Does block ownership by pension service firms impact corporate governance?

The paper specifically looks at block ownership, meaning any institution owning more than five per cent of a company’s stock. “In the past two decades, this has become more and more widespread if you look at ownership structures of a firm. As a matter of fact, about 96 per cent of U.S. companies have at least one blockholder as their shareholder,” says Zhi Jay Wang, an associate professor at the University of Oregon and one of the paper’s authors.

The trend has led researchers to consider what drives institutional investors to build out block holdings in a company and, once they become blockholders, what the implications are for the portfolio company’s corporate governance, he notes.

In a nutshell, institutional investors can build block ownership purely for investment purposes to achieve capital gains or they can do it for private contracting benefits because some block institutions may have private contracting relationships with the firm in which they’re investing.

Firms may also choose both reasons, adds Wang.

The different reasons for investment have different implications for corporate governance. For example, if an investor is building block ownership for investment reasons, they may be incentivized to monitor the management more closely, Wang says. “In that case, they can improve corporate governance.”

However, if the investment is for private benefits, the investor may compromise corporate governance because they want to keep the private contract with the company.

In particular, the research looked broadly at service providers using the definition from Form 5500 that must be filed with the U.S. Department of Labor if the provider is receiving at least $5,000 from the company. It included contract administration, investment managers, legal counsel, record keeping, accounting, consulting and trusteeship.

The paper looked at 2006 changes to U.S. legislation that removed restrictions on auto-enrolment, which led to many companies significantly expanding their 401(k) plans. Using this event as a shock to the normal course of business helped the researchers draw inferences about whether the block ownership could be tied to the pension plan, which would regularly be very hard to determine.

“You can see the logic,” says Wong. “We do not directly observe their investment decision. But we are trying to infer through some observations, which may be consistent with this line of decision-making process.”

Private contracting benefits attract pension service providers to build up ownership blocks in companies, according to the paper. “And we also show that if you build up a large block ownership in the company that indeed increases your likelihood of obtaining pension service contracts in the future with the company,” he says.

On the bright side, the researchers also found that, even if a pension service provider becomes a blockholder in a portfolio company, its corporate governance role isn’t compromised, on average.

More specifically, the report found these block holdings are associated with higher chief executive officer pay and lower CEO turnover following poor performance, yet there isn’t any evidence suggesting large pension block holdings are associated with declining firm profitability.

These blockholders have dual incentives, Wang says. “On the one hand, they do probably have some motivation to protect their pension service contracting benefit. On the other hand, they also have incentive to protect their investment value.”

Regardless of the underlying motivation for building up block ownership, he adds, the owner is still a big shareholder and has every incentive to protect the value of its investment and ensure the stock doesn’t depreciate too much.

The paper was also authored by Jing Huang, assistant professor at the Virginia Polytechnic Institute and State University, and Steven Matsunaga, a professor at the University of Oregon.