STEWARDSHIP THEATER.

• Author: Schwartz, Jeff

ABSTRACT

Large asset managers like BlackRock and Vanguard have amassed staggering equity holdings. The voting rights that accompany these holdings give them enormous power over many of the world's largest companies. This unprecedented concentration of influence in a small group of financial intermediaries is a pressing policy concern. While law and finance literature on the topic has recently exploded, no one has offered a satisfying theory to explain their voting behavior. Existing work tries to understand their approach to voting in conventional terms--as an attempt to improve the performance of portfolio firms--but this is not why large asset managers vote the way they do.

In contrast, this Article offers a political theory of asset-manager voting. Because of the power they wield, and the high stakes involved, large asset managers risk severe political blowback from looking like reluctant participants in corporate governance and from voting counter to the views of powerful politicians. As a result, politics rather than finance drives their decisions.

Politically motivated asset-manager voting is problematic. It leads to market uncertainty and threatens the core division between business and government. It is also an illegitimate use of the voting power that asset managers are duty-bound to exercise on behalf of the shareholders in the funds that they oversee. But voting authority is a privilege, not a right. To draw politics out of corporate governance, regulators should require that asset managers seek input from fund shareholders and reflect that input in their votes.

TABLE OF CONTENTS INTRODUCTION I. ASSET MANAGERS AND CORPORATE CONTROL A. The Structure of the Asset-Management Industry B. Voting Power and Stewardship C. The Twilight of The Berle-Means Thesis II. THE LAW AND ECONOMICS OF ASSET-MANAGER STEWARDSHIP A. Asset-Manager Incentives to Engage in Stewardship B. The Illusory Promise of Stewardship Profits C. The Illusory Promise of Additional Fund Flows and Higher Fees D. Empirical Evidence of Asset-Manager Voting 1. The Stewardship Process 2. The Three Eras of Asset-Manager Voting III. STEWARDSHIP THEATER A. A Political Theory of Asset-Manager Voting 1. The Threat of Regulation 2. The Political History of the Asset-Management Industry B. Review of the Empirical Evidence of Asset-Management Voting C. Other Influences on Asset-Manager Voting IV. IMPLICATIONS A. Social- Welfare Implications B. Policy Implications C. Implications for Corporate-Governance Theory CONCLUSION INTRODUCTION

A small group of asset managers have accumulated unrivaled wealth and power. (1) Industry leaders--like BlackRock, Vanguard, and State Street (the "Big 3")--have compiled massive equity holdings in public companies through the mutual funds and exchange traded funds (ETFs) that they oversee. (2) The voting rights that come with these holdings give them enormous clout. (3) For example, in May 2021, the Big 3 supported an improbable challenge to the oil giant Exxon from a little-known hedge fund, Engine Company Number l. (4) They backed three directors for Exxon's board, all of whom were nominated because they planned, if elected, to press the company to change its focus to renewable energy. (5) Thanks to the Big 3's support, the provocateurs won.6 Their election illustrates that leading asset managers have power over the biggest and most fundamental questions of firm strategy and mission at the biggest companies in the world. There is perhaps nothing more momentous than upending Exxon's 135-year emphasis on oil. (7) A few months after the electoral rebuke, Exxon, once "unrepentant in its defense of crude," (8) announced that it was considering the previously unthinkable--a carbon-neutral pledge. (9)

Because the large asset managers wield such tremendous power, understanding why they vote the way they do is crucially important to law and society. Why did the Big 3 choose to shake up Exxon rather than support the status quo1! A wave of recent scholarship has studied asset-manager voting through a conventional law-and-economics lens. These scholars have focused on whether industry leaders are using their voting power to improve the performance of portfolio firms. (10) The literature reveals that the large asset managers have little economic incentive to do so, but it fails to provide a plausible alternative account of their motives. In this Article, I look beyond the conventional economic incentives. Instead, I show that politics largely motivates voting at the largest managers--and that this is problematic.

The concentration of equity ownership in a small group of financial institutions has transformed U.S. equity markets. Historically, individual investors drove U.S. markets. Millions of individuals held stock directly in public companies, and none had anything approaching a controlling interest. (11) The assumption of dispersed ownership formed the basis of the Berle-Means thesis. (12) In its modern incarnation, this theory posits that dispersed ownership causes a collective-action problem: shareholders bear all of the costs of overseeing corporate managers, but enjoy only a sliver of the gains if their oversight leads to performance improvements. (13) As a result, shareholders ignore oversight and leave corporate leaders with a great deal of discretion over how they run their firms--discretion that allows for mismanagement and abuse. (14) Overcoming the problems that stem from this separation of ownership from control, so-called "agency costs," has long been considered the principal problem in corporate governance. (15)

The existing scholarship on asset-manager influence seeks to understand their voting from within this tradition. At first blush, it seems that replacing dispersed individual investors with a small group of sophisticated institutions should greatly ameliorate agency-cost concerns. The literature shows, however, that the large asset managers face a complex mix of financial incentives. And scholars are divided on how this affects agency costs. One camp argues that these financial institutions adequately police corporate managers; (16) others argue that they fall far short. (17) The disagreement centers on whether asset managers earn enough money from improving their portfolio firms to invest in careful oversight. (18)

This debate is useful and important, but not in the way the participating authors imagine. Those who argue that asset managers have little financial incentive to improve firms in their portfolios have the better case, (19) but this insight begins the analysis rather than completes it. Stepping outside the agency-cost framework reveals a profound implication: since engaged voting is unprofitable, something else is dictating how asset managers vote.

This is unprecedented. A group of hugely powerful financial institutions control corporate America, but they are not using their power to improve the firms they own.

The lack of a purely financial motivation creates the vacuum that politics fills. Since voting offers little prospect of direct profits, it makes sense for asset managers to use their influence to serve their political interests. It is well-known and understood that companies try to influence regulators and politicians through lobbying and other forms of direct political engagement, like financially backing certain candidates. (20) Underexplored is how they influence politics through their actions. Acting in a way that regulators and politicians have signaled that they prefer reduces the risk of regulatory action and increases the chances of regulatory forbearance. And large asset managers have much to fear.

The Big 3 and others face more regulatory and political uncertainty now than at any time since the New Deal. (21) An array of journalists, politicians, and academics worry that they are destabilizing equity markets, (22) suppressing competition in major industries, (23) and failing to act as responsible stewards on behalf of their funds' shareholders. (24) NPR asked, Is Your Retirement Fund Ruining Our Economy? (25) The Atlantic echoed, Could Index Funds Be 'Worse than Marxism 7 (26)

A bit hyperbolic, but this agita has generated a slew of reform proposals. Influential scholars even suggest breaking up the Big 3. (27) All of this makes it likely that the large asset managers view voting as a way to reduce the political heat. Their institutional history further supports this conclusion. They are an industry bom of regulation, one which views itself as a partner with regulators, and carefully cultivates an image as the lone part of the finance industry that has its investors' interests at heart. (28) Voting in a manner that pleases politicians and regulators seems like an obvious way for them to build on this reputation.

Recent voting on environmental issues illustrates what is happening. Prior to 2021, the Big 3 had consistently voted against shareholder proposals focused on environmental accountability. (29) That year, they not only supported the fundamental change at Exxon, but also vastly increased their support for environmental proposals. (30) BlackRock's support for such proposals was ten times higher than the previous year. (31) This shift lines up with the change from the Tmmp administration, which was hostile to institutional-investor involvement in environmental issues, to the Biden administration, which has pressed for it. (32) It also accords with a policy reversal at the Securities & Exchange Commission (SEC), the industry's primary regulator. In 2021, the agency abandoned its long history of focusing almost solely on mandating disclosure of financial information to make environmental accountability a top priority. (33) This abrupt change in political winds seems to be the only thing that can explain the equally abrupt change in asset-manager voting.

While the Big 3 may have gotten things right with Exxon, politically motivated voting is nonetheless...