The Case against Passive Shareholder Voting

By Lund, Dorothy S. | Journal of Corporation Law, Spring 2018 | Go to article overview

The Case against Passive Shareholder Voting


Lund, Dorothy S., Journal of Corporation Law


I. INTRODUCTION II. AGENCY COSTS, INSTITUTIONAL INVESTORS, AND THE MARKET FOR CORPORATE INFLUENCE III. THE THREAT OF PASSIVE INVESTING        A. The Rise of Passive Investing        B. Passive Investing and Corporate Governance            1. Passivity, Voting, and Engagement            2. Passivity and Hedge Fund Activism IV. POLICY PROPOSALS        A. Rethinking Passive Fund Voting            1. Eliminate Passive Fund Voting            2. Institute Pass-Through Voting for Passive Funds            3. Institute Pass-Through Voting as a Default        B. The Difficulty of Incentivizing Beneficial Investment in          Governance V. CONCLUSION 

I. INTRODUCTION

In the past few years, millions of investors have abandoned actively managed mutual funds (active funds) in favor of passively managed funds (passive funds). This past year alone, investors withdrew $340 billion from active funds (approximately four percent of the total) while investing $533 billion into passive funds (growing the total by nine percent). (1) This historically unprecedented shift in investor behavior has generated a flurry of news coverage, with articles proclaiming that index funds "are eating the world." (2)

The rise of passive investing is good news for investors, who benefit from greater diversification and lower costs. But the implications for corporate governance are less positive. Unlike active funds, which pick stocks based on their performance, passive funds--a term that includes index funds and exchange traded funds (ETFs)--are designed to automatically track a market index. For this reason, this Article contends that the growth of passive funds has the potential to distort and dampen the market for corporate influence. (3)

Participants in the market for corporate influence--generally institutional investors and activist hedge funds (4)--use the influence that accompanies their large ownership positions to discipline management. Although these investors lack perfect incentives to engage in corporate stewardship, (5) their presence provides a check against managerial slack, primarily because they identify underperforming firms as part of their investing strategy and are motivated to discipline wayward management.

Passive funds are different. Because they seek only to match the performance of a market index, passive funds lack a financial incentive to ensure that each of the companies in their portfolios are well-run. For one, passive funds tend to have very large portfolios, and therefore, an investment in improving governance at a single firm is especially unlikely to enhance the fund's overall performance. Second, passive funds face an acute collective action problem because investments in governance equally benefit all funds tracking the index, while only the activist fund bears the costs. Third, governance interventions are especially costly for a passive fund--unlike active funds, passive funds do not generate information about firm performance as a byproduct of trading. Therefore, thoughtful interventions would require the passive fund to expend additional resources gathering firm-specific information as well as develop governance expertise. Such expenditures would undo the cost savings that attracted investors to the passive fund in the first place.

Accordingly, as assets continue to flow into passive funds, agency costs will increase because managers of passive funds will be less likely to engage thoughtfully with portfolio companies and discipline management. Passive fund managers will also be likely to adhere to low-cost voting strategies, such as following a proxy advisor's recommendation or voting "yes" to any shareholder proposal that meets pre-defined qualifications. And without a consensus about what constitutes good governance, there is reason to believe that the proliferation of an unthinking, one-size-fits-all approach to governance will make many companies worse off. …

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