Local investors and corporate governance

Abstract

This paper shows that local institutional investors are effective monitors of corporate behavior. Firms with high local ownership have better internal governance and are more profitable. These firms are also less likely to manage their earnings aggressively or backdate options and are less likely to be targets of class action lawsuits. Further, managers of such firms exhibit a lower propensity to engage in “empire building” and are less likely to “lead the quiet life”. Examining the local monitoring mechanisms, we find that local institutions are more likely to introduce shareholder proposals, increase CEO turnover, and reduce excess CEO pay.

Introduction

An emerging literature in accounting and finance demonstrates the economic benefits of geographical proximity. For example, both retail and institutional investors are able to benefit from their superior information about local firms (e.g., Coval and Moskowitz, 1999, Coval and Moskowitz, 2001, Ivković and Weisbenner, 2005, Baik et al., 2010, Bernile et al., 2010), although this informational advantage has disappeared after Regulation Fair Disclosure (Bernile et al., 2011).³ Another distinct strand of literature on shareholder activism shows that large institutional investors may influence corporate policies (e.g., Bushee, 1998, Hartzell and Starks, 2003, Parrino et al., 2003, Chen et al., 2007).

In this study, we link these two strands of research and examine whether physical proximity between firms and investors allows large institutions to monitor corporate activities more effectively. Specifically, we examine whether firms with more local shareholders are better governed and are less likely to engage in corporate misbehavior. We also investigate whether monitoring activities of local investors affect the profitability of local firms. Although there is an obvious free-riding problem associated with the monitoring of geographically proximate firms, the potential benefits from monitoring can outweigh the monitoring costs, especially for large shareholders (e.g., Grossman and Hart, 1980, Shleifer and Vishny, 1986).

Our key conjecture is that in an economic setting where monitoring costs vary inversely with distance, firms with high local institutional ownership would have better governance characteristics. In particular, firms with more proximate shareholders would exhibit a lower propensity to engage in undesirable corporate behavior like option backdating or aggressive earnings management. As a result of better monitoring, firms with high local institutional ownership would have a lower propensity to be a target of class action lawsuits. Further, because of geographical proximity, local institutions are more likely to attend shareholder meetings and introduce shareholder proposals, facilitate CEO turnover, or limit excess CEO pay.⁴ This form of local activism could also have an indirect influence on the selection of board members and the structure of compensation contracts.

There are several reasons why monitoring costs and benefits might be correlated with distance to institutional shareholders. For example, local institutions are likely to have lower communication costs, lower information gathering costs, and may even have easier access to firm-level information. Unlike remote institutions, local institutions may directly inspect a local firm and more easily acquire knowledge about the management and internal operations (e.g., Lerner, 1995). In addition, the local media is likely to provide greater coverage of local firms and increase the awareness of those firms among local investors, including institutions (e.g., Engelberg and Parsons, 2011, Gurun and Butler, 2012). Local institutions are also more likely to belong to the social networks of local managers (e.g., they may be members of the same country club), which might give them easier access to “soft” information and allow them to exert greater influence on corporate policies.⁵

Beyond these visible channels, due to their geographical proximity, local institutions may be in a better position to seek quiet agreement on governance changes. And they may informally approach the board and express displeasure about corporate policies and governance changes. Due to data limitations, we cannot precisely identify all these channels through which local institutions could affect corporate governance, but we present several pieces of evidence to establish the causal relation between shareholder proximity and corporate governance.

To measure shareholder proximity, we use the portfolio holdings of 13(f) institutional investors during the 1980–2007 period. For each firm, at the end of each year, we compute the mean distance between the firm's headquarters to the ten largest institutional shareholders. This measure captures both geographic proximity as well as stake of the institution in the firm. For robustness, we also consider other measures of local ownership, including a measure of firm ownership by institutions located within 250 miles of a firm, ownership by institutions located within a state, and the mean distance to all institutional investors.

We first examine whether monitoring activities of local institutions impact the governance of a firm. Motivated by Chhaochharia and Grinstein (2007), our internal governance proxies include a board independence score which captures the degree to which the board and the committees have a majority of independent directors. Following Yu (2008), we consider a measure of discretionary accruals to capture the firm's propensity to manage earnings. In addition, we examine whether, through its impact on internal governance, shareholder proximity affects a firm's propensity to engage in potentially fraudulent activities such as option backdating. These forms of risky firm behavior in turn could affect the firm's likelihood of being a target of class action law suits.

To study the potential indirect benefits of governance, we investigate whether local institutions influence financial outcomes such as operating performance and accounting measures that proxy for “empire building” by the manager and the extent to which a manager might “enjoy the quiet life”, as defined in Bertrand and Mullainathan (2003) and Giroud and Mueller (2010). To identify some of the channels through which institutions monitor local firms, we investigate whether local institutions are more likely to introduce shareholder proposals, affect CEO turnover, and influence excess CEO compensation.

Our results indicate that firms with high local institutional ownership are more profitable and have more independent boards. Managers of those firms are less likely to engage in “empire building” and less likely to “lead the quiet life”. In addition, firms with local shareholders are less likely to engage in undesirable corporate activities such as aggressive earnings management or option backdating. Consequently, they exhibit a lower propensity to be a target of class action lawsuits. Examining the mechanisms through which local institutions monitor, we find that local institutions are more likely to introduce shareholder proposals, increase CEO turnover, and reduce excess CEO compensation. Taken together, these results are consistent with our key conjecture that local institutions are more effective monitors of corporate behavior because monitoring costs vary inversely with distance.

We rule out several alternative explanations for our findings. For example, it is possible that our results merely reflect the clustering of firms and institutions in certain geographical areas such as New York and California. We introduce a variety of geographical controls and show that our baseline results do not reflect geographical clustering of firms and institutions.

Another possibility is that local institutions do not influence corporate behavior but they are able to identify better managed and better performing local firms due to their informational advantage. We use the implementation of Regulation Fair Disclosure (Reg FD) as a natural experiment to rule out the information channel as the main explanation for our findings. This test is motivated by the evidence in Bernile et al. (2011), who show that Reg FD and SOX “leveled the playing field” and eliminated the local informational advantage of institutional investors. We find that local institutions have a significant impact on firm performance even after the implementation of Reg FD. Thus, our results are unlikely to reflect the informational advantage of local investors.

A third alternative explanation for our findings is that local institutions are not better monitors but they are better informed and are able to anticipate future changes in corporate policies more accurately. To address potential concerns about endogeneity and reverse causality, we follow Bertrand and Mullainathan (2003) and use oil price as an instrument for performance to demonstrate that firm performance does not affect shareholder proximity. We also estimate change-on-change regressions and show that the lagged change in distance to institutional shareholders is significantly related to changes in operating performance, but not vice versa. In addition, we examine changes in corporate behavior around corporate headquarter relocations. We find that when firm headquarters change, there is an improvement in firm performance when the distance between the moving firm and its institutional shareholders declines.⁶

Collectively, these results suggest that local institutional investors serve as effective monitors of corporate policies. Our findings extend the literature on shareholder activism and the monitoring effects of institutional investors (e.g., Bushee, 1998, Hartzell and Starks, 2003, Chen et al., 2007). Like those earlier studies, we show that institutions play a monitoring role but, more importantly, we establish that institutions are more effective monitors when they are geographically closer to a firm.

A handful of previous papers have also examined the effect of local investors on corporate policies and governance. Gaspar and Massa (2007) use the level of local mutual fund ownership as a proxy for private information and show that informed investors improve corporate governance but reduce liquidity. In a closely related paper, Kang and Kim (2008) show that block acquirers exhibit a preference for local targets and monitor them because geographical proximity reduces both information gathering and monitoring costs. Further, Becker et al. (2011b) show that local firms exhibit a greater propensity to pay dividends and pay larger dividends if the proportion of local seniors is high. Most recently, Ayers et al. (2011) show that local institutions with strong incentives to monitor reduce opportunistic financial reporting activities of corporate managers.

Our paper extends these recent empirical studies on shareholder proximity and corporate policies along several dimensions. First, we study the monitoring effects of different types of local institutions beyond mutual funds. While local mutual funds may engage in monitoring activities, motivated by the evidence in Chen et al. (2007), we conjecture that other types of local institutions such as public pension funds or “dedicated” institutions (Bushee, 1998) with longer investment horizons would monitor even more effectively. Second, we focus on a comprehensive set of corporate governance and policy indicators, including various measures of corporate fraud, managerial propensity to engage in “empire building” or the likelihood of “leading the quiet life”, as well as firm profitability. Overall, we provide evidence of local monitoring in broader economic settings and show that local institutions influence corporate governance through multiple channels.

The rest of the paper is organized as follows. In the next section, we describe our main data sources and present summary statistics. In Section 3, we present our main empirical findings. In Section 4, we present results from tests designed to address potential concerns about endogeneity and reverse causality and in Section 5 we examine whether our results are induced primarily through information channels. Section 6 presents the results from additional robustness checks and we conclude in Section 7 with a brief discussion.