The Case Against Passive Shareholder Voting.

• Author: Lund, Dorothy S.

1. INTRODUCTION II. AGENCY COSTS, INSTITUTIONAL INVESTORS, AND THE MARKET FOR CORPORATE INFLUENCE III. THE THREAT OF PASSIVE INVESTING A. The Rise of Passive Investing B. Passive Investing and Corporate Governance 1. Passivity, Voting, and Engagement 2. Passivity and Hedge Fund Activism IV. POLICY PROPOSALS A. Rethinking Passive Fund Voting 1. Eliminate Passive Fund Voting 2. Institute Pass-Through Voting for Passive Funds 3. Institute Pass-Through Voting as a Default B. The Difficulty of Incentivizing Beneficial Investment in Governance V. CONCLUSION I. INTRODUCTION

   In the past few years, millions of investors have abandoned actively managed mutual funds (active funds) in favor of passively managed funds (passive funds). This past year alone, investors withdrew $340 billion from active funds (approximately four percent of the total) while investing $533 billion into passive funds (growing the total by nine percent). (1) This historically unprecedented shift in investor behavior has generated a flurry of news coverage, with articles proclaiming that index funds "are eating the world." (2)

   The rise of passive investing is good news for investors, who benefit from greater diversification and lower costs. But the implications for corporate governance are less positive. Unlike active funds, which pick stocks based on their performance, passive funds--a term that includes index funds and exchange traded funds (ETFs)--are designed to automatically track a market index. For this reason, this Article contends that the growth of passive funds has the potential to distort and dampen the market for corporate influence. (3)

   Participants in the market for corporate influence--generally institutional investors and activist hedge funds (4)--use the influence that accompanies their large ownership positions to discipline management. Although these investors lack perfect incentives to engage in corporate stewardship, (5) their presence provides a check against managerial slack, primarily because they identify underperforming firms as part of their investing strategy and are motivated to discipline wayward management.

   Passive funds are different. Because they seek only to match the performance of a market index, passive funds lack a financial incentive to ensure that each of the companies in their portfolios are well-run. For one, passive funds tend to have very large portfolios, and therefore, an investment in improving governance at a single firm is especially unlikely to enhance the fund's overall performance. Second, passive funds face an acute collective action problem because investments in governance equally benefit all funds tracking the index, while only the activist fund bears the costs. Third, governance interventions are especially costly for a passive fund--unlike active funds, passive funds do not generate information about firm performance as a byproduct of trading. Therefore, thoughtful interventions would require the passive fund to expend additional resources gathering firm-specific information as well as develop governance expertise. Such expenditures would undo the cost savings that attracted investors to the passive fund in the first place.

   Accordingly, as assets continue to flow into passive funds, agency costs will increase because managers of passive funds will be less likely to engage thoughtfully with portfolio companies and discipline management. Passive fund managers will also be likely to adhere to low-cost voting strategies, such as following a proxy advisor's recommendation or voting "yes" to any shareholder proposal that meets pre-defined qualifications. And without a consensus about what constitutes good governance, there is reason to believe that the proliferation of an unthinking, one-size-fits-all approach to governance will make many companies worse off.

   In addition, the rise of passive investing has the potential to distort hedge fund activism. Hedge fund activists are increasingly moderated by large institutional investors with the power to block campaigns that are not in the interest of their long-term shareholders and catalyze interventions that are deemed beneficial. Passive funds, however, are less likely to serve as a "keel" to activism, which means not only that certain beneficial interventions will not occur, but also that certain detrimental interventions may nonetheless garner substantial support.

   For now, the majority of mutual fund assets are invested in active funds, which lessens concerns about governance distortions. (6) But the rapid growth of passive investing is predicted to continue, and already some S&P 500 companies have passive fund ownership in excess of 20%. Moreover, the institutional investors that dominate the passive fund market--Vanguard, BlackRock, and State Street Global Advisers--already have a substantial voice in corporate governance. Together, the "Big Three" are the largest shareholder of 88% of major U.S. companies. (7) In other words, the institutional investors that favor a passive investing strategy are beginning to crowd out the active investors.

   So long as institutional investors house passive funds and active funds under the same roof, the passive funds may be able to free ride off of information generated by active funds when there is investment overlap. But active funds invest in a smaller number of companies than passive funds and so overlap is not guaranteed. Additionally, as assets continue to flow out of active funds, there will be even fewer common investments, as well as less information generated by active fund managers.

   There is another reason to suspect that passive fund ownership will soon approach a problematic level: the optimal amount of active participation in governance is likely to be greater than the amount that is necessary to keep stock market pricing efficient. If a few active funds police the market for underperforming stocks and use that information to inform trading decisions, stock prices will rise and fall with company value. (8) But a small percentage of informed investors cannot control governance outcomes. If passive funds own only 51% of a company's stock, they will be able to unilaterally determine the success of shareholder proposals, proxy contests, and hedge fund activism, even in the face of total opposition from informed investors. Even with less than absolute voting control, passive funds could still substantially affect corporate behavior. (9) This means that governance distortions will appear long before stock price inefficiencies do.

   The legal literature has thus far focused on a different problem associated with the rise of passive investing, and institutional investing more broadly--the potential for anticompetitive behavior that arises when institutional investors own large stakes in rival firms in oligopolistic industries. (10) The theory is that managers of highly diversified institutional investors may pressure portfolio company management to refrain from aggressive price competition that would harm their other horizontal investments. (11)

   This Article provides an alternative explanation: rather than inducing companies to collude, passive fund managers are not doing enough to push management to maximize shareholder welfare. In oligopolistic industries, management may respond to the lack of shareholder discipline with the path of least resistance: tacit collusion. (12) In more competitive industries, we can expect other problems: inflated executive compensation, reduced productivity and growth, and inefficient acquisitions, to name a few. (13) For that reason, the scope of the problem is potentially much larger than the legal literature has recognized because it extends beyond companies in oligopolistic industries, and concerns all companies with a high concentration of passive ownership, which is a large and growing segment of the U.S. market.

   In linking passive investing and governance distortion, this Article makes four novel contributions. First, it redeems the oft-criticized institutional investor as an important participant in the market for corporate influence. It shows that there is a difference between institutional investors that favor an active management strategy and those who take a passive approach to investing and supports this observation with a description of mutual fund activism. Second, it solves a puzzle that has perplexed some corporate law scholars--why passive funds have failed to act as seriously engaged owners in spite of the fact that their buy-and-hold investment strategy gives them an interest in the long-term health of portfolio companies. In so doing, the Article develops a theory describing the acute incentive problems that prevent passive funds from participating thoughtfully in governance. Third, the Article shows how the rise of passive investing may exacerbate agency cost problems at corporations, with the potential to create billions of dollars in social welfare losses.

   Finally, the Article offers a novel policy proposal for lawmakers: restrict truly passive funds from voting at shareholder meetings. By diminishing the role of passive investors in governance, this rule would not only reduce the risk of distortion, but also preserve the voice of informed investors as a force for discipline. In addition, there is a compelling legal rationale for such a restriction. Passive funds lack governance expertise and firm-specific knowledge, and so a thoughtful voting strategy would increase costs without meaningfully improving portfolio returns. Thoughtless voting is also likely to harm investors, as well as other shareholders, especially as passive funds grow in size and influence. In other words, pursuit of either approach would put the passive fund at risk of breaching its fiduciary duty to act in its investors' best interests. A law restricting passive funds from voting, therefore, would make both investors and fund managers better off.

   This Article proceeds...