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Master’s Thesis
The Rise of Exchange Traded Funds and its Impact on the Corporate
Governance of Publicly Listed Firms
A Survey on the firms of the S&P 500 index Andreas Stasinakis
S3401855
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Abstract
Exchange Traded Funds or “passive index funds” have grown in importance over the last fifteen years, as the value of their Assets under Management has increased vastly, and is comprised of large and famous firms’ shares, like the ones constituting the S&P 500 index. This research aims to identify the effects of the rise of the ETFS on the Corporate Governance of the firms included in the S&P 500, and its findings show that the presence of ETFs impacts mainly the proportion of the independent board members and the members of the nomination and compensation committees.
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Introduction
Exchange Traded Funds or so-called “passive index funds”, had by 2015 over $4 trillion in Assets under Management, and the “Big Three” of them, namely Blackrock, State Street and Vanguard, were by 2015 the largest shareholders of 88% of the firms included in the S&P500 ( Fichtner, Heemskerk and Garcia-Bernardo (2017)). Since the financial crisis that peaked at 2008, ETFs have had more than a trillion dollars of inflows. Although the first ETF (the S&P 500 Depository Receipt or SPDR, ticker symbol: SPY) was issued in the January of 19931, the fact that influential investors such as Warren Buffet are already talking favorably towards ETFs 2, the impressive reports in the press3, and also the extreme growth of the value of their Assets under Management , indicate that the latter already have and will probably continue to have an important presence in firms. With this research I aim to identify and to quantify the effect those institutional investors have on Corporate Governance of public firms. Fichtner et al. (2017), McCahery, Sautner and Starks (2016) and Mazur and Salganik-Shoshan (2017) denoted that ETFs have become increasingly important investors for U.S. firms. What these funds do is similar to what traditional, passively or actively managed mutual funds do in terms of how they are structured, managed and regulated. But unlike mutual funds, ETFs are listed and traded intraday, using a mechanism called “Creation/Redemption”, where an “Authorized Participant” (authorized by the firm issuing the ETF) receives orders from the ETF issuer to acquire a certain “basket” of securities, with a specific weight on each security, and a certain value for the whole “basket”, and then trade that basket to the ETF issuer in exchange for a corresponding amount of ETF shares (“Creation”), or do the exact opposite (“Redemption”). With that mechanism, ETFs can actually track the movements of an index like the S&P500 ( Caginalp, DeSantis and Sayrak (2014) ). Due to the low costs that this mechanism requires, as ETFs interact mainly with Authorized Participants and do not require any registering of investors’ preferences or other data, and also the fact that individual investors can easily “cash-out”, without the fund having to raise cash by liquidating
1 Information acquired by “The ETF Book” by Richard Ferri
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https://www.forbes.com/sites/johnwasik/2018/01/08/how-buffett-won-his-1-million-bet/#5fc82ec02a6c
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positions ( and thus realize most likely taxable capital gains), but simply sell the shares to another investor, ETFs have on average quite lower fees than traditional mutual funds, while most of them pay quarterly dividends, in cash, but also in shares4.As holders of shares of several firms, ETFs have the right to vote in shareholder meetings and to decide on the issues presented in them. Fichtner et al. (2017) indicate that the “Big Three” do indeed try to have integrated and unified Corporate Governance policies, even though they are comprised of a multitude of funds, and that at least since 2016 they have all of them stated their intentions to become even more active in their efforts to affect firm policies and decisions.
This research contributes to the literature in that it only investigates the effects of Exchange Traded Funds in Corporate Governance and specifically shareholder rights and level of participation on firm decisions and policies, and management accountability. The most recent major publications have been focusing index investors as a whole ( Mullins (2014) and Crane, Michenaud and Weston (2014)) or investigate the impact of “passive” investors without further discrimination (Appel, Gormley and Keim (2015)).
My results indicate a significant influence only on the proportion of independent members of the nomination and compensation committees and the proportion of independent Board members, as well as the process through which directors are elected (majority or simple plurality) and decisions are made ( a confidential voting/secret ballot policy ). Although from 2007 to 2017 I find that most firms improved their Corporate Governance on several provisions that harm shareholder rights, I do not find strong evidence that ETFs are strongly associated with those improvements.
Literature Review
Large Shareholders, Management Performance and Corporate Governance
Jensen and Meckling (1976) pointed the agency costs between shareholders (principal) and management (agent) that arise in the context of a corporation. The optimal allocation and use of resources provided by shareholders and the accountability of
4 Information acquired from “The Exchange Traded Funds Manual” by Gary Gastineau, “The ETF
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management towards the shareholders, as well as the mechanisms and processes available by which managers and shareholders or investors in general attempt to gain power, pieces of the produced or anticipated wealth, or merely protect their investments or managerial positions in a firm, are issues still under discussion. The presence of large shareholders and especially institutional investors, under which category Exchange Traded Funds fall, is of particular importance, as the following literature discussed shows.
Shleifer and Vishny (1986), following Demsetz (1983) and Demsetz and Lehn (1985), have indicated that the presence of large shareholders facilitates better monitoring and overall better management performance. Bolton and von Thadden (1998), attempting to construct an optimal dynamic ownership model regarding management monitoring, stressed that it is important for public firms to have some level of ownership concentration in order to mitigate agency costs compared to their shares being dispersed. Maug (1998) emphasized the importance of market liquidity for effective monitoring and governance improvement by large shareholders, as “exit”, that is, selling shares of a firm when they disapprove of its management, becomes an easier option for them. Cremers and Nair (2005) showed that the mechanism called “the market for corporate control”( Jensen and Ruback (1983) give an elaborate analysis of the term), where an overvalued or undervalued firm may become a target for takeover by some external party, as well as “shareholder activism”, where shareholders utilize means like “exit” to change policies or decisions made by management, can complementarily affect governance and consequently firm performance when large institutional investors (in the cases they investigate, pension funds) are present, although their findings apply mainly to firms with relatively low leverage.
While there is no widely accepted definition of a “significant investor” in financial literature, in many countries, including the U.S.A., public firms have to publicly disclose the holders of 5% or more of their shares (rules 13D and 13G of the S.E.C.) ; such investors are considered as “blockholders”5 . For robustness checks, I decided to
put the limit of “blockholding’ to 3%. Arguably, the fact that ETFs may remain as blockholders for an important amount of time, offers them the facility to influence management policy and decisions in other ways, which this research aims to show.
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In a meticulous research, Cronqvist and Fahlenbrach (2009) identified the effect that the presence of various types of blockholders have on firm policies, and showed that mutual funds tend to invest in firms which exercise policies they already approve, while activists or pension funds favor inducing changes themselves, a notion that gives valuable information when combined with the study by Chung and Zhang (2009), who conducted a very robust research for the presence of institutional investors and their effect on Corporate Governance, as well as with the one by Chen, Harford and Li (2007), which tracked the methods followed by institutions characterized by long-term or short-term investment horizons, even though they did so by utilizing firm performance and mergers and acquisitions premiums rather than actual governance changes. Borochin and Yang (2017) contrasting short-term to dedicated investors found that the later have a positive impact on Corporate Governance, as they are better informed, and Elyasiani and Jia (2010) underlined the positive effect that stable institutional ownership has on effective monitoring.
A very interesting perspective on the topic is given by Doidge, Dyck, Mahmudi and Virani (2015), who focus on the joint effect that multiple institutional investors may have on Corporate Governance, a concept that is difficult to be applied as most institutional investors do not easily publicize their practices ( Aggarwal, Saffi and Sturgess (2015) try to address this issue), but can give very illuminating results. Edmans and Manso (2011) described the various aspects such as liquidity that may make the presence of multiple blockholders advantageous for a firm in terms of performance, a notion also indicated by Back, Li and Ljungqvist (2014) and Edmans, Fang and Zur (2013), who in their researches point the importance that share liquidity has for the convenience with which large shareholders may impose changes in Corporate Governance.
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investors, and Mullins (2014), focusing on index funds, use similar approaches and both find that the significant presence of institutional investors correlates with improved management decisions and policies, better treatment of shareholders and increased acceptance of their proposals, and overall better quality of governance, for the firms constituting the Russell 1000 and Russell 2000 indexes. The insights provided from those researches suggest that the significant presence of ETFs could most probably have a traceable impact on Corporate Governance.
ETFs as Institutional Investors
As already mentioned, ETFs fall under the general category of “Institutional Investors”. As it happens with all Institutional Investors in general, their preferences and their policies are difficult to investigate, although in the last years there has been a series of papers which give us valuable information on that topic, especially regarding institutional investors’ voting strategies (Aggarwal et al.,2015) and preferences ( McCahery et al.,2015), but also on how they affect compensation policies (Mazur and Salganik-Shoshan,2016). Aggarwal et al.(2015) showed that institutional investors restrict their shares’ supply and recall lend shares when their proxies are about to vote in firms that they have identified as having poor governance. McCahery et al.(2015) conducted an anonymous survey on institutional investors and concluded that while “exit” remains a reliable measure of influencing management, there are other practices such as private engagement with management and voting against management proposals which are also considered by many investors as effective.
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Fichtner et al. (2017) focus on the “Big Three” index funds, and show that while they almost never use an “exit” strategy, they have the opportunity to heavily influence management, and according to the authors’ research they do actively influence it, not so much through voting decisions as with board member proposals, and generally by engaging with managers privately. More precisely, they tend to vote in favor of management proposals, but propose new board members other than the management’s. They keep a significant amount of shares of a firm and the majority of them avoids using the option of “exiting” a firm (liquidate their holdings) as a means of rejecting or influencing a firm’s governance as it is decided by its management (hence they fall under the general category of “passive funds”). The authors do include in their research the guidelines that the funds themselves have issued regarding proxy voting and the overall investing behavior they favor, as well as comments and statements by officers of the funds, which are all very helpful in constructing a concise picture of their behavior. Although their paper is very illuminating as to the methods that the “Big Three” utilize to affect the governance of the firms in which they invest, they do not focus so much on the terms and issues of the Corporate Governance context, and merely superficially refer to the agency problems and costs that may arise from the change of the balance of power that may ensue with the growing presence of the later. An issue that occurs is how to trace those changes.
Measuring Corporate Governance
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the management takes shareholders’ opinions and proposals under consideration. Using stock returns and market value as proxies for equity performance, the authors found that “democracies” had a much better performance than “dictatorships” for the 1990-1999 period.The G-index has been used by several researchers as a proxy for Corporate Governance quality, linking its score with the market value and overall performance of firms (some notable examples are Klock, Mansi and Maxwell (2005) , Amit and Villalonga (2006) and Dittmar and Mahrt-Smith (2007)).
A year later, Bebchuk, Cohen and Ferell (2004, revised in 2009) developed the Entrenchment index or E-index, in which merely six of the twenty-four provisions used by Gompers et al. were considered as important and correlated with firm performance. The authors argued that the G-index was not refined enough so that only the really important provisions be included. Their index is called “Entrenchment index” because it tries to measure the level at which the firm’s management is entrenched to shareholder judgment and criticism, but also from the “external market for corporate control”, which plays a very significant role in a market-oriented system such as in the United States ( see Moerland (1995 )). It is still considered as quite reliable and has been used in over 300 researches6.
Both the G-index and the E-index received criticisms and were proven not so reliable when used to predict firm performance or prospects for specific periods of time ( Core, Guay and Rusticus (2006) and Larcker, Reiss and Xiao (2015) give elaborate and valuable criticisms). Brown and Caylor (2004, revised in 2014) also formulated the so-called Gov-score by measuring 51 provisions and measures in which they included most of the 24 provisions that Gompers et al. used, and with which they were able to predict firm performance and market value, using a variety of data which are very difficult to collect in order to replicate their research. Although it does not have the same popularity as the G-index, it is also used as a basis by researchers, especially when they try to capture Corporate Governance performance of firms active in non-developed markets or network-oriented markets, with a different board culture than the United States, where the research of Gompers et al. was mainly focused on. In a very recently published book by Larcker and Tayan, “Corporate Governance Matters” (2016), the authors indicate that whatever the predictive ability of a single index for a
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certain period, the overall governance quality of a firm should be examined given its own unique features and characteristics, as credit rating agencies such as Fitch do when they incorporate governance characteristics in their credit analysis (page 389). According to Larcker and Tayan (2016), who quote Olson’s (2005) Fitch’s guidelines for Corporate Governance evaluation, “related party transactions, reasonableness of management compensation, integrity of audit process, executive and director stock ownership, and shareholder rights/takeover defenses” should be considered when assessing a firm’s governance quality. Larcker, Richardson and Tuna (2007) also used a variety of measures when trying to create their own, less restrictive version of a Corporate Governance index, including 4 Antitakeover Provisions, namely Poison Pill, Supermajority, Staggered Board, Unequal Voting and the State of each firm’s incorporation as a proxy for the option for firms to use another variety of Antitakeover Provisions which are included in the state laws, but also taking under consideration measures such as Debt levels and the presence of Institutional Investors ( Since my research focuses specifically on the effects of ETFs and their influence on the Corporate Governance quality of the firms constituting the S&P500 index, an index of firms with the highest Market Capitalization in the United States, I do not consider the Debt level factor as so important for this research, as those firms will most possibly be able to raise and renew their debt with the same level of ease and cost. The presence of other significant investors will be taken under consideration, but only in the discussion of the final results.).
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Focusing on more specific Corporate Governance measures, a series of papers discussing the importance of the presence of Poison Pills -one of the oldest Provisions that appeared in company charters - , Malatesta and Walkling(1988) demonstrated that Poison Pill adoption reduces firm and shareholder value, while Datta and Iskandar-Datta (1996) argued that it mostly affects firm-bondholders. Ryngaert (1988) found that Poison Pill adoption causes a negative reaction by the stock market, and Brickley, Coles and Terry (1994) conducted a more meticulous study and found that the adoption of a Poison Pill provision makes the stock market react positively to the adoption announcement when Outside Directors are a majority, and negatively when not. The more recent studies of Harris and Madura (2010) and Heron and Lie (2015) seem to support that notion, proving that firms with more outsider ownership and directors do not have strong incentives to adopt Poison Pills.
Regarding Staggered Board structure, Gompers et al. (2003), Bebchuk et al. (2004), as well as Brown and Caylor (2004) and Cremers and Nair (2005) included this Provision when constructing their Corporate Governance quality indexes, as this Provision entrenches management from scrutiny and judgment from shareholders. Amihud and Stoyanov (2017) question the actual effects that the presence of this provision has on firm value, but Cohen and Wang (2013) seem to confirm a negative relationship. A more meticulous paper by Cremers, Litov and Sepe (2017) indicates that Staggered Board structure is much more important for firms based on innovation and which have long-term relationships with their stakeholders and that undertake long-term projects. Firms with Dual Class common stock, where cash-flow rights are separated from voting rights, were excluded from the research of Gompers et al. (2003) to avoid the difficulties that their unique structure of voting rights and governance would pose on their research. The same authors (2008) found that insider voting rights have a strong relative correlation with firm value, while Masulis, Wang and Xie (2009) support that notion and furthermore indicate that divergence between cash-flow rights and shareholder rights is associated with higher CEO compensations and less value for outside-related investors.
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lower Governance quality have higher CEO compensations, and they link Board Structure and Characteristics with a negative relation regarding firm value and stock performance. Fauver, Hung, Li and Taboada (2017) conducted a research in 41 countries and came to the conclusion that Board reforms, especially those regarding Board and Audit Committee Independence, are strongly associated with increases of firm value, while reforms such as CEO/Chairman of Board separation did not present strong effects, and Boone, Field, Karpoff and Raheja (2007) found that Board Independence relates negatively to manager’s influence.
The presence of Non-Executive Members in the Board of Directors are almost by definition an important attribute for a decent quality of Corporate Governance. Larcker and Tayan (2016) in their book stress the importance of the presence of a sufficient number of members of the Board that have no other affiliation with the firm and can therefore not be influenced by management when expressing their opinions and propositions, even though that also means that they may lack the experience and/or expertise needed (page 119). The authors also point that the limitations (Majority required) regarding the election and the re-election of Board Members, is of high importance, as those processes designate if and how management decisions and policies can be put before judgment (see page 64 and the whole discussion of the issue of the market for corporate control in chapter 11 , page 311 and on).
ETFs and Corporate Governance
The most prominent researches on ETFs have so far focused mainly on the portfolio theory aspects and effects of ETFs, how ETFs’ price return movements and volatility seem to affect the price return volatility of stocks constituting them ( Ben-David, Franzoni and Moussawi (2018)), how they affect market liquidity ( Boehmer and Boehmer (2003)), or how sectoral ETFs may indirectly affect Corporate Governance by influencing information transfer among same industry firms (Bhojraj, Mohanram and Zhang (2018)).
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shareholder proposals in firms which have Boards of that quality, especially when the proposal regard governance and Board accountability. They are expected to oppose Antitakeover Provisions such as Poison Pill, Unequal Voting Rights or Dual Class common stock, which limit or prevent Board accountability, even if that means that it leaves the firm more open to hostile bids by activist investors. Appel et al. (2015) refer to actual cases where activist investors do in fact want the large presence of passive investors generally as shareholders, because that gives their campaigns for changes in management “creditability” (see page 1). Of course, large share ownership and economies of scale and the consequent lower costs that it produces, mentioned both by Appel et al (2015) and Fichtner et al. (2017) are always very helpful when trying to cause changes in a firm. When additionally to that we consider the fact that ETFs tend to keep their shares of a firm for the reasons discussed above, firm managers are sure to “listen” to what ETFs have to say on firm policy and decisions. The motivation for ETF managers to actively care and pursue better management for firms, also mentioned by Appel et al. (2015) for passive investors generally, is of course the fiduciary duty that ETF managers have against their investors, which, even though it is not so strong in the case of ETFs which can easily be traded, is nevertheless not eliminated when considering the aforementioned low costs from the economies of scale and the certainty that firm management will listen to a large shareholder.
The mechanisms that passive investors actually use to affect Corporate Governance are thoroughly explained and tested by Appel et al. (2015) (pages 15 to 24) and are quite illuminating as to their effectiveness. Fichtner et al. (2017), as I have already mentioned, expose the ways by which ETFs in particular impose changes on firm management, mainly relying on the “Big Three” index funds’ voting documents and proxy voting policy issues. Since I have limited access to the voting records of the S&P 500 firms, I use a different approach to try to identify and measure the possible changes that ETFs may induce on the Corporate Governance of these firms.
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significant presence (blockholding) the ETFs have on their Corporate Governance. More details are given in the Methodology section.
Research Question
Following the insights of the existing literature, we can establish that the significant (at least a 3% of the total shares) and growing, or at least, not falling below the threshold, presence of a shareholder in a firm gives her the opportunity to influence the firm’s Corporate Governance, directly or in collaboration with other shareholders. Reckoning that there are two recognizable ways with which, especially an institutional investor such as an Exchange Traded Fund can modify Corporate Governance, I focus my research on the aforementioned features of Corporate Governance that mainly regard shareholder rights and the degree to which they can have a say on the firm’s policies and decisions, the accountability of management to shareholders, and the level of independence of the members of the Board of Directors and a series of committees. Whatever effects will be identified to be caused by, or at least correlated with a significant presence of ETFs as shareholders, will have to be juxtaposed with the guidelines that those ETFs issue for their contributors, to find if they comply with the later.
Given the literature findings for Corporate Governance and its link to firm performance, and also given the fiduciary duty of the ETF managers toward their investors, but also the fact that any attempt to influence Corporate Governance bears a certain cost, the question is to what extend have ETFs during the period from 2007 to 2017 to actually affected Corporate Governance in firms constituting the S&P 500 index, and is that traceable?
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Data
The two types of data that I use are the share percentages at the end of each year (December) of the issuers of S&P 500 Exchange Traded Funds, for each firm included in the S&P 500 index during the period of 2007 until 2017, and the Corporate Governance measures, which are Antitakeover Provisions that are used by public firms in order to prevent or delay takeovers, and simple measures that show the percentages of independent members, or the processes through which directors are elected or decisions are made inside the firm, as pointed out in the Literature Review section. Specific details and explanations on each provision and measure are provided in the Appendix.
From Orbis database which is created by Bureau van Dijk, I acquire data to identify firms included in the S&P 500 index that have index funds as important shareholders, based on their total ownership – whether it is direct or indirect type of ownership is not taken under consideration.Exchange traded funds that track the returns of the S&P 500 index are issued by BlackRock, Vanguard, State Street, ProShares and Rafferty7. I use
data from Thomson’s Reuters available in Datastream, and wherever needed I also look at Institutional Shareholder Services data, available in Wharton’s Research Data Services, to give the overview of the Corporate Governance of the firms through time and to compose the E-index and their overall Corporate Governance quality assessment. Both Orbis and Datastream include the whole list of firms constituting the S&P 500, and provide data, with Orbis focusing on financial and ownership data, and Datastream providing data of a wide variety, including Corporate Governance measures.
For the provisions measured, both the Datastream and the WRDS databases note either a “Yes” or a “No” regarding their presence in the firms’ charters or bylaws, and in order to include them in the regressions, I calculated them by giving them either an actual value of “1” or “0” (more extensive explanations can be seen in the Appendix). Since the data to construct the E-Score were for some firms not sufficient, I managed to construct it for 390 out of the total number of firms. I still consider it a sufficiently large sample to include the E-Score in the research.
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Sufficient data for ownership were collected for 494 out of the 505 firms constituting the S&P500 index. For some years, especially 2014 and 2017, the total share percentage held by either of the ETF issuers were not available for some firms. Nevertheless, the data that I was able to collect are safe enough to come to a series of conclusions. The average share percentages are already by 2007 above the 3% threshold for Vanguard and State Street, and for BlackRock it is approximately 1% for 2007 and 2008.
Table 1 Summary Statistics
Variable Obs. Mean Median Max Min St. Dev.
ETF shares held
BlackRock % 4,259 5.099 5.580 13.750 0.100 2.593 Vanguard % 4,374 5.318 4.680 17.890 0.110 2.560 State Street % 4,751 3.880 3.890 20.970 0.100 1.572 Total % 5,419 11.717 12.260 36.480 0.000 6.349 Measures E-Score 4,893 2.697 3.000 6.000 0.000 1.209
Market capitalisation $(mil) 4,867 30,606.902 13,422.400 796,064.910 179.760 53,199.347
LN(MarketCap) 4,867 9.610 9.505 13.587 5.192 1.134
Compensation
Committee Independence %
4,814 98.949 100.000 100.000 0.000 7.060
Confidential Voting Policy 2,708 0.817 1.000 1.000 0.000 0.387
Dual Class 4,854 0.075 0.000 1.000 0.000 0.263
Golden Parachute 4,767 0.958 1.000 1.000 0.000 0.201
Limitations on Removal of Directors
3,293 0.556 1.000 1.000 0.000 0.497
Limited Shareholder Rights to Call Meetings
4,652 0.939 1.000 1.000 0.000 0.239
Majority Requirements for Election of Directors 4,854 0.704 1.000 1.000 0.000 0.457 Nomination Committee Independence % 4,617 98.707 100.000 100.000 0.000 8.329 Poison Pill 2,399 0.264 0.000 1.000 0.000 0.441
Staggered Board Structure 4,780 0.296 0.000 1.000 0.000 0.457
Requirements to Amend Charter/Bylaws
4,427 0.557 1.000 1.000 0.000 0.497
Independent Board Members % 4,836 81.507 84.620 100.000 0.000 11.237
(Equal) Voting Rights 4,854 0.910 1.000 1.000 0.000 0.286
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Summary Statistics
Table 1 provides the summary statistics. Vanguard has the highest average percentage of shares held (5.318%), followed by BlackRock (5.099%) and State Street (3.88%). ProShares and Rafferty have extremely poor observations that never exceed 0.20%, and are therefore included for the rest of the research only by adding their percentages to the Total ETF percentage, which on average is 11.717%. The most popular provisions are Golden Parachute with 95.8% of firms using it on average for the whole period, Limitations on Shareholder Rights to Call Meetings with an average of 93.9% of firms using it, Equal Voting Rights with 91% of the firms providing them, and Confidential Voting policy with 81.7% of the firms using this provision. The least popular provisions are Dual Class common stock, with only 7.5% of the firms using it on average for the whole period under investigation, Poison Pill with an average of 26.4% of the total number of firms, and Staggered Board structure with 29.6% of the firms using that provision on average. The average E-Score for the total number of firms throughout the period is 2.67. The average percentage of Non-Executive Board Members is 85.73%, the one for Independent Board Members is 81.5% , and the average percentages of independent members of the Compensation and Nomination Committees are 98.94% and 98.7%, respectively.
Research Method
The main focus and purpose of this research is not to establish or quantify the exact measures that actually affect, or to what extend the may do so, the Corporate Governance quality of a firm in relation to its particular or overall performance. Its purpose is, based on existing literature, to identify Corporate Governance measures which are undoubtedly important for a publicly listed firm and in conjunction and juxtaposition with the voting guidelines that the Exchange Traded Funds issue for their members, examine and measure the effect that the important presence of these funds has on a firm.
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of the three major ETFs (Vanguard and State Street) are blockholders in more than half of the S&P500 firms and that for all the years until 2017 their share percentages steadily increase, I find it more interesting to examine all the firms, trying to capture a possible connection between their Corporate Governance quality changes and the changes of the level of ETF holdings, in order to give a clearer view of the possible effects of the “rise” of the ETFs.
Utilizing data for the Antitakeover provisions that each of these firms use and several other Corporate Governance quality indicators which are briefly described in the Appendix, I give a concise description and evaluation of their Corporate Governance quality, and also compose the E-index (see Bebchuk et al.(2003)) as proxy for the Corporate Governance performance of each firm. The E-index is composed by examining the following Antitakeover Devices and simply adding one point if the firm uses them, or zero points if not. The provisions measured in the index are the following: Staggered Board, Bylaw Amendment, Charter Amendment, Poison Pill, Golden Parachute, Supermajority required for Mergers and Acquisitions.The highest score that a firm can get is six (6), and the lowest is zero (0)
While the main focus of the E-index is to measure the Corporate Governance quality of firms in terms of shareholder rights, I additionally investigate the relationship between the presence of passive index funds and the performance of the firm in fourteen (14) measures that directly affect Corporate Governance, which are presented and analyzed in the Appendix.
The period on which my research will focus is 2007 to 2017, covering the period slightly before and after the financial crisis that peaked during 2008. The S&P 500 index is one of the most popular indices, and examining firms included in it can guarantee, a sufficient level of share liquidity.
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each of the three is present as an individual independent variable, essentially splitting the Total percentage to its three components. This is done to avoid possible multicollinearity or other issues that may occur.
(1) 𝑦𝑖𝑡 = 𝛼 + 𝛽𝑡1∗ 𝑇𝑜𝑡𝑎𝑙𝑖𝑡+ 𝛽𝑡2∗ 𝑙𝑛(𝑀𝑎𝑟𝑘𝑒𝑡𝐶𝑎𝑝)𝑖𝑡
where 𝑦𝑖𝑡 denotes the value of the dependent variable for company i at year t, regressed
on the total percentage held by ETFs at the end of year t for firm i and the logarithm of the total market capitalization of the firm for year t.
(2) 𝑦𝑖𝑡= 𝛼 + 𝛽𝑡1∗ 𝐵𝑙𝑎𝑐𝑘𝑅𝑜𝑐𝑘𝑖𝑡+ 𝛽𝑡2∗ 𝑆𝑡𝑎𝑡𝑒 𝑆𝑡𝑟𝑒𝑒𝑡𝑖𝑡+ 𝛽𝑡3∗ 𝑉𝑎𝑛𝑔𝑢𝑎𝑟𝑑𝑖𝑡 + 𝛽𝑡4∗ ln (𝑀𝑎𝑟𝑘𝑒𝑡𝐶𝑎𝑝)𝑖𝑡
where 𝑦𝑖𝑡 denotes the value of the dependent variable, regressed with the percentages held by BlackRock, Vanguard and State Street for company i at the end (December) of the year t and the logarithm of the total market capitalization of the firm i for year t. Consistently with my hypothesis. I expect that by 2017, the firms constituting the S&P500 index which have a significant and/or growing presence of ETFs, will have an improved Corporate Governance quality by having: 1.A lower E-score, and therefore less management entrenchment, 2. A higher percentage of Compensation Committee Independent members, 3. A higher percentage of Nomination Committee Independent members, 4. Increases of Majority Requirements for Election of Directors, 5. Removal of Poison Pills, 6. Less Staggered Boards, 7. Removal of Golden Parachutes, 8. More Independent Board Members (percentage), 9. More Confidential Voting policies, 10. More Equal Voting Rights policies, 11. Less Dual Class common stocks in place, 12. Removal of Supermajority or Qualified Majority Requirements for Charter or Bylaws Amendment,13. Removal of Limitations on Shareholder Right to Call Meetings, 14. Removal of Limitations on Removal of Directors.
Robustness Tests
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on the exertion of influence through “exit”, a notion I have already mentioned in the literature review as it was addressed by Maug (1998), and considering that Fichtner et al. (2015) have already established that ETFs very rarely, if ever, use “exit” as a way to induce changes on Corporate Governance, one could argue that liquidity might be irrelevant for the case of ETF effects on Corporate Governance. But taking also into account Appel et al. (2015), who argue that the presence of passive investors may facilitate the campaigns of active investors, increasing the likeliness of their success, and also considering that one would have to use a proxy for the presence of other significant investors, as it would be quite difficult to include them all in a 11-year spanning research, and even more difficult to assign to each of them a weight proper to their effect on Corporate Governance changes, it is for that reason, that I decided to add the total (annual) level of Market Capitalization of each firm as a measure of firm stock liquidity for more robust results.
Also to ensure robustness, I afterwards estimate regressions with White period, cross section and diagonal coefficients method, based on the methods used by White (1980) and more recently by Cribari Neto and DaSilva (2011) for standard errors robust to heteroscedasticity which may occur when the dependent variable is binary ( 0 or 1) for the provisions. I intend to present only the initial results, unless I find important differences to exist between the results of the two methods.
Results
21
1 and Table 2) show the significant presence, individual and total, of the “Big Three”, with 3% and 5% as a “blockholder” threshold.
By 2017, 92.54% of the 494 firms had a combined presence of 5% or more, and 97.58% had a combined presence of 3% or more by BlackRock, State Street and Vanguard combined. For the firms that by 2017 had a lower than 3% total presence, I did not have sufficient data either for one or two of those ETFs, and I have to assume, based on the investing practices of the ETFs, that the percentage of shareholdings of the ETFs could not deviate very much from the values of the previous years. The overall tendency for
Table 2 : Blockholders (3% or more) in % of the 494 firms per year
BlackRock State Street Vanguard Total
22
all three ETFs under consideration, is to quite steadily increase their presence on the vast majority of the 494 firms. Table 3 and Image 1 point out the rising presence of ETFs, especially the Big Three for the firms constituting the S&P 500 index.
Table 3: Average shares held (%) 2007-2017 BlackRock Vanguard State Street Total
2007 0.96 3.16 3.18 6.27 2008 1.02 3.52 3.29 6.83 2009 5.86 3.89 3.56 11.68 2010 6.01 4.15 3.61 12.14 2011 5.92 4.54 3.86 13.00 2012 5.78 5.12 4.13 13.66 2013 5.70 5.65 4.06 10.60 2014 5.49 6.24 4.14 9.38 2015 6.30 7.05 3.99 13.45 2016 6.67 7.82 4.27 15.44 2017 7.00 8.86 4.49 16.22
Corporate Governance changes
For the 390 firms for which I could acquire full data to compose the E-Score, I find that 194 firms out of the total 390 improved (lowered) their E-Score for the period between starting at 2007 and ending at 2017, and I can therefore assume that they improved their Governance in terms of Management Entrenchment. All of them had by 2017, at least a 3% presence of one or more of the “Big Three”.
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average level of independent directors increased from 2007 to 2016 and 2017, as well as the level of independent members in the Nomination and Compensation committees. By 2016, out of the provisions that are harmful for shareholder rights (more extensive information are given in the Appendix), the only the provisions, namely Qualified Majority or Supermajority Required to Amend Charter or Bylaws, Golden Parachute and Limitations on Shareholder Rights to Call Meetings appeared in more firms than 2007. The number of firms using the provision Limitations on Removal of Directors remained quite stable, and the number of firms using Poison Pills, a Staggered Board structure, and Dual Class common stock decreased. On provisions that are or can be beneficial for shareholder rights, more firms than in 2007 adopted the provisions of Confidential Voting, Equal Voting Rights and Majority Requirements for Election of Directors. All of those firms had a significant and rather stable presence of ETFs (at least 3%) during the years between 2009 (the year when all three of BlackRock, Vanguard and State Street become significant for most firms) and 2017. These results of course do not indicate, much more establish, causation, or even correlation between the presence of ETFs and the Corporate Governance changes noticed. I expect that the regression results can show the possible correlations.
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Table 4: Correlations Between ETF share percentages and Corporate Governance measures and provisions
BlackRock Vanguard State Street Total
E-Score 0.098 -0.088 0.004 0.008
Nomination Committee
Independence % 0.041 0.0005 0.105 0.054
Compensation Committee
Independence % 0.031 0.014 0.114 0.058
Confidential Voting Policy -0.415 -0.164 -0.130 -0.337
Dual Class -0.138 -0.164 -0.147 -0.192
Golden Parachute 0.127 0.095 0.058 0.127
Limitations on Removal of
Directors 0.079 0.109 0.018 0.099
Limited Shareholder
Rights to Call Meetings 0.481 0.201 0.062 0.354
Majority Requirements for
Election of Directors -0.241 -0.218 -0.202 -0.285
Poison Pill 0.199 0.137 0.183 0.228
Staggered Board Structure 0.110 0.105 0.149 0.152
Requirements To Amend
Charter/Bylaws 0.112 0.084 -0.020 0.091
Independent Board
Members % 0.138 0.099 0.252 0.194
(Equal) Voting Rights 0.130 -0.127 0.152 0.172
Non-Executive Board
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Table 5. Regression analysis of Confidential Voting, Poison Pill and Requirements Amend Charter/Bylaws The symbols***,**,* indicate significance of 10%, 5%, 1% respectively. The Dependent variables are described in the Appendix, and they have a value of 1 in case they are used by a firm or a value of 0 if not. The Independent variables are the share percentages held by BlackRock, Vanguard and State Street, which are used in equation (1), and the Total ETF share percentages, used in equation (2). All regressions include both year and firm fixed effects. The standard errors for each coefficient are given in the parentheses. The intercept, as well as the coefficient for ln(MarketCap) are ignored.
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Table 6. Regression analysis of Compensation and Nomination Committee Independence and E-Score The symbols***,**,* indicate significance of 10%, 5%, 1% respectively. The Dependent variables are described in the Appendix, and they have a value of 1 in case they are used by a firm or a value of 0 if not. The Independent variables are the share percentages held by BlackRock, Vanguard and State Street, which are used in equation (1), and the Total ETF share percentages, used in equation (2). All regressions include both year and firm fixed effects. The standard errors for each coefficient are given in the parentheses. The intercept, as well as the coefficient for ln(MarketCap) are ignored.
27
Table 7. Regression analysis of Majority Requirements for Election of Directors, Equal Voting Rights and Limited Shareholder Rights to Call Meetings
The symbols***,**,* indicate significance of 10%, 5%, 1% respectively. The Dependent variables are described in the Appendix, and they have a value of 1 in case they are used by a firm or a value of 0 if not. The Independent variables are the share percentages held by BlackRock, Vanguard and State Street, which are used in equation (1), and the Total ETF share percentages, used in equation (2). All regressions include both year and firm fixed effects. The standard errors for each coefficient are given in the parentheses. The intercept, as well as the coefficient for ln(MarketCap) are ignored.
28
Table 8. Regression analysis of Independent and Non-Executive Board Members and Staggered Board The symbols***,**,* indicate significance of 10%, 5%, 1% respectively. The Dependent variables are described in the Appendix, and they have a value of 1 in case they are used by a firm or a value of 0 if not. The Independent variables are the share percentages held by BlackRock, Vanguard and State Street, which are used in equation (1), and the Total ETF share percentages, used in equation (2). All regressions include both year and firm fixed effects. The standard errors for each coefficient are given in the parentheses. The intercept, as well as the coefficient for ln(MarketCap) are ignored.
29
Table 9. Regression analysis of Limitations on Removal of Directors, Dual Class and Golden Parachute The symbols***,**,* indicate significance of 10%, 5%, 1% respectively. The Dependent variables are described in the Appendix, and they have a value of 1 in case they are used by a firm or a value of 0 if not. The Independent variables are the share percentages held by BlackRock, Vanguard and State Street, which are used in equation (1), and the Total ETF share percentages, used in equation (2). All regressions include both year and firm fixed effects. The standard errors for each coefficient are given in the parentheses. The intercept, as well as the coefficient for ln(MarketCap) are ignored.
Limitations on Removal of Directors(1) Limitations on Removal of Directors (2)
Dual Class (1) Dual Class (2)
30
Regressions Results
All the results are robust to the level of Market Capitalization, and the results regarding binary dependent variables are robust to heteroscedasticity after testing with White cross section, period and diagonal coefficient covariance method. The coefficients are found to have some minor differences, only to the fourth or fifth decimal for each regression, which I consider as insignificant. I also have to note that regressions of all the dependent variables with the changes of the ETF percentages between years ( 𝐸𝑇𝐹𝑡− 𝐸𝑇𝐹𝑡−1) as the independent variables were conducted, with totally
insignificant results.
After running the regressions, I find that only Vanguard’s level of shareholdings have a significant association with the changes of the E-Score. Neither BlackRock’s nor State Street’s share percentages of ETFs seem to have any significant relation with the E-Score changes, showing that a 1% increase of Vanguards share percentage is linked with a 0.056 points increase of the E-Score. Regarding the Total ETF share percentages, on a 10% level, a 1% increase is associated with a 0.005 points increase of the E-Score, which is also contrary to my hypothesis that E-Score would decrease with a higher ETF presence.
31
the Nomination Committee Independence level – a 0.091% increase for every 1% increase of the Total ETF percentages.
The increases of ETF share percentages, except for the ones of State Street which are insignificant, are strongly associated with the percentages of Independent Board Members on the highest (1%) level. A 1% increase of the share percentages of BlackRock relates with approximately a 0.297% increase of Independent Board Members and a 1% increase of Vanguard’s share percentages with a 0.533% increase. A 1% increase of the Total ETF shareholdings is linked with approximately a 0.1% increase of the Independent Board Directors percentage on the 1% level. A slightly significant association can be seen between the Total ETF share percentages and the proportion of Non-Executive Board Members, even though the presence of State Street seems, only on a 10% level of significance, to be negatively associated with the latter, which hints for a statistical error. A rise of 1% of the Total ETF percentages is linked with a 0.032 rise of the percentage of Non-Executive Board Members on a 10% level of significance.
Looking at specific provisions, I identify no significant links between ETF presence and the removal of Staggered Boards, Dual Class common stocks, Golden Parachutes or Poison Pills.
I recognize some quite significant relations for the removal of the Limited Shareholder Rights to Call Meetings provision, where on a 1% level of significance, a 1% increase of State Streets shares percentage is associated with a 0.017% higher probability on the provision being removed but the Total presence of ETFs is insignificant, and also for Confidential Voting policy, on which Vanguard and State Street seem to have a significant influence, where Vanguard’s presence has a positive effect on the highest level and State Street’s a negative one on a lower (5%) level, but where a 1% increase of the Total ETF blockholdings are linked with a 0.002% increase of the likelihood of Confidential Voting policy being induced on a 10% level of significance. I find only a slightly significant (on a 10% level) positive association between Equal Voting Rights policy and Vanguard’s growing presence, and a much more significant one (on a 1% level) again with Vanguard’s presence and the increase of Limitations on Removal of Directors provision.
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the Total ETF level, a 1% increase of ETF share proportion held, relates with a 0.003% increase on a 1% level of significance of the provision being used, instead of a single plurality.
Discussion of the results
While these results do not strongly support the hypothesis that was formulated on the notion that ETFs would be actively involved in the improvement of Corporate Governance measures and that they would impose positive changes, in accordance to what Appel et al. (2015) or Mullins (2015) had found, they do, however, comply with the proxy voting guidelines that the ETF issuers have themselves formulated. A brief look at the recent (2018) guidelines of BlackRock8, Vanguard9 and State Street10 alike, denotes that while all of them are against of provisions that reduce shareholder rights and entrench management, the practice which they employ to induce changes is mostly and predominantly to vote against boards and board members that are, to their judgement, not acting to the best interests of the shareholders, or that seem to not respond in an adequate level to the shareholders’ expressed concerns. Unfortunately, I did not have access to the past guidelines issued by either of the Big Three, but based on the information that Fichtner et al. (2017) provide, I can certify that their policies for the period under consideration for this research did not importantly deviate from the recent ones.
At the same time, provisions such as Poison Pill or Golden Parachute for directors are not totally and unconditionally opposed by either of the “Big Three”, and in their guidelines one can see that in case the majority of the shareholders are in favor of the firm having those two provisions, all those three ETF issuers will comply with the opinion of the majority, unless they deem it as harmful to the interests of the shareholders. Also, ETFs are in line with a 10% or 15% minimum threshold of the total shares to call a Special Meeting. My results, based on the data provided by Thomson Reuters, mark the “Limitations to Shareholder Rights to Call a Special Meeting”
33
provision as a “Yes” when there are no rights or when the minimum threshold of 10% to call a special meeting is in place, and therefore it is rather difficult to identify the possible associations with the presence of ETFs and the changes on this provision. Another issue is that while BlackRock and Vanguard have a policy supporting totally independent committees, State Street declare that they are in favor of the “minimum standards” for independent committee members.
Conclusion
This research is conducted in order to address the issue of the possible effects that the rise of Exchange Traded Funds may have on the Corporate Governance of publicly listed firms, focusing on the firms constituting the S&P 500 index. The rise of the importance of the so-called “passive index funds”, especially the three biggest of them in terms of Assets under Management, has been stressed in several researches and articles, and is also established with this research, which certifies that from 2007, the Big Three have grown in presence and importance for virtually all the firms for which data were provided. Inquiring the effects that this growing presence might have on the Corporate Governance quality of these firms, a significant association was found only on the proportion of independent Board members, the members of the compensation and nomination committees, as well as the processes with which directors are elected (Majority requirements, Confidential voting and Limitations on Removal of Directors). These results, considering that all those measures have a significant impact on the entrenchment of management , its accountability towards shareholders and the overall level of involvement of the shareholders in corporate policies and decisions, show that for the period under consideration, ETFs , in accordance to their policies, exerted efforts to implement changes whenever they deemed it as necessary, mainly through the process of voting for elections of directors and the committees that control certain aspects of the corporate policy.
34
overall performance. Perhaps a research examining firms with lower levels of capitalization could bring clearer results as to the exact level of influence of ETFs. The changes that I noticed in Corporate Governance of those firms, positive in their majority, could also be attributed to the effects of other important shareholders which could either be more “active” or “passive” compared to ETFs.
Out of the 494 firms, a percentage of 3.64% (18 out of 494) have a Controlling Shareholder with a total percentage of 50% or more of outstanding stocks held. For these firms, I consider it arguable to make the assumption that even if the presence of the ETFs, total or individual, is marked as important, it would still be difficult to have a strong (positive) effect on their Corporate Governance.
Even though it would certainly be a difficult task, both those indications show that a research where the effects of the efforts of ETFs to induce changes would be quantified in correspondence with the presence of other significant investors would provide better insights. Additionally, since Fichtner et al.(2017) have noted that ETFs have the tendency to have “private engagement“ with firm management, a view in their records would be also very illuminating.
I consider it as important to continue to try to assess the impact of the rise of ETFs on Corporate Governance, especially since there have been in the recent years statements from their CEOs that they plan to intensify their efforts to improve Corporate Governance11, especially BlackRock 12. As a series of papers already mentioned in the literature review imply, the mere fact that ETF presence continues to grow, makes it easier and cheaper for them to impose changes in Corporate Governance.
11
https://www.wsj.com/articles/vanguard-and-blackrock-plan-to-get-more-assertive-with-their-investments-1425445200
12
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APPENDIX
Provisions/
Measures
Explanation, Impact on Corporate Governance and
ETFs’ policy based on their more recent statements
MajorityRequirement for Election of Directors
Are the Board Members elected by a Majority (Yes=1) or a single Plurality (No=0) ?
It provides that directors are elected on a majority requirement, rather than a plurality. That means that directors have the approval of a wide number of shareholders, and not just a shareholders with a vast number of shares that may promote their own favorite.
BlackRock and State Street specifically state they are in favor, Vanguard merely implies it.
Poison Pill Does the firm have a Poison Pill provision? (Yes=1, No=0) A provision that delays takeovers by providing shareholders the right to purchase stock and thus create obstacles for the takeover. All three ETFs are tolerant to this provision, provided that the majority of shareholders approves it, it is short-term oriented and they (the ETFs) do not find it harmful to shareholders’ interests. Staggered
Board
Does the firm have a Staggered Board structure? (Yes=1, No=0) A Board structure where not all directors cannot be replaced in one year, but only a number of them, and are therefore less accountable.
All three ETFs are against it Dual Class
common stock
Does the firm have different share classes, with different voting rights? (Yes=1, No=0)
It separates cash-flow rights from voting rights, and therefore provides little or no voting power to some shareholders. All three ETFs are against it.
(Equal) Voting Rights
Do all the shares of the firm providing equal voting rights? (Yes=1, No=0)
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Confidential Voting
Does the firm have a Confidential Voting policy, where the management cannot view the voting results? (Yes=1, No=0) Do shareholders cast their votes secretly or publicly? If the latter is in practice, smaller shareholders may be susceptible to
pressure by others regarding their voting decisions. All three ETFs are in favor of Confidential Voting. Golden
Parachute
Does the firm have a Golden Parachute clause (lucrative benefits, vesting of stocks) for Executives in the event of a takeover and the loss of their position? (Yes=1, No=0)
Provides managers with severance in cash or other forms, in case of a change in control of the firm. It can eliminate the gains of possible takeovers, and it can harm the shareholders’ right to fire executives.
All three ETFs are principally against it, unless the majority approves it and ETFs do not find it harmful for their
investments. (Supermajority or Qualified Majority Vote) Requirements to Amend Charter or Bylaws
Does the firm have a supermajority or qualified majority requirement to amend its Charter or Bylaws statutes? (Yes=1, No=0)
Is there a majority higher than 50% plus one vote required for certain governing documents like the charter or bylaws of a firm to be changed or amended?
All three ETFs are against it and favor a simple majority. Limited
Shareholder Rights to Call Meetings
Do the shareholders have a right to call a special meeting
(Yes=1), or do they not, or at least need a 10% threshold (No=0) ?
Do the shareholders need to exceed a certain threshold to call a special meeting, if they have that right at all?
All three ETFs are against limitations. Limitations on
Removal of Directors
Are there limitations (e.g. a majority vote, only for cause) to the removal of directors? (Yes=1, No=0)
Can Board members removed only for a certain cause, or is there a supermajority required to do so, or is a simple majority
enough?
Only State Street has explicitly stated to be against it. Compensation
Committee Independence
The percentage of independent members in the Compensation Committee as reported by the firm.
Nomination Committee Independence
The percentage of independent members in the Nomination Committee as reported by the firm.
E-Score The “Entrenchment-index” score, with a minimum of 0 and a maximum of 6.
Independent Board Members
The percentage of Independent Board Members as reported by the firm.
Non-Executive Board
Members
