Able but not willing: the failure of mutual fund advisers to advocate for shareholders' rights.

• Author: Taub, Jennifer S.

1. INTRODUCTION II. BACKGROUND ON MUTUAL FUNDS A. Structure and Distribution Channels B. Benefits and Costs C. Regulation III. BACKGROUND ON CORPORATE GOVERNANCE IN THE UNITED STATES AND UNITED KINGDOM AND THE MUTUAL FUND PROXY VOTING RULE A. Corporate Governance Perspectives 1. Corporate Governance Divided: Agency Perspective vs. Stakeholder Perspective 2. Agency Perspective Divided: Director-Centric vs. Shareholder-Centric, 3. Shareholder-Centric Divided: Shareholder Democracy Perspective vs. Shareholder Profit Maximization Perspective B. Comply or Explain in the United Kingdom C. Proxy Voting and Shareholder Proposals Overview D. The Mutual Fund Proxy Voting Rule IV. CONFLICT OF INTEREST IN PROXY VOTING A. Anecdotal Evidence and Examples B. Review of Prior Research Studies C. Original Empirical Research: Methodology and Results V. OTHER EXPLANATIONS A. Wall Street Rule B. Alignment of Economic Interests C. Legal and Political Obstacles D. Cost-Benefit and the Free Rider Problem E. More Effective Behind-the-Scenes F. Fiduciary Duty G. Contract H. No Shareholder Demand I. Lack of Confidentiality J. Special-Interest Agenda K. Lack of Expertise VI. RANGE OF REFORMS A. Separation of Money Management from Retirement Plan Recordkeeping B. Separation of Voting from Money Management C. Pass-Through Voting and Proxy Assignments D. Default Proxy Assignments E. Best Practices for Proxy Voting and "Comply or Explain" F. Uniform Disclosure "Product Label" for Voting Procedures G. Choice at the Point of Sale H. Suitability Requirement that Includes Investment Objectives and Governance Topics VII. A BROADER PERSPECTIVE I. INTRODUCTION

   Approximately 77.7 million individuals in the United States invest in equities through stock mutual funds. (1) When these investors put their money to work and at risk, they depend upon strong corporate governance structures at corporations (portfolio companies) held by the mutual funds that they own. (2) Unlike direct retail investors who can take action to influence corporate governance, (3) these 77.7 million individuals depend upon mutual fund advisers (Advisers) to advocate for them. Yet, when it comes to pushing portfolio companies for shareholder governance reforms, mainstream fund families remain passive. Even in areas where Advisers have an affirmative duty to act on behalf of the funds they manage (and thus to benefit the underlying investors in those funds), they fall short. Subject to a fiduciary standard, Advisers owe a duty of care and loyalty with respect to all services performed on behalf of the mutual fund's owners. (4) This includes an obligation to monitor corporate events and to cast proxy votes in the best interests of funds. (5) Yet data show that mainstream fund Advisers overwhelmingly cast votes in favor of management and against shareholder advisory resolutions on matters including corporate governance. (6)

   Many theories have been advanced for the reluctance of Advisers to take an active or even passively supportive role in matters of shareholder empowerment. Under one, the "conflict of interest theory," Advisers favor corporate management (or disfavor corporate shareholders) because of existing or potential business ties with corporate managers. While many have argued that conflicts of interest influence Advisers to act in promanagement, antishareholder ways, (7) very little empirical research has emerged thus far to support such claims.

   Accordingly, I sought to explore whether shareholder empowerment behavior is associated with an Adviser's economic interests. I linked the 2006 corporate proxy voting records on eleven key corporate governance topics for the ten largest fund families to the defined contribution (DC) assets under management of each family's Adviser for the year that ended December 31, 2005. The result was a statistically meaningful negative correlation between DC assets and support for shareholder resolutions. Specifically, the analysis revealed that the greater the dependency of the Adviser upon the DC channel for asset management business, the less likely the fund family will be to support shareholder-sponsored governance resolutions.

   Next, I considered possible explanations for this correlation, other than conflict of interest. I have grouped these into the following categories: (1) Wall Street Rule; (2) Alignment of Economic Interests; (3) Legal and Political Obstacles; (4) Cost-Benefit and the Free Rider Problem; (5) More Effective Behind the Scenes; (6) Fiduciary Duty; (7) Contract; (8) No Shareholder Demand; (9) Lack of Confidentiality; (10) Special-Interest Agenda; and (11) Lack of Expertise. While these defenses may work to explain passivity in some types of activism, none are solid explanations in the case of these corporate governance-related proxy votes.

   In response to the results, this paper explores a range of reforms that would help make mutual fund Advisers less dependent upon corporate clients and more accountable to investors. These include: (a) Separation of Money Management from Retirement Plan Record Keeping; (b) Pass-Through Proxy Voting and Proxy Assignments; (c) Default Proxy Assignments; (d) Best Practices for Proxy Voting and "Comply or Explain"; (e) Uniform Disclosure "Product Label" for Proxy Policies and Procedures; (f) Choice at the Point-of-Sale; and (g) a Voting Suitability Requirement.

   In its conclusion, this paper takes a broader perspective, suggesting that corporate governance scholars and reformers use the mutual fund case to reexamine the prevailing framework that is largely based upon the agency problem recognized in 1932 by Adolf Berle and Gardiner Means. (8) Berle and Means saw a shift between the nineteenth- and twentieth-century business enterprises. "Persons other than those who [had] ventured their wealth" were directing industry. (9) They recognized that the separation of ownership from control would lead to "directors or titular managers who can employ the proxy machinery to become a self-perpetuating body, even though as a group they own but a small fraction of the stock outstanding." (10) They identified the agency problem as a conflict between the interest of management and owners, whereby management "can serve their own pockets better by profiting at the expense of the company than by making profits for it." (11)

   In response to the fruition of their observations, much of corporate governance work focuses on that power balance between management and owners, and seeks to find ways to enhance shareholders' rights. Or, the work looks to the failure of the boards of directors to look out for shareholders. Leading corporate governance scholar John Coffee observed, "Academics tend to plough and re-plough the same furrow over and over. Nowhere is this truer than in the case of the scholars of corporate governance, who have studied the board of directors and shareholders endlessly." (12) In the world beyond academia, the effort to "shift control of the company from the board to shareholders has been constant and increasing." (13)

   For those who subscribe to a shareholder-centric vision of corporate governance, focusing just on direct shareholders ignores how much capitalism's environment has changed. The concentration of ownership through pooled investment vehicles, such as mutual funds, and the growth of retirement savings plans, has led to a further revolution--an Intermediation Revolution. A staggering 69.4% of U.S. equities are owned by institutional investors. (14) In fact, ownership is concentrated, with 100 institutions owning 52% of U.S. equities. (15) Yet these institutional owners are often collective investment vehicles like state and union pension funds and mutual funds. In other words, they are legally constructed vehicles through which individual savers put their money at risk. Yet, those who make decisions as to the direction of those investments and those who exercise the legal rights of ownership are not the real investors, but managers or "registered investment advisers." (16) While "working people through their savings today hold the majority of stock in the most powerful enterprises in the world," (17) they are not even mere legal owners anymore. Thus, ownership is now separated again. Investment has been separated from legal title. Investors who are the risk-takers are now pushed further away from the decisionmakers, and the agency problem is amplified.

   Accordingly, we should shift our focus from the empowerment of shareholders to the empowerment of the underlying equity investors. More than just a semantic distinction, this new framework would recognize that institutional shareholders (such as mutual fund advisers) cannot be expected to wrest power from or demand accountability from corporate managers. The intermediaries who stand between investors and corporate managers have their own interests, which are often at odds with the investors who trust them, and at times aligned with corporate management. This is seen in the arena of proxy voting. Accordingly, the first set of reforms to help not just investors in mutual funds, but also corporate shareholders at large, should start there.

2. BACKGROUND ON MUTUAL FUNDS

   Mutual funds hold tremendous wealth, are ubiquitous savings vehicles for individual investors, and have consolidated power. In terms of wealth, as of the year-ended 2006, assets in mutual funds worldwide stood at $21.8 trillion. (18) Of that, approximately 48%, or $10.4 trillion, was held in U.S. mutual funds. (19) In terms of ubiquity, the United States has approximately 90 million mutual fund shareholders. (20) Nearly half of all U.S. households (51.8 million households) own stocks through mutual funds. (21) That is, approximately 77.7 million Americans invest in equities through stock mutual funds. (22) There are more than 4000 individual equity mutual funds in the United States with more than $4 trillion in assets. (23) With holdings of approximately 25% of...