THE CONFLICT BETWEEN BLACKROCK'S SHAREHOLDER ACTIVISM AND ERISA'S FIDUCIARY DUTIES.

• Author: Sharfman, Bernard S.

ABSTRACT

The focus of this Article is on the agency costs that may be created by the empty voting of investment advisers to index funds and how they can be mitigated so as to protect the value of private employee pension benefit plans. This Article focuses on BlackRock because it has taken a leadership role in the leveraging of its delegated voting authority. Therefore, the issue I address in this Article is whether the fiduciary duties of a plan manager of an "employee pension benefit plan," as authorized under the Employee Retirement Income Security Act of 1974 ("ERISA"), requires it to investigate BlackRock's shareholder activism. This indirect approach is required as the fiduciary duties of ERISA do not generally extend to mutual funds and ETFs and their investment advisors.

This Article takes the position that a plan manager has a fiduciary duty, the duty of prudence, to investigate BlackRock's shareholder activism. This duty applies not only to BlackRock's mutual funds or ETFs that an ERISA plan invests in but also to those BlackRock fund selections that it makes available to its participants and beneficiaries in self-directed accounts.

Given these fiduciary duties, this Article argues that if a plan manager were to investigate BlackRock's shareholder activism, especially its engagement strategy, it would likely find it to be in conflict with the manager's fiduciary duties. Such a finding would require a plan manager to seek out other reasonably available alternatives that are not associated with such shareholder activism.

While the focus of this Article is on BlackRock's delegated voting authority and associated shareholder activism, it is meant to apply to any and all investment advisers who attempt to leverage their delegated voting authority for purposes of engaging in such activism. Moreover, the Department of Labor should provide guidance to plan managers on when the investment products of investment advisers with delegated voting authority need to be excluded.

INTRODUCTION I. BLACKROCK'S RHETORIC A. A Focus on Stakeholders B. The Primary Objective: Marketing BlackRock's Investment Products to Millennials C. BlackRock's Engagement Strategy II. PUTTING WORDS INTO ACTION: BLACKROCK'S VOTING AND ENGAGEMENT RECORD III. ERISA's FIDUCIARY DUTIES A. Duty of Loyalty B. Duty of Prudence C. ERISA's Duties and Shareholder Voting/Engagement 1. Shareholder Voting 2. Shareholder Engagement IV. ERISA's FIDUCIARY DUTIES AND INDEX FUNDS: ISSUE AND RULE A. The Issue B. The Rule C. Rationales for the Rule V. APPLYING THE RULE TO BLACKROCK'S SHAREHOLDER ACTIVISM A. BlackRock's Shareholder Activism in a Theoretical Framework B. Marketing Objective C. Engagement Strategy and Stakeholder Approach 1. A Harmful Engagement Strategy a. The Complexity of Stakeholder Relationships b. An Extremely Uninformed Shareholder 2. Summary of BlackRock's Engagement Strategy D. Under ERISA, What Kind of Shareholder Activism and Engagement Strategy Adds Value? 1273 CONCLUSION INTRODUCTION

The world is full of surprises. One of those surprises is that BlackRock, Inc. ("BlackRock"), an investment adviser (1) that primarily markets and manages index funds to millions of passive investors around the globe, has become a leading shareholder activist. Based on the extremely large amount of assets it has under management, approximately $7.3 trillion with approximately $3.5 trillion of that being the common stock of publicly traded companies, (2) its importance as an activist cannot be overstated.

BlackRock and its major index-fund rivals Vanguard and State Street Global Advisors (the "Big Three"), have an enormous amount of proxy voting power. According to Bebchuk and Hirst, as of 2017 BlackRock held in its managed portfolio a 5% or more position in 488 out of the 500 common stocks that make up the S&P 500, Vanguard had such a position in all 500 companies, and State Street Global Advisors in 130. (3) According to Fichtner, Heemskerk, and Garcia-Bernardo, as of March 2016 BlackRock had a 5% or more position in about 2,000 out of the approximately 3,900 U.S. publicly listed companies then existing, Vanguard had such a position in 1,750 such companies, and State Street Global Advisors in 260 companies. (4)

Yet this voting power actually understates the size of the Big Three's voting influence; the reason being that they vote virtually all of the shares they manage while other investor types, such as retail investors, do not. For example, Brav, Cain, and Zytnick, over the time period 2015 to 2017, found that while retail investors held approximately 26% of the shares in their sample, they only cast a ballot 32% of the time. (5) This explains Bebchuk and Hirst's findings that while on average the Big Three controlled 20.5% of shares of the companies that make up the S&P 500. they cast a combined 25.4% of the proxy votes. (6) Bebchuk and Hirst also estimated that Vanguard had an average voting influence of 11.1%. BlackRock 8.7%, and State Street 5.6%. (7) Consistent with Bebchuk and Hirst, Caleb Griffin finds that while the Big Three control approximately 20.1% of shares at the largest 250 publicly traded companies in the U.S., they cast a combined 25% of the proxy votes. (8) He further estimated that Vanguard had an average voting influence of 10.6%. BlackRock 9.0%, and State Street 5.4%. (9)

What has allowed the Big Three to become such large players in proxy voting? Basically, it is a combination of the strong investor interest in such index funds combined with how these funds have been traditionally managed. It begins when an individual investor or institution (beneficial investor) decides to invest in an index mutual fund or exchange traded fund ("ETF") that predominately invests in equity securities--for example, a fund that invests in equities that make up the S&P 500. This decision usually means that the beneficial investor is delegating its shareholder voting to the index fund, a common industry practice which relieves the beneficial investor of having to worry about shareholder voting. And the delegation of voting authority does not stop there. The mutual fund or ETF will then turn around and delegate its voting authority to the fund's investment adviser, the adviser that is responsible for managing the fund's portfolio of investments.

These standard practices, combined with the large movement of assets into the index funds of a relatively small number of investment advisers, has resulted in a concentration of voting power. But what is most striking about this arrangement is that the investment advisers to the funds have no economic interest in the underlying securities. This "decoupling" or "unbundling" of voting interests from economic interests in the context of shareholder voting is referred to as "empty voting." (10)--here, the empty voting of investment advisers to index mutual funds and ETFs. (11)

Empty voting creates a potential misalignment between the interests of voters (investment advisers to index mutual funds and ETFs) and the residual risk bearers (beneficial investors that own shares in the index mutual funds and ETFs) and therefore creates the potential for agency costs (12)--more precisely, what Gilson and Gordon would call "the agency costs of agency capitalism." (13) In the case of investment advisers to index funds, these agency costs come in two flavors. The first are "passive" agency costs. (14) These costs refer to the economic disincentives investment advisers to index funds have in becoming informed about the investments they manage, including when they vote their proxies. (15) The second are "proactive" agency costs. (16) These costs refer to the economic incentives investment advisers have to leverage their delegated voting authority for their own gain. (17)

Moreover, BlackRock, like the other members of the Big Three, has centralized this enormous voting authority and influence into the hands of a small group of individuals, its investment stewardship team. This allows BlackRock to aggregate shareholder voting across a myriad of funds for purposes of taking advantage of economies of scale and cost minimization. Its team is made up of forty-five professionals globally, with twenty-two based in the U.S. (twelve are global, and ten are local), who are, on an annual basis, responsible for the voting of tens of thousands of proxies and engaging on various matters with the management of hundreds of publicly traded companies. (18) Therefore, at many public companies, BlackRock's investment stewardship team, like its chief rivals, "may now control the fate of a shareholder or management proposal, whether a nominated director receives a required majority of votes to remain on the board of directors, or if a proxy contest succeeds or fails." (19)

BlackRock's creation of an investment stewardship team also allows it to coordinate its shareholder activism based not only on popular corporate governance principles but also on its own company objectives. This activism is reflected in its rhetoric disclosing the objectives of its activism and the engagement strategy that it intends to use to achieve its objectives, shareholder voting, and engagement with portfolio companies. As subsequently discussed, such activism contains elements of both passive and proactive agency costs that may be harmful to both beneficial investors and public companies.

The focus of this Article is on the agency costs that may be created by the empty voting of investment advisers to index funds and how they can be mitigated so as to protect the value of private employee pension benefit plans. This Article focuses on BlackRock because it has taken a leadership role in the leveraging of its delegated voting authority. Therefore, the issue I address in this Article is whether the fiduciary duties of a plan manager of an "employee pension benefit plan," as authorized under the Employee Retirement Income Security Act of 1974 ("ERISA"), (20)...