Problems and Limitations of Institutional Investor Participation in Corporate Governance

INSTITUTIONAL INVESTOR PARTICIPATION 65

Introduction

S ince the early 1990s, the subject of corpo-rate governance in the UK has grown

dramatically in importance. Several supra-regional factors have contributed to thisemerging interest, such as the globalisation ofcapital markets, the growing emphasis on consumer rights and the shifting investmentlandscape (Kole and Lehn, 1997; Coffee, 1999;Cioffi, 2000). Regionally, high-profile financialscandals, either involving UK companies orcompanies operating within the UK, havecreated significant pressures for change in theway publicly traded corporations are heldaccountable for their actions.

The key UK development involved the pub-lication of four reports: the Cadbury Report,

the Hampel Report, the Turnbull Report and,more recently, the Myners Report.1 While originally formed to assess progress with theimplementation of Cadbury and Greenbury,the Hampel Report specifically examined theway in which institutional investors couldcontribute to the realisation of the existingcode (Drennan et al., 2001).2 This concern withinstitutional investors was based, in the firstinstance, on the sheer extent of institutionalshare ownership as well as the implicit reali-sation that, in the UK, the market for corpo-rate control, which relied on the action ofinstitutional shareholders, was weak. In thiscontext, section 5, “The Role of Shareholders”of the Hampel Report noted that:

60 per cent of shares in listed UK companiesare held by UK institutions – pension funds,insurance companied, unit and investmenttrusts. Of the remaining 40 per cent about

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Problems and Limitations ofInstitutional Investor Participation inCorporate Governance*

Robert Webb**, Matthias Beck and Roddy McKinnon

During the past decade, major governance breakdowns in public limited companies havebrought issues of corporate governance to the forefront of debate. As a result, a series of gov-ernance codes have been introduced into the UK that have sought to obligate publicly listedcompanies to certain practices in their overall operations. One of the codes, the Hampel Code,specifically called for an increased role for institutional investors in governance issues. Usingfinancial system theory as a framework for discussion, this paper questions the viability ofinstitutional investors taking a more active role in monitoring and enforcing governance inthe UK. It is argued that, if institutional investors choose to increase participation, then itcould create anomalies to the efficient operation of the capital markets, involve institutionalinvestors as delegated monitors, increase costs and create free rider problems.

Keywords: Corporate governance, institutional investors, Cadbury, Hampel, Myners, financialsystem architecture, financial market efficiency

** Address for correspondence:Division of Risk, CaledonianBusiness School, GlasgowCaledonian University, Cow-caddens Road, Glasgow G40BA. Tel: 0141 331 8955; fax:0141 331 3229; E-mail:[email protected]

*Presented at the 2nd Conference for the BAA Special Interest Groupon Corporate Governance, Cardiff University, December 2001.

66 CORPORATE GOVERNANCE

half are owned by individuals and half byoverseas owners, mainly institutions. It isclear from this that a discussion of the roleof shareholders in corporate governancewill mainly concern the institutions, partic-ularly UK institutions. (sub-section 5.1)

Having acknowledged the paramount role ofinstitutional shareholders, the Report movedon to discuss the past track record with respectto investment goals and policy. According tosub-section 5.2 of the same Report, there wasevidence that institutional investors weremoving from largely passive policies towardsa more active involvement in companies:

Institutional investors are not a homoge-neous group. They all have an overridingresponsi-bility to their clients, but they havedifferent investment objectives. Typicallyinstitutions used not to take much interestin corporate governance. They tried toachieve their target performance by buyingand selling shares, relying on their judg-ment of the underlying strength of compa-nies and their ability to exploit anomalies inshare prices. Institutions tended not to votetheir shares regularly, and to intervenedirectly with company management only incircumstances of crisis.

Institutions’ attitudes have changed some-what recently. The proportion of shareswhich they own has increased, and it ismore difficult for them to sell large numbersof shares without depressing the market.Some institutions now aim to match theirportfolio to the components of a share index– index tracking – which they think mayhave better long-term results than an activetrading policy. Where an institution is com-mitted, explicitly or de facto, to retaining asubstantial holding in a company, it sharesthe board’s interest in improving thecompany’s performance. As a result, someinstitutions now take a more active interestin corporate governance. They can do thisby voting on resolutions in General meet-ings, and informally through contact withthe company.

In the past, most criticism of Hampel centredon the voluntary nature of its recommenda-tions rather than the role ascribed to indi-vidual and institutional shareholders. Oneexception to this was Dignam (1998), who pro-vided a comprehensive critique of Hampel’sassumptions with regard to institutionalinvestors. In his analysis of section 5, Dignampointed to some of the key regulatory con-tradictions of Hampel’s recommendations.Dignam’s criticism rested on two observa-tions. Firstly, he restated the well-known argu-

ment that, through focusing on performanceindicators, institutional investors pressuredirectors to emphasise short-term earnings tothe detriment of typically more long-term gov-ernance issues.3 Dignam also argued that thisshort-termism was encouraged by renumera-tion packages that tie directors’ earnings to theshare price through shares and share optionsas well as the insecurity of tenure of individ-ual directors. Noting the Hampel Committee’srecommendation that director contract lengthbe one year or less (section 4, paras 4.9–4.10)and its enthusiasm for share options, Dignamconcluded that the given recommendationssupported short-termism rather than strength-ening the discretion of directors in pursuinglong-term governance issues.

Dignam’s second argument concerned theCommittee’s reluctance to impose any statu-tory obligation on institutional shareholders tovote their shares and/or to publish their votes.Interestingly, it should be noted that the Com-mittee suggested that there was a “clear case”for requiring the publication of global figureson institutional voting – that is figures whichreport the proportion of voting opportunitiestake up and non-discretionary proxies beinglodged. One expectation of the Committeewas that the requirement to publish voteuptake alone would ensure that, over time,institutional investors will increase theirinvolvement in companies. This assumption,according to Dignam, must be viewed asexceedingly optimistic on two counts. First,there is no indication that there will be censurefor those companies who do not publish thisinformation or for those institutional investorswho do not vote. Secondly, assuming thatinstitutions have direct formal or informalaccess to the board as a policy-making unit,institutional investors would have little in theway of additional incentives to vote at thegeneral meeting.

These issues, while in no way being thefocus of the work, were again addressed in theMyners Report on Institutional Investment(2000). For example Myners notes on p. 10,paras 54 and 55 of the summary that:

In particular, the review found evidence ofgeneral reluctance to tackle corporate under-performance in investee companies, particu-larly pre-emptive action to prevent troubledcompanies developing serious problems.

The review was given a number of reasonsfor this, none of which it believes to be com-pelling: a culture that seeks to avoid con-flict; unwillingness of managers to act onjudgements about the strategy and topmanagement of the companies in whichthey retain holdings, despite being highly

Volume 11 Number 1 January 2003 © Blackwell Publishing Ltd 2003


paid to make such judgements; alleged regulatory obstacles, which the reviewfound difficult to verify; the lack of incentivefor managers to intervene in a company, ifthey feel the key issue for their client is thenext quarter’s performance figures; andpotential conflicts of interest.

Utilising the recent literature on financialsystems design, this article seeks to extend thework of Dignam and Myners by further ques-tioning Hampel’s (and to some extent Myners)assumptions regarding the potential role ofinstitutional investors. The work of Dignam,and a significant portion of the existing litera-ture in general, adopts a legal and regulatoryperspective in examining governance initia-tives,4 whereas Myners believes that interven-tion should take place because at timesintervention is “the right action to take” andbecause “it is the basic duty of the manager todo their best for the client”.

In contrast, our investigation focuses on thetheoretical arguments traditionally espousedfor market-based financial systems and theassumed role of institutional investors. By pre-senting these arguments it is hoped that thereasons for the low involvement of institu-tional shareholders in UK company corporategovernance will be more clearly understood.Overall, our contribution seeks to highlightthe simple but salient point that there hasbeen, and there will remain, a dearth of credible incentives for institutional investorsto involve themselves more systematically incorporate governance matters and that fundmanagers may be doing their best by remain-ing passive.

The organisation of the financial system

As part of its recommendations, section 5 ofthe Hampel Report conveys the view thatinstitutional investors have a responsibility tomake considered use of their votes. We wouldargue that, leaving to one side the ambiguityof the word “considered”, the increasedinvolvement of institutional investors in cor-porate decision-making itself may be flawedand the proposals, if implemented, could haveserious implications on the efficient operationof the financial system. Our argument com-mences by examining the objectives of finan-cial systems in general and the espousedbenefits of market-based systems.

Relatively recently, there has been a growthin interest in financial system design and whysome countries perform better, in terms of eco-nomic growth and standard of living, than do

others (see Allen and Gale, 2001). The basictenet of this type of analysis is that finan-cial systems exist to allocate resources fromsurplus agents to deficit agents who requirefunds for investment. If the financial systemcan appease the differences between the wants of borrowers with those of lenders, andfind an efficient method of signalling whereresources should be allocated to gain max-imum benefit, then economic growth canresult. The literature concentrates on two, simplified, approaches to analysing theseprocesses: the bank-based system approachand the capital-market-based approach (seeLevine, 2000; Allen and Gale, 2001).

The aims of both bank-based and market-based systems, it can be presumed, is toachieve efficient resource allocation, efficientmonitoring and low transaction costs. Yet,financial transactions are inherently complexand fraught with asymmetric informationproblems, which make these aims difficult toachieve in practice. For example, a bank mayhave difficulties in assessing the integrity ofthe borrower both during the initial stages ofthe loan-making decision and then, in thelonger term, checking that the borrower isundertaking the agreed course of actions. Forshareholders, as mentioned in the seminalwork of Berle and Means (1932), it is difficultto ensure that managers do not pursue theirown interests at the expense of the interests of the owners, the shareholders. The issue ofaccountability between managers and owners(or stakeholders) itself has a rich researchhistory. Beginning in a modern sense withJensen and Meckling (1978), the agency andcontracting literature has identified the diffi-culties in aligning owner and manager ob-jectives. Miller and Thakor (1985), to cite justone example, have studied the particularproblem of information asymmetry and haveobserved that the effectiveness of contractsbetween managers and owners is influencedby the quality and availability of informationfor all parties. These two examples, along withthe more recent work of Allen and Gale (2001),albeit forming part of the analysis of bank-based and market-based approaches, alsoserve in this discussion to help identify themajor deficiencies in the way the HampelReport has conceptualised the roles of institu-tional investors.

Concentrating, for the purposes of our argument, on market-based systems,5 there isa rich literature that considers the desirableeffect of stock-market-based resource alloca-tion. Market-based systems provide greaterincentives to gather information, which is thenused to trade in the market. This, in turn,becomes reflected in the share price of the

© Blackwell Publishing Ltd 2003 Volume 11 Number 1 January 2003


company, thus giving a signal for the efficientallocation of resources (Grossman and Stiglitz,1980). The basis of this argument resides in the repeated analysis by investors of eachcompany’s future prospects, and their abilityto ensure a profit from information evaluation.Another proposed advantage of market-basedsystems is that they provide a means by whichinvestors can benefit from efficient risk-sharing and diversification. Capital marketsallow the investor to disaggregate financialasset risk and to be aware of where the risk islocated, thus enabling the investor to build a portfolio dependent on their preferred riskprofile (Diamond, 1967). In addition, efficientmarket-based systems, such as those of the UKand US, have a high degree of liquidity, whichallows investors the flexibility to switch theirinvestments at low cost at any time. This, it hasbeen argued (see Jensen and Meckling, 1976;Holmstrom and Tirole, 1990), provides anincentive for managers to focus on share-holder value because poor performance willresult in a fall in the share price and ultimatelya takeover which leads to the expulsion of theincumbent management. Therefore, efficientmarket-based systems maintain managerialincentives to profit-maximise.

Capital markets and shareholderparticipation

It is generally accepted that the UK financialsystem is market-based. Accordingly, the rolesof the capital market is central and the mainform of external control and governance is the hostile takeover (Allen and Gale, 2000).Moreover, it has been suggested that the UK is characterised by the domination of the stock market by domestic institutionalinvestors (see Table 1, from Gaved, 1998).6Therefore, any discussion of corporate gover-nance issues in the UK cannot be conducted

without consideration for the role to be playedby shareholders, including domestic institu-tional investors.

In the UK, managers of public listed com-panies (PLCs) are responsible to their share-holders, and managers have a fiduciary dutyto act in their interests. Shareholders who are unsatisfied with the broad, or a specificcompany strategy, have generally twoavenues open: either sell the shares or take anactive role in influencing strategy. The lattercan be achieved by participating in the elec-tion of the board of directors and by voting atthe annual general meeting (AGM). However,in practice, this is fraught with difficulties andevidence from the UK suggests that it sel-dom occurs. For example, a recent report bythe Manifest Voting Agency, which analysedproxy votes in 2001, notes that 92.54 per centof all votes lodged at meetings are in favour ofmanagement and only 4.04 per cent against.This figure highlights two issues. First, thatshareholders in the UK are actually remark-ably passive. Second, that there are drawbacksin attempting to foster reliance on shareholderinput in the operation of efficient corporategovernance in the UK.

The financial system design literaturewould suggest that reasons for such a lowdegree of active participation are twofold.First, there is a difficulty in monitoring andsupervising companies which arises becausethere are no major shareholders large enoughto be concerned about monitoring overall per-formance. This can lead to free-rider problems,whereby the ill-informed will freely follow the more informed analyst and reduce his or her profit and therefore their incentives tomonitor.

Second the transaction costs involved inmonitoring are often prohibitive. There is aninherent disincentive to monitoring due tohigh transaction costs incurred by less knowl-edgeable investors. For example, in order togain a meaningful analysis that can be tradedupon, institutional investors must first spendtime, and possibly money, collecting informa-tion. This process may be incomplete, insuf-ficient and suffer from asymmetry that caneasily arise when investors are external to thecompany and have little way of knowing orsubstantiating whether the information sup-plied by managers is correct and true.

A further issue that has been linked to theoperation of stock markets, and one that hasbeen much analysed in the literature, is thepreviously mentioned tendency towardsshort-termism (for a review see Miles, 1992).As a result of investors wanting a bi-annualincrease in company profits in order, not least,to signal certainty and reduce the effects of


Table 1: Institutional investor financial assets as %of equity value

1990 1995

Australia 39 50Canada 20 24France 22 22Germany 9 12Italy 16 17Japan 23 18UK 66 69US 23 36


asymmetry, companies will target short-termprofit at the cost of the long term in order toappease shareholders. All of this leads to whatPorter (1992) has described as the fluid capi-tal system, whereby temporary shareholdershave expectations of short-term results whichleads to a fragmentation of interests. At the same time, the use of external informa-tion leads to a short-term and uncertain eval-uation of decisions on which shareholdershave little influence. Problematically, it istowards this “short-termist” outlook thatHampel appears to turn in order to provide asuggested solution to help redress the per-ceived inadequacies of corporate governancein the UK.

Hampel, institutional investors andcorporate governance

The literature on the benefits of large share-holders intervening in a company is extensive,with Stiglitz (1985) arguing that one way thatshareholder maximisation can be ensured is through the concentrated ownership of afirm’s shares. Similarly, Shleifer and Vishny(1986) and Huddart (1993) find that monitor-ing and firm performance increases for firmsthat have a predominant shareholder.

However, there seem to be at least three con-cerns regarding the reliance on institutionalinvestors as corporate governance agents.First, it is difficult to align the idea of financialmarket efficiency as outlined by Fama (1970,1991, 1998) with corporate governance byinvestors. Second, if institutional investors are being asked to act as delegated monitors,without holding non-marketable debt, thenincentive concerns arise. Third, in order for a single institution to influence company strategy, they must absorb the cost of gaining asufficient shareholding to influence companypolicy together with the uncertainty that thechosen strategy will result in future benefits.7However, gaining a sufficient stake may resultin increased cost to the institutional investor,more volatility in the market and free-riderproblems. The following section will addressthese three concerns in greater detail, payingparticular attention to the realism of theHampel-type assumption that institutionalinvestors should act more actively as corpo-rate governance agents.

Addressing the first concern, conventionalwisdom in the burgeoning financial literaturewould suggest that the pricing of an asset iscorrect and (semi-strong form) efficient if itreflects all known relevant fundamental infor-mation correctly and rapidly. In this context,

as outlined in the efficient market hypothesis(Fama, 1971), efficiency is interpreted andmodelled as a direct function of fundamentalworth and a clear representation of opti-mal economic performance. This is the basis of the efficiency of capital-market resourceallocation.

As a consequence of the need to act effi-ciently in this sense, institutional investorsmust quickly absorb, evaluate and trade onnew information coming to the market inorder to make positive returns. In the major-ity of cases, institutional investors will tradewhen doing so will increase profitability eitherfor themselves or for the trustees of themanaged fund. Traditionally, institutions havenot been concerned with corporate gover-nance and, importantly, they have not beenrestrained by anything other than their ownmyopia and bounded rationality. However,the inference of the Hampel Committee is thatwe should expect institutional investors toconsider wider issues beyond those aimedsolely at increasing performance.

Specifically, point 33 of the “Conclusionsand Recommendations” (Appendix 1) of theHampel Report explicitly encourages trusteesemploying institutional investors to take alonger-term view. The evidence as to whethermarkets are short-term is inconclusive, butattempting to coerce institutions into consid-erations other than those that would increaseshareholder value is at odds with the efficientworkings of financial markets and can ulti-mately result in an abnormal resource alloca-tion. Obviously, there will be times when thetrading of shares coincides with good gov-ernance practice within a firm. However,without further evidence, this must be seen as a random occurrence. Moreover, finan-cial market efficiency theory dictates that it is not advisable for governments or com-mittees to persuade or coerce institutionalinvestors as to how they should manageinvestments.

Our second concern is associated with theReport’s observation that significant changeshave occurred during the past two decades in the size and significance of institutionalinvestor equity holdings. Hampel postulatesthat these changes have made the buying andselling of equity difficult, without having sig-nificant market impact, and has made it diffi-cult for institutional investors to exit at lowcost. For this reason, it has been argued that there are increased incentives to monitorcompany performance, vote at AGMs andgenerally contribute to corporate affairs.However, the Hampel interpretation of thecurrent market conditions brings to the atten-tion two limitations. First, the growth in size



of institutional investor equity holdings hasfuelled the rise in the use of passive indexfunds tracking the movements of majorindexes such as the FTSE100 or 250. The usageof these index funds is unlikely to foster thetype of corporate monitoring advocated byHampel because passive index-tracking fundsaim to minimise costs, but monitoring and cor-porate governance is undertaken under uncer-tainty at significant cost.

Second, the Hampel Report expects thatinstitutional investors, given their increasedexposure to changes in market values, willbecome more actively involved in the dailyrunning of companies. In doing so Hampelanticipates investors within the UK market-based system to lumber themselves with theperceived burdens of bank-based monitoringwithout gaining the perceived full advantagesengendered by such a system.8 Specifically, ina bank-based system, banks traditionally holdnon-marketable debt9 and therefore have afirm and 100 per cent incentive to monitor and check company performance. Under thissystem risks and expected returns can, undercertain circumstances, be aligned. In contrast,under the proposed Hampel-type regime, anysingle institutional investor will remain unableto change a company’s strategy, so the incen-tive still remains either to free-ride on otherinstitutions or to exit. As temporary share-holders, institutional investors are able tomake liquid at least a proportion of theirequity holdings and they have an incentive todo so. Therefore, implicit in the Hampel modelis the expectation that institutional investorswill operate as banks and incur the respectivecosts when it comes to monitoring and gover-nance issues, without reaping the benefits thatbank-based monitoring brings.

The final questionable assumption implicitto the Hampel recommendations concerns theissue of an investor’s ability to change thestrategy of a company. In the UK, the indi-vidual exposure of any institutional investorremains such that they will face incentiveissues when attempting to force companies to adhere to corporate governance. This isbecause in order to sway company strategy orattempt to get a company to adhere to corpo-rate governance, the institution will have totake an influential shareholding.10 The takingof such a position will be costly and uncertain.Moreover, it will take place in full view of therest of the market, thus allowing other institu-tions to free-ride. As a result, as long as the cal-culated costs of exit are cheaper than the costsof taking a more active role in the managerialfunctions, institutional investors will be morelikely to choose exit, rather than attempting togenuinely reform a company.

More specifically, fund managers at invest-ing institutions will not want to hold illiquidpositions or significant percentages of com-panies (fund managers have stock limits, riskcontrols in the form of active stock, sector,market weight limits) because they will not beable to unwind the positions profitably.11 Inorder to enact or vote on important corporategovernance issues, fund managers will have tobuild up a large holding in the company andbuild up company specific knowledge beyondthe average fund manager. As a result, thefund manager may add value; however, theywill not be able to take that value because ifthey try to sell, the action contains informedinformation. That is, the fund manager will bethe one with superior or even insider knowl-edge and thus will be a signal to the market ofthe future outcomes of the company.12 If thisoccurs, the only hope the fund manager willhave is to break up the company and sell offthe components to private buyers. Ultimately,this can only result in an inefficient corporategovernance system, in which some companiesengage in potentially loss-making activities,while other, more profitable companies, free-ride on their activities.

However, such action may be observed butfor different reasons. For example, it will be acertain type of fund manager who holds stocklong enough and who will use voting rightsfor medium to long-term gain. Growth ormomentum managers will be more interestedin playing the market and getting out at thetop – taking no role in corporate governance.In contrast, value houses may well have aninterest in buying undervalued shares wherecorporate governance can make a real dif-ference, effecting decisions on cost cutting ordeal-making that will affect future prospectsand turn bad stocks back to normal, or votingto break up the company to release value. Itwill be these small undervalued stocks inwhich there is hope for “releasing value”,where fund managers will direct corporategovernance voting rights. However, thesepoints are indicative of further contradictionswith Hampel’s recommendations. First, in thevalue investors case, they choose companieswhich they believe to be undervalued andpurchase in order to realise value in the stock – not to take on the broader issues of corporate governance. Second, it is question-able that fund managers have the appro-priate entrepreneurial approach for governing such companies. Fund managers want lowrisk quick returns. Value stock investmentsrepresent high risks in the medium- to long-term, and fund managers may damage theseundervalued stocks by voting to extract quickgains.



Conclusion

Commencing from the critical perspective offinancial system theory, this article has soughtto investigate the specific assumptions of the Hampel Report that institutional investorsshould act as guardians of corporate gover-nance. The article utilised the academic litera-ture on financial system design to question the validity of several of the expectations of the Hampel Committee. More specifically, wequestioned the view that, in the currentmarket environment, institutional investorswill have incentives to more actively under-take corporate governance without requiringthe introduction of a mandatory regulatoryframework.

In reviewing the benefits associated withmarket-based financial systems, this articlehas postulated that the role of institutionalinvestors in corporate governance is likely toremain low key for three reasons in particular.These include, first, the difficulty of aligningHampel recommendations with theoreticalexpectations about financial market efficiency;second, the lack of incentives for institutionalinvestors to become more active; third, themarket uncertainty created by, and associatedwith, institutional investors becoming major-ity shareholders.

In discussing these issues, the paper high-lights the partial misconception by the regula-tory authorities that institutional investors canact as banks. This can never be the case, notleast because institutional investors lack theincentives that are evident in bank operations.Specifically, banks hold non-marketable debtand, as a result, liquifying their positions iscostly and monitoring essential. Therefore, it is not appropriate to expect institutionalinvestors to behave like banks in long-termpartnership with companies. They have dif-ferent constraints, objectives, horizons andabilities.

The arguments presented seek to widen thedebate for future research. In particular, wesuggest that future research should attempt to evaluate the expectations of regulatoryauthorities for the nature of institutionalinvestor involvement in corporate gover-nance. Further, work should also be under-taken to disclose more precisely the actual, butcurrently poorly understood, roles played byinstitutional investors in corporate gover-nance. The actions of institutional investors,both implicit and explicit, must be betterunderstood.

Acknowledgement

The authors would like to thank AndrewDrake for comments on earlier drafts

Notes

1. The full titles of these reports are, for Cadbury:Committee on the Financial Aspects of Corpo-rate Governance, The Financial Aspects of Corpo-rate Governance (1993). For Hampel: Committeeon Corporate Governance, Final Report (1998).For Turnbull: Institute of Chartered Accoun-tants in England & Wales, Internal Control: Guid-ance for Directors on the Combined Code (1999).For Myners: Institutional Investment in the UK(2001). The Greenbury Report, which followedthe publication of Cadbury, covers issues ofdirector’s remuneration.

2. Institutional investors are categorised as pen-sions funds, insurance companies and mutualfunds. Traditionally, in terms of value of assets,pension funds are the biggest of these three cat-egories. While in the US insurance companiestend to focus their investments on bonds, thisis not so in the UK, where insurance companiesinvest the bulk of their capital in the stockmarket (ABI, 2000; Vittas, 1998).

3. Nikonoff (1999) reports that the average dura-tion of share holdings of US pension funds isonly nine months.

4. Similar arguments have been espoused byJulian Franks and Colin Mayer (2000) in theirreport for the Department of Trade and Indus-try’s Company Law review.

5. Readers are directed to the work of Allen andGale (2001) and Levine (2000) for a full and critical exposition of bank-based systems.

6. This contrasts with countries such as France,where 40 per cent of stock holdings are ownedby foreign institutional investors (Nikonoff,1999).

7. During interviews conducted by the authorswith three leading institutional investors, thereappeared to be a consensus that a “significant”stake required taking a holding of between 5per cent and 10 per cent of a company’s shares.This is in line with disclosure requirements asstated in Company Law outlined in note 10.

8. Importantly, in either system monitoring hascosts and, due to the reliance on the loan officer,bank-based systems also face incentive incom-patibilities which can arise from the fact thatloan officers may place their career aspirationsbefore the set requirements, or future, of the bank. As a result, when comparing thesesystems the perceived problems of monitoringin the market-based systems, where exit is relatively less costly, has to be contrasted withthe costs and problems associated with bank-based monitoring.

9. Recent developments concerning spectrumfilling have increased the efficiency of the finan-cial markets and, as a result, have allowedbanks to increase loan sales and securitise the



non-marketable proportion of their asset port-folio. However, it should be noted that bothloan sales and securitisation are not limitless.Loan sales, for example, can adversely affectcustomer relationships, while securitisation of bank assets relies upon standardisation ofassets, rating of risk through underwriting and reliable credit enhancers. In addition, size,recourse and risk issues remain. For example,the most marketable bank assets will be theones of the highest quality and securitisingthese will leave the bank with the poorerquality assets on its balance sheet. In summary,difficulties still persist in finding large homoge-nous asset packages and this is why the processhas taken place primarily in the mortgagesector and credit card receivables. For thesereasons we assume that incentives to monitor,whilst weakened over the past decade, haveremained strong within the bank’s activities.

10. Again, the precise percentage holding thisrequires will depend on the ownership struc-ture of the company; however, as a rule ofthumb this will usually involve an acquisitionof 5 per cent or more of the total shares.

11. For a definition of a significant percentage, seenote 7. However, it must be noted that anotheradditional issue concerning these arguments isthat the UK Takeover Panel, under its “RulesGoverning Substantial Acquisition of Shares”requires any institution taking an aggregate of between 15 per cent and 30 per cent of thevoting rights of any company to declare thebuild-up of their holding in order that the Panelcan restrict the speed of the acquisition. Anystake over the 30 per cent can trigger a manda-tory offer for the company.

12. It must be noted that institutional investorshave to comply with Company Law, Section 199(b) which states that “where a person is inter-ested in shares comprised in relevant sharecapital, then (b) he has a notifiable interest atany time when . . . the aggregate nominal valueof the shares in which he has interests is equalto more than 10 per cent of the nominal valueof the relevant share capital”. Further, the UKListing Authority requires all non investmenttrust companies to “include in its annual reportand accounts a list of all investments with avalue greater than 5 per cent of the company’sinvestment portfolio, and at least the 10 largestinvestments . . .” and all “open ended invest-ment companies . . . which exceed 10 per cent of the issued shares of any class in the capitalof a company” to disclose their holdings (UKListing Authority Notebook; Financial ServicesAuthority, 2002, chapter 21.20). As a result, allinvestments are transparent and any significantholdings cannot be secretly held by any singleinstitutional investor.

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Robert Webb is Senior Lecturer in Bankingand Finance at Glasgow Caledonian Univer-sity and formerly Senior Lecturer in Econo-

mics and Programme Leader for BA (Hons)Money Banking and Finance at MiddlesexUniversity. He researches and publishes in thefields of bank efficiency, wage overpayment infinancial services, financial market efficiencyand informal money transfer networks. Cur-rent research projects include an analysis of wage overpayment in European financialservices, the effect of internal labour marketson wages in UK financial services and the atti-tudes of institutional investors in corporategovernance.Matthias Beck: Undergraduate studies, Universitaet Stuttgart (Germany); M.ArchM.U.P University of Kansas, 1989; PhD Massachusetts Institute of Technology (MIT),1989; Graduate Teaching Assistant at MIT,1990–1994; Lecturer in Economic History andEconomics at the University of Glasgow,1994–1995; Lecturer in Economics at the Uni-versity of St Andrews, 1995–1998, Professor of Risk Management at Glasgow CaledonianUniversity, 1999–present. Matthias Beck pub-lishes in leading international journals in theareas of health and safety regulation and corporate governance.Roddy McKinnon was Formerly a lecturerdelivering courses in the financial servicesprogramme of the Division of Risk at GlasgowCaledonian University. He now works as aRegional Research Analyst with the Interna-tional Social Security Association (ISSA) inGeneva, Switzerland. Roddy McKinnon haspublished extensively in international acade-mic journals in the fields of social security, old age pensions, social risk management, anddeveloping market financial services. He is co-author (with Roger Charlton) of Pensions inDevelopment (Ashgate, 2001). Current researchinterests include the design and provision oftax-financed universal old-age pensions forleast developed countries.


“The aims have to be to make the best corporate governance practices today the norms oftomorrow. It needs the global spread of higher standards of corporate governance and ahigher degree of corporate social responsibility and it requires protest and public pressure– for which I believe there is a place – to be directed at specific and justified targets, notdissipated on trying to stop the world.” George Cox, Director General, Institute of Directors atIoD Annual Convention 2002.

Problems and Limitations of Institutional Investor Participation in Corporate Governance

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