Are Board Directors Infectious Agents?
In an attempt to improve their governance, mutual funds install independent boards, partly by recruiting executives from publicly-traded firms. But Paul Calluzzo, assistant professor of finance at Queen’s School of Business, says that in doing so, fund interests shift away from the shareholder and toward the director’s private interests. He found that funds held about 25 percent larger stakes in the directors’ firms. When the fund bought stock in these firms, it earned an abnormal return of 2.07 percentage points over the following quarter, and when it sold the stock it underperformed by 3.76 percentage points over the following quarter. As well, Calluzzo found that, through director control of proxy voting, mutual funds are more likely to cast votes that support the management of the firms that employ the directors. Calluzzo suggests that independent directors introduce either good or bad governance habits to mutual fund boards depending on the experience with their own firms, a process he terms “governance contagion.”
A decade ago, the mutual fund industry had a serious reputation crisis on its hands. In 2003, a number of U.S. funds were charged with illegal late trading and market timing practices. A year later, in relatively clean and sober Canada, the Ontario Securities Commission probed a number of high-profile mutual funds for market timing violations.
In an attempt to improve governance and protect shareholder interests, mutual funds began installing more independent boards, often by recruiting executives from publicly-traded firms. Over the past decade, the percentage of mutual fund boards with more than 75 percent of board seats held by independent directors increased to 88 percent from 52 percent. But this trend seems to have created a new set of problems.
In a series of studies, Paul Calluzzo, assistant professor of finance at Queen’s School of Business, found that these seemingly independent directors, besides overseeing fiduciary aspects of the funds, also influence investment decisions and undermine shareholder interests via the proxy voting process.
His results suggest that when funds and publicly-traded firms connect through a dual-employed director, “fund interests shift away from shareholder interests and toward the director’s private interests.”
Calluzzo’s studies are based on a painstakingly built dataset. He developed a web crawler algorithm that searched more than 130,000 mutual fund filings with the U.S. Securities and Exchanges Commission (SEC) for the names of corporate directors who were also executives of outside firms. This process identified 856 fund-firm director connections from the period 1994 to 2011. He also hand-collected information about fund directors’ employment history.
Funds Take Big Stakes in Directors’ Firms
In one study using this dataset, Calluzzo found that, on average, 17 percent of mutual funds were director-connected to at least one Standard & Poor’s 1500 firm. And this connection was not benign. He found that mutual funds concentrated their holdings and traded profitably in the stock of the director's firm. Funds held about 25 percent larger stakes in these firms. When the fund bought the shares, it earned an abnormal return of 2.07 percentage points over the following quarter, and when it sold the shares it underperformed by 3.76 percentage points over the following quarter. When a director changed jobs, the mutual funds increased their holdings in the stock of the newly-connected firm.
“This result suggests that director connections cause funds to bias their holdings towards the stock of the connected firms,” says Calluzzo.
Both the fund managers and directors recruited from publicly-traded firms benefit from this arrangement. The mutual fund taps the executives' inside information about their firms, giving them an edge when making investment decisions. The directors boost their careers by holding a prestigious and profitable board position; in the U.S., fund directors earn on average $258,000. (Former SEC chairman Arthur Levitt once said that being on a mutual fund board “is the most comfortable position in corporate America.”) Calluzzo found that the more profitably a fund trades in a connected stock, the more likely the director will retain his or her board appointment at the fund.
Proxy Votes Work Against Shareholders
One way that directors may extend their influence on fund behaviour is through proxy voting. Fund directors oversee proxy votes of mutual funds on behalf of the fund’s shareholders. Shareholders rely on the voting process to discipline poor management and to influence the investment and acquisition policies of the firm.
A 2014 study that Calluzzo co-authored with Simi Kedia (Rutgers University) found that, while directors are legally bound to represent shareholder interests, this can be challenging when they are forced to cast votes on issues that affect their personal interests or the interests of their firms.
“Fund directors act as vectors, transmitting governance attributes from their primary place of employment to the fund”
Calluzzo and Kedia found that mutual funds are more likely to cast votes that support the management of the firms that employ the directors. “Results suggest that dual-employed directors can cause management-friendly voting, and we found that this is concentrated in proposals that directly impact the directors’ private interests.”
When searching for an explanation for why poor governance still dogs the mutual fund industry, Calluzzo sees a possible answer in epidemiology. He suspects that independent directors introduce either good or bad governance habits to mutual fund boards that they bring from their own firms, a process he terms “governance contagion.”
Vectors of Governance Disease
“Fund directors act as vectors,” he says, “transmitting governance attributes from their primary place of employment to the fund.”
To test this idea, Calluzzo worked with G. Nathan Dong (Columbia University) on a study using his original dataset as well as data on governance quality of firms (using markers such as litigation record and shareholder rights).
They found that mutual fund boards dominated by independent directors with ties to the financial industry, shareholder-unfriendly firms, and shareholder-unfriendly funds were all associated with negative fund governance. “This result suggests a director’s employment network (his prior and current employment outside the fund) plays a role in propagating business malpractice,” says Calluzzo.
Good governance, however, is also contagious. Directors connected to well-governed firms and firms outside the finance industry were shown to have a positive influence on fund governance.
So what should be done about director-related governance issues in the mutual fund industry? Is more regulation needed? Calluzzo demurs. “As we have demonstrated, regulatory changes need to be considered carefully, as they can have unintended consequences.”
— Kirsteen MacLeod