According to the Securities and Exchange Commission (SEC) release establishing the Proxy Voting Rule, an investment adviser “is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting.” This was the rationale behind the rule, which requires investment advisers, including mutual fund advisers, to create and disclose their proxy voting policies and procedures. However, the SEC and its staff have yet to clarify what these fiduciary duties mean for the largest mutual fund advisers now that they control an extraordinary amount of shareholder voting power at many of our largest public companies. This phenomenon did not exist at the time the Proxy Voting Rule was implemented in 2003.
This concentration of voting power creates significant value for an adviser if it can be traded for something that the adviser wants. For example, an adviser may use its voting power to support the activism of current and potential institutional clients in exchange for the ability to acquire more assets under management. The result is that an adviser has not cast its delegated voting authority “in a manner consistent with the best interest of its client” and has subrogated the “client interests to its own,” a breach of its fiduciary duties to its mutual fund clients and its shareholders.
The Changing World of Proxy Voting
The Proxy Voting Rule was promulgated to address concerns that an investment adviser may vote its own preferences, not the preferences of its funds and their shareholders. The original concern was that advisers would in some situations be reluctant to vote against management for fear of impairing their ability to maintain or obtain their pension plan business. Or, an adviser may use its vote opportunistically when “the adviser may also have business or personal relationships with other proponents of proxy proposals, participants in proxy contests, corporate directors or candidates for directorships.” However, the world has changed since the Proxy Voting Rule first went into effect. Currently, an unprecedented concentration of voting power now resides in the hands of our largest mutual fund advisers. For example, BlackRock, Vanguard, and State Street Global Advisors (the Big Three) control enormous proxy voting power without having any economic interest in the shares they vote. According to Shenkar, Heemskerk, and Fichtner, this concentration of power was and is being caused by a large shift from actively managed equity funds to equity index funds:
In contrast to the fragmented and sizeable group of actively managed mutual funds, the fast-growing index fund sector is highly concentrated. It is dominated by … BlackRock, Vanguard and State Street …. Together they stand for a stunning 71 percent of the entire Exchange Traded Fund (ETF) market and manage over 90 percent of all Assets under Management … in passive equity funds…. Seen together, the Big Three are the largest single shareholder in almost 90 percent of all S&P 500 firms, ….
This new concentration of voting power is the unintended consequence of the industry practice of centralizing the voting of mutual funds into the hands of their adviser’s corporate governance department. In essence, not only would portfolio management be delegated to the mutual fund adviser, but also the voting of proxies. I refer to this as the “empty voting of mutual fund advisers.” That is, they have the voting rights but not the economic interest in the underlying shares.
Advisers Subrogating the Interests of Mutual Funds and Their Shareholders
Such a concentration of power always brings with it the potential for abuse. It is easy to envision new scenarios where this voting power can generate significant value for the adviser if it decided to vote in a certain way, whether or not it is in the best interests of its clients to do so. In essence, the large mutual fund adviser will be tempted to breach its fiduciary duties and monetize or take special advantage of the delegated voting power it has accumulated.
One scenario where a large mutual fund adviser may be tempted to monetize its newly found voting power is to vote in unison with public pension and union-related funds, such as on shareholder proposals these funds initiate or promote, if it will lead to bringing more assets under management. Public pension funds control approximately $4.2 trillion in assets, a prime target for a mutual fund adviser looking to increase the size of its equity index funds. Since the objective of an index fund is not to beat the market, but simply to match it, increasing profitability through increased assets under management is a critical business strategy for the adviser.
Another scenario is where a mutual fund adviser may utilize its delegated voting power to appease shareholder activists who attack the business decisions, procedures, and objectives of the adviser’s management. For example, in early 2017, both BlackRock and Vanguard (two of its equity funds received the proposals, 500 Index Fund and Total Stock Market Index Fund) received shareholder resolutions from Walden Asset Management requesting a review of their proxy voting policies and practices related to climate change. Yet, the clear intent of the proposals was not just to review but to encourage the advisers to be a stronger supporter of climate change proposals. In sum, the submitted proposals were intended to dictate to both BlackRock and Vanguard how they were to fulfill their fiduciary duties under the Proxy Voting Rule.
It appears that the tactic worked. Walden Asset Management withdrew both proposals in return for commitments by the companies to address the request. Moreover, both companies started to support 2-Degree Scenario Proposals, something neither company did prior to 2017.
Voting Policies on Shareholder Proposals
Shareholder proposals provide a significant opportunity for mutual fund advisers to abuse their voting power. Unfortunately, many of these proposals have nothing to do with shareholder wealth maximization and may ultimately end up having a negative impact on shareholders. A recent study by Kalt and Turki found that the adoption of climate change resolutions “has no statistically significant impact on company returns one way or the other.” Matsusaka, Ozbas, and Yi found that labor unions use shareholder proposals as bargaining chips to extract side payments from management. Matsusaka, Ozbas, and Yi, in a separate paper, found that the stock market reacted positively when the SEC permitted shareholder proposals to be excluded.
This lack of connection between shareholder proposals and shareholder wealth maximization is an issue that all retail investors must be concerned about. Shareholder proposals, if implemented subsequent to a shareholder vote or prior to through the process of engagement, while perhaps not reducing shareholder wealth, may at best do nothing to enhance it. If so, then wealth maximizing opportunities may be foregone as finite company resources are devoted to responding to and subsequently implementing these proposals.
In a proxy voting world where voting is dominated by a handful of extremely large investment advisers, the commission should provide clarification that mutual fund advisers must disclose in their voting policies, consistent with the Proxy Voting Rule’s requirement that they vote proxies in the best interests of their clients, the procedures they will use to deal with the temptation to use their voting power to retain or acquire more assets under management and to appease activists in their own shareholder base.
In addition, shareholder proposals are a prime area where this opportunistic use of an adviser’s voting power may be in play. Therefore, mutual fund advisers must disclose the procedures they will use to identify the link between support for a shareholder proposal at a particular company and the enhancement of that company’s shareholder value.
Finally, consistent with these new disclosures and procedures, the commission should clarify that voting inconsistent with these new policies and procedures or omission of such policies and procedures will be considered a breach of the Proxy Voting Rule. I urge the SEC to be diligent in enforcing all breaches of the Proxy Voting Rule. While enforcement most clearly applies to the Big Three mutual fund advisers, it should also apply to any mutual fund adviser that has delegated voting authority.
 17 C.F.R. § 275.206(4)-6. The Proxy Voting Rule was promulgated under the Investment Advisers Act of 1940, 15 U.S.C. 80b-6.
 Carmel Shenkar, Elke M. Heemskerk & Jan Fichtner, The New Mandate Owners: Passive Asset Managers and the Decoupling of Corporate Ownership, CPI Antitrust Chron. 51 (Volume 3, June 2017), https://www.competitionpolicyinternational.com/wp-content/uploads/2017/06/CPI-Shenkar-Heemskerk-Fichtner.pdf. See also, Jan Fichtner, Eelke M. Heemskerk and Javier Garcia-Bernardo, Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk, 19 Bus. & Pol. 328.
 Proxy Voting by Investment Advisers, Investment Advisers Act Release No. IA-2106.
 See Shenkar, Elke M. Heemskerk & Jan Fichtner, supra note 3.
 Bernard S. Sharfman, Mutual Fund Advisors’ “Empty Voting” Raises New Governance Issues, Colum. L. School: Blue Sky Blog (July 3, 2017), https://clsbluesky.law.columbia.edu/2017/07/03/mutual-fund-advisors-empty-voting-raises-new-governance-issues/.
 Walden Asset Management, Review and report on ESG proxy voting (BLK, 2017 Resolution), https://engagements.ceres.org/ceres_engagementdetailpage?recID=a0l12000005OdxTAAS.
 Vanguard Funds, Preliminary Proxy Statement (August 21, 2017), https://www.sec.gov/Archives/edgar/data/34066/000093247117004594/pre14aproxystatement.htm.
 Rob Berridge, Ceres, Four Mutual Fund Giants Begin to Address Climate Change Risks in Proxy Votes: How About Your Funds? (Dec. 21, 2017), https://www.ceres.org/news-center/blog/four-mutual-fund-giants-begin-address-climate-change-risks-proxy-votes-how-about.
 Walden Asset Management, Review and report on ESG proxy voting (BLK, 2017 Resolution), https://engagements.ceres.org/ceres_engagementdetailpage?recID=a0l12000005OdxTAAS; Vanguard Funds, Preliminary Proxy Statement (August 21, 2017), https://www.sec.gov/Archives/edgar/data/34066/000093247117004594/pre14aproxystatement.htm.
 Berridge, supra note 13.
 Joseph P. Kalt and Adel Turki et al., Compass Lexecon, Political, Social, and Environmental Shareholder Resolutions: Do They Create or Destroy Shareholder Value? (June 2018), https://mainstreetinvestors.org/wp-content/uploads/2018/06/ESG-Paper-FINAL.pdf.
 John G. Matsusaka, Oguzhan Ozbas, and Irene Yi, Opportunistic Proposals by Union Shareholders (July 8, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2666064.
 John G. Matsusaka, Oguzhan Ozbas, and Irene Yi, Can Shareholder Proposals Hurt Shareholders? Evidence from SEC No‐Action Letter Decisions (June 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2881408.
This post comes to us from Bernard S. Sharfman, chairman of the Main Street Investors Coalition Advisory Council, an associate fellow of the R Street Institute, and a member of the Journal of Corporation Law’s editorial advisory board. It is based on a comment letter, available here, that he sent to the SEC in connection with its Staff Roundtable on the Proxy Process. The opinions expressed here are the author’s and do not represent the official position of the Coalition or any other organization with which he is affiliated with.