteristics and types of proposal on the ballot. Firms with poor performance, weaker governance, and smaller size exhibit higher recall of shares on the record date. Additionally, recall is higher for record dates associated with meetings that have important proposals on the ballot related to non-routine items, compensation, anti-takeover, and corporate control. For example, the recall effect is almost 40% higher for record dates with corporate control- related proposals than those without. These results support the hypothesis that shareholders value the vote and are keener to vote when it is more “important” to do so. When we examine the subsequent vote outcome, we find that higher recall of lendable supply is associated with less support for management proposals, such as those relating to 4 compensation and corporate control, and more support for shareholder proposals. In additional tests, we focus on the voting behavior of mutual funds, since these institutional investors provide a large fraction of lendable supply. Mutual funds are significantly less likely to vote in favor of contentious proposals where recall in lendable supply is greater and the proxy advisory firm ISS recommends voting against the proposal. These results on mutual fund voting address any concern that recall could be negatively associated with support because institutions recall shares to vote with management when support for management is low. There are several reasons why examining recall in the lending market, as opposed to the borrowing fee, improves our understanding about institutional investor voting preferences. Kolasinski, Reed, and Ringgenberg (2013) show that the supply of lendable shares is essentially flat in the equity lending market, and Prado, Saffi and Sturgess (2014) document that this market clears with high levels of slack lendable supply for the average firm. Therefore, borrowing fee can be insensitive to both changes in demand and supply. Consequently, examining changes in the borrowing fee alone may underestimate the value of the vote, and could even result in concluding that the value of the vote is close to zero. To isolate record date effects due to changes in preferences for supplying shares from changes due to demand-side effects, we use an instrumental variables setup. One of our major contributions is to show that it is important to analyze both the lendable supply and the loan demand side of the market. The issues we examine are particularly relevant for a period that has seen increased emphasis on both shareholder activism and proxy voting. Voting provides an important mechanism for shareholders to affect firm-level corporate governance and policies. The paper proceeds as follows. Section I provides a literature review. Section II provides background on the securities lending market. Section III describes the data on proxy voting, securities lending, and other firm- 5 level corporate attributes. In Section IV, we discuss our methodology and identification strategy. Section V contains the main empirical results. Section VI presents results of our empirical findings on voting outcomes and the role of lendable supply. Section VII concludes. I. Literature Review Prior research has attempted to examine the preferences of institutional investors based on inferences of corporate governance attributes deemed important to institutional investors. Gillan and Starks (2000) study the effectiveness of shareholder activism in the U.S. Other studies have found that institutional investors affect CEO turnover (Parrino, Sias, and Starks (2003) and Helwege, Intintoli, and Zhang (2012)), anti-takeover amendments (Brickley, Lease, and Smith (1988)), executive compensation (Hartzell and Starks (2003)), and mergers (Gaspar, Massa, and Matos (2005) and Chen, Harford, and Li (2007)). In an analysis of 23 countries, Aggarwal, Erel, Ferreira, and Matos (2011) find that changes in institutional ownership are positively associated with subsequent changes in firm-level governance, but the opposite is not true. Cuñat, Gine and Guadalupe (2012) show that passing a governance provision is associated with an increase in shareholder value, and more so when proposals are sponsored by institutions. Maug (1998) and Kahn and Winton (1998) show how large stakes bias investors towards more shareholder activism. Edmans (2009) argues that the effectiveness of activism depends on the threat to sell shares and exit the firm, which in turn is greater for investors with larger stakes. Empirically Gillan and Starks (2000) examine the reaction of different types of shareholders to proposals through their voting behavior. Duan and Jiao (2014) show that mutual funds with smaller ownership blocks and shorter investment horizons are more likely to exit rather than vote against management. Bushee, Carter and Gerakos (2013) show that institutional preferences about governance and voting vary based on several factors including investment philosophy and 6 fiduciary responsibility. Preferences may also depend on other factors such as investment horizon and economic stakes. In a survey of institutional investors, McCahery, Sautner, and Starks (2011) find that corporate governance is important to institutional investors, and many institutions are willing to engage in shareholder activism via the proxy process. Recent papers such as Brav, Jiang, Partnoy, and Thomas (2008); Clifford (2008); and Klein and Zur (2009) study activism by individual funds, such as pension funds or hedge funds. Fos (2011) shows that proxy contests play a role in disciplining managers, while Gantchev (2013) finds that proxy contests are costly and that monitoring costs wipe out activist returns, on average. Illiev and Lowry (2013) conclude that certain types of funds invest considerable resources examining firm-level governance issues, and then voting accordingly. Some controversy exists in the literature regarding how changes in the supply and demand for lending shares around the record date affect the borrowing fee and what these changes imply in terms of the value of a vote. Christoffersen, Géczy, Musto, and Reed (2007) use 1998-1999 data from a large lending agent to examine borrowing demand and fees aspects of the securities lending market around a proxy vote. They find a marginally significant increase in borrowing fee around the proxy record date. The authors conclude that the price of a vote is zero because investors are not selling their votes but willingly letting them go, and speculate that this result is due to information asymmetry. Examining the change in fee alone, we find that fee increases by two basis points on the record date, approximately three times as large as the value found by Christoffersen, Géczy, Musto, and Reed (2007). Using option prices, Kalay, Karakas, and Pant (2014), find the value of voting rights for the average firm to be 0.16% of the stock price with an average option 7 maturity of 38 days. Moser, Van Ness, and Van Ness (2013) examine securities lending activity around proxy voting record date for potential abuse and empty voting. II. Securities Lending Market Securities lending is a transaction in which the beneficial owner of the securities, normally a large institutional investor such as a pension fund or mutual fund, agrees to lend its securities to a borrower, such as a hedge fund, in exchange for collateral consisting of cash and/or other securities.4 Although lenders refer to these shares as being “on loan”, the lender actually transfers ownership and voting rights. Shares may be borrowed for a variety of reasons, including short selling, or for trading strategies such as convertible bond arbitrage and dividend tax-arbitrage, and possibly for empty voting.5 The lender earns a spread by investing the collateral in low-risk short- term securities. In a typical U.S. loan, the collateral is 102% on domestic securities and 105% for international securities. The increased interest in proxy voting and securities lending has resulted in fund boards now paying attention not only to the fee received from a securities lending program but also to whether the securities are being loaned to “responsible” borrowers. According to a survey of institutional investors by ISS, 37.9% of the respondents stated that a formal policy on securities lending is part of their proxy voting policy.6 Some funds require a total recall of shares, while others weigh the lost revenue against the benefits of voting on a case-by-case basis. Below, we provide some examples from funds’ proxy voting guidelines. Putnam Funds “The funds’ have requested that their securities lending agent recall each domestic issuer’s voting securities that are on loan, in advance of the record date for the issuer’s shareholder meetings, so that the funds may vote at the meetings.” 7 8 TIAA-CREF “Even after we lend the securities of a portfolio company, we continue to monitor whether income from lending fees is of greater value than the voting rights that have passed to the borrower. Using the factors set forth in our policy, we conduct an analysis of the relative value of lending fees versus voting rights in any given situation. We will recall shares when we believe the exercise of voting rights may be necessary to maximize the long-term value of our investments despite the loss of lending fee revenue.” 8 The SEC requires funds to recall shares for “material” events but has not defined materiality. In a survey by ISS, 92.3% of the respondents indicated that mergers and acquisitions were the most important reason to recall shares.9 One of the challenges to recalling shares is that shareholders typically do not receive the proxy material until after the record date. However, in order to vote, institutions must recall the shares by the record date. III. Data A. Securities Lending Descriptive Statistics We obtain a proprietary equity lending data set from Data Explorers (now Markit) for the period January 2007 to December 2009. They collect this information daily from 125 large custodians and 32 prime brokers in the securities lending industry. Our data covers more than 85% of the securities lending market. While there are 4,333 firms in the equity lending sample, the proxy voting data limits the analysis to the constituents of the Russell 3000 index. As of December 2009, there was $1.55 trillion available to lend, out of which $113 billion was actually lent out and would be considered as being on loan. Saffi and Sigurdsson (2011) provide a detailed description of the data. 9 The main dependent variables in our study are defined as follows: lendable supply (SUPPLY) is the dollar value of supply available on a given day relative to a firm’s market capitalization; loan quantity (ONLOAN) is the dollar value of shares on loan relative to market capitalization; utilization rate (UTILIZATION) is ONLOAN divided by SUPPLY; and borrowing fee (FEE) is the average transaction-weighted rate reported by Data Explorers and expressed in basis points (bps) per annum. Firms that have a fee greater than 100 basis points (1%) are commonly considered to be SPECIAL. Such firms are more closely watched by investors and are more expensive to borrow. In Table 1, we present descriptive statistics for the equity lending market. On average, 23.78% of a firm’s market capitalization is available for lending, with 4.06% being on loan and resulting in a utilization rate of 17.78%. The minimum and maximum values of SUPPLY (winsorized at the 1% level) are 1.65% and 48.57%, respectively. ONLOAN varies from a high of 20.49% to a low of 0.01%. Some firms are heavily borrowed while others are not borrowed at all. UTILIZATION is as high as 69% in our sample. [Table 1 around here] The mean annualized fee is 48.3 bps, implying that it is very cheap, on average, to borrow shares. However, this cost can quickly rise for firms in high demand reaching a maximum of 1,114 bps in our winsorized sample. About 9% of the firms have a fee greater than 100 basis points and are considered to be “on special”. The mean and median number of days for which loans are outstanding is 16 days and one day, respectively. Most loans are “open ended” and rolled over every day without a specific maturity date. Figure 1 plots lendable supply, loan demand, utilization, and borrowing fees for the period starting 30 days before the record date and ending 30 days after the record date. We define the 10