Proxy Scorecard and Fund Competition

James McRitchie is the publisher of Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

Corporations facilitated the most dynamic economic growth in history. Dispersed ownership hampers their ability to address adverse impacts that undermine workers, society and the environment. Ironically, the concentrated power of giant index funds presents an opportunity to address those issues through proxy scorecards providing increased feedback. See SEC rulemaking petition, File 4-748, Request to amendment of Title 17, §270.30b1-4, Report of proxy voting record. Real-time disclosure of corporate proxy votes would lead to competition among funds, based not only on historic costs and returns, but values expressed in vigorously debated proxy scorecards.

Suggested Tax Reforms Will Not Change Mutual Funds into Worker Advocates

Leo E. Strine, Jr, Chief Justice of the Delaware Supreme Court, and Antonio Weiss, of Harvard’s Kennedy School), argue large institutional investors fail to engage on behalf of workers in corporate governance debates (Why Isn’t Your Mutual Fund Sticking Up for You?). Since worker interests go unrepresented, America suffers growing inequality, environmental degradation and a host of other ill-effects. Most Americans invest through their employer’s 401(k) accounts.

At the average S. & P. 500 company, the 15 largest institutional investors own over half the shares, effectively determining the outcomes of shareholder votes. And the top four stockholders control over 20 percent… reforms must make sure that mutual funds align their investing and voting behavior with the interests of the individuals whose capital they control.

Strine and Weiss propose to solve the problem with a fractional tax on all securities trades and making lower capital gains tax rates available only on investments held for at least five years.

The proceeds could be used to make long-term investments in the environmental efficiency of infrastructure, basic scientific research, better training for America’s students and workers, and in helping workers move from carbon-intensive industries to the sustainable-energy industries of the future.

A small tax on trades and requiring a longer holding period to qualify for lower capital gains tax rates may be beneficial. However, neither reform would incentivize mutual funds to stick up for workers. Neither reform would lead to “a more rational corporate governance framework that holds both institutional investors and corporations accountable,” as the authors suggest.

The largest funds trade only to reflect changing indexes, as well as inflows and outflows. Their passive trading behavior would not change with a small trading tax. Extending the holding time for a lower capital gains tax would also have little or no impact on workers, since most of their investments are held in tax deferred savings plans. Workers pay no taxes on such investments until they retire. At that point, they pay income taxes on the full amount withdrawn, not lower capital gains tax on the increased value of their investments.

The recommendations of Strine and Weiss would do little or nothing to help workers hold corporations accountable. Additionally, both suggestions would require changes in law, something unlikely if Congress remains gridlocked.

Worker-Investors Need a Voice

Strine and Weiss do recognize a real problem. Workers need a voice in how mutual funds vote their proxies. Pass-through voting is impractical. Aside from the difficulty of calculating pro-rata shares, funds have specialized staff and contractors dedicated to analyzing and reviewing tens of thousands of proxy votes every season. Workers lack such resources. That is probably why up to 91.6% of retail shareholders fail to vote. (See “Positions Voted % by Distribution Type,” page 4 at Analysis of Distribution and Voting Trends Fiscal Year Ending June 30, 2017.)

The ability to move investments to another fund is a familiar form of voting through the marketplace. With better information, workers would seek to invest in funds that vote in alignment with their values. If their employer offers limited options, workers could pressure their employer for better options or could at least put pressure on the voting behavior of funds on offer. Action begins with awareness. Competition or pressure work only if voting records are available and can be easily compared, like proxy scorecards.

One out of every four dollars under professional management in the United States, $12.0 trillion, was invested according to SRI strategies as of year-end 2017. That represents a 38% increase between 2016 and 2018. (Report on US Sustainable, Responsible and Impact Investing Trends) ESG (Environmental, Social and Governance) funds from BlackRock, Vanguard, Fidelity Investments, TIAA-CREF, and others, cast a number of votes that appear to conflict with an SRI/ESG focus. By way of contrast, among nine fund companies with a long-term ESG focus, not a single vote was cast against climate-change resolutions that garnered more than 40% of the shareholder vote. (Morningstar Direct Uncovers ESG Hypocrites)

ESG funds within large fund families continue to vote in lockstep with their fund family. Those votes may not reflect the wishes of worker-investors. Workers are often given scorecards comparing the historical costs and gains of funds on offer through their available plan. However, few are given proxy scorecards comparing fund votes on ESG issues that may be important to them. Fund names are often misleading.

Failed Attempt by SEC to Create Proxy Voting Accountability

In 2003 the SEC enacted a rule requiring funds to disclose their proxy votes using form N-PX. In contrast to the rule’s stated intent (Final Rule: Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies), a review of its impact would find N-PX filings do not “enable fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies.” Filings do not shed light on mutual fund voting to “illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders’ best interests.” Filings do not enable shareholders to “evaluate how closely fund managers follow their state proxy voting policies, and to react adversely to fund managers who vote inconsistently with these policies.”

To my knowledge, no retail investors use N-PX filings for their stated purpose. Data reported on the N-PX is not freely available in a user-friendly format. Year-old data is out-of-date in an age when most news arrives instantaneously on social media. Compare the sortable near real-time voluntary disclosure of Trillium Asset Management (under “search proxy votes”), which even includes the rationale for each vote, with the currently mandated disclosure of the Vanguard Index Trust Total Stock Market Index Fund, which requires a laborious effort to decipher.

Creating even a simple proxy scorecard to compare the voting records of two funds, such as Trillium and Vanguard, would be difficult. That difficulty increases exponentially if we try to compare dozens, hundreds or thousands of fund proxy voting records.

Proxy Scorecards Will Drive Fund Competition and Corporate Behavior

The SEC could accomplish the original goals of Rule 30b1-4, including the empowerment of worker-investors, by simply revising its N-PX reporting rules to require filings in real-time and in a user-friendly format. Rapid disclosure and reporting of proxy votes would foster public debate on the issues faced by corporations and investors. With real-time disclosure, funds would begin to compete not only on the basis of cost and returns but also on how their votes align with the values of Main Street investors or Mr. and Ms. 401(k), as SEC Chairman Clayton frequently calls working investors.

No act of Congress is needed to incentivize mutual funds to stick up for workers. Five SEC commissioners from both sides of the aisle should be able to agree that competition around proxy voting records will increase accountability to workers and to other stakeholders, as recently espoused by the Business Roundtable (So Long to Shareholder Primacy).

Minor amendments to a rule mandating an obscure reporting form could make all the difference in getting mutual funds to stick up for workers and other stakeholders. Proxy scorecards will take their place alongside scorecards comparing historical costs and returns. Mutual funds will become advocates for the workers they represent, and corporate directors will see worker-investors as important constituents.

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