Towards a New Solution to Retail Investors’ Apathy

Kobi Kastiel is a Research Director of The Project on Controlling Shareholders at the Harvard Law School Program on Corporate Governance, and Yaron Nili is Assistant Professor at University of Wisconsin Law School. This post is based on their recent article, forthcoming in the Delaware Journal of Corporate Law. Related research from the Program on Corporate Governance includes Frozen Charters by Scott Hirst (discussed on the Forum here).

Corporate law scholars have taken investors’ rational apathy for granted for decades, considering it a necessary evil once ownership is no longer closely held. The traditional explanation is well known: diversified retail investors, who individually hold small fractions of a firm’s equity capital, often lack the financial incentives to monitor management, as they know that their vote probably will not affect the outcome. Since the process of informing and expressing one’s preferences is costly, these investors often choose to refrain from any involvement in the governance of the corporation. For such a shareholder, it is simply economically rational to stay uninformed and not to vote at all.

However, the increasing emphasis on shareholder input on corporate affairs has led to renewed concern regarding the impact that retail investors’ rational apathy may have on modern corporate governance. Indeed, first signs of a shift in the regulatory approach to retail investors’ participation can be found in a roundtable that the Securities and Exchange Commission (SEC) organized in early 2015 that focused on the possible ways and means to increase retail shareholder participation in the proxy process. Our article, In Search of the “Absent” Shareholders: A New Solution to Retail Investors’ Apathy, forthcoming in the Delaware Journal of Corporate Law, aims to advance this SEC mission by focusing on three important questions. First, how significant is retail investors’ apathy in the era of increased shareholder activism and after the employment of the Internet to facilitate shareholder voting? Second, why should one care if certain investors choose, rationally or otherwise, to stay out of the game? Third, is there a cost-effective strategy for increasing retail shareholder participation in the voting process?

We start by providing novel empirical data, exposing the true magnitude and significance of retail investors’ apathy. Surprisingly, despite technological advances, such as the employment of online voting, and the recent rise in shareholder activism, we show that the problem of investors’ apathy continues to exist in U.S. capital markets in a significant manner. In particular, using empirical data on the voting patterns at S&P 500 companies in the years 2008-2015, we find that the percentage of shares that do not vote is still very significant, standing at 21.7 percent of the total votes in 2015. We also identify that non-participation rates have been trending up by 42 percent, from 15.2 percent in 2008 to 21.7 percent in 2015.

This significant increase in non-participation could be explained, at least partially, by changes that the New York Stock Exchange (NYSE) made in 2009 and 2011 to the ability of brokers to vote shares that they received no voting instructions for (often termed as “Broker Non-votes”). As brokers have become more restricted in their ability to vote uninstructed shares, the true scope and impact of retail investors’ apathy is finally revealed. More importantly, we also argue that regulatory reforms that took place in the past decade and were aimed at providing additional monitoring rights to shareholders and enhancing disclosure (positive goals in our view) also had an unintended consequence: increasing the costs associated with exercising an informed vote, and thus, aggravating the problem of investors’ apathy.

Consider the example of Apple. In 1994, the company proxy statement had 18 pages, and only two proposals were submitted to shareholder votes. Twenty years later, the company proxy statement was more than five times longer. It held 90 pages, and 11 different proposals were brought to shareholder vote. Moreover, since many investors tend to hold stocks in numerous companies for diversification purposes, each proxy season, they have to read hundreds of disclosure pages and examine dozens of different proposals in order to exercise an informed vote. This is clearly an impossible task for the average individual investor.

We then move to explore the impact of retail investors’ apathy in the era of activist investing. In contradiction to the traditional belief that retail investors’ participation has marginal impact, if at all, on the vote outcome, we show that retail shareholders’ vote and their participation in corporate decision making is more important today than it has ever been in the past. Aside from the traditional argument regarding potential distortion in voting outcome, we show that recent changes in U.S. corporate governance landscape, including the rise in hedge fund activism and the increasing importance of proxy advisers, coupled with the credible sanctions against companies that ignore shareholder concerns, have made retail investors’ votes more important than ever.

In this new reality, where just a small percentage of votes can make a big difference, and where the threshold of voting impact is not always the 50.01% majority requirement, but often much less (in the range of 30% for negative say-on-pay votes or withhold campaigns), retail investors’ lack of participation may have significant impact on the results of matters brought to a vote of shareholders, or on directors’ chances to be re-elected. When a non-negligible number of shareholders avoid participating in the vote, the ability of shareholders to initiate important governance changes or to convey their dissatisfaction with the board’s poor practices is impaired. This is because the voice of shareholders is diluted, which, in turn, reduces boards’ incentives to remain accountable to shareholders.

Finally, building on behavioral economics tools, we present a novel solution that could substantially mitigate, if not fully eliminate, the long-standing problem of investors’ rational apathy, with minimal regulatory burden. The solution is based on the premise that the high economic and mental costs associated with voting could be dramatically reduced by providing retail investors with a little “nudge” in the form of highly-visible voting default arrangements that would allow (or force) them to choose from a menu of voting short-cuts. By allowing retail investors to choose the best agent to make an informed decision on their behalf and by increasing the visibility of the potential voting short-cuts (e.g., through the use of pop-up screen and opt-out option), our proposed solution has the potential to increase shareholder involvement significantly. Under our proposed framework, by checking a box, a retail investor could instruct that her shares be voted in the same manner as a specific large and sophisticated shareholder, with management, in accordance with the recommendation of a proxy advisor, or in accordance with the majority vote of institutional investors not affiliated with management.

From a policy perspective, our call for the use of voting heuristics has another important advantage: it does not impose substantial costs or time commitment on issuers or the market. We do recognize, however, that the design of such a voting short-cut system is far from simple and involves different choices and considerations that regulators will have to take into account. To that end, we identify several levels of design-choice that a policy maker would need to consider before adopting such a regime. We conclude by considering a wide range of possible objections to our suggested proposal to provide retail investors with voting “short-cuts,” arguing that none of them provides a sufficient basis for rejecting our proposed framework.

The full article is available for download here.

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