Indirect Investor Protection

Holger Spamann is the Lawrence R. Grove Professor of Law at Harvard Law School. This post is based on his recent paper.

In a paper just posted on SSRN, I argue that the central mechanisms protecting most investors in public securities markets—beyond deterring theft, fraud, and fees—are indirect. They do not rely on actions by the investors or by any private actor directly charged with looking after investors’ interests, such as their fund managers. Rather, investors’ main protections are provided as a byproduct of the (mostly) self-interested but mutually and legally constrained behavior of (mostly) sophisticated third parties without a mandate to help the investors, such as speculators, activists, and plaintiff lawyers. This elucidates key rules, resolves the mandatory vs. enabling tension in corporate/securities law, and exposes passive investing’s fragile reliance on others’ trading.

My argument that the key protective mechanisms are indirect contrasts with the standard view in most policy discourse. According to the standard view, investors are protected directly by the governance rights and information that companies provide them, and by the investment professionals—particularly fund managers—that they may employ to digest this information and exercise their rights. But retail investors cannot possibly digest the necessary information themselves. Their fund managers might, but theory and empirics suggest they will be at most partially effective. Passive (index) funds eschew selection of investments by definition and, competing on costs, have low incentives, if any, to exercise governance rights. Actively managed funds have better but, barred from charging performance fees, still weak incentives, and in any event have historically been mostly inactive in governance and notoriously underperformed the market, at least net of fees. Some other institutional investors are more able, but many struggle as much as retail funds, or more.

Investors’ good fortune is that none of this really matters in the public securities market. For reasons explained momentarily, little would be lost if investors in the public market picked their portfolios randomly and never exercised their control rights except for minimally informed voting by institutional investors. By contrast, such a hands-off approach would be a recipe for disaster in the private securities markets, from which retail investors are generally barred: there, unsophisticated investors could lose their shirt by buying overpriced or selling underpriced firms, or by failing to monitor them.

Two main categories of indirect mechanisms protect in public markets. First, competition between speculators ensures that public market prices for stocks and other liquid securities are at least roughly equal to their fundamental value, obviating the need for careful selection of assets—including their governance—by investors and their agents. Second, once investors’ money is invested in a portfolio company, diversion or mismanagement of this money by the portfolio company’s managers or controlling shareholders is policed by plaintiff lawyers, activists, and takeovers.

Speculators, plaintiff lawyers, activist hedge funds, and buyers are not motivated by a concern for the investors. Nor are they legally mandated to have such a concern (with the partial exception of plaintiff lawyers). But under the rules in place, they (mostly) cannot make money without helping others. This is so in part because they constrain each other, i.e., the protection they provide is an emergent property of an interdependent ecosystem: plaintiff attorneys police collusion between activists, buyers, and management; prices informed by speculators constrain activists to value-enhancing interventions; buyers compete with each other for target firms; and speculators constrain each other by competing to eliminate pricing inaccuracies.

Indirect investor protection requires rules and enforcement just like direct investor protection would. The difference is which private actors fulfill which important roles, and hence which rules and enforcement are important. Indirect investor protection requires rules restricting its protagonists to gain if and only if (other) investors gain, and that steer unsophisticated investors into markets where the indirect mechanisms are active. This analysis unifies the evaluation of well-understood issues such as attorney fee awards and 13D disclosures. It also elucidates otherwise puzzling rules, such as the securities laws’ restriction of open-end mutual funds to liquid assets.

It follows naturally that some, but only some, rules of corporate and securities law need to be mandatory: those ensuring interest alignment of sophisticated and unsophisticated investors. This question had hitherto lacked a convincing answer. In the standard, direct investor protection frame, mandatory rules, especially for corporate governance, are paradoxical: If investors can decide which businesses to invest in, then those same investors should also be able to decide which governance arrangements to invest in. Attempts to resolve this paradox within the direct investor protection frame by appeal to externalities or contracting failures have been unsuccessful. By contrast, the paradox dissolves in the indirect investor protection frame. Unsophisticated investors do not need to understand the business of their portfolio companies because the smart money does the work for them. However, unsophisticated investors cannot rely on the smart money’s scrutiny of the investment terms to the extent those terms could be written precisely to allow the smart money to abuse the dumb money. Unsophisticated investors and their funds should also be barred from private markets, where indirect investor protection is mostly inoperative.

Finally, my analysis exposes indirect investor protection’s fragile reliance on trading, which is threatened by the rapid rise of passive investing. Speculators and activist hedge funds make money by buying low and selling high. Those on the other side of the trade lose. Meanwhile, passive investors—who do not trade—receive the benefits (unbiased informative prices, activist interventions) for free. This should not be an equilibrium—who would accept losing money forever?—, and the extremely rapid growth of index funds suggests that it isn’t. The more assets come to be held by passive investors, however, the less trading there will be, and hence the less subsidies will be provided to the governance and price discovery work of hedge funds and speculators. This may require new solutions to compensate socially valuable activity.

The full paper is available for download here.

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