We Three Kings: Disintermediating Voting at the Index Fund Giants

Abstract

The meteoric rise of passive investing has placed three large index funds in a new and pivotal role as the arbiters of corporate law controversies and the framers of market-wide governance standards. Collectively, the “Big Three” — Vanguard, BlackRock, and State Street — control a supermajority of index funds assets. Together, they constitute the single largest investor in 9 out of 10 publicly-traded companies. As their growth is projected to continue unabated, it is difficult to overstate the centrality and importance of these institutions for the future of corporate governance.

Society is only just beginning to grapple with the implications of this concentrated economic power. On the one hand, there is potential for this power to be used for good. Index fund investors are uniquely concerned with long-term, sustainable economic growth and stability, and they are likely to be more representative of the average American investor than many other financial industry players, such as hedge funds. Concentrating the power of many dispersed “ultimate investors” through index fund voting has the potential to better align corporate behaviors with the interests of a broad swath of American society. On the other hand, to the extent that this power is divorced from the actual interests and perspectives of individual investors, index funds’ considerable power may instead be used to advance the interests of index fund agents or other special interests in a way that is harmful to society at large.

As it currently stands, individual index fund investors are utterly unable to express their preferences in how voting decisions are made. They cannot rely upon index fund providers to take their unique interests and values into consideration when deciding how to vote (or even to know what these interests and values might be). Further, index fund investors cannot even indirectly express their preferences by selecting a particular fund or a particular index fund provider that is more likely to vote in line with their interest and values, since the shares controlled by different individual funds are nearly always voted in the exact same manner and since the different index fund providers share very similar voting philosophies and priorities. As a result, a small number of individuals at a handful of index fund providers wield increasingly dominant power with only very limited accountability.

To address this problem, a number of corporate law scholars have recently proposed solutions that would limit index fund providers’ power in some way, whether by requiring increased transparency, placing caps on index funds’ ownership of a given company or industry, or even going so far as to disenfranchise index funds entirely. Instead of these solutions, which generally rely upon regulators, auditors, or index fund advisers themselves to promote better outcomes, this Article proposes a novel solution that would harness the voice of individual index fund investors in the decision-making process. This approach builds off of the technological innovations that have permitted index funds to streamline the process of deciding how to vote their funds’ shares. It proposes using this infrastructure to overcome individual shareholders’ rational apathy instead of using that infrastructure merely to simplify the work of index fund employees.

The involvement of individual investors could take one of three forms. First, an “indirect democracy” approach would allow individual investors to elect to have the votes corresponding to their indirect share ownership cast according to the recommendations of a particular agent (such as the index fund provider, portfolio company management, a particular proxy adviser, or another institutional investor). Second, a policy of “informed discretion” would entail solicitation by index fund providers of more information about the characteristics and values of their investors, which they would use to better inform their voting decisions. Third, “pass-through voting instructions” would give individual investors the opportunity to participate in shareholder voting by completing a general, issue-based survey about how they desired to vote on a number of key corporate governance issues. The answers to this survey would effectively create basic proxy voting guidelines for a given investor’s shares, which would guide fund advisors in voting the proxies corresponding to the investor’s fund ownership. The uniting feature of all three approaches is that they would involve individual investors in the voting process to a greater degree, thereby diminishing the power of index fund agents, mitigating concerns about the concentrated power of index funds, and reducing agency costs. The proposals set forth in this Article set out to re-democratize shareholder democracy and to give voice to individuals typically shut out of the corporate decision-making process. With passively-indexed investments set to overtake active investments in the very near future, now is a crucial time to map the future exercise of funds’ corporate governance power.

Keywords: Index Funds, Shareholder Democracy, Shareholder Voting, Market for Corporate Control, Indexation, Corporate Governance, Passive Investment, Big 3, Proxy Voting, Proxy Advisors, Corporate Law, Securities Law, Institutional Investors, Hedge Fund Activism, Shareholder Activism, Passive Investing

JEL Classification: G3, K2, K22, G23, G34, G20, G28