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08 Mar. 2019 | Comments (1)

On Governance is a series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.

This blog post originally appeared in the University of Oxford Business Law blog on Feb. 27, 2019.

In the United States, investment advisers to mutual funds (mutual fund advisers), exchange-traded funds, and separately managed accounts are typically delegated the authority to vote their clients’ securities, including the voting rights associated with a public company’s common stock. Therefore, it should not be surprising that the United States Securities and Exchange Commission (SEC), in its Release establishing the Proxy Voting Rule (Release), took the position that an investment adviser (15 USC 80b-2(a)(11)) ‘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 Proxy Voting Rule[1] requiring 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, such as BlackRock, Vanguard, and State Street Global Advisors (the Big Three), now that they control an extraordinary amount of shareholder voting power at many of the United States’ largest public companies (see Shenkar, Heemskerk and Fichtner). This phenomenon did not exist at the time the Proxy Voting Rule was implemented (see Fichtner, Heemskerk and Garcia-Bernardo).

Moreover, this concentration of voting power is expected to increase over time. In a recent article, Professor Coates predicts that in the near future, the majority of voting shares of US public companies will be held by only 12 mutual fund advisers.

This concentration of voting power creates significant value for a mutual fund adviser if it can be traded for something that the adviser wants in return. 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. Or, an adviser may use its voting power to support the activism of its own shareholders at the advisor’s portfolio companies in exchange for those shareholders agreeing not to target the adviser itself for such activism. The result is that an adviser has not cast its delegated voting authority, to use the words of the Release, ‘in a manner consistent with the best interest of its client’ and has subrogated the ‘client interests to its own,’ a breach in its fiduciary duties to its mutual fund clients and its shareholders.

In my new essay, forthcoming in the American University Business Law Review, I describe these examples as creating a certain type of agency cost, the ‘proactive’ agency costs of agency capitalism. Agency capitalism arises, as it has in the US equity markets, when institutional investors, such as mutual fund advisers, not retail investors who provide the funds, come to dominate the ownership of common stock and other voting instruments. According to the publication Pensions & Investments, institutional investors currently own approximately 80% of the market value of US publicly traded equities. This compares to approximately 6% in 1950 (see Tonello and Rabimov). Agency costs of agency capitalism are generated when an institutional investor utilizes its voting power to satisfy its own preferences (and thereby enhances the welfare of the institutional investor or its managers) and not the preferences of investors who have provided it with the funds to purchase securities.

The understanding that proactive agency costs of agency capitalism exist is nothing new. For example, the SEC Release, Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, the companion release (Companion Release) to the Release, recognized the agency costs generated when mutual fund advisers are reluctant to vote against a company’s management for fear of losing the company’s retirement business. Even though it was not labeled as such, this type of agency cost falls in the proactive category.

Articles by Gilson and Gordon and by Bebchuk, Cohen and Hirst also focus on the economic disincentives mutual fund advisers have in becoming informed prior to voting their proxies. These can be referred to as the ‘passive’ agency costs of agency capitalism. Therefore, my essay is distinguished from those articles by its recognition of additional types of agency costs of agency capitalism that fall into the ‘proactive’ category, as well as the use of the term ‘proactive,’ and by categorizing the agency costs generated by the economic disincentives that discourage mutual fund advisers from becoming sufficiently informed voters as falling in the ‘passive’ category.

My essay does not address the “passive agency costs of agency capitalism.” Instead, it focuses only on the proactive agency costs generated by mutual fund advisers that hold large concentrations of delegated voting power. These are the agency costs that the SEC can help mitigate.

To combat the proactive agency costs of agency capitalism as described in the examples in my essay, I argue that the Commission should provide clarification that mutual fund advisers must disclose how they will deal with these new conflicts in their voting policies, consistent with their fiduciary duties to act in the best interests of their mutual fund clients and their shareholders. In addition, shareholder proposals are a prime area where this opportunistic use of an adviser’s voting power may be in play. Therefore, the adviser’s voting policy must also explain how voting on these proposals are linked to maximizing shareholder value.

Furthermore, 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 established by the Release. Such guidance should apply to any mutual fund adviser that is delegated voting authority. I urge the SEC to be diligent in taking enforcement action in response to breaches of the Proxy Voting Rule.

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.

  • About the Author:Bernard Sharfman

    Bernard  Sharfman

    Bernard Sharfman is an associate fellow of the R Street Institute, chair of the Advisory Council of the Main Street Investors Coalition, a member of the Journal of Corporation Law’s editorial ad…

    Full Bio | More from Bernard Sharfman


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  1. James McRitchie 0 people like this 08 Mar. 2019 03:38 PM

    Sharfman, Gilson and Gordon, Bebchuk, Cohen and Hirst and others raise valid concerns but the first step to take in dealing with the issues should be to reinforce disclosure mechanisms, enabling the market to function properly.

    The Commission should review SEC Rule 30b1-4, which required funds to file annual reports of their proxy votes beginning in 2004 using the N-PX form. The final rule stated, “increased transparency will enable fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies, which may have a dramatic impact on shareholder value.”

    A review by the Commission would find N-PX filings are not fit for purpose. Filings do not “enable fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies.” Filings do not shed light on mutual fund voting to “illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders’ best interests.” They do not enable shareholders to “evaluate how closely fund managers follow their state proxy voting policies, and to react adversely to fund managers who vote inconsistently with these policies.”

    Proxy voting data are displayed in user-unfriendly pdf format. Main Street investors would need to hire a researcher or subscribe to a data provider, such as Proxy Insight to make them useful. The average 401(k) account balance is less than $40,000 for those under age 40, about the time many employees typically get serious about investing in retirement. Hiring a researcher or subscribing to a database to conduct their own research would not be cost effective.

    Currently collected data is underutilized because it is not freely available in a user-friendly format. Year old data is seen as dated in an age when most news arrives instantaneously on social media. Compare the sortable disclosure of Trillium Asset Management, which includes the rationale for each vote, with that of the Vanguard Index Trust Total Stock Market Index Fund. vs

    "Best practices" and voting policies are largely driven by news coverage and public opinion. The benefits to be derived from enhanced attention by beneficial owners to proxy voting have yet to materialize because annual idiosyncratic reports do not facilitate the “rapid and informative” disclosure assumed by Justice Kennedy when writing Citizens United. Real-time proxy voting disclosure by big funds would enable both news reporters and Main Street investors to compare voting records when writing the news and when making investment decisions.

    The SEC could accomplish the original goals of Rule 30b1-4, including the empowerment of individual investors, by revising its N-PX reporting rules to require filings be timelier and more user-friendly.

    All funds claim to vote their proxies conscientiously in the “best interest” of their clients. Pensions & Investments (P&I), “Winning over proxy voters,” argues pensions have a fiduciary duty to announce their proxy votes in advance of annual meetings if doing so is likely to influence the vote. Of course, the same logic applies to all big funds. If funds really believe their votes enhance value, why do they hesitate to disclose them?

    Rapid disclosure and reporting of proxy votes and the reasons for those votes will foster real dialogue on the issues faced by corporations and investors. With real-time disclosure, the Big 4 and other funds would begin to compete not only on the basis of cost and returns but also based on how their votes align with the values of Mr. and Ms. 401(k). Additionally, real-time disclosure would spark renewed interest in services such as that previously provided by MoxyVote to facilitate the use of standing voting instructions by retail shareholders.

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