Rational apathy stands at the center of current and long-time developments and debates in corporate governance and activism. Dominance of index funds in share ownership, prevalence of proxy advisers, pass-through voting programs, trading proxy votes on an exchange, and the entire proxy system (“proxy plumbing” as the SEC calls it) all have something to do with rational apathy. So, we dig into it, briefly, for activists and shareholders.
The idea goes back to Berle & Means in 1932, the original source on separation between ownership and control of a corporation. Then, they called it passivity rather than apathy. One recent observer found it makes sense, as an economic decision, for some shareholders to avoid voting (our emphasis):
The idea of shareholder passivity gained wide traction after [Berle & Means]. Decades later, the law and economics movement refashioned shareholder passivity as ‘rational apathy.’ In Berle and Means’s conception, shareholder passivity was irresponsible and blameworthy, but also inevitable in light of the separation of ownership and control. In the law-and-economics view, shareholder passivity evidenced the ‘free rider problem’ and was explained by incentives operating on homo economicus. It was rational decision-making by utility-maximizing investors and, therefore, a good (and efficient) thing. After shareholder passivity was reconceptualized by the law and economics movement, it ceased to be a governance problem in need of a legal solution.
Gratified to see a law professor invoke homo economicus.
A few legal scholars addressed rational apathy over the years. Bernard Black wrote the most complete treatment in 1990, with Dov Solomon writing a follow-up many years later. Kobi Kastiel and Yaron Nili, whom we know from their time at the Harvard Law School corp gov center, wrote two papers proposing ways to address rational apathy (here and here). In a slight disappointment to our economist sensibilities, most of the literature appears in law reviews, with nothing similar in corporate finance journals.
Our read of this work on rational apathy prompts a few observations.
Benefit and Costs
Rational apathy represents the outcome of an investor’s analysis of the benefits and costs of voting proxies. For most shareholders, the direct benefit to the value of their specific portfolio holding from their specific vote becomes mostly negligible. Black (above) sets forth a formal model of the benefits and costs and shows how most votes don’t produce material benefit for the voter.
As for costs, these fall into two categories. First, voting requires time and expense of learning about the subject of the vote: the company, its corporate governance, director credentials, and many other elements. Many investors don’t know where to find the proxy statement and other materials needed to research these questions, much less how to read these materials critically.
Second, voting requires navigating a complicated and arcane system for casting a vote. How a proxy card and the related voting systems work demands knowledge of the proxy system that few shareholders have.
Most assessments of rational apathy address how to lower the cost of voting rather than increasing the benefits. It seems easier to make company information more available and the voting process more accessible than to somehow increase the value of an individual vote.
Individuals and Institutions
The idea of rational apathy applies to institutions as well as to individuals. Much of the analyses of the subject addresses retail shareholders – why they don’t vote proxies and how to encourage it. It seems institutions, even ones with significant holdings in a company, can also experience rational apathy. Institutions can estimate in some detail the value of their holdings relative to a vote and how investing in a proper vote will affect that value.
Size of Holding, in Two Ways
The decision to vote depends on the size of an investor’s holding in a company. There are a couple of dimensions to size, though. First, size involves how much of the company’s equity the shareholder owns. The larger the percentage of the company’s shares, the greater the impact a vote will have on the company. This translates to an increase in the benefit or value of the vote.
Second, size also involves how much of the investor’s portfolio the investment in the company represents. The larger the allocation, the less a vote costs the shareholder.
Percent of the company and percent of the portfolio interact, too. Even for a large allocation, if the investment is a small enough share of the company equity, the benefit of voting becomes similarly small. Or, for an investment that represents a significant share of the company equity, if it’s a small part of the investor’s portfolio, then again voting will cost more than it’s worth.
Everything is Rational Apathy
Rational apathy appears many places:
• Pass-through voting suffers from it
• Proxy advisers exist to lower the cost (research and process) of voting – regulations require institutions to vote even though a utility-maximizing fund wouldn’t otherwise do it
• Proxy-vote trading makes explicit the benefit and cost of a vote, allows shareholders to transform a voting decision into a financial one, and thus maximizes their individual utility from voting
• Most innovations in proxy voting, such as “investor assemblies,” seek to address rational apathy, either by lowering the cost or increasing the value of voting.
With a little understanding of what it looks like and where to find it, understanding rational apathy improves our understanding of activism and corporate governance.
This post comes to us from Michael R. Levin, founder and editor of The Activist Investor.