The future of corporate stewardship – and therefore corporate governance – rests in the hands of a few large institutional investors. Questions of whether these funds have the necessary incentives to pursue stewardship have set off an explosion of research by both legal scholars and economists alike. Some say that funds lack even the basic incentives to vote on value-enhancing corporate governance matters because, while even large benefits diffuse among investors, funds bear the totality of the upfront costs. Others argue that funds – through their common ownership of nearly all public companies – have perverse incentives to encourage anti-competitive behavior.
These questions are hard to answer empirically because fund incentives are not directly observable. But regulatory changes can provide an opportunity to observe how funds adjust their behavior in response, revealing a window into their incentives.
In a new paper, we look at exactly this: We examine funds’ incentives through an empirical study of the lending-voting tradeoff after the Securities and Exchange Commission’s 2019 guidance on funds’ fiduciary duties. The guidance departed from prior practice by encouraging funds to take into account “opportunity costs” of share lending when making their voting decisions. In the past, SEC staff guidance required that funds recall shares they loaned when material items were on the ballot to ensure that voting would occur.
We show that after the new guidance, funds dramatically increased share lending. Specifically, we show that for stocks with high index fund ownership – those having the strongest economic incentive to try to earn additional lending fees – the supply of shares on loan increases from 15.6 percent to 22.3 percent. Share supply increases by 3.8 percent, even for proxy fights.
More share lending means less voting – regardless of whether the shares are borrowed in the end. Because shares can be borrowed at-will from the lending agent or broker, and then voted by the ultimate holder as of the record date, shares put on loan do not carry voting instructions. Hence, shares made available for loan but not borrowed are not voted – making share lending a significant contributor to non-voting. By one estimate, in 2010 alone, 60 billion shares went unvoted, with 15 billion shares on loan.
With no fiduciary constraint on share lending, corporate elections can have surprising results. Most notably, in June of 2020, a proxy fight at GameStop surprised the investor and corporate community when activists with only 7.3 percent of shares won board seats despite opposition from large institutional investors that collectively owned around 40 percent of shares. This was possible because nearly 40 percent of GameStop shares (nearly all the shares held by institutions) were on loan, most of which were presumably borrowed by short sellers and other investors with goals contrary to the funds and similar long-term investors.
Our evidence supports the hypothesis that funds face a lending-voting dilemma, which speaks to their incentive problems. While funds can in theory effectuate beneficial governance changes through cooperation and voting, each has strong private incentives to favor certain lending revenues over the uncertain and diffuse benefits of voting. Hence, the free-rider problem – made worse by the guidance – can lead to under-voting from a social welfare perspective.
Low turnout by funds can have broad implications beyond governance. Today funds are beginning to lead the charge on environmental and social reforms. Indeed, recent research shows that funds can play an important role in identifying value-enhancing socially responsible investing (SRI) proposals and helping to increase overall shareholder welfare. But public pronouncements will amount to nothing more than cheap talk if funds choose to lend rather than vote.
For those interested in fund stewardship the story does not end here. The Department of Labor has finalized rulemaking that would require pension funds to focus only on risk-adjusted financial returns in their investment and stewardship decisions. While the goal may be to protect investors from expropriation, the result may be to discourage voting on even widely accepted governance proposals such as separating the CEO and board chair positions when the implications for an individual company’s stock returns may be hard to predict.
As we have shown, funds already have strong incentives to favor lending over voting. Tipping the scales even further against voting, as the SEC and DOL have done, will likely drive funds away from participating in corporate elections – shielding management from accountability at the expense of shareholder welfare.
 Coates, John, C. (2018). The Future of Corporate Governance Part I: The Problem of Twelve.
 Bebchuk, L. and Hirst, S., 2019. Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy. Colum. L. Rev., 119, 2029.
 Azar, J., Schmalz, M. C., & Tecu, I. (2018). Anticompetitive effects of common ownership. J.Fin., 73, 4, 1513.
 See supra note 2.
 Hu, H. T., & Black, B. (2005). The new vote buying: Empty voting and hidden (morphable) ownership. S. Cal. L. Rev., 79, 811.
 Broccardo, E., Hart, O., & Zingales, L. (2020). Exit vs. Voice. NBER Working Paper 27710.
This post comes to us from Edwin Hu, research fellow at the NYU School of Law’s Institute for Corporate Governance & Finance; Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School; and Haley Sylvester, research fellow at the NYU School of Law’s Institute for Corporate Governance & Finance. It is based on their recent paper, “The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff,” available here.