Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Georgia State University — J. Mack Robinson College of Business, Center for the Economic Analysis of Risk (CEAR) — Department of Finance, CEAR Workshop — Institutional Investors: Control, Liquidity, and Systemic Risks, The Commerce Club, Atlanta, GA
April 19, 2013
Good evening. Thank you for that kind introduction. I am glad to be here at Georgia State University and the J. Mack College of Business. I would like to thank the Center for the Economic Analysis of Risk (CEAR) and the Department of Finance for sponsoring this workshop. Before I begin, let me issue the standard disclaimer that the views I express this evening are my own, and do not necessarily reflect the views of the U.S. Securities and Exchange Commission (SEC), my fellow Commissioners, or members of the staff.
I am particularly pleased to be at a conference that focuses on the role of institutional investors and their impact on corporate control, market liquidity, and systemic risk. The SEC has a great deal of interest in these areas and I hope that you will provide us with any observations that can help inform the SEC’s understanding.
Role Played by Institutional Investors
The topic of your conference recognizes the important role played by institutional investors and the great influence they exert in our capital markets. The role and influence of institutional investors has grown over time. For example, the proportion of U.S. public equities managed by institutions has risen steadily over the past six decades, from about 7 or 8% of market capitalization in 1950, to about 67 % in 2010.1 The shift has come as more American families participate in the capital markets through pooled-investment vehicles, such as mutual funds and exchange traded funds (ETFs).2
Institutional investor ownership is an even more significant factor in the largest corporations: In 2009, institutional investors owned in the aggregate 73% of the outstanding equity in the 1,000 largest U.S. corporations.3
The growth in the proportion of assets managed by institutional investors has been accompanied by a dramatic growth in the market capitalization of U.S. listed companies. For example, in 1950, the combined market value of all stocks listed on the New York Stock Exchange (NYSE) was about $94 billion.4 By 2012, however, the domestic market capitalization of the NYSE was more than $14 trillion,5 an increase of nearly1,500%. This growth is even more impressive if you add the $4.5 trillion in market capitalization on the NASDAQ market, 6 which did not exist until 1971.7 The bottom line is, that as a whole, institutional investors own a larger share of a larger market.
Of course, institutional investors are not all the same. They come in many different forms and with many different characteristics. Among other things, institutional investors have different organizational and governance structures, and are subject to different regulatory requirements. The universe of institutional investors includes mutual funds and ETFs regulated by the SEC, as well as pension funds, insurance companies, and a wide variety of hedge funds and managed accounts, many of which are unregulated.
And, of course, institutional investors don’t all buy or sell the same asset classes at the same time. To the contrary, they have a wide variety of distinct goals, strategies, and timeframes for their investments. As a result, their interaction with, and impact on, the market occurs in many different ways.8
The growth in assets managed by institutions has also affected, and been affected by, the significant changes in market structure and trading technologies over the past few decades, including the development of the national market system, the proliferation of trading venues — including both dark pools and electronic trading platforms — and the advent of algorithmic and high-speed trading. These changes — largely driven by the trading of institutional investors — have resulted in huge increases in trading volumes. For example, in 1990, the average daily volume on the NYSE was 162 million shares.9 Today, just 23 years later, that average daily volume is approximately 2.6 billion shares10 — an increase of about 1,600%.
Simply stated, institutional investors are dominant market players, but it is difficult to fit them into any particular category. This poses a challenge for regulators, who must take into account all the many different ways institutional investors operate, and interact, with the capital markets.
It is clear, however, that professionally-managed institutions can help ensure that our capital markets function as engines for economic growth. Institutional investors are known to improve price discovery, increase allocative efficiency,11 and promote management accountability. They aggregate the capital that businesses need to grow, and provide trading markets with liquidity — the lifeblood of our capital markets.
In doing all this, institutional investors — like all investors — depend on the assurance of a level playing field, access to complete and reliable information, and the ability to exercise their rights as shareowners. That is why fair and intelligent regulation is necessary for the proper functioning of our capital markets.
With that in mind, I would like to discuss two specific regulatory issues of particular interest to institutional investors:
- First, the importance of reliable information to investors, and some troubling efforts to scale back disclosures and reduce transparency; and
- Second, the need for institutional investors to be heard on corporate governance issues, especially on executive compensation.
The Importance of Reliable Information — How the JOBS Act Affects Institutional Investors
As you well know, disclosure is the foundation of our federal securities laws. Fair and accurate disclosure has been the central goal of U.S. securities laws for 80 years.12 This goal is so fundamental to our understanding of securities regulation that the benefits of transparency might almost be taken for granted.
A recent academic paper demonstrates the value of public disclosure in a compelling way.13 This paper found that newly public companies with the highest levels of institutional investment significantly outperformed those with the lowest levels.14 According to the study, institutional investors were not appreciably better than individual investors at picking big winners, but they were much better at avoiding the worst-performing investments.15 The interesting thing is how they did it: The authors found little evidence that institutions were able to exploit private information to improve investment returns.16 Nor did the evidence of that particular study suggest that institutions were able to improve the performance of companies they invest in through active monitoring.17 Instead, it seems that these institutional investors succeeded by making better use of the available public information — focusing on fundamentals like operating history, prior earnings, size, and liquidity.18
This is a significant observation for securities regulators and lawmakers. If investors improve performance by focusing on a company’s publicly available information, then preserving access to such information is critically important, for both investor protection and capital formation.
Now here’s my concern. Just last year, Congress enacted legislation — the so-called Jumpstart Our Business Startups Act, or “JOBS Act” — that actually reduces the amount of information required to be provided by a wide category of public companies.19
Supporters of the JOBS Act hoped that the legislation would encourage so-called “emerging growth companies” to raise capital through initial public offerings (IPOs), enabling them to expand and — hopefully — create jobs. To achieve that goal, the legislation tries to reduce the cost of going public for these companies. This is an extremely broad swath of the market. The JOBS Act defines emerging growth company to include businesses with up to $1 billion in annual gross revenue, for up to five years after their IPO.20 This definition would encompass more than three-quarters of all active filers today — and it has been estimated that 98% of all IPOs since 1970 would have fit into that category.21
Unfortunately, the JOBS Act tries to cut the cost of capital raising by limiting the financial and other information that these companies are required to provide to their investors. This reduced disclosure can make it harder for investors to evaluate companies by obscuring the company’s track record and material business and financial trends. The result could be an adverse impact on capital formation.
For example, under the JOBS Act, an emerging growth company only has to provide two years (rather than the typical three years) of audited financial statements, and the company can omit the selected financial data otherwise required for any earlier period. In addition, these companies may also omit certain compensation-related disclosures. Moreover, in certain cases, the JOBS Act allows emerging growth companies to postpone compliance with new or revised financial accounting standards. This exemption may result in inconsistent accounting rules, damage financial transparency, and make it difficult for investors to compare the merits of investing in emerging growth companies against other investment options.
Adding to these concerns, emerging growth companies are also exempted from the outside audit of internal controls required by the Sarbanes-Oxley Act, and from future rules that the Public Company Accounting Oversight Board (PCAOB) may issue with respect to certain auditor reporting requirements. This is particularly problematic because audits of internal controls, and other audit requirements, provide important information in assessing the reliability of an issuer’s financial statements. Failure to comply with those standards makes the financial statement audit less informative, and could potentially reduce the reliability of financial information available to investors.
In that regard, there is good data to suggest that independent attestation of internal controls actually promotes good financial reporting. For example, last year, the SEC’s Office of Chief Accountant completed a study and recommendations on the attestation requirement for certain mid-cap issuers. The study concluded that financial reporting is more reliable when the auditor is involved with the assessment of internal controls.22
In particular, the study observed that auditor testing resulted in disclosure of control deficiencies that were not previously disclosed by management, and that companies that relied solely on management certifying their own internal controls were more likely to restate their financial statements. The benefits of auditor attestation are also confirmed by other commenters, including the Council of Institutional Investors, the Center for Audit Quality, and the AICPA.23
Given the number of studies indicating the positive impact to capital formation when investors have access to useful and reliable information, it is troubling that disclosures are being scaled-back. Reducing the quality of information is simply unproductive.
Regrettably, there continues to be efforts to lobby for limiting disclosure requirements, on the claim that reducing the amount of required disclosures will lower the cost of capital raising. In my view, that would be penny-wise and pound-foolish, as money raised for inefficient uses does not in the long-term create jobs or help the economy grow. The goal should be capital formation, not just capital raising.
Proponents of less disclosure lose sight of the fact that capital raising is not the same as capital formation. By itself, selling a bond or a share of stock doesn’t add a thing to the real economy, no matter how quickly or cheaply you do it. True capital formation requires that the capital raised be invested in productive assets — like a factory, store, or new technology — or otherwise used to make a business more productive. The more productive those assets are, the greater the capital formation from the investment — and, importantly, the more jobs created.24 And study after study makes it clear that high-quality public information gives investors the confidence they need to invest,25 and ultimately results in better allocation of assets — which, after all, is what grows our economy and creates jobs.
So, what can be done? Institutional investors, as well as members of the academic community, can play a valuable role in this debate, by monitoring the performance of emerging growth companies that elect to provide limited disclosure and determining if real capital formation is being helped or hurt. Your insights into the impact of these rules would be invaluable.
Empowering Investors to Exercise Rights as Shareowners
Institutional investors also have an important role in monitoring corporate governance issues. In recent years, these issues have included, among others, majority voting, splitting the Chairman and CEO roles, and focusing on the quality and diversity of Boards of Directors, as well as compensation structures and concerns about the runaway growth in executive pay.
Let me briefly talk about the so-called “say-on-pay” provisions of the Dodd-Frank Act.26 The “say-on-pay” provisions empower all shareholders, both institutional and retail, to vote on the executive compensation paid by the companies they own.27 As Senator Carl Levin has said, these provisions are intended to “instill a culture of accountability in the executive pay arena.”28 Although these “say-on-pay” resolutions are not directly binding on the corporation, early experience suggests that corporate boards are paying close attention to the voting results and will seek to avoid “no” votes that are greater than 25-30%.29 As a result, “say-on-pay” is an opportunity for shareholder engagement — providing investors with a forum to discuss compensation and other corporate governance issues with management, and enhancing the ability of institutional investors, in particular, to have their voices heard.30
Given the percentage of company stock held by institutions, and the low participation rates of individual shareholders in corporate elections, the vote of institutional investors can often determine the outcomes of “say-on-pay” votes.31 As a result, public companies now regularly arrange meetings with institutional investors to lobby these large block holders.
Beyond “say-on-pay” issues, institutional investors are involved in a wide range of corporate governance and other important issues. For example, and just to mention a matter recently in the press, news reports have highlighted how, in the wake of the infamous “London Whale” trading losses, the management of J.P. Morgan Chase & Co. has engaged in substantial efforts to reach out to a number of large institutional investors. Reportedly, management wants these investors to oppose a shareholder proposal which seeks to separate the CEO and board chairman role at the bank.32
But it’s not only management that is seeking support from institutional investors. The supporters of the proposal are also taking their arguments directly to institutional investors, including meeting with funds that are substantial shareholders in J.P. Morgan. 33
Campaigns like these — which are becoming more and more common — underscore the tremendous importance of institutional investors and the influence that they can have. The experience also underscores the potential impact of shareholder proposals on corporate governance matters. It has been reported that companies received over 600 shareholder resolutions this proxy season.34 Each of these resolutions provides an opportunity for institutional investors to engage with management and have an impact on corporate governance. After all, it is often their votes that can make the difference.
Clearly, institutional investors have a great deal of power in our capital markets. And, as Franklin Delano Roosevelt wrote, on another April night in Georgia — “great power involves great responsibility.”35 The responsibility of institutional investors stems, in large part, from their stewardship of assets that belong to others. The one indispensable fact to remember is that behind all institutional investors and their portfolio managers are millions of American workers, savers, policy holders, retirees, and other individual investors, who rely on those they entrust with their monies to provide for a safe and secure retirement, to help them save for a home or college education, and to participate in the American dream.
Too often, public company management and other issuers — represented by their lawyers, investment bankers, and industry groups — dominate the regulatory discussion. Institutional investors need to exercise their collective influence to improve the ongoing dialogue. We need to hear their views on the benefits of transparency through disclosure, corporate governance, appropriate compensation structures and amounts, and other important issues. That call to action is also applicable to those academicians and researchers who have salient information on the roles of institutional investors and how their actions impact corporate America and the economy. As an SEC Commissioner, I also would be particularly interested in how SEC rules affect — and are affected by — the behavior of institutional investors.
The SEC needs to hear from all credible voices that can add value to the ongoing public dialogue on the issues facing the capital markets today. You should speak out, and hold the SEC accountable to act on behalf of investors. I look forward to hearing what you have to say.
Thank you for the opportunity to speak with you this evening.
1 Marshall E. Blume and Donald B. Keim, Working Paper, Institutional Investors and Stock Market Liquidity: Trends and Relationships, The Wharton School, University of Pennsylvania (Aug. 21, 2012), available at http://finance.wharton.upenn.edu/~keim/research/
ChangingInstitutionPreferences_21Aug2012.pdf, at p.4 See, also, The Conference Board, 2010 Institutional Investment Report: Trends in Asset Allocation and Portfolio Composition (November. 2010) (“Conference Board Report”).
2 U.S.-registered investment companies managed $13 trillion in assets for more than 92 million U.S. investors at year-end 2012. Investment Company Institute, 2012 Investment Company Fact Book, available at http://icifactbook.org/fb_ch1.html#americans.
3 Conference Board Report, supra note 1, p. 22.
4 U.S. Dep’t of Comm., Statistical Abstract of the United States 1968, 89th ann. ed., p. 456, table 653.
5 World Federation of Exchanges, http://www.world-exchanges.org/statistics/monthly-reports, Equity-1.1-Domestic market capitalization (last visited, April 11, 2013).
8 Market participants are often described as either “buy-side” or “sell-side”. Buy-side firms, like asset managers, buy financial products and services; while sell-side firms, like broker-dealers and investment banks, create and sell those products and services. When viewed in these simple terms, institutional investors are generally considered to be on the buy-side. However, mutual fund and asset management companies can also act like sell-siders when they market their own pooled-vehicles, whether directly or through broker-dealers.
11 Capital markets promote allocative efficiency when capital is allocated to its most productive uses. See, e.g., Dhananjay K. Gode And Shyam Sunder, What Makes Markets Allocationally Efficient?, Quarterly Journal Of Economics (May 1997) 604, 608-12.
12 William O. Douglas and George E. Bates, The Federal Securities Act of 1933, Yale Law Journal, Vol. 43, No. 2 (Dec. 1933), pp. 171-217, at 171.
13 Laura Casares Field and Michelle Lowry, Institutional versus Individual Investment in IPOs: The Importance of Firm Fundamentals, Journal of Financial and Quantitative Analysis, Vol. 44, No. 3 (June 2009), pp. 489-516.
15 Id., 490.
16 Id., 505-06. But Cf. Thomas J. Chemmanur, Gang Hu and Jiekun Huang, The Role of Institutional Investors in Initial Public Offerings, The Review of Financial Studies, Vol 23, No. 12 (2010), p. 4496 (suggesting that institutional investors possess significant private information about IPOs). Note: The term “private information” is used in economic theory to describe the relative position of participants in markets reflecting information asymmetry. There are many types of private information in economic theory that would not constitute “insider information” as contemplated by U.S. securities law. In those cases where an investor is trading on the basis of insider information (that is, material non-public information obtained in violation of a duty), law enforcement and regulatory authorities should investigate and, where warranted, take appropriate enforcement action.
17 Id., 510-12.
18 Id., 501. There is extensive literature on the ability of institutional investors to exploit private information and on the costs and benefits of monitoring by institutional investors. A substantive review of such research is beyond the scope of these remarks.
19 Pub. L. No. 112-106, 126 Stat. 306, 313 (2012).
20 Section 101(a) of the JOBS Act amends the Securities Act of 1933 to define "emerging growth company" as any issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year. An issuer that is an emerging growth company as of the first day of a fiscal year continues to qualify as such until (A) the last day of the fiscal year in which it has annual gross revenue of $1 billion or more, (B) the last day of the fiscal year following the fifth anniversary of its initial registered public offering, (C) such issuer has issued more than $1 billion in non-convertible debt over a three-year period, or (D) such issuer becomes a large accelerated filer (i.e., has a $700 million public float, measured as of the end of the company's most recent prior second fiscal quarter).
21 See, Statement of Lynn E. Turner before the Senate Committee on Banking, Housing, and Urban Affairs on Spurring Job Growth Through Capital Formation While Protecting Investors, Part II (March 6, 2012), at 12, citing Audit Analytics, available at, http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=5aaabb66-36eb-4b1e-8195-3cbeda832814.
22 Office of the Chief Accountant, Securities and Exchange Commission, Study and Recommendations on Section 404(b) of the Sarbanes-Oxley Act of 2002 For Issuers With Public Float Between $75 and $250 Million, available at http://www.sec.gov/news/studies/2011/404bfloat-study.pdf.
23 See, Letter from Cindy Fornelli, Center for Audit Quality, and Jeff Mahoney, Council of Institutional Investors, to the Hon. Spencer Bachus, Chairman, and the Hon. Barney Frank, Ranking Member, Committee on Financial Services, U.S. House of Representatives (November 29, 2011), available at http://www.aicpa.org/Advocacy/Issues/DownloadableDocuments/
404b/CAQ-CII_404_letter_11-29-11.pdf; Letter from Barry C. Melancon, AICPA, to Chairman Bachus, Ranking Member Frank, and the Hon. Scott Garrett, Chairman, and the Hon. Maxine Waters, Ranking Member, Subcommittee on Capital Markets and Government Sponsored Enterprises, U.S. House of Representatives (October 4, 2011), available at http://www.aicpa.org/Advocacy/Issues/DownloadableDocuments/404b/10_4_11-404SubcommitteeLetter.pdf.
24 U.N. Conf. on Trade and Development, Macroeconomic Policies to Promote Growth and Job Creation (New York, March 12-13, 2012), p.3. ("There is also a strong positive correlation between investment in fixed capital and employment creation in developed countries." Chart: Growth of Employment and Gross Fixed Capital Formation in Developed Countries, 1971—2010.) http://www.un.org/esa/ffd/ecosoc/springmeetings/2012/Unctad_BGNote.pdf.
25 Luigi Guiso, Paola Sapienza, and Luigi Zingales, Trusting The Stock Market, 63 The Journal of Finance, No. 6 (Dec. 2008), available at http://www.kellogg.northwestern.edu/faculty/sapienza/htm/trusting_stock.pdf. ("The decision to invest in stocks requires not only an assessment of the risk—return trade-off given the existing data, but also an act of faith (trust) that the data in our possession are reliable and that the overall system is fair.")
26 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 (2010) (the “Dodd-Frank Act”).
27 §951 Dodd-Frank Act (adding §14A of the Securities Exchange Act of 1934, which generally requires a shareholder vote to approve the compensation of executives disclosed pursuant to SEC regulations).
29 2011-12 Corporate Governance Update, RR Donnelley SEC Hot Topics Institute , slide 12 (“Companies with a significant “no” say-on-pay vote (e.g., 30% or more) should be wary of potential consequences of inaction in 2012 season), http://www.rrdonnelley.com/_documents/industry-solutions/financial_services/5_corporate_governance_sec_ht_irv2011.pdf. Cf. Institutional Shareholder Services Inc., 2011-2012 Policy Survey Summary of Results (September 2011), p. 13 (Asked, “At what level of opposition on a say-on-pay proposal should there be an explicit response from the board regarding improvements to pay practices?” 72% of the investors surveyed , and 40% of the issuers surveyed, said that the board should respond to “no” votes above 30%, or lower thresholds), available at http://www.issgovernance.com/files/PolicySurveyResults2011.pdf. See, also, Council of Institutional Investors, Say on Pay: Identifying Investor Concerns (September 2011), available at http://www.cii.org/files/publications/white_papers/
30 “Say-on-pay” and other regulatory changes may contribute to reduce the costs and/or increase the benefits of monitoring by institutional investors. I look forward to reviewing the results of research in this area, after economists have had an opportunity to study the effects of such provisions.
31 The important role of institutional investors in “say-on-pay” votes was implicitly recognized by Congress when it required large investment managers (that is, managers that exercise investment discretion for accounts holding certain equity securities having an aggregate fair market value of $100 million or more) to publicly disclose how they voted the shares over which they have voting power. See, Exchange Act §14A(d), which was added by §951 of the Dodd-Frank Act. This effort to shine a light on how investment managers vote recognizes that the institutions managed by such investment managers are using other people’s money. As Senator Carl Levin explained, “Empowering shareholders to track and analyze the votes cast by investment managers, using publicly available information, will enable them to determine whether the manager they use is voting in accordance with their wishes and, if not, which manager might be a better choice.” Sen. Levin, supra, note 27, at p. 4. Such disclosure should not be difficult or burdensome to provide. Mutual funds and closed-end investment companies are already required to provide a subset of this information at the fund level, pursuant to Rule 30b1-4 under the Investment Company Act, and Exchange Act Section 14A(d) expressly permits duplicative disclosures to be omitted. In accordance with the Congressional mandate, the Commission proposed a rule to facilitate investment manager reporting of say-on-pay votes. However, although this proposal was approved 2½ years ago, the Commission has yet to adopt such rule. Given the importance that Congress has placed on “say-on-pay,” this delay is unacceptable. I hope that adoption of the rule will be prioritized by the Commission’s new leadership.
32 Dan Fitzpatrick, et. al., J.P. Morgan Will Lobby for Dimon, The Wall Street Journal (April 6-7, 2013), B1.
34 Sean Di Somma, Senior Vice President, Alliance Advisors LLC, 2013 Proxy Season Preview: Key Shareholder Proposals, posted in The Harvard Law School Forum on Corporate Governance and Financial Regulation, http://blogs.law.harvard.edu/corpgov/2013/03/21/2013-proxy-season-preview-key-shareholder-proposals/ (last visited, Apr. 18, 2013).
35 Franklin Delano Roosevelt, undelivered Jefferson Day Address, scheduled for April 14, 1945, available at GeorgiaInfo, a website published by the Digital Library of Georgia, an initiative of the University System of Georgia, http://georgiainfo.galileo.usg.edu/FDRspeeches/FDRspeech45-1.htm. President Roosevelt died the next day.