ASSET MANAGERS AS REGULATORS.

• Author: Lund, Dorothy S.

INTRODUCTION 79 I. BACKGROUND 90 A. The Modern Public Regulatory Environment 90 B. The Growth of the Big Three and Shareholder Power 92 II. ASSET MANAGERS AS REGULATORS 95 A. Theory and Incentives 96 B. Regulation by Asset Managers 105 1. Board Diversity 105 2. Climate Risk 113 3. Counterexamples 123 C. Why Regulation? 127 III. IMPLICATIONS 130 A. What's Going on Here?: A Novel Privatization Dynamic 131 B. Advantages 133 C. Concerns 137 CONCLUSION 144 "We [] see many governments failing to prepare for the future.... As a result, society increasingly is turning to the private sector and asking that companies respond to broader societal challenges. Indeed, the public expectations of your company have never been greater." --Larry Fink, 2018 BlackRock CEO Letter (1) "It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the 'Big Three' might own 30% or more of the U.S. stock market--effective control. I do not believe that such concentration would serve the national interest."--Jack Bogle, founder of the Vanguard Group and the creator of the index fund (2) INTRODUCTION

Our understanding of the corporation's role in society is in flux. Previous generations viewed corporate power with skepticism and saw government as an important bulwark against corporate harm. (3) There has been a shift, however, toward viewing corporations in a more positive light; indeed, corporate America is now thought to be a solution to government dysfunction around issues like inequality and the environment. (4) In addition, the "Big Three" asset manager giants that specialize in index funds (5)--Vanguard, State Street, and BlackRock--have voiced concern over many of these same issues and promised that they will push companies to address them. (6)

This Article provides a lens to evaluate this dramatic shift in the corporate political environment. It theorizes that demand for regulation has outstripped supply, and that asset managers have stepped in to address the shortfall. More specifically, it reveals that the Big Three (7) are providing a form of privatized regulation--a body of standards and mandates that is more stringent than existing law, enforced with penalties, and applied across the market. (8)

This dynamic--where shareholders have become regulators--is a modern one, made possible by the rise of institutional investing, the recent popularity in index funds, and the growth of shareholder power. (9) As a result of the convergence of these forces, the Big Three now hold large (10) (and in the not-so-distant future, controlling (11)) stakes across the public market, (12) which gives them ample influence over companies and their management. Although they have historically taken a passive approach to governance, since 2017, the Big Three have launched policymaking initiatives in two areas of great social importance: improving board gender diversity and reducing climate risk. (13) As for the first, the Big Three mandated that companies improve the diversity of their boards, and some even specified a quota. The asset managers then enforced these mandates by voting against directors at noncompliant companies--a powerful motivator. (14) As a result, their policies led companies to take action where other measures had fallen short: empirical research suggests that the Big Three's mandates caused companies to add 2.5 times as many women directors in 2019, as compared to 2016. (15)

The Big Three have likewise urged companies to reduce carbon emissions and improve their disclosure of environmental, social, and governance (ESG) information. (16) By 2020, soft encouragement in the form of "engagement" evolved into an aggressive voting policy when BlackRock announced it would require companies to disclose ESG information and operational plans in compliance with the Paris Agreement and committed to voting against directors that failed to make sufficient progress in doing so. (17) Vanguard and State Street quickly followed suit. (18) As with board gender diversity, these climate policies appear to have influenced corporate conduct. One empirical study determined that there is a strong negative association between Big Three ownership and subsequent carbon omissions. (19) Companies have also increased climate disclosures since the Big Three began to focus on it, and many credit the Big Three's mandates as being a substantial motivator. (20)

Therefore, in light of their size and "universal ownership"--the fact that they hold stakes in nearly every company in the public market (21)--the Big Three have been able to assume regulatory functions that typically reside in the hands of large government agencies like the Environmental Protection Agency or Securities & Exchange Commission (SEC). (22) Like those public bodies, the Big Three adopt marketwide standards governing firm conduct, assess compliance with those standards, and then penalize violations with their voting power. (23) Although their enforcement relies on different tools--not the power to tax or fine, but instead, to subject management to possible job loss or reputational penalties--it is no less coercive. (24) In this way, the Big Three have supplied rules where public bodies have failed to move quickly (or at all).

And as this discussion reveals, there is much that is puzzling about this dynamic. From starting principles, the concentration of power in the hands of three private for-profit companies that lack democratic legitimacy and electoral accountability is seriously concerning. (25) And yet, their chosen rules seem relatively benign, and indeed, offer benefits. For these reasons, commentators are divided on whether the rise of asset manager regulation is a benefit or curse. (26)

This Article provides a framework to evaluate this regulatory dynamic and these outcomes. Specifically, I theorize that market mechanisms constrain the exercise of power by the Big Three: because they are profit-maximizing asset managers, they must secure broad consensus from their clients when adopting rules. (27) Indeed, Section III posits that in the areas that they have been the most proactive, the Big Three are responding to a demand for rules from these clients--and their institutional clients in particular.

More broadly, this framework suggests that the issue of whether and how asset manager agency costs undermine the interests of beneficial owners is more complex than many recognize. The literature has generally assumed that there is only a single intermediary standing between beneficial owners and portfolio companies, as occurs when an individual chooses to invest in an index fund managed by BlackRock. (28) But instead, as my analysis reveals, intermediation is often more complex. Indeed, many beneficial owners have two layers of intermediaries exercising influence over their investments and the use of their governance rights (I call this "double intermediation"). Consider, for example, a state employee who makes monetary contributions into a public pension fund during their career. That public pension fund is fiduciary-bound to manage the employee's investment prudently, and as such, may choose to invest in an index fund managed by State Street, in exchange for a fee. Consider, too, a corporate employee whose employer selects a menu of funds offered by State Street for that employee's 401(k) contributions. In these examples, the employee's governance rights would be exercised by State Street, (29) but that fact obscures the reality that the beneficial owner employee is subject to two layers of intermediation (and accompanying agency cost issues), rather than one.

It is likely, therefore, that double intermediation will affect the Big Three's policy initiatives. In particular, the Big Three's interventions will be shaped by their desire to satisfy their institutional clients--the corporations and public pensions in the above examples--as well as those individuals that invest in their funds directly. In addition to ensuring support from these clients (or at least, avoiding client alienation), the Big Three's interventions will be calculated to maximize support from the government, (30) which is an institutional client as well as a regulator of the Big Three's activities. (31) This separate limit suggests that the Big Three's regulatory interventions will take the public interest into account to some degree: if they were to veer too far afield, they would likely face public and regulatory backlash. (32) But my theory also suggests an important limitation. In particular, the Big Three will never adopt socially beneficial policies that lack broad support from their clients, and particularly the corporate clients that supply a large percentage of their assets under management (AUM). Relatedly, the need to ensure client approval indicates that the Big Three are likely to mandate only tepid changes in corporate behavior, and that their rules will not bring about the sweeping changes that may be necessary to address pressing social problems.

My theory is therefore distinct from others that attempt to explain the Big Three's puzzling interventions in environmental and social areas, and an analysis of their policies suggests it is a better fit. In particular, scholars have argued that the Big Three's activism is motivated by a desire to market the asset managers' funds to millennial investors, who will become important sources of wealth in the coming years. (33) Although this explanation is partially correct, it is incomplete. The majority of the Big Three's revenue comes from institutions--and corporate and public pension plans in particular--rather than individuals. (34) Therefore, the Big Three's interventions must be calibrated to generate support from those clients, too. Again, this insight helps us evaluate and even predict the substance of the Big Three's regulatory policies, and in particular, suggests that they are unlikely to go as far as...