Speech by Acting Chair Lee on the Importance of Fund Voting and Disclosure

Allison Herren Lee is Acting Chair at the U.S. Securities and Exchange Commission. This post is based on her recent remarks at the 2021 ICI Mutual Funds and Investment Management Conference. The views expressed in the post are those of Acting Chair Lee, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff. 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).

Good afternoon everyone, and thank you to the ICI for inviting me to speak with you today at the 2021 Mutual Funds and Investment Management Conference.

I gave my last in-person speech on March 5, 2020. It’s hard to believe that a full year has passed and we are still operating in a virtual environment. Among the many lessons this last year has taught, we’ve learned that we can still come together to exchange ideas as we do this week at the ICI’s conference. The exchange of information and ideas, the goal of any conference, relates to one of our underlying democratic norms: that knowledge is empowering. That principle is also the basis of shareholder democracy: through clear and timely disclosure, we empower investors to hold the companies they own accountable—including accountability on climate and ESG matters. But in a world where institutional investors play an unprecedented role in our economic future, the people in this virtual room are also increasingly key to making sure companies are accountable to their shareholders—on those very issues, which, it’s no secret, have long been a focus of mine in large part because it is the focus of investors representing tens of trillions of dollars.

I am concerned our regulations have not kept up with this new landscape of institutional investor-driven corporate governance. That’s why today I want to solicit your help in considering updates to our rules governing the critical role you play on behalf of your investors in corporate elections—to ensure we work together to empower the retail investors you represent so they can hold companies and their executives accountable for the decisions they make.

Ultimately, corporate accountability is only possible when the funds that manage American investors’ savings diligently exercise their authority to vote, clearly disclose their votes to investors, and operate in a system that efficiently provides accurate information about vote execution.

Historical Background

Proxy voting has been a subject of continued focus for market participants and regulators, and for good reason—it is a central component of our corporate governance system. While the exercise and form of shareholder voting rights have evolved over time, voting has long been an important part of how we conceptualize the structure of a corporation where the board and management are overseen by their shareholders. [1] The early part of the twentieth century saw a diminishment in shareholder rights, including the elimination of the right of shareholders to remove directors at will and a reduction in the types of transactions that required unanimous shareholder approval. [2] Some have viewed the erosion of shareholder rights during that time period as contributing to corporate abuses that precipitated the 1929 market crash. [3] Congress empowered the SEC in 1934 to engage in rulemaking on the solicitation of proxies, and as you all know, the Commission and its staff have revisited this and other related proxy voting issues a number of times since. Today, I want to explain why proxy voting deserves our continued focus.

A New Reality Regarding Proxy Voting

There are two key trends that have brought us to our current posture and which necessitate updates to our rules and guidance to reflect a new reality regarding proxy voting and corporate governance. First, is the growth in households invested in funds. It is estimated that in 2020, nearly 47% of US households owned funds, up from 6% in 1980. [4] So retail investors today are increasingly relying on index funds to vote in annual corporate elections—making funds’ proxy voting practices more important than ever to our collective economic future.

A second key trend is the soaring demand for opportunities to invest in vehicles with ESG strategies. Millennials, in particular, are increasingly attuned to the specific ways in which funds and companies utilize their money, and their influence will only grow. We will soon see the largest wealth transfer in history as some $24 trillion makes its way from baby boomers to millennials. [5] ESG funds are attracting investors at a record pace, and this appears to have only accelerated during the Covid-19 pandemic. Global sustainable funds saw inflows of approximately $45.7 billion, while the larger fund universe had outflows of $384.7 billion in the first quarter of 2020. [6] What has become clear is that a growing pool of investors, including smaller retail investors, are interested in the implications of their investments, in addition to, or as part and parcel of their financial returns. [7] Those investor interests vary widely from a focus on the safety conditions of company employees, to prioritization of investment choices around a company’s carbon footprint. [8]

But a new landscape emerges as we consider these two trends together. That is, the rise of passive index funds, which has benefited retail investors in so many ways, may operate to the detriment of corporate accountability—and on ESG matters in particular—especially given that our rules have not kept up with these developments. [9] We know investors are demanding ESG investment strategies and opportunities, but funds may not always reflect those investor preferences in their voting. Addressing this agency cost is at the heart of corporate governance today, and that is why it is critical that we at the SEC—along with all of you in this virtual room—focus more attention on fund and adviser voting duties and disclosure.

Fund and Investment Adviser Voting

Funds serve their shareholders’ needs in a variety of ways, and that includes involvement in corporate governance and consideration of shareholder proposals. Advisers are often charged with exercising voting authority on behalf of clients and must determine how to do so consistent with their fiduciary duties. Further, the act of voting is itself a critical part of funds’ and advisers’ fiduciary obligations.

As we all know, proxy voting can play a key role in achieving a client’s investment goals. Through consideration of various shareholder proposals, director elections, and corporate actions such as mergers, clients can advance their investment objectives. [10] And academic literature finds that proxy voting is a critical part of shareholder oversight of corporate management because it can enhance value. [11]

However, many have called into question how well index funds harness the power of their voting capabilities to hold corporate managers accountable. [12] Take, for example, securities lending. [13] Because index funds cannot sell out of their positions, proxy voting becomes a particularly important tool for maximizing value. [14] But the economic benefits of voting are diffused among all shareholders, while index funds face their own economic pressure to lend out their shares, or not recall shares, instead of voting. [15] These pressures can also present potential conflicts of interest for advisers in light of fee splits and revenue sharing that an adviser may receive. [16] The revenue generated by securities lending can lower costs when passed back to investors—but this should be carefully balanced against, and potentially moderated by, the value to shareholders in exercising oversight of boards and management in the companies they own. In balancing these interests, advisers should carefully consider the types of arrangements that clients have consented to regarding the decision to vote shares.

Fiduciaries should be mindful of these competing concerns so as not to risk undermining the foundation of how shareholders engage with corporate management to maximize the long-term value of their holdings. As much as deciding how to vote requires due diligence, deciding not to exercise voting rights requires equally careful consideration. [17] I am concerned that the Commission guidance issued in 2019 on the proxy voting responsibilities of investment advisers attempted to, and may have, tilted this calculus against shareholder voting without sufficient data or analysis to support the wisdom of doing so. [18] This guidance should be revisited to ensure that fiduciaries understand how to weigh competing concerns of all types in deciding whether and how to cast votes on behalf of their beneficiaries.

Form N-PX and Disclosure of Fund Voting

These are not easy decisions, but they should be transparent ones, which brings me to Form N-PX. In describing the rationale for adopting Form N-PX, the Commission explained that fund investors have “a fundamental right to know how the fund casts proxy votes on shareholders’ behalf.” [19]

At the time of its adoption, Form N-PX was a big step forward in advancing transparency into fund voting. It has been nearly two decades since the form’s adoption, however, and the disclosures have not lived up to their potential. They are unwieldy, difficult to understand, and difficult to compare across fund complexes. So these limitations only heighten the fund agency costs that I discussed earlier.

Retail investors need more meaningful insight into how their money is voted, and that insight is more important than ever with the growth of interest in ESG shareholder proposals. It’s hard to see how retail investors can formulate an accurate and reliable picture of how a fund votes on ESG issues when they are forced to parse voluminous forms that often use bespoke shorthand for shareholder proposals. [20] Importantly, funds also stand to benefit from more effective disclosure as the fund landscape becomes increasingly competitive. Indeed, an updated and clearer Form N-PX can serve as a tool for funds to more readily distinguish their voting records from that of their competitors.

It is high time to revisit this critical form and make it useful in creating needed transparency around the fundamental exercise of shareholder voting. The Commission proposed a rule to implement a Dodd-Frank provision requiring certain institutional investment managers to report on Form N-PX their votes on executive compensation. [21] But that proposal has remained outstanding for eleven years now.

Potential rulemaking could address this outstanding Dodd-Frank mandate, and also more broadly update Form N-PX to make it more useful for investors. A new rule could, for example, standardize voting disclosures, structure and tag the data, provide more clarity in the description of issues voted on, provide the number of shares voted versus shares available to vote, and facilitate more timely disclosure so investors can act quickly to reward fund managers that best match their needs and expectations. [22] Accordingly, I have asked staff to begin preparing options for updating Form N-PX.

A ‘Public Option’ for Fund Voting Transparency

I’ll note, however, that just as the wheels of justice turn slowly, so too the mechanics of regulation. In the meantime, given the complexity and opacity of current disclosures, only certain market participants who are able to pay a premium for commercial data and have the ability to analyze the unstructured data I mentioned earlier, currently have actionable insight into fund voting. This inequity could be alleviated in the shorter term by the SEC sorting and organizing Form N-PX disclosures and other data to enhance investors’ ability to understand how funds or fund families vote on shareholder proposals. Accordingly, I have asked the staff to develop options for how the SEC can improve transparency using existing data sources, including the possible creation of a website to present this information.

Structural Issues with Voting – Fund as Issuer/Proxy Plumbing

Finally, any conversation about fund voting should include a discussion about the structural voting issues that pose tremendous challenges to funds. On one front, funds as issuers themselves are confronted with obstacles when trying to obtain a quorum, while funds as voters face difficulties in obtaining information about their votes. Funds as an issuer community face a unique landscape as their ownership is highly intermediated and diffuse, making it difficult and expensive to identify shareholders. [23] This is coupled with the challenge that funds have in communicating directly with investors. [24] These unique problems translate into increased expenses for funds to carry out their regulatory obligations to obtain shareholder approval for items such as a change in a fund’s fundamental investment policy and certain agreements.

Conversely, when funds and advisers exercise their authority to vote, it is often difficult to obtain vote confirmations given the multitude of intermediaries involved in the voting process, from transfer agents to tabulators. [25] While accuracy of vote confirmations has been a persistent concern, so has timeliness of these vote confirmations. Commenters have suggested tackling this issue in a variety of ways, such as requiring intermediaries, including transfer agents, to transmit the necessary information to confirm votes, while others have suggested that we explore use of a permissioned blockchain to record beneficial ownership and execute votes. [26] Both of these issues—problems obtaining a quorum and problems confirming fund votes—deserve attention as we examine and attempt to modernize our proxy voting system.

Conclusion

In sum, there is a lot of work to do in this area. And it is important work because it gets to the heart of ensuring that our system of shareholder democracy works. As investor preferences continue to transform, proxy voting will become an increasingly important component of that transformation. We must ensure that current incentives and rules for voting and voting disclosure are really serving the needs of investors today. The ICI has always been a great partner in providing research, analysis, and valuable input into our regulatory efforts. I thank you for that, and look forward to your assistance related to the many facets of proxy voting and corporate governance that I’ve discussed today.

Endnotes

1See Social Conceptions of the Corporation: Insights from the History of Shareholder Voting Rights, Colleen Dunlavy, Washington and Lee Law Review (2006), available at https://law2.wlu.edu/deptimages/Law%20Review/63-4Dunlavy.pdf.(go back)

2From Legitimacy to Logic: Reconstructing Proxy Regulation, Jill Fisch (Oct. 1993), available at https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=2288&context=faculty_scholarship.(go back)

3Id.(go back)

4ICI 2020 Fact Book, available at https://ici.org/pdf/2016_factbook.pdf; see also Division of Investment Management: Report on Mutual Fund Fees and Expenses (December 2000), available at https://www.sec.gov/news/studies/feestudy.htm#P108_8842; see also The Future of Corporate Governance Part I: The Problem of Twelve, John C. Coates (Jun. 24, 2018) (noting purely passive US funds have increased from less than one percent of the equity market in 1990 to around ten percent by 2013), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247337.(go back)

5The Future of Wealth in the United States: Mapping Trends in Generational Wealth, Deloitte University Press, Val Srinivas and Urval Goradia (2015), available at https://www2.deloitte.com/content/dam/insights/us/articles/us-generational-wealth-trends/DUP_1371_Future-wealth-in-America_MASTER.pdf.(go back)

6Sustainable Investing is Set to Surge in the Wake of the Coronavirus Pandemic, Pippa Stevens (Jun. 7, 2020), CNBC, available at https://www.cnbc.com/2020/06/07/sustainable-investing-is-set-to-surge-in-the-wake-of-the-coronavirus-pandemic.html (“So far this year, U.S.-listed sustainable funds are seeing record inflows, despite the market turmoil,” citing data from Morningstar).(go back)

7See Retail Shareholder Participation in the Proxy Process: Monitoring, Engagement, and Voting, Alon Brav, Matthew Cain, and Jonathon Zytnick (Nov. 6, 2019), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3387659; see also Retail Investors Eye ESG Factors, Survey Finds, (Apr. 26, 2019), IR Magazine, available at https://www.irmagazine.com/shareholder-targeting-id/retail-investors-eye-esg-factors-survey-finds.(go back)

8Other investment strategies fully integrate ESG factors to optimize risk adjusted returns for investors. See Funds’ Use of ESG Integration and Sustainable Investing Strategies: An Introduction, Investment Company Institute (July 2020), available at https://www.ici.org/pdf/20_ppr_esg_integration.pdf.(go back)

9See Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, Lucian Bebchuk and Scott Hirst (Dec. 2019), available at https://columbialawreview.org/content/index-funds-and-the-future-of-corporate-governance-theory-evidence-and-policy/ (finding that an agency-cost analysis shows that index fund managers have a strong incentive to underinvest in stewardship and defer to corporate managers); see also The Agency Costs of Agency Capitalism, Ronald Gilson and Jeffrey Gordon (May 2013), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2206391; see also The Future of Corporate Governance Part I: The Problem of Twelve, John Coates (Sept. 20, 2018), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247337.(go back)

10See Concept Release on the U.S. Proxy System, Release No. 34-62495 (July 14, 2010) (“Concept Release”).(go back)

11See The Vote is Cast: The Effect of Corporate Governance on Shareholder Value, Vicente Cunat, Mireia Gine, and Maria Guadalupe (Feb. 24, 2012), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1555961 (finding “that, on average, the market reacts to the passage of a governance‐related shareholder proposal with positive abnormal returns of around 1.3% on the day of the vote. This reflects an increase in market value of 2.8% per implemented proposal.”).(go back)

12See, e.g., The Party Structure of Mutual Funds, Ryan Bubb and Emiliano Catan (Dec. 15, 2020), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3124039; see also Do Index Funds Monitor?, Davidson Heath, Daniele Macciocchi, Roni Michaely, and Matthew Ringgenberg (Nov. 4, 2020), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3259433.(go back)

13See How Investing Giants Gave Away Voting Power Ahead of a Shareholder Fight, Dawn Lim (Jun. 10, 2020), Wall Street Journal, available at https://www.wsj.com/articles/how-investing-giants-gave-away-voting-power-ahead-of-a-shareholder-fight-11591793863 (noting that “if fund managers don’t recall the [loaned] shares in time for votes, they can’t cast shareholder ballots.”).(go back)

14Funds also of course engage with companies as another tool to communicate views about corporate governance. See, e.g., Stewardship Report 2018-2019, State Street, available at https://www.ssga.com/library-content/products/esg/annual-asset-stewardship-report-2018-19.pdf (describing the fund’s engagement with companies).(go back)

15See The Index Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff, Edwin Hu, Joshua Mitts, and Haley Sylvester (Dec. 2, 2020), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3673531 (“We show that, after the SEC clarified funds’ power to lend shares rather than vote them at shareholder meetings, institutions supplied 58% more shares for lending immediately prior to those meetings. The change is concentrated in stocks with high index fund ownership.”).(go back)

16Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5325 (Aug. 21, 2019)(“Investment Adviser Proxy Voting Guidance”) at n. 34 (noting that an investment adviser must make any determination regarding whether to retain a security and vote the accompanying proxy or lend out the security in the client’s best interest).(go back)

17Proxy Voting by Investment Advisers, Release No. IA-2106 (Jan. 31, 2003) (“The duty of care requires an adviser with voting authority to monitor corporate actions and vote client proxies.”).(go back)

18See Investment Adviser Proxy Voting Guidance, supra note 16.(go back)

19See Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, Release No. IC-25922 (Jan. 31, 2003) (“[W]e continue to believe that requiring funds to disclose their complete proxy voting records will benefit investors by improving transparency and enabling fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies. . . . [R]egardless of whether all, or a majority of, investors are interested in proxy vote disclosure, we believe that fund shareholders who are interested in this information have a fundamental right to know how the fund has exercised its proxy votes on their behalf.”).(go back)

20See Do Mutual Funds Represent Individual Investors? Jonathon Zytnick (March 7, 2021) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3803690 (finding “evidence consistent with rational inattention—the costs [to shareholders] of acquiring more granular detail about funds, as compared to readily available information, exceeding the benefits.”).(go back)

21See Reporting on Proxy Votes on Executive Compensation and Other Matters, Release No. 34-63123 (Oct. 18, 2010).(go back)

22Some of these issues—particularly timeliness of disclosure and identification of shares voted vs. available shares—will also need to be addressed through efforts on proxy plumbing, which is a critical piece of this puzzle.(go back)

23See Letter dated December 23, 2019 from Paul Schott Stevens, President and CEO, ICI, to Vanessa Countryman, Secretary, U.S. Securities and Exchange Commission, available at https://www.sec.gov/comments/4-725/4725-6580709-201124.pdf.(go back)

24Beneficial owners who do not object to having their names and addresses provided to issuers are referred to as “non-objecting beneficial owners” or “NOBOs.” With respect to beneficial owners who object to the disclosure of their names and addresses to issuers, referred to as “objecting beneficial owners” or “OBOs,” issuers may only communicate with such owners through a securities intermediary. See Concept Release, supra note 10.(go back)

25See Concept Release, supra note 10.(go back)

26Letter dated November 8, 2018 from Kenneth Bertsch and Jeffrey Mahoney, Council of Institutional Investors to Brent Fields, Secretary, U.S Securities and Exchange Commission, available at https://www.cii.org/files/20181108%20CII%20Letter%20for%20SEC%20Proxy%20Roundtable.pdf; see also Roundtable on the Proxy Process, U.S. Securities and Exchange Commission at 62 (Nov. 15, 2018), transcript available at https://www.sec.gov/files/proxy-round-table-transcript-111518.pdf.(go back)

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