Friday, June 23, 2017

Index funds and voting shares

Todd Henderson and Dorothy Shapiro Lund have an interesting OpEd in the Wall Street Journal, "Index funds are great for investors, risky for corporate governance." In brief, index funds don't participate heavily in monitoring companies, finding information about companies, or corporate control contests.

This point echoes larger complaints that with the spread of index funds there won't be enough active money to make markets efficient, and especially to make efficient the market for corporate control. One of the most important functions of a public market is, if you think that a company is mismanaged, you can buy up a lot of shares, vote out the management, and run it better. This is an imperfect system, to be sure, but note how many nonprofits (universities) and privately held companies, immune from this pressure, are run even more inefficiently than public companies.

Todd and Dorothy, law professors, after very nicely reviewing how funds currently deal with voting issues, seem to favor more law.
So how can the law ensure that these institutions make informed decisions about corporate governance? ... The first is to encourage them to rely on third-party corporate governance experts. It may be necessary... for the law to create incentives for institutional investors ...option three: encouraging passive institutional investors to abstain from voting altogether.   
Hmmm. When "the law," not a person or people, is the subject of a sentence, I get cautious. When the law wants "to encourage" people, my hackles rise.  The law "encourages" and "creates incentives" pretty bluntly. One example, though discarded, is a bit chilling,
 This could be accomplished by providing a legal cause of action to shareholders that are harmed by uninformed or conflicted voting decisions. But this would be a blunt tool for curbing abuse. 
Indeed it would.

But this is forgiveable. They are lawyers, so more law is the answer. We are economists, and law a necessary evil when contracts and markets fail. Is there not an economic solution, a Coasean way to slice the knot?

I think so. Companies should issue, and index funds should want to buy, non-voting shares.  Non-voting shares seem to be regarded as a little infamy of internet companies, used to keep control in the hands of founders. But a split between voting and non-voting shares seems ideally suited to a mass of indexing investors, and a few active, information-based traders and active corporate control investors. In this vision, most of those voting shares are in public hands, unlike the internet companies.  In fact, most corporate stock grants and options to insiders should be in the form of non-voting shares.

Non-voting shares are treated exactly the same for all cash flow purposes. They receive the same dividends, same rights in repurchase, same treatment in any reorganization. They just do not allow the right to vote.

Since index funds don't value the option to vote, they should want non-voting shares.

Would such shares trade at a discount? Yes, likely so. And that's a benefit, not a cost, a feature not a bug. Index funds could buy the same cash flow, which is what they want, cheaper, by giving up the value of their votes, which they're not interested in. Buying the same cashflow cheaper gives you a better return.

Todd  and Dorothy actually advocate a form of this idea, that the index funds voluntarily refuse to vote.  But then the index funds pay the cost of an option they do not use. By purchasing non-voting shares they do the same thing, and reap a financial reward.

This separation between voting and non-voting shares would make the market for corporate control more efficient. It is easier for someone who wants to buy the voting rights to buy them from other active investors than from passive mutual funds. It also separates the stock market price into guesses about cash flows and guesses about corporate control events. As a long-term investor I'm interested in the former and less in the latter.

Non-voting shares become a sort of state-contingent long term debt. Rather than guarantee payment by its fixed value, as in debt, payment is guaranteed by its equality with whatever other shareholders are paid, and similar rights in court as debt-holders have to enforce their right to be paid ahead of voting shareholders.

I've asked a few of my corporate finance colleagues about this idea, and their general reaction is that it won't work, because sooner or later the investors with voting shares find ways to screw the non-voting shares out of money, not just out of votes. The ability to vote is the ultimate guarantor of payment.

I'm still not totally convinced.  (I admit I did not follow all of the shenanigans they suggested to accomplish stealing money from voting shares.) If we're bringing in law here, and if we're designing a security, it seems not impossible to create a class of non-voting shares whose equal treatment in all cashflow related events is the same as those of voting shares, and who have strong rights to sue to guarantee those rights. Long-term debt works, after all, as the voting shares don't find a way to escape interest and principal payments. The contract design for that right seems easier than the legal means to "encourage" behavior that Todd and Dorothy imagine.

Update: See Todd and Dororthy's response and more discussion.


  1. Perhaps another alternative.

    How about detachable voting rights which are marketable? That is, give shareholders the ability to buy and sell their voting rights. Create a market for corporate governance. Shareholders who are uninformed or uninterested in the votes might like the cash which would be priced to the margin of either the insurgent or the incumbent. So the proxy might take a new look:

    a) For
    b) Against
    c) Sell my votes and send me the money

    ps - It seems to work in Congress :)

    1. Hunter, It worked on the Chicago Board of Trade. CBOT members had trading rights on the CBOE. CBOE traders, of whom I was one, leased the rights but had no voting rights on the CBOT. Good suggestion.

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    3. Thank you. Dodd & Dorothy should consider. Note in the simple example that the voting rights were issue/event specific & are continuously retained by the unless sold. Certainly any & all future voting rights could be also sold, producing a synthetic swap akin to voting/non-voting shares. The virtue it seems is that the price would continuously induce owners to pay attention to important issues rather than heave the proxy in the trash (or the institutional equivalent of outsourcing it to 'governance experts' to avoid duty of care).

  2. is the premise of the article even that accurate? i thought that at least the really biggest index funds did pay attention corporate governance?
    for instance,

  3. A good legal scholar should understand the impact of the law, as well as the absence of law. So I am less forgiving that their solution is found in the narrow confines of more law. In addition non-voting shares, I think that the market already has in place another solution which is that an increase in passive funds to the point of poor corporate governance will lead to a natural incentive to have active asset managers who do vote, in order to exploit the very market inefficiencies that concern the professors. This leads me to believe that these 'legal incentives' would artificially encourage the propagation of index funds at the expense of severe market inefficiency much more dangerous that the inefficiency they are concerned about.

  4. One of my wonders when I first learned about stocks (back in high school) was why necessarily each one who buys a stock would be interested in having voting rights. It seemed to make sense for an investor who holds a large share of a company, but not necessarily for a small share owner who might have many other stocks in his portfolio. Such small share owner might (1) hold the former just for diversification with no plans to substantially increase the holding of a stock, (2) know that anyways his share is too small to have a real impact on the voting outcome, (3) be too busy to keep a track of developments in all companies he owns. Having to make voting decisions might even be a burden for such investor as he has other (more) important things to do/track. These might have been naive thoughts, but maybe not only index funds might be interested in abstaining from voting in exchange for a lower price.

    For finance academics, having an ability to observe two prices – one for shares with voting rights and another for shares without voting rights – would help to better understand the sources of stock price fluctuations.

    Ok, this was my today’s minuscule contribution into blogosphere and commentariat.

  5. The 'stock market' as we know is is a value added chain that delivers the cost of regulations. In return for creating the cost chain, dealers get an implied currency insurance from government.

    Market means no observable supply chain, but the market needs the supply chain concept to allocate regulatory costs. Consider the pure model in which each traderhas equal access to public information, in the queue. The deraler, in this model, gets most of pricing directly from the balance sheet of the fair traded corporation. How is pricing set? The dealer sometime pays more for discovery of inside information, or pays less, often. The over and unders trigger asynchronous changes in the S&L stacks, triggers asynchronous, adjustable interest pay ins and outs. Price is set when queues are stable. No intermediate supply chain. Index funds are used to measure the aggregate effect of government regulatory costs, an intermediate supply chain.

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    1. I let this in because of the good citations. However, let's be polite. You have no way of knowing whether the authors did or did not read current research. Opeds have stringent word count limits and do not allow long literature review sections. ``X hasn't read'' is the sort of unverifiable statement that some of my fellow bloggers and economic journalists like to stoop to, but is really an unethical statement without verification.

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  8. Another alternative is to shift to a more bank-based world financial system. Buyers of index funds are basically using them as savings accounts, but with a higher yield. Banks can't offer such funds because equity is not an efficient use of regulatory capital. But if the typically saver could put their money in a large, globally-diversified depository, that institution could invest in large blocks of equity and help improve corporate governance. This would avoid the byproducts of common ownership that critics of index funds are writing about today.

    1. Don't mutual funds (both open-ended and close-ended) as well as, to some extent, holding companies, already provide this financial service? It's not necessary for banks to do everything.

  9. "They also serve who only stand and wait."

    In a previous millennium, I was a "corporation lawyer". I agree with your corporate finance colleagues that "sooner or later the investors with voting shares find ways to screw the non-voting shares out of money, not just out of votes". Except that it will be sooner not later.

    I also think that the right to sue errant corporate insiders has about the same value as a case of boils. Corporate law cases are heard in courts descended from the English Court of Chancery. Indeed, in Delaware, where many corporations are domiciled, the court is called the Court of Chancery. Charles Dickens wrote his novel "Bleak House" about the English Court of Chancery in the Victorian Era, but the advice is still wise. He said:

    "This is the Court of Chancery, which has its decaying houses and its blighted lands in every shire, which has its worn-out lunatic in every madhouse and its dead in every churchyard, which has its ruined suitor with his slipshod heels and threadbare dress borrowing and begging through the round of every man's acquaintance, which gives to monied might the means abundantly of wearying out the right, which so exhausts finances, patience, courage, hope, so overthrows the brain and breaks the heart, that there is not an honourable man among its practitioners who would not give—who does not often give—the warning, 'Suffer any wrong that can be done you rather than come here!'"

    I am not inclined to give any credence to the fears that if most shares are held by index investors the markets will suffer from a lack of activist investors. Indeed, in the posited situation, the rewards to short sellers and takeover artists will pyramid. Hundred dollar bills are, in fact, not left lying in the street.

    Indeed, I think there is a very good reason why index funds should avoid voting shares. It costs money. One of the good things about index funds is their miniscule expense ratios. The more that are forced to hire people to study and think about voting corporate shares, the higher their expenses go, with no guarantee that their activity will put money in investors pockets.

    Personally, my policy for proxy statements and proxies is that they go straight from my mail box to my recycling bin without being opened. I hope my index funds do the same thing.

    Finally, I would note one real problem with shares in non-voting hands. Many corporate actions such as mergers and recapitalizations must be approved by a majority of all of the outstanding shares, not just a majority of the shares that are voted. Unvoted shares count as no votes in those situations. My own solution to the problem would be to allow shares held by index funds and others who actually abstain to be excluded from the determination of a majority.

  10. A too-complete separation of control from interest creates huge opportunities for raiders. The game plan might be:

    1. buy control on the cheap (nobody wants it) without paying for the dividend stream.
    2. replace management with your cronies
    3. have management make deals with your other companies on terms that disadvantage the non-voting stakeholders.

    Non-voting shares will be bought by precisely the kind of investors that are least capable and willing to detect and effectively sue upon such exploits.

    Put simply, passive investors (whether through index funds or not) are easy to fleece one way or another. They cannot rely on laws for fairness because the business people will always find a way to work around these laws. You cannot fix the principal-agent problem with regulation alone. Passive investors can only prosper by free-riding on the diligence of active investors, so they must own exactly the same assets that active investors own (or buy some actively-managed fund). Perhaps we need not worry too much about protecting the interests of free-riders, though?

    Still, many active investors do buy non-voting interests in companies. They do so when they trust the controlling stakeholders. For that, control in the company must not change hands frequently or cheaply, and the controlling party's reputation must be more valuable to her than the non-controlling interests' share of the company. So those are the constraints, I think, on separating control from interest.

  11. Non voting shares is either inefficient or dangerous. The active investor is not rewarded for his extra effort at managing and monitoring the company, compared to the passive guy: they get the same dividends. There's freeriding.

    Why would investors want to be active? In order to steer the company in a particular way, according to their own interests (if they're a client, supplier or ally of the company). That's an agency problem and passive investors make it worse.

  12. The simplest suggestion is to require index fund participants (the individuals actually making the contributions) to either vote or vote by proxy. The most recognizable parallel is our electoral college. We (as voters) don't actually vote for president / vice president. We vote by proxy and the actual presidential / vice presidential votes are cast by electoral college members.

    1. Why would this be a good thing? Can you really improve corporate governance by forcing uninformed and uncaring voters to cast an (indirect) vote? On the contrary, I'd expect democracy to work better when the low-information voters abstain.

  13. "We are economists, and law a necessary evil when contracts and markets fail."

    What does this even mean? Contracts and markets don't exist outside of the law, they are *legal institutions.*

    There isn't some magic "law" button you press to "add more law" to an existing market. Come on.

    1. Rohan,

      "We are economists, and law a necessary evil when contracts and markets fail."

      Kind of like saying Newton's laws of motion are a necessary evil for physicists?

      A legal system is a necessary pre-cursor for coordination among a large set of economic agents and certainly required for any type of serious economic analysis.

      To classify the legal system underpinning economic activity as "an evil", even a necessary one, suggests a religious / moral overtone that is inappropriate for any scientific endeavor.

      We managed to get past calling the theory of evolution the work of the devil. Or at least most of us have:

  14. This whole discussion appears to be based on the assumption that passive index funds are passive in regards to governance. However, an article forthcoming in the Journal of Financial Economics shows that index funds are actually quite active in regards to governance.

  15. Interesting post! I really enjoy these sort of theory of the firm posts. As of late this topic has become especially relevant given a few failed take over attempts attributed to the bargaining problems created by non-voting index funds. I don't really understand though why index funds are passive. As large shareholders, it seems they ought to use this advantage to shape company governance to their advantage. Why don't index funds actively use their voting rights? Are they constrained by law?

    To me it seems like a no brainer to divide shares into voting and non-voting shares, and allowing the price to be set accordingly. As to whether voting shares will find ways to screw voting members out of money, I think this could be solved through a sort of restructuring or bankruptcy hierarchy. In addition to voting rights, voting shares could be placed ahead of non-voting shares in the case of bankruptcy. Although I am not sure this is relevant, given that shareholders rarely receive anything back in such cases. In any case, I don't think that the right to vote is necessary to guarantee payment. There are strong incentives for companies to due good on their payment obligations. Any failure would surely result in an appropriate market reaction punishing the company, or voting shareholders, for such behavior. Furthermore, given strong enforcement institutions, I think the advantages non-voting shares provide outweigh their potential risks.


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