Reforming U.S. Capital Markets to Promote Economic Growth

Hal S. Scott is the Emeritus Nomura Professor of International Financial Systems at Harvard Law School and John Gulliver is the Kenneth C. Griffin Executive Director of the Program on International Financial Systems. This post is based on a report by the Committee on Capital Markets Regulation. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock by Lucian Bebchuk and Kobi Kastiel (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy and The Specter of the Giant Three, both by Lucian Bebchuk and Scott Hirst (discussed on the forum here and here); and Short-Termism and Capital Flows by Jesse Fried and Charles C. Y. Wang (discussed on the Forum here).

Executive Summary

Vibrant and well-functioning U.S. capital markets create jobs, bolster investment, promote innovation, and enhance retirement savings. Capital markets function best when regulations allow for the efficient allocation of capital while protecting investors. In this report, we evaluate major trends and developments in U.S. capital markets and assess whether existing regulations are continuing to serve U.S. companies and investors. We then set forth regulatory reforms to further enhance the performance of U.S. capital markets.

The report consists of four chapters: (1) The Rise of Dual Class Shares: Regulations and Implications, (2) Short-termism, Shareholder Activism and Stock Buybacks; (3) The Rise of Index Investing: Price Efficiency and Financial Stability; and (4) An Analysis of Investment Stewardship: Mutual Funds and ETFs. An executive summary of each chapter appears below.

Chapter 1: The Rise of Dual Class Shares: Regulations and Implications

Shares of common stock in corporations represent a bundle of rights: economic rights, such as the rights to receive dividends declared by the corporation and to the residual assets of a corporation after all of its creditors have been paid, and governance rights, including the right to vote on certain corporate decisions. These rights are typically allocated proportionally, with each share of common stock entitled to the same economic and voting rights as every other share. However, many jurisdictions allow corporations to offer classes of common stock with unequal voting rights.

In recent years, several prominent companies, such as Google, Facebook, and Alibaba, have gone public with dual class structures in which a minority of the shares, held by the company´s founders and executives, have special voting rights that provide their holders with effective control, while a majority of the company’s stock, which has regular voting rights, is held by outside investors. The increase in companies going public with dual class share structures, and the corresponding desire by stock exchanges to attract public offerings, have drawn renewed attention to these structures.

This chapter surveys the prevalence of dual class structures in several jurisdictions and the laws in those jurisdictions governing their use. It also considers the approach taken by stock exchanges, providers of stock indexes, and institutional investors with respect to dual class equity structures. That discussion is followed by consideration of the empirical evidence in favor of and against restricting the use of dual class equity structures. This chapter then evaluates specific proposals to regulate dual class equity structures.

We recommend that the Securities and Exchange Commission encourage dual class issuers to provide more robust disclosures regarding material risks associated with the dual class structure, through the SEC’s review of and comment on public filings by these issuers. For example, where appropriate, the SEC should direct a dual class issuer to disclose the risk that shares will be excluded

from major indexes. We also recommend that the SEC encourage each dual class issuer to disclose data showing the divergence between economic ownership and control, such as the numerical gap between a shareholder’s ownership interest and voting rights.

Chapter 2: Short-termism, Shareholder Activism and Stock Buybacks

According to the short-termism thesis, public companies in the United States are excessively focused on increasing short-term stock prices and are therefore foregoing valuable long-term investment. We evaluate the evidence to support the short-termism thesis including the role of shareholder activism and stock buybacks by public companies.

The first section of this chapter focuses on the empirical literature addressing whether short-termism exists, the potential causes of short-termism, and the economic effects of short-termism, if any. We find that U.S. public companies engage in similar amounts of long-term investment as private companies and public companies’ long-term investment has increased substantially in recent years. We therefore do not find support for the contention that short-termism is a problem in U.S. markets.

We then consider the rise of shareholder activism, which refers to tactics employed by shareholders of a company that are aimed at increasing the value of their stake in the company. Shareholder activism is often identified as a cause of short-termism as presumably these shareholders are focused on short-term returns. Overall, activism confers positive benefits on firms in the short run and the evidence regarding activism’s long-term effects is mixed.

The third section of this chapter considers the rise in stock buybacks by public companies. Critics of stock buybacks argue that the recent rise in stock buybacks is a symptom of short-termism—an attempt by companies to boost their stock prices in the near term, while foregoing long-term investment. However, we describe a number of motivating factors for stock buybacks that are not short-term. We also review empirical literature finding that stock buybacks often do not increase short-term stock prices and that long-term investment is particularly strong at companies engaged in share buybacks.

The final section of this chapter sets forth our policy recommendations to enhance long-term investment in U.S. public markets. First, we recommend that U.S. public companies weigh carefully the costs and benefits of issuing quarterly earnings guidance and consider ending the practice if they determine that such guidance is discouraging long-term investment. Second, the SEC should issue guidance clarifying that, when a company’s Board of Directors authorizes a stock repurchase program, the company should disclose on a timely basis certain material elements of the program, including its approximate intended duration and the maximum approved repurchase amount (for example, as a total number of shares or a total dollar value). Public companies should disclose these material elements within five business days of the authorization of the repurchase plan, through a press release or other Reg FD-compliant method that ensures broad public dissemination.

Chapter 3: The Rise of Index Investing: Price Efficiency and Financial Stability

Index investing is based upon a set of predefined, mechanical rules for choosing a publicly known set of stocks. The strategy of index investors is to gain exposure to the performance of the market as a whole or a particular segment of the market. Given its mechanical, rules-based nature, index investing does not require investment in fundamental research about security prices and typically entails significantly less trading activity than active investment. As a result, index investing tends to provide low-cost access to diversified portfolios.

In this chapter, we begin by tracking the growth of index investing in U.S. equity markets from a small niche strategy in the 1970s into an investment style comparable in scale to the active management of mutual funds. We then consider whether the rise of index investing has reduced the extent to which prices of individual stocks reflect their underlying value (price efficiency). We then examine whether the rise of index investing has increased risks to financial stability through three channels: (a) stock market bubbles and crashes; (b) concentration of asset managers; and (c) liquidity and redemption concerns. In conclusion, we find that the empirical evidence, while mixed, indicates that the rise of index investing has not had negative effects on price efficiency or financial stability. We recommend continued study of index investing in the years to come.

Chapter 4: An Analysis of Investment Stewardship: Mutual Funds and ETFs

Investment stewardship refers to shareholder engagement with public companies, including voting and other direct communications between investors and public companies. This chapter focuses on investment stewardship by investment advisers on behalf of index mutual funds and ETFs.

This chapter is divided into five sections.

Section 1 of this chapter provides a very brief introduction to mutual funds and exchange-traded funds and presents data showing their importance as shareholders of public companies. It also summarizes the regulatory framework governing mutual funds and ETFs (regulated as “investment companies” under the Investment Company Act of 1940) and the firms that manage these funds (regulated as “investment advisers” under the Investment Advisers Act of 1940).

Section 2 describes the existing legal and regulatory requirements regarding investment adviser and investment company voting and engagement. Investment advisers have fiduciary duties of care and loyalty to clients, including the investment companies that they manage, that require investment advisers to exercise reasonable care to ensure that votes are cast in the best interest of their clients. In connection with these duties, investment advisers must develop voting policies, describe these policies to clients, and make voting policies and voting records available to clients.

Investment companies are required to publicly disclose voting policies and voting records. We then compare U.S. requirements with rules in the European Union, Hong Kong and Japan.

Section 3 describes the voluntary investment stewardship practices of BlackRock, Vanguard and State Street, whose mutual funds and ETFs are the three largest holders of many U.S. public companies. With respect to voting, we find that these investment advisers voluntarily disclose highly detailed voting guidelines and consolidated voting statistics. With respect to non-voting engagement, including meetings with public companies, we find that these investment advisers disclose their engagement priorities and efforts undertaken to advance them. Such disclosures allow investors to evaluate whether investment advisers’ investment stewardship policies are consistent with investor priorities.

Section 4 reviews the empirical literature as it relates to investment stewardship by investment companies. First, we consider studies that evaluate the frequency with which investment companies oppose management proposals and support shareholder proposals. Second, we consider studies that evaluate whether holdings by investment companies are positively correlated with improved performance of public companies. Third, we review studies that assess whether holdings by investment companies are correlated with positive measures of corporate governance at public companies. In doing so, we also consider empirical studies that are focused exclusively on index funds as a subset of investment companies.

In Section 5, we evaluate proposals to reform voting by index funds. We begin by evaluating proposals that would require index funds to allow for “pass through voting,” whereby the millions of individual shareholders in index funds would provide instructions on how to vote. Second, we consider proposals that would require that index funds “poll” their shareholders to determine their voting decisions. Third, we evaluate proposals that would effectively eliminate index funds’ authority to vote their shares. We conclude by recommending enhanced transparency of non-voting engagement practices by investment advisers.

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This report was prepared by Committee staff, including John Gulliver, Executive Director, Megan Vasios, Deputy Director, and Jonathan Ondrejko, Senior Research Fellow, as well as Hillel Nadler, Senior Research Fellow at the Program on International Financial Systems. In addition, the Committee drew on the expertise of its members, who provided commentary and insight to our team. The members of the Committee are listed in the report.

The complete report is available for download here.

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