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E-MailJill E. Fisch is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Carey Law School and Jeff Schwartz is the Hugh B. Brown Presidential Professor of Law at the University of Utah, S.J. Quinney College of Law. This post is based on their recent paper, forthcoming in the Texas Law Review. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen, Scott Hirst; Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy (discussed on the Forum here) and The Specter of the Giant Three (discussed on the Forum here) both by Lucian Bebchuk and Scott Hirst; and The Limits of Portfolio Primacy (discussed on the Forum here) by Roberto Tallarita.
Institutional investor voting and engagement has been transformative. Institutional involvement has largely overcome the Berle and Means problem of dispersed passive shareholders, reduced agency costs, and improved corporate governance. Increasingly, however, society is demanding that institutional investors call on their portfolio firms to address social problems and operate sustainably. This shift in objectives—from focusing exclusively on economic value to incorporating values-based considerations—brings a new perspective to institutional engagement. In particular, it highlights the fact that institutional investors engage in “empty voting” in that they are intermediaries who act on behalf of the beneficiaries whose interest are at stake. In our article, Corporate Democracy and the Intermediary Voting Dilemma (forthcoming Texas Law Review), we argue that the shift requires institutional intermediaries—namely, mutual and pension fund managers—to pay greater attention to the views of their beneficiaries.
Fund managers have a fiduciary duty to act on behalf of their funds, and ultimately the beneficiaries of those funds, in their voting and engagement efforts. When corporate governance focused on reducing impediments to shareholder power and increasing managerial accountability, fund managers could meet their fiduciary obligations through thoughtful engagement on such matters. The rise of ESG, however, changes this calculus.
Because ESG implicates contested values, fund managers can no longer plausibly claim to represent their beneficiaries without having a sense of their views. Voting without regard to beneficiary views on environmental and social issues not only generates agency costs but is also deeply undemocratic. Issues like how to address climate change are fundamental public policy questions, and fund managers lack the legitimacy to make such choices on their own.
In the article, we consider and reject conventional approaches to the intermediary voting dilemma. One possible option is greater regulation. The UK and Europe have embraced stewardship codes to encourage both active engagement and support for ESG. Stewardship codes, however, take a directive approach that we argue is inconsistent with the diversity of views in the U.S. about ESG issues, a diversity of views that is likely reflected in the values of fund beneficiaries.
The Securities and Exchange Commission has focused more on increasing fund disclosure obligations, based on the premise that better disclosure would facilitate efforts by individuals to choose funds that align with their views. While relying on market forces to generate an alignment between funds and investor preferences is conceptually attractive, frictions in the fund marketplace raise practical limits on the efficacy of this approach. Drafting comprehensive, meaningful, and clear disclosures that articulate a fund’s position across a growing range of issues is exceedingly difficult, and existing research suggests that investors are unlikely to use such disclosures effectively. In addition, the fund marketplace fails to offer a full range of stewardship alternatives and is not set up to do so. In particular, the double intermediation of the employment-based retirement system, heavily constrains true investor choice.
A third option is pass-through voting. Pending legislation in Congress, the Investor Democracy is Expected Act, would require mutual fund managers to implement pass-through voting for their passively managed funds, and some intermediaries are already experimenting with this approach. For example, in January 2022, BlackRock began to offer certain institutional clients the ability to vote their own shares, and in June 2022, it announced that it was expanding the program to more of its institutional clients and exploring the potential for individual investors to participate.
We question, however, whether pass-through voting is the optimal way to address problems with intermediation. Fund beneficiaries are not well-situated to participate directly in corporate governance. Given the small stake that mutual fund shareholders hold in any given portfolio company and the large number of companies in a mutual fund portfolio, fund shareholders lack the incentive and capacity to exercise pass-through voting rights effectively. As a result, shares are likely to go unvoted or may be voted based on limited analysis. In sacrificing the sophistication and influence of fund managers, pass-through voting threatens to weaken corporate governance.
History also counsels against pass-through voting. Intermediated voting has dramatically reduced the agency cost problem between corporate managers and shareholders. When voting was dispersed among millions of individual investors, managers held little regard for shareholder views. The reconcentration of ownership in the hands of institutional intermediaries has given fund managers the heft to engage effectively, and the result is that today’s corporate leaders are extraordinarily responsive to institutional investor demands. The solution to the agency costs between fund managers and their beneficiaries is not to return to the previous era of unaccountable corporate executives, but to render fund managers accountable to fund beneficiaries.
Our proposed alternative is “informed intermediation.” We argue that fund managers should ascertain the views of their beneficiaries, reflect those views in their voting and engagement efforts, and publicly report on how they do so. We further argue that regulators should adopt rules clarifying these obligations, offering guidance as to acceptable approaches, and providing fund managers with flexibility both as to how to collect beneficiary views and how to incorporate them without the risk of excessive liability exposure.
To allow fund managers to compete and innovate, we caution against regulatory efforts to detail specific procedures for beneficiary engagement. We observe that market providers are already offering products and platforms to enable fund managers to solicit input from their beneficiaries, and we anticipate the regulatory action will generate further innovation in this space. We also acknowledge that differences among funds and fund providers counsels against a one-size-fits all approach.
Importantly, our proposal gives fund managers discretion in how to incorporate the views they collect into their stewardship practices. Their job would be to use their experience and expertise to translate aggregate individual preferences—which might be incomplete, vague, and contradictory—into individualized and informed votes at each of their portfolio firms.
Finally, we recommend that only regulators, and not private plaintiffs, be tasked with enforcement. A private right of action might chill innovation and make fund managers fearful of exercising their discretion, particularly as they adapt to the new rules.
Our proposal strikes a balance. Institutional intermediaries play a valuable—even essential—role in corporate governance. Our approach would preserve the advantages of intermediation, but would harness its power for the good of the mutual fund investors and pension fund participants who are the true investors in portfolio firms.
The full paper is available for download here.
