Conflicted Mutual Fund Voting in Corporate Law

In their challenge to Tesla’s $2.6 billion merger with SolarCity, the shareholder plaintiffs raised a novel argument. Because Tesla’s top 25 institutional investors—those holding 45.7% of Tesla’s stock—also held SolarCity stock, they stood on both sides of the transaction and therefore, the shareholder plaintiffs argued, their votes should not be treated as “disinterested.” The Delaware Court of Chancery never reached this argument, dismissing the case on other grounds, but predicted that the argument would resurface one day. We think it will too. It is an example of a paradigmatic conflict caused by the increasing intermediation of corporate shareholdings by institutional investors in general, and mutual funds in particular.

Having been steadily growing for decades, institutional investors’ share of U.S. equity markets now stands at over 80%, with mutual funds holding more than half of that amount. In the past decade, investor demand for passively managed mutual funds—index funds and exchange-traded funds (“ETFs”)—has rendered the institutions that favor passive management especially powerful: BlackRock now controls 5% blocks of more than half of U.S. publicly traded companies, and Vanguard has 5% blocks in over 40% of such companies.

Institutional ownership is intermediated ownership. The fund controls the vote of shares held in by the fund, yet the individual investor receives the economic returns of ownership. It has long been understood that the separation of ownership from control gives rise to conflicts. Yet to our knowledge, there is no systematic account of the conflicts created by modern mutual fund investing. We seek to provide that account our recent article, Conflicted Mutual Fund Voting in Corporate Law, forthcoming the Boston University Law Review.

In our article, we provide a typology of three paradigmatic forms of conflict created by mutual intermediaries. These are: Cross-Ownership Conflict, Corporate Client Conflict, and Uniform Policy Conflict.

Cross-Ownership Conflict applies to situations like the Tesla-Solar City example, in which mutual funds have interests on both sides of a transaction or, alternatively, with industry competitors. That interest may cause the funds to use their vote to benefit their investment in another company to the detriment of the real parties in interest. In the Tesla-Solar City example, institutional investors may have voted their Tesla shares in favor of the deal in order to prevent Solar City from falling into bankruptcy, thereby destroying the value of their investment in that company. Thus, although the merger might not have been a great deal from the perspective of Tesla shareholders—the Wall Street Journal described it as “the equivalent of a shipwrecked man clinging to a piece of driftwood grabbing on to another man without one”—institutions with interests on both sides might have been tempted to vote their Tesla shares in favor of the deal.

Corporate Client Conflict refers to situation in which mutual funds cast votes to curry favor (or avoid upsetting) corporate managers, whom they see as current or potential clients for investment advisory services, rather than voting in their investors’ best interests. For example, mutual fund sponsors often count company management as a client for 401(k) accounts and other services.

Finally, Uniform Policy Conflict is created by the policy of many mutual fund complexes of voting all of their funds in a uniform way or, more generally, in conformity with a complex-wide voting policy. But the funds within a complex will not have identical portfolios or interests. When these funds are made to hew the line of a complex-wide voting policy, they may act contrary to the interests of the individual fund’s investors. Uniform Policy Conflict can create a number of sub-conflicts, which we detail in the article. For example,

• Favoring Active. Fund complexes may use uniform voting to favor the interests of active funds in the portfolio since more fee income is generate by active rather than passive funds.
• Favoring Passive. Fund complexes may use uniform voting to favor the interests of passive funds if their passive holdings significantly outweigh their active holdings.
• Disregarding Unique Fund Goals. Fund complexes may hew to uniform voting without regard to divergent fund objectives generated by divergent time horizons (e.g., target date funds) or risk preferences (e.g., actively managed value funds).
• Favoring Debt. Fund complexes with large debt portfolios may vote their equity interests in a way that favors debt positions held by bond funds.
• Favoring Vocal Interests. Fund complexes may vote according to the interests of large and vocal investors, such as public pension funds.
• Favoring Something Else. Fund complexes may use their voting policies to flatter the vanities of their managers with regard to social issues or to appease employee concerns or to appeal to actual or prospective customers, such as universities with strong voting interests on particular social issues. These preferences may clash with the interest of current mutual fund investors focused principally on maximizing their investment return.

Ultimately, we recommend that Delaware courts should consider these potential shareholder conflicts before abandoning judicial scrutiny of M&A transactions. In particular, if a plaintiff presents evidence of a disabling economic conflict—either Cross-Ownership Conflict or Corporate Client Conflict—the institutional investor, like conflicted management, should not qualify as “disinterested.” Such conflicts undermine the rationale justifying the application of the deferential business judgment standard of review—that the underlying investors have spoken in favor of the transaction. Moreover, when there is a conflict, the court lacks assurance that fiduciaries are necessarily voting to further their investors’ best interests. In some cases, the conflicts may result in a vote that is aligned with investors’ interests, but not always. And in cases where diversified shareholders favor a vote for a value-reducing transaction, that conflict provides an additional reason for enhanced scrutiny: the shareholders are not playing the gate-keeper role—approving good transactions and vetoing the bad—that the court intended they would play.

The complete article is available for download here.