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The rise of index fund investing has created a low-cost investment vehicle that enables investors to capture market returns without the high cost of active investing. As I have examined in two prior posts, “A Proposed Solution to the Index Fund Free Rider Problem” and “The Problem With Index Investing,” one adverse side effect of this salutary development is the creation of large blocks of voting stock whose holders are disincentivized from expending funds to engage in proxy analysis. These blocks of shares can become a voting dead weight, enabling management to entrench themselves at the expense of shareholders and market efficiency. I refer to this as the “Index Fund Free Rider Problem.” I have previously proposed a legal infrastructure to allow index fund investors (and others) the option of voting pro rata with all other holders (or with other holders excluding insiders) as a solution. The SEC has since begun to study the index fund free rider problem, and is taking the first steps to address it.
The SEC’s Approach to the Index Fund Free Rider Problem
Historically, the SEC has not addressed the index fund free rider problem. Instead, the commission simply imposed a duty on all registered investment advisors to “adopt written policies and procedures…to ensure that [advisors] vote client securities in the best interest of clients.” In a series of “no-action letters” (letters issued to individuals posing specific questions) and a staff legal bulletin, the SEC has provided guidance that investment advisors could rely on an independent third party (such as a proxy advisory firm) in exercising their corporate franchise, so long as the advisor followed proper procedure. This has created a new problem: over-reliance on the proxy advisory, some of whom now provide advisory services to issuers to help them achieve favorable recommendations. To some extent this is reminiscent of the conflicts created by the advisory services provided by the credit rating agencies prior to the global financial crisis of the last decade.
SEC Taking Action
One month after my last post on this subject, the SEC began taking steps to study the proxy rules. In July, the SEC announced a roundtable to be held in November to consider the proxy rules. In September, addressing the SEC Investor Advisory Committee, SEC Chairman Clayton charged the committee with analyzing “the growth of passive investing and its implications” and noted that “[m]arket analysts also posit that risk may be amplified as a result of concentration in passive strategies.” He asked the committee to address the question as to how “passive funds should approach engagement with companies” in which they invest.
On September 13, SEC staff withdrew the two key no-action letters allowing advisors to rely on proxy advisory firms, but left out a staff legal bulletin that covers much of the same ground. The staff indicated that the withdrawal was designed to “facilitate the discussion at the Roundtable.” However, by not withdrawing the related Staff Legal Bulletin No. 20, there may be little effect to the withdrawal of the letters. In addition, on the same day, SEC Chairman Jay Powell reiterated “the Commission’s longstanding position…that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.”
What’s Next?
It is fair to say that we can expect a lot of lobbying over these issues. Public company management teams and the proxy advisory firms are likely to advocate for the maintenance of the status quo. Passive fund managers are looking for a simple system which does not require them to expend resources on proxy voting (unless they want to) and does not expose them to liability. Activist investors will seek a mechanism that removes that inherent structural bias for passive investors to vote in favor of incumbent management. Finally, advocates of good corporate governance will seek a system that works. The risk is gridlock and no solution to the index fund free rider problem.
Pro Rata Voting is Still the Answer
Famously, Abraham Lincoln’s strategy in the 1860 Republican Convention was not to be everyone’s first choice—it was to be everyone’s second choice and to alienate no one. Although pro rata voting may not be ideal, as a permissive option that is consistent with the efficient market hypothesis underlying index investing, it is an easily implementable second choice that should be acceptable to all.
Author’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, this post may constitute attorney advertising.
