Three years ago, Professor John Coates of Harvard Law School, currently on leave and serving as general counsel for the Securities and Exchange Commission (“SEC”), wrote an extremely insightful article, “The Future of Corporate Governance Part I: The Problem of Twelve.” His thesis was that the growth of index funds was leading to such a concentration of shareholder voting power that “in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies.”
Such a concentration of shareholder voting power is no doubt undesirable. Unfortunately, we don’t have to wait until the Problem of Twelve becomes a reality to see the harmful effects of such power. We already have the “Problem of Three”—the concentration of shareholder voting power that resides with the three largest investment advisers to index funds (“the Big 3”): BlackRock, State Street Global Advisors, and Vanguard. Through the standard industry arrangement of delegating voting authority from the index fund to its investment adviser, the Big 3 now have control over the votes associated with over 20% of the outstanding shares of the public companies that make up the S&P 500. They have also garnered this large amount of voting power without even having an economic interest in the underlying shares.
The problem of the Big 3’s concentration of voting power is illustrated in Engine No. 1’s proxy fight at ExxonMobil, a proxy fight that is discussed in my new writing, “The Illusion of Success: A Critique of Engine No. 1’s Proxy Fight at ExxonMobil” (forthcoming, Harvard Business Law Review Online). Engine No. 1, a small hedge fund with an investment of less than $40 million worth of ExxonMobil common stock, submitted a partial slate of four director nominees (out of 12 total directors) whom it wanted appointed to ExxonMobil’s board at the 2021 annual meeting. Since these four nominees were not supported by ExxonMobil’s board, a competition for shareholder votes ensued between Engine No. 1 and the board of directors. This is referred to as a proxy fight, as most voting is done by proxy and not by in-person voting at the annual meeting.
Engine No. 1’s stated objectives in seeking the election of its own nominees was to: 1) enhance the value of ExxonMobil’s common stock; 2) reduce ExxonMobil’s carbon emissions; and 3) transition ExxonMobil into a global leader in profitable clean-energy production. Yet Engine No. 1 never provided specific recommendations on how it was going to accomplish these objectives. This was odd, as one would expect Engine No. 1 to present such recommendations if it were to convince shareholders that its director nominees were worthy of being elected.
The inability to provide such recommendations must have been a clear indication to the shareholders of ExxonMobil, including the Big 3, that Engine No. 1 was not truly informed about the operations of ExxonMobil or how it was going to achieve its stated objectives. Nevertheless, Engine No. 1 succeeded in getting three of its four nominated directors elected to Exxon’s board. How in the world was it able to do this?
The reason resided in the voting power of the Big 3. As a group, they are the owners of approximately 21% of ExxonMobil’s voting stock. However, they have much greater voting influence because they most likely voted 100% of their shares while individual investors—those most likely to vote with management—most likely voted a much smaller percentage of their shares. BlackRock ended up supporting three Engine No. 1 director nominees, while Vanguard and State Street Global Advisors each supported two.
I argue in my writing that Engine No. 1 was able to get the Big 3’s support by appealing to their desire to be perceived as investment advisers who are making a difference in mitigating climate change. Such a perception is necessary to attract millennial investors, the investor segment that will soon be the dominant investor type in index-fund investing. Therefore, the Big 3 were under a lot of pressure to support Engine No. 1’s efforts—or else they would be perceived as not walking the talk on climate change. Based on their voting, it appears that the marketing implications won out over the need to actually implement value-enhancing change at ExxonMobil.
Such opportunistic shareholder voting by investment advisers is arguably a breach of an investment adviser’s fiduciary duties under the Investment Advisers Act of 1940. If so, it is up to the SEC to provide the necessary investor protection through enforcement actions.
Alternatively, there is a potential market solution for mitigating the “Problem of Three.” This market solution, first proposed in my recent op-ed Giving Index-Fund Investors a Voice in Shareholder Voting, is for index funds to provide investors with some policy control over their proportional voting interest, as represented by their percentage of ownership in a specific fund. For example, index funds should allow their investors the opportunity to establish general voting policies on director nominations, shareholder proposals, and proxy fights. This would be a simple check-the-box approach on the part of the investor directing the fund to: 1) abstain from all voting; 2) vote according to the voting recommendations provided by the portfolio company’s board of directors; or 3) defer to the discretion of the investment adviser.
Regardless of whether the SEC decides to engage in enforcement actions, if enough investors demand some control over their voting preferences, this may have a significant impact on reducing the harm caused by the Problem of Three and perhaps indefinitely delay the realization of the Problem of Twelve. In sum, it is an opportunity to create a roadblock to the unnatural oligopoly that is already tainting the voting of shares in public companies.