The Push Towards Corporate Guidelines

In recent years, there has been a debate in the corporate world about the capabilities and incentives of institutional investors to invest in corporate stewardship – defined as monitoring, voting, and engagement – of their portfolio companies. The main focus has been on mutual funds, which hold most of the assets of institutional investors.

According to conventional wisdom, which finds support in theoretical and empirical studies, institutional investors are not active stewards for four reasons. First, managers of mutual funds have poor incentives to invest in active stewardship because of their compensation structure – a tiny fixed percentage of assets under a fund’s management, with no consideration of performance – and because of free-rider concerns. Second, the stewardship budgets and staff of mutual funds, including the three largest funds – BlackRock, State Street and Vanguard – are too small for them to invest in informed voting and engagements at the thousands of corporations in their portfolios. Third, mutual funds and other types of institutional investors have business ties with the corporations in which they invest, and so active intervention in those corporations may lead to confrontations that jeopardize those ties. Fourth, and relatedly, managers of corporations wield political power, and confrontations with those managers may cause a political backlash against institutional investors. This concern is especially acute in light of recent criticism against the largest mutual funds and calls to further regulate their activities.

Meanwhile, passively managed funds – index mutual funds and exchange traded funds (ETFs) – run by the likes of BlackRock, Vanguard and Fidelity have been gaining popularity. Unlike active mutual funds that pick stocks, index funds are designed to replicate the return of a selected index (e.g., S&P 500) and minimize any tracking error with low fees. As a result, investment in active stewardship is not aligned with the business model of passive funds.

All these factors have prompted calls for regulatory reform of corporate stewardship.

There has, however, been little attention given to what I term “passive stewardship.” This term reflects institutional investors’ use of proxy voting guidelines that they publish annually and letters that outline their priorities, views, and philosophy. This term also reflects principles, standards, and general statements published by organizations and groups of institutional investors, such as the Council of Institutional Investors (CII) and the Institutional Stewardship Group (ISG) (collectively “corporate guidelines” or “investors’ corporate guidelines”).

Large institutional investors publish their corporate guidelines not only to inform their own voting at the shareholder meetings of their portfolio companies but also to communicate with the management of those companies. Through corporate guidelines, institutional investors convey their priorities, views, and philosophy regarding corporate governance and related issues and their expectations for their portfolio companies on those issues. The issues relate to boards and directors, audits, capital structure, mergers and asset sales, executive compensation, environmental and social matters, and shareholder rights and protections.

Institutional investors use corporate guidelines, first, to strike a balance between their strict fiduciary duties and their need to be cost-effective. Institutional investors are subject to legal and regulatory duties to vote in thousands of shareholder meetings in a way that reflects the best interests of their clients. This is a colossal burden. Relatedly, given their enormous power, institutional investors are expected to act as responsible “corporate citizens.” Hence, they cannot disregard their stewardship duties. This is especially true given the harsh criticism of institutional investors for outsourcing their voting tasks to proxy advisory firms, moving towards the passive indexing, and abandoning stewardship to lower costs for their clients. This criticism has forced investors to devote resources to in-house analysis before voting and to emphasize their willingness to invest more resources in stewardship.

Institutional investors also face fierce competition and must be cost-effective in engaging in active stewardship. Using corporate guidelines, for example helps them control costs. Yet mutual funds may also have incentives to invest in stewardship because they hold large stakes in corporations:  approximately 5 percent in almost all of the companies in the S&P 500. As a result, they can have meaningful influence over these companies.

The second reason that institutional investors use corporate guidelines is that the guidelines are considered a “soft” and less adversarial device that does not dictate specific governance structures. Consequently, guidelines allow institutional investors to reduce both the potential for confrontation with the management of their portfolio companies and the risk of damaging business ties with those companies and of provoking a political backlash.

Finally, the use of corporate guidelines has gone global, with stewardship codes and principles having been adopted by the OECD, many leading countries in the field of corporate governance, and the largest institutional investors. This includes the principles developed in 2018 by the ISG, which is composed of the largest institutional investors in the U.S. and their international counterparts.

There is also new empirical evidence that corporate guidelines are being used as a passive stewardship mechanism. Companies in the S&P 500 refer to corporate guidelines in their proxy statements, for example, to communicate with their shareholders and other constituencies, and to express their commitment to their largest investors and to good corporate governance. Corporations also refer to guidelines in responding to shareholder proposals. In addition, leading law firms advise corporations to review and pay close attention to those guidelines. Lastly, even proxy advisers rely on institutional investors’ guidelines to advise investors on voting.

Moreover, beyond the stand-alone and explicit use of institutional investors’ guidelines, corporate guidelines may shape corporations’ governance regimes without being mentioned by companies in their proxy statements. When a corporation designs its own guidelines or adopts a certain governance arrangement, it might say it did so in line with industry best practices, rather than explicitly referring to specific institutional investors’ guidelines. Empirical evidence supports this possibility, with many corporations saying that their boards review the corporation’s policies, and guidelines according to, and are otherwise committed to, best practices. Shareholders also rely on the guidelines to support their proposals and to convince corporations to make changes and adopt certain governance arrangements.

In sum, there are clear theoretical explanations, supported by empirical evidence, for the growing power of corporate guidelines, which supplement active voting and engagement as an effective governance tool.

This post comes to us from Professor Asaf Eckstein at The Hebrew University Law School in Jerusalem. It is based on his recent article, “The Push Towards Corporate Guidelines,” available here.