Due to the rapid growth of passive indexing, three large fund families – Vanguard, BlackRock, and State Street – are now the de-facto arbiters of U.S. corporate law controversies. In 9 out of 10 publicly-traded companies, one of the ‘Big Three’ is the largest shareholder. Passive funds will soon own the majority of all U.S. equity assets, and the way they vote their proxies will effectively be the ‘last word’ in corporate governance.
As a result of this phenomenon, two seismic shifts in corporate governance are underway. The first is an unprecedented concentration of voting power in the hands of these few large shareholders. Indeed, passive indexing has concentrated the power of dispersed investors to such a degree that it is beginning to challenge long-held assumptions about the separation of ownership and control. Due to their dominance, Big Three proxy voting ‘guidelines’ essentially become market-wide governance standards, which issuers ignore at their peril. Thus, indexation has concentrated shareholder power to such an extent as to potentially upend the balance of power assumed in a Berle-Means corporation.
At the same time, there is an ongoing transformation in who wields that voting power. Traditionally, voting power has been tied to an investment in an issuer’s shares, and, as such, investors have had a direct voice in the companies in which they invest. Because index fund investors are not entitled to engage in the proxy voting process, the growth of index funds has disrupted the alignment between ownership and control. This means that funds may vote proxies with considerable discretion, subject only to the constraint that they vote ‘in a manner consistent with the best interests of the fund and its shareholders’ (see here). However, it appears that funds are largely free to vote as they see fit, even on contentious and binary issues – for instance, if a vote against gender diversity on the board is just as valid as a vote for the same, then the ‘best interests’ standard is, at best, a weak constraint. Individual investors are left with little to no ability to shape corporate decision making.
Together, these phenomena have resulted in something of a paradox: individual index fund investors have essentially no power to shape corporate governance, while index funds themselves arguably have too much power over corporate governance.
In order to address these two problems, I propose here that index funds take steps to incorporate the input of their investors when making corporate governance decisions. Because it would be irrational for individual index fund investors to engage with the tens of thousands of ballot items at issue in the thousands of companies in which they invest, I propose a variety of alternatives.
The first option would give individual investors the ability to elect to have the votes corresponding to their indirect share ownership cast according to the recommendations of a particular agent (such as the index fund provider, portfolio company management, a particular proxy adviser, or another institutional investor). This ‘indirect democracy’ option would allow investors a simple way to align themselves with another party who broadly shares their views or values. Because the proxies belong to the index fund, and there is thus no ‘solicitation’ of a proxy, this proposal would sidestep many of the burdensome legal and regulatory requirements that hampered similar efforts in the past, such as Moxy Vote. Although the indirect democracy would, by definition, not allow issue-specific investor input, it would substantially enhance investor voice and help mitigate the concentrated power of index funds. Such a change could be mandated through regulation, or it could arise through the private market as a way to differentiate a fund from its competitors.
Under the second option (‘informed discretion’), index fund providers would seek more information about the characteristics and values of their investors, which funds would use to better inform their voting decisions. Under this approach, funds would solicit input on general investor information and values, which would then be interpreted by the fund and used to inform its voting. Specifically, such information could be utilized in one of two ways. First, it could be used to inform the way a fund votes all of its proxies (winner-take-all), since many fund families vote in an essentially unitary manner. Alternatively, it could be used to vote proxies proportionately according to the views of a fund’s investors. Both sub-methods would reduce the discretion of fund advisors and make voting more responsive to investors.
Finally, fund investors could be given even greater control by implementing ‘pass-through voting instructions’. Such instructions would be analogous to ‘standing voting instructions’ in the context of retail investor voting (as discussed by Jill Fisch and others), but, because the proxies belong to the funds themselves, pass-through voting instructions would sidestep many of the legal and regulatory hurdles that have prevented implementation in the context of direct ownership. Indeed, funds could implement this option today without any legislative or regulatory change. Investors could create pass-through voting instructions by completing an issue-based survey about how they desire to vote on a number of key corporate governance issues (for instance, when they created an account with their chosen fund provider). Survey response would effectively bind fund advisors in voting on company-specific questions—as fiduciaries, index funds would be hard-pressed to argue that they were voting in an investor’s ‘best interest’ when the investor had expressly stated otherwise. While index fund investors may be rationally apathetic about any one of the many thousands of shareholder votes held each year, the opportunity to ‘vote’ in an issue-based manner (analogous to how index funds already vote, given their heavy reliance on generic voting guidelines) would make investor engagement drastically more efficient.
Each of the proposals entails minor costs, such as costs associated with developing and administering a survey. Automating voting according to investor input would entail some cost, but sophisticated proxy voting technology is already used by institutional investors - currently it is used by funds to automate voting according to their own guidelines rather than any expressed preferences of their investors. Additionally, some investors may be happy to pay a few basis points in fees to have a say in voting. The potential for competition on something other than fees could spur welcome new entrants into the index fund space.
The above proposals could help decrease investors’ rational apathy towards voting, make the proxy voting process more responsive to the concerns of ultimate investors, help reduce agency costs, and mitigate the concentrated (and growing) governance power of index funds. Moreover, each of them could be implemented today, with no legislative or regulatory changes.
With passively-indexed investments set to overtake active investments in the very near future, now is a crucial time to shape how those funds wield their corporate governance power. Involving the owners of the majority of all equity assets in the voting process is essential if we are to maintain a robust shareholder democracy in this new era of indexation.
Caleb N. Griffin is Assistant Professor at Regent University School of Law, US.