The realization-based capital gains tax in the United States – that is, taxes are paid on gains on assets like stocks only when they are sold – has been shown to influence investor behavior and financial markets. For example, mutual fund managers are more likely to sell stocks that have fallen than have risen, particularly those with tax-sensitive investors, consistent with tax-motivated trading. Also, the higher-than-average return of stocks in the month of January has been in part attributed to individual investors dumping losing shares in the month of December (with the subsequent price rebound when selling pressure subsides in the new tax year). Capital gains lock-in was even cited on ESPN as a reason why Donald Sterling would not want to sell the Clippers for $2 billion (because most of the $2B would be gains that would be taxed upon sale). That’s right, capital gains taxes on ESPN!
In a recent paper, “Capital Gains Lock-In and Governance Choices,” NBER Working Paper 20176 (May 2014), Stephen Dimmock, Will Gerken, Zoran Ivković and I consider whether capital gains taxes may also play a role in whether an important class of shareholders, mutual funds, monitor a firm’s management. Over the last thirty years, the share of U.S. equity held by mutual funds has grown drastically, accounting for roughly a third of total U.S. equity (French (Journal of Finance, 2008)). Despite this growth, we know relatively little about the governance activities of mutual funds. Our study investigates one channel that may influence the governance activities of this growing shareholder group – the capital gains lock.
A mutual fund faces a dilemma when considering how to vote on a proposal for which the fund believes that opposing management is likely value-enhancing for shareholders. We define such “contentious” votes as votes for which Institutional Shareholder Services (ISS), an advisor on corporate governance issues, recommends that a vote against management is in the interests of shareholders. The mutual fund must weigh the potential value created by opposing the firm’s management on a contentious proposal against the potential costs of providing governance (such as lost retirement plan business with the firm or access to information).
Another consideration, relevant for mutual funds with tax-sensitive investors and a capital gain on a stock, is that exiting a position, rather than “staying and fighting” the firm’s management, would impose tax costs on the funds’ investors. Thus, for a position with an unrealized capital gain, mutual funds with taxable clientele must trade off these countervailing forces.
We find that capital gains lock-in is indeed related to funds’ willingness to oppose management on contentious proposals at annual shareholder meetings, with this effect much stronger for mutual funds with more tax-sensitive investors. Thus, a mutual fund locked-in to a position for tax reasons seems to be more likely to stay around and oppose management because the capital gains tax provides an incentive to hold a position with an accrued gain even if the fund is not fully enamored with the firm’s management. There are two related reasons for this. First, because exit from a holding with a gain is more costly for funds with tax-sensitive investors, the fund’s investment horizon increases and the fund can benefit from the long-term value created by the corrective action they take through their voting. Second, funds that are not locked-in and that continue to hold the position are more likely aligned with management than funds holding the stock because exit would trigger a tax liability for investors. Thus, funds with larger accrued gains in a stock and with a tax-sensitive clientele may be more likely to oppose management on contentious votes because the lock-in effect, rather than an affinity for management, causes them to continue holding the stock in the first place. Thus, for funds that are locked into a holding for tax reasons, a pragmatic alternative to sale is actively monitoring the firm while continuing to hold the stock.
Finally, the effect of capital gains lock-in on voting has important implications for the firm, that is, the effects on mutual fund voting behavior at shareholder meetings is large enough to materially affect the outcome of the vote as well the type of proposals that are put up for vote on the meeting agenda in the first place. Specifically, the presence of accrued capital gains among mutual funds with taxable investors leads to a higher likelihood of a vote outcome against management and a lower likelihood of a contentious proposal being voted on at the meeting in the first place. In sum, our results thus show one determinant of corporate governance by mutual funds, operating through the tax-induced capital gains lock-in channel. As open-end mutual funds continue to own an increasingly larger fraction of total U.S. equities, mutual funds’ decisions regarding whether to exit, stay and support, or stay and fight a firm’s management will be an increasingly important component of corporate governance.
Professor of Finance and James F. Towey Faculty Fellow
EMBA Professor of Investment Finance