Index Fund Enforcement

Three financial institutions now vote 25% of the stock in the largest U.S. public companies. Soon, the figure may be closer to 40%. Vanguard, BlackRock, and State Street Global Advisors—the so-called “Big Three”—dominate the market for index funds and other passively-managed investment vehicles. As passive investing has grown increasingly popular with investors, these institutions have accumulated astonishing levels of economic power.

To date, however, the debate over the rise of the Big Three has overlooked an area where this concentration of power may have a particularly significant effect: the corporate enforcement ecosystem. The analysis of some leading corporate governance scholars suggests that there is reason to worry that the Big Three’s rise could significantly undermine the current system of private and reputational mechanisms to hold companies and managers accountable for fraud and misconduct. Proponents of what I call the “Passivity Thesis” have argued that index fund managers have generally overriding incentives to refrain from meaningful corporate “stewardship”—i.e. actions to influence and enhance the value of individual portfolio companies. [See, Index Funds and the Future of Corporate Governance (discussed on the Forum here) and The Agency problems of Institutional Investors by Bebchuk, Cohen, and Hirst (discussed on the Forum here)] If that’s true, the Big Three might also be expected to use their considerable power and influence to effectively insulate managers and companies from accountability for wrongdoing.

But the Passivity Thesis is incomplete. In a new article, Index Fund Enforcement, I show that, in the wake of certain corporate scandals, the Big Three’s general incentives to remain passive are overcome by countervailing “pro-enforcement” incentives. For instance, using hand-collected data from class action filings and SEC disclosures, I demonstrate that non-class litigation against portfolio companies provides a viable mechanism for index funds to achieve a competitive advantage over otherwise identical funds managed by rivals. And I show that, for the Big Three, responding to corporate misconduct is both less costly and potentially more valuable than other forms of individualized corporate stewardship.

In my article, I present a global review of the Big Three’s enforcement activities in litigation, voting, engagement, and guidance—drawing on several original data sets as well as insights from conversations with inside and outside counsel for the Big Three. This evidence confirms that in an important minority of cases the Big Three do take action to hold individual companies and their managers accountable for corporate fraud and misconduct and that these actions can have a significant impact. For instance, the Big Three have pursued a moderate slate of non-class litigation against portfolio companies, have used their substantial power to vote against culpable directors in the wake of high-profile corporate misconduct, and have regularly engaged with portfolio companies in the aftermath of corporate scandals to gather information and demand action.

These findings provide a good reason to hesitate before embracing the proposals that have been advanced by a wide range of commentators that would restrict the Big Three’s ability to influence portfolio companies. As policymakers weigh new regulations for the industry, they should not overlook the important social benefit—punishing and deterring corporate fraud and misconduct—that the Big Three may provide through their influence over portfolio firms.

At the same time, however, my article shows that the Big Three are not yet living up to their full enforcement potential. While they have pursued a moderate slate of non-class litigation, I find that they have done so predominantly against non-U.S. firms. Similarly, while the Big Three have regularly voted against culpable directors in the wake of a major corporate scandals, they have often continued to support that same director at other companies where he or she serves, diluting the deterrent force of the “no” vote. And the Big Three have failed to promulgate virtually any guidance regarding how they exercise their enforcement powers—i.e., when they will litigate against a portfolio firm, or when they will vote against a director for his or her complicity in corporate misconduct.

But at least some of this enforcement shortfall appears to be attributable to gaps in the regulatory regime governing the Big Three rather than to fundamental financial incentives. For instance, while mutual funds have extensive disclosure requirements with regard to proxy voting, they have no parallel obligations in the domain of litigation and therefore are free to make these decisions in a non-transparent and potentially conflicted manner. As policymakers weigh new index fund regulation, they should consider reforms to enhance index fund enforcement, rather than weaken it.

The complete article is available here.