From time to time I am asked to explain how I can support the disproportionate voting found in dual class shares while at the same time strongly criticizing the 'empty voting' of mutual fund advisors. While both are corporate governance issues that need to be addressed separately, both do involve the same phenomenon, the ability of certain shareholders to obtain voting power that is much greater than their economic interest.
Here is how I differentiate between the two:
Dual class shares (shares with unequal voting rights) arise when the board of directors of a company decides to raise capital through the sale of newly issued shares, but wants one or more insiders, who may be giving up economic control through the issuance of the shares, to retain voting control in the company. Typically, this occurs in an initial public offering (IPO), but it can also occur before. In an IPO, a company will usually issue a class of common stock to the public that carries one vote per share (ordinary shares), while reserving a separate class, a super-voting class, that provide insiders with at least 10 votes per share. However, both types of shares will have equal rights to the cash flow of the company. The issuance of dual class shares may create a wide gap between voting and cash flow rights over time, especially if the insiders periodically sell a significant amount of their ordinary shares.
But this is the critical point. A dual class share structure cannot exist without the permission of those shareholders who are purchasing the ordinary shares at the price offered. The bargaining process that leads to the issuance of dual class shares is referred to as 'private ordering'. As I discuss in my recent paper on dual class shares, the ability to engage in private ordering is value enhancing for shareholders:
Private ordering is considered efficient and desirable because it allows for the implementation of market-driven corporate governance arrangements. That is, it allows the internal affairs of each corporation to be tailored to its own attributes and qualities, including its personnel, culture, maturity as a business, and governance practices. In effect, observed governance choices are the result of value-maximizing contracts between shareholders and management. (citations and quotation marks omitted)
Thus, the issuance of dual class shares is simply the result of the bargaining process that leads to the most preferred corporate governance arrangements in a specific company.
By contrast, the empty voting of mutual fund advisors is not a firm specific corporate governance arrangement that results from private ordering.It is the consequence of the industry practice of centralizing the voting of mutual funds into the hands of their advisor’s corporate governance department. As a result of this delegation of voting authority, mutual fund advisors have the voting power, but not the economic interest in the shares that they vote.
When mutual funds were a relatively small part of the investing market, this was not a significant problem. However, as the mutual fund industry has continued to grow at a rapid pace, especially in the form of index funds, this empty voting has created an enormous concentration of delegated voting power. For example, Blackrock, Vanguard, and State Street Global Advisors (the Big 3) now control, without having any economic interest in the underlying shares, the voting rights associated with trillions of dollars worth of equity securities.
This success has given rise to an unintended consequence. With all this voting power, how a particular mutual fund advisor votes can easily determine whether or not a shareholder proposal passes, if a nominated director receives the majority of votes, or if a proxy contest succeeds or fails. If so, then it is easy to envision scenarios where this voting power can generate significant economic value for the advisor if it decides to use its power to act opportunistically for its own interests, not necessarily the interests of its mutual fund investors.
For example, an advisor may be tempted to act opportunistically when an advisor is also a company’s retirement plan administrator and is very hesitant to vote against management for fear of losing the company’s business. This is one of the reasons why the SEC implemented its proxy voting rule for investment advisors back in 2003. Or, an advisor may be tempted to support public pension funds in their efforts to remove dual class shares from being listed on stock exchanges if it will lead to bringing more public pension fund assets under management. For the same reason, advisors may support proxy access proposals initiated by public pension funds. Or, advisors may try to avoid confrontation with their own shareholder activists by being more supportive of social responsibility proposals, such as those dealing with climate change, than they would otherwise.
The above are examples of advisors converting their voting power into economic value. They are also examples of how advisors may breach the fiduciary duty they owe to their mutual fund investors. As fiduciaries, these kinds of considerations should never interfere with how an advisor votes.
Dual class shares are a value maximizing result of a specific firm’s private ordering of corporate governance arrangements. They are only agreed to when it is expected to result in a successful offering to new investors. In contrast, empty voting has become a new systemic risk for all those who invest in the equities of US public companies and for public companies in general. It is an agency cost that needs to be addressed and controlled.
Bernard S. Sharfman is a Visiting Assistant Professor at the University of Maryland School of Law, an Associate Fellow of the R Street Institute, and a member of the Journal of Corporation Law’s editorial advisory board.
This post was originally published on the Conference Board's Corporate Governance Blog on 2 July 2018.