Home > Voting Rights > The Case Against Passive Shareholder Voting, by Dorothy Shapiro Lund

The Case Against Passive Shareholder Voting, by Dorothy Shapiro Lund

The increase in the power of shareholders faces big challenges as regulation is not necessarily followed by a correct valuation of voting (the most powerful of their capacities), by them. The One Share One Vote principle is affected by dual-class share systems and no voting shares; but shareholders also suffer from rational apathy and collective action problems, so that the objective of empowering shareholders is not easily reached. See my previous posts on the topic here (1)

Dorothy Shapiro Lund from the University of Chicago recently published an article in which she analyzes the effect on rational voting practices stemming from the shift of investors (American in her study) from actively managed funds investing into (indexed) passive funds. (2) She states this trend will damage the market for corporate influence, thus lowering the discipline imposed on managers. Their investment in Corporate Governance (CG from now on) and/or in gathering firm-specific information leaves them with the cost and only a small fraction of the eventual profit…so they lack the financial incentive to invest. Furthermore, passive funds are less likely to channel funds to hedge funds, (which could help correct the problem, -see (3)), and will adhere to low-cost governance solutions, following proxy advisors or simple-not-so-smart criteria).

150331130735-motley-index-funds-780x439

As Jason Zweig states (4), the optimal amount of active participation in CG is higher than the one needed to keep efficient markets, so that anomalies in CG appear well before they do so in the price mechanism.

Dorothy Shapiro Lund introduces us to a complete view of the market for corporate influence; starting with the separation of ownership and control; following with the deceiving role of institutional investors in using the “voice” mechanism, (through actions against management, voting, or providing shareholder proposals) and the corrective action by equity hedge funds; she nevertheless states that their activity has been undervalued as they often engage with management (which is less observable and costly), as they also use the exit threat, and  cooperate with other investors (such as hedge funds) so as to influence management.

  1. What is the threat introduced by Passive investing?

Dorothy Shapiro Lund introduces two main ideas:

  1. The rise of Passive Investment.

Passive funds generally automate their stock trading as they try to match an Index or part of it, (this is the reason why their fees are lower). As the rewards offered by actively managed and hedge funds have not (after-fees) been sufficiently and consistently higher than the ones granted by passive funds, investors are shifting their investments into the latter ones, the author offers data since 2008 into 2016). Even after the change, their share of investment in the S&P 500 only reaches 12%. But the forecast is that they will keep growing their share, (Vanguard, Blackrock, State Street –the Big Three- and a few others in a concentrated industry will benefit). The author does not abound in the results for the capital market efficiency and liquidity, (effects would not be definitive until passivity reaches 90% of share according to Bogle (4)).

There is also a second problem that she only refers to, the effect on competition as institutional investors own large stakes in competitive companies in similar industries (5).

But the author concentrates her effort in the second idea, the passivity problem.

  1. The passivity Problem.

The problem as introduced above, arises for several reasons that reduce their financial incentive to invest in research:

  1. Every fund owns very little stock of a particular company, as it is usually strongly diversified. It would not really benefit from CG investment in particular firms.
  2. An intervention will also benefit all other funds, so that its relative performance (their true target) would not improve.
  3. Even more, given their passivity, any investment requires expensive and not internally available resources.
  4. When they eventually intervene, they would choose low-cost tools and eventually harmful to CG tools.

The damage will appear when the market share of passive funds reaches a much more reduced level than the one Bogle referred to when analyzing the stock market pricing efficiency, (90%). For example a 51% market share could be harmful enough. When institutional investors are present in both active and passive funds, the latter could eventually free-ride the former´s efforts, but as the passive industry gains share, this would be less the case.

  • The passivity´s effects in CG through Voting and Engagement.

The Big Three seem to be proud of their activism, but the truth is different. Their CG teams are centralized, understaffed, misaligned. They rely on proxy advisory firms and follow guidelines that the SEC tries to illuminate, judging them insufficient. Their votes are casted by almost all funds in the same manner. Accordingly, they have affected CG: rejection of dual-class shares systems, independence, removal of poison pills and anti-takeover defenses, etc. The one-size-fits-all approach will surely damage CG, Shapiro Lund says.

As for engagement, the Big Three disclose the meetings held with companies and their coverage, and negligence seems to be even a soft description. Most of the research done by active funds arises when analysts of portfolio managers meet boards and management, so that most of it gets lost with the transition to passive funds.

  • Hedge Funds.

Their effectiveness will eventually be reduced by the loss of tipping by active funds and also by the new wave of passive funds themselves as these ones will not help adequate proposals to succeed (and the opposite), because of the costs or because of the eventual loss of customers. Furthermore, passive funds presence apparently changes the type of activism, (favoring board presence claims against campaigns asking for strategy or capital allocation changes).

  1. Policy Prescriptions

Losses for shareholders and the general economy are not directly measurable, but some studies suggest they could be huge, (just think of a decline in the effectiveness of the market for corporate control). So, apart from leaving the market to react or from prohibiting or discouraging low-fee investment activities, perhaps regulators could restrict passive funds from CG activities. Shapiro Lund analyzes the options.

  1. Rethinking Passive Fund Voting.

In 2003 the SEC issued a rule mandating that the funds disclosed the sense of their votes. But the rule does not force them to vote, but only to abide by their fiduciary duty; accordingly funds could avoid voting if the cost was higher than the eventual profit for their customers. If they did, part of the above said problems would not appear; but CG activity has by now been adopted in the core of marketing materials by institutional investors. Should the law restrict uninformed voting and consequently give informed shareholders a greater voice? Shapiro presents the three existing options for that:

  1. Eliminate Passive Fund Voting. Shares would still provide the right to vote but passive funds –those that simply match an index would be presumed to be passive- would be restricted to use their right. The rule is simple to apply: it reduces costs and obligations, and it would accept passive funds to proof CG activity and defense in case the minority attached passive funds economic interests.
  2. Pass-through voting to investors in the case of non-routine matters. It is the same that occurs with ESOP plans. The burden could be large but if restricted to non-routine matters, the cost would not be so high neither for funds nor for investors. A cost would exist which would reduce the free-riding problem (with active funds under same umbrella) and reduce the cash flow to them.
  3. Pass-through voting as a default. This would allow some funds to differentiate investing in CG and research.

      The structure of the industry should nevertheless be considered; for instance, where the banking system controls the distribution of fund services, there is a case to regulate the fees passed to retail investors, which contributes to increase the flow from active to passive funds, (see 2017 regulatory changes in Spain, for example).

       2.   Introducing incentives to beneficial investment in CG. Why so difficult?

Forcing disclosure has apparently only had the result that funds have started to vote all shares uninformedly. Giving a fund the option to recover the costs of a profitable intervention in a company would be a good tool, that would alleviate the free-riding problem; nevertheless implementing this tool would be very difficult because assessing costs and benefits won´t be an easy task.

Shapiro concludes that “Thus, by restricting passive funds from voting, the law would reduce the risk of governance distortion created by the rise of passive investing.”

 

(1) https://joaquinbarquero.wordpress.com/2017/06/18/voice-the-perspective-of-minority-shareholders/ , https://joaquinbarquero.wordpress.com/2017/03/30/corporate-governance-challenges-in-controlled-companies-usa-versus-eu/ , https://joaquinbarquero.wordpress.com/2013/03/05/one-share-one-vote/,  and https://joaquinbarquero.wordpress.com/2016/07/18/why-do-institutional-investors-exit-instead-of-raising-their-voice/ .

(2) Lund, Dorothy Shapiro, The Case Against Passive Shareholder Voting (July 7, 2017). Journal of Corporation Law, Forthcoming . Available at SSRN: https://ssrn.com/abstract=2992046

(3) https://joaquinbarquero.wordpress.com/2013/09/21/159/ and Rose & Sharfman, “ Shareholder Activism as a Corrective Mechanism in Corporate Governance”, September 2013, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324151

(4) http://jasonzweig.com/are-index-funds-eating-the-world/

(5) José Azar, Martin C. Schmalz, & Isabel Tecu, Anti-Competitive Effects of Common Ownership, Ross School of Business Paper No. 1235 (2016), available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2427345

(6) Elisabeth Kempf, Alberto Manconi, and Oliver G. Spalt, Distracted Shareholders and Corporate Actions, REV. OF FIN. STUDIES (forthcoming 2017).

 

Advertisements
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: