The creation of the mutual fund will go down as one of the greatest innovations in financial history. It has provided tens if not hundreds of millions of unsophisticated and uninformed stock market investors with easy access to low cost portfolio diversification. Moreover, for those investors who do not want to spend time and money searching for portfolio managers who can earn excess risk-adjusted returns, passively managed index funds provide tremendous value.
But mutual funds also have their downside. They generate what Ronald Gilson and Jeffrey Gordon would call the “agency costs of agency capitalism.” Mutual funds generate these costs through the industry practice of delegating voting rights to mutual fund advisors. These advisors are also the ones who are contracted to manage the investments of the mutual funds. This delegation of voting rights allows for a stock market phenomenon that is rarely discussed in the press or in academic papers, the “empty voting” of mutual fund advisors. Empty voting is when persons or entities obtain “voting rights greater than their economic interest.” The risk is that empty voting will lead to a reduction in overall shareholder wealth as the empty voter uses its voting power to act opportunistically at the expense of shareholders. For example, a hedge fund that owns a significant number of shares in a company could also own so many put options on the company’s stock that it would have “negative economic ownership” and vote according to its negative economic interest.
The potential agency costs of this practice have only increased as voting power has become concentrated with the rise of the mega-mutual fund advisor: Blackrock, Vanguard, State Street Global Advisors, and Fidelity, etc. These mega-fund advisors now control, without having any economic interest in the underlying shares, the voting rights associated with trillions of dollars worth of equity securities. For example, as of December 31, 2016, Blackrock had over $5.1 trillion of assets under management, with a little over half of those assets being equity securities.
In a recent op-ed piece in the Wall Street Journal, Todd Henderson and Dorothy Shapiro Lund discuss how an activist hedge fund, acting with the support of the two leading proxy advisors, was allegedly impeded in moving forward on its proxy contest because several mega-mutual fund advisors balked at voting to support the hedge fund’s director nominees for fear that doing so would “threaten their ability to retain that company as a client for corporate retirement fund assets.” This conflict of interest, the desire not to offend management for fear of losing business, encompasses the conventional wisdom of how mutual fund advisors may use their empty voting power opportunistically and has been the subject of empirical study.
But there may be more to this empty voting story than just conventional wisdom. It can be argued that mega-mutual fund advisors have been drawn into an alliance with the shareholder empowerment movement on the issues of proxy access and dual class share structures created through IPOs like Snap Inc.’s, which resulted in a class of non-voting shares, simply because of the business opportunity such an alliance represents. That opportunity is to attract or retain the business of public pension funds and union related funds (which control approximately $3 trillion in assets), the institutional leaders in the shareholder empowerment movement, which are shifting their portfolios away from high cost, actively managed mutual funds and hedge funds to low cost indexed funds, the kind of funds that the top 10 largest mutual fund advisors dominate in terms of market share.
The shareholder empowerment movement advocates shifting corporate decision-making authority to shareholders, and thus away from boards of directors and executive management, without regard to the impact on the decision-making of public companies. Shareholder empowerment, not shareholder wealth maximization or enhanced company performance, is the objective of this movement. Therefore, this alliance cannot be understood as being wealth maximizing for mutual fund investors.
Moreover, this alliance puts mega-mutual fund advisors in very awkward advocacy positions. For example, given the voting power they have gained from being empty voters, it is quite ironic that mega-mutual fund advisors have joined forces with the shareholder empowerment movement in its advocacy of a “one share, one vote” policy and, more specifically, in its call for the elimination of dual class share structures. Yes, mega-mutual fund advisors have the one vote, millions if not billions of them, but no share ownership. This is a classic example of the pot calling the kettle black.
More generally, when mega-mutual fund advisors join forces with institutions that represent the shareholder empowerment movement in its advocacy for certain types of corporate governance arrangements, such as proxy access, they become what many board of directors fear the most, a wolf pack, i.e., a “loose network[s] of parallel-minded shareholders … that act together to effect change in a given corporation [or private ordering in general] without disclosing their collective interest.” Unlike activist hedge funds, the mega-mutual fund advisors that make up a wolf pack do not have significant ownership stakes in the companies they target for advocacy, creating the risk that they will use their voting power opportunistically and not with the objective of making sure the most value enhancing governance arrangements are implemented or maintained.
The power of this wolf pack is enhanced by having a leader(s), the institution(s) that represents the shareholder empowerment movement. In cases where the advocacy is for a one-size-fits-all change in private ordering, such as with dual class share structures, that leadership is provided by the Council of Institutional Investors (CII), the trade organization that represents public pension funds and union related funds. Given such significant voting power and leadership, boards, stock exchanges, index providers and the U.S. Securities and Exchange Commission (SEC) will be hard pressed to overcome the power of this wolf pack’s advocacy.
If this alliance between mutual fund advisors and the shareholder empowerment movement is allowed to stand without challenge, then public companies will be pressured into more and more sub-optimal corporate governance arrangements. Ironically, there will then be a greater and greater need for dual class share structures, even when they are not being used to protect the “idiosyncratic vision” of a company’s founders. Instead, they will be used to protect against the sub-optimal arrangements that would be forced upon them as public companies.
How to address the empty voting of mutual fund advisors will be one of the great corporate governance challenges of the foreseeable future. It is not unreasonable to argue that the empty voting of mutual fund advisors needs to be limited. Such voting power is not warranted when it does not come with equivalent economic ownership.
This post comes to us from Bernard S. Sharfman, who is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, a visiting professor at the University of Maryland School of Law (Spring 2018), and a former visiting assistant professor at Case Western Reserve University School of Law (Spring 2013 and 2014). Mr. Sharfman’s articles on corporate law and governance can be found here.