[Senate Hearing 117-716]
[From the U.S. Government Publishing Office]
S. Hrg. 117-716
CONSIDERING THE INDEX FUND VOTING PROCESS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE INDEX FUND VOTING PROCESS
__________
JUNE 14, 2022
__________
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Available at: https: //www.govinfo.gov /
______
U.S. GOVERNMENT PUBLISHING OFFICE
55-779 PDF WASHINGTON : 2026
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
SHERROD BROWN, Ohio, Chairman
JACK REED, Rhode Island PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey RICHARD C. SHELBY, Alabama
JON TESTER, Montana MIKE CRAPO, Idaho
MARK R. WARNER, Virginia TIM SCOTT, South Carolina
ELIZABETH WARREN, Massachusetts MIKE ROUNDS, South Dakota
CHRIS VAN HOLLEN, Maryland THOM TILLIS, North Carolina
CATHERINE CORTEZ MASTO, Nevada JOHN KENNEDY, Louisiana
TINA SMITH, Minnesota BILL HAGERTY, Tennessee
KYRSTEN SINEMA, Arizona CYNTHIA LUMMIS, Wyoming
JON OSSOFF, Georgia JERRY MORAN, Kansas
RAPHAEL G. WARNOCK, Georgia KEVIN CRAMER, North Dakota
STEVE DAINES, Montana
Laura Swanson, Staff Director
Brad Grantz, Republican Staff Director
Elisha Tuku, Chief Counsel
Dan Sullivan, Republican Chief Counsel
Cameron Ricker, Chief Clerk
Shelvin Simmons, IT Director
Pat Lally, Hearing Clerk
(ii)
C O N T E N T S
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TUESDAY, JUNE 14, 2022
Page
Opening statement of Chairman Brown.............................. 1
Prepared statement....................................... 23
Opening statements, comments, or prepared statements of:
Senator Toomey............................................... 3
Prepared statement....................................... 24
WITNESSES
Senator Dan Sullivan of Alaska................................... 5
Prepared statement........................................... 25
John C. Coates IV, John F. Cogan, Jr., Professor of Law and
Economics, Harvard Law School.................................. 7
Prepared statement........................................... 26
Responses to written questions of:
Chairman Brown........................................... 76
Senator Sinema........................................... 78
Senator Tillis........................................... 78
Caleb Griffin, Assistant Professor of Law, University of Arkansas
School of Law.................................................. 8
Prepared statement........................................... 35
Responses to written questions of:
Senator Sinema........................................... 78
Senator Tillis........................................... 79
Additional Material Supplied for the Record
Letter submitted by Kathryn Fulton, Managing Director, BlackRock. 81
(iii)
CONSIDERING THE INDEX FUND VOTING PROCESS
----------
TUESDAY, JUNE 14, 2022
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10 a.m., via Webex and in room 538,
Dirksen Senate Office Building, Hon. Sherrod Brown, Chairman of
the Committee, presiding.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
Chairman Brown. The Senate Committee on Banking, Housing,
and Urban Affairs will come to order. Today's hearing, as
others have been, is a hybrid format. Our witnesses are in
person. Members have the option to appear in person or
virtually.
My colleagues and I often say the U.S. markets are the envy
of the world. Our strong and diverse economy and the rule of
law benefit families and workers saving for the future. The
breadth of our markets allows many workers to plan for the long
term and to take advantage of low-cost, diversified investment
funds.
Whether investing for retirement or for college tuition,
low-fee, broad-based index funds have been an essential
resource for millions of families. That has become more
important over the last few decades, as corporations have cut
or eliminated pension plans, and fewer and fewer workers have a
union to fight for their retirement security.
For all the benefits index funds provide, they draw
criticism for everything from being Marxist, to promoting anti-
competitive business behavior, to being too active in the
affairs of the companies they own, or too passive in the
affairs of the companies they own.
Many academics, including our witnesses today, have
considered aspects of these questions. We will hear from our
colleague, Senator Sullivan, who recently introduced
legislation that addresses his concerns. To be sure, there are
important questions, given how important index funds are for
pensions and retirement accounts.
Today's hearing considers how index funds vote on company
shares, and whether fund investors should be able to vote on
the shares held and managed by the fund adviser. In some ways
this issue boils down to one question--who should exercise the
market share that index funds have gained?
The law professors testifying today can tell us how
corporate and securities law grants power to the fund directors
and fund managers. Critics say that puts too much power in the
hands of too few people at the largest fund companies.
Some skeptics say that fund companies have too much
influence over corporate America to pursue activist social
policies. Other critics say fund companies should be doing more
to hold public companies accountable.
We know index funds are long-term investors that think
about long-term results. This debate, to me, is about how we
can hold corporate executives accountable and make sure they
are thinking about long-term value of their companies. It means
putting at the center the workers and communities that make
those companies work, not just the next quarter's profits. It
is just common sense.
Sometimes the long-term success of a company means voting
in favor of policies that consider climate risk or workplace
diversity or human capital management. And now, all of a
sudden, there are people who do not want index fund managers to
vote.
I am afraid that is what would happen under Senator
Sullivan's bill.
As we will hear, the INDEX Act strives to achieve democracy
for fund investors. It starts by singling out index funds,
taking aim at the biggest firms, but potentially capturing even
smaller fund companies. The bill says fund managers cannot vote
company shares unless they get direction from the fund
investors. It is an idea that sounds democratic, but does not
consider the cost or complexity or the sheer number of votes
involved.
For popular, widely held index funds, that could mean
reaching out to hundreds of thousands of clients, about tens of
thousands of corporate votes each year. Industry data tells us
that savers who own stock on their own, not through any kind of
fund, vote only 30 percent of the time.
It is hard to imagine that someone who specifically picked
a professional to invest their money for them would want to
become an expert in corporate proxy voting and be forced to
keep track of hundreds of corporate meetings.
It is an obvious problem, so the INDEX Act solves for it by
telling fund managers they do not have to vote, even though
current law requires them to.
The act would then leave Americans whose money is invested
in these index funds with two bad outcomes, either to have no
voice, because the bill protects fund managers when they do not
want to ask for directions on voting, or to be inundated with
votes on thousands of corporate issues.
To complicate things further, the INDEX Act could give more
power to short-term investors or large foreign investors.
Smaller companies could be worse off because the bill would
make it more expensive and time-consuming, a Federal mandate of
sorts, to reach out to stockholders.
Index funds are targeted in part because of their success.
But if we are really trying to improve transparency and
accountability for fund managers and for public company
management, it is important to consider potential reforms in
this area without undermining the clear benefits index funds
provide, that is low-cost access to diversified savings and
investments.
The SEC is working to improve the process of corporate
voting and increase transparency, and market participants are
developing technology solutions to improve the voting process.
The current system, of course, is far from perfect, but
moving to a system that would suppress voting or potentially
give more influence to short-term interests is not the answer
either.
I look forward to hearing the testimony today from the two
professors and from our colleague, Senator Sullivan. We will
hear some criticism, but also some solutions. I think it is
important to start this conversation.
Ranking Member Toomey.
OPENING STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thank you, Mr. Chairman, for holding this
important hearing.
You know, over the last several decades there has been an
amazing democratization of the American capital markets. Today,
retail investors have access to investment products more easily
and at lower costs than ever before. They have zero-commission
trading, narrower bid-offer spreads, all kinds of convenient
and user-friendly interfaces. Retail investors have access to
countless low-cost, or even zero expense, passive index funds
and ETFs. And it turns out, investors particularly like low-
cost, diversified funds that track an index like the S&P 500.
At the end of 2021, index funds held $12.5 trillion in
assets. Index funds have been a tremendous boon for retirement
savings. However, their tremendous growth presents a problem.
A retail investor who buys an index fund technically does
not own the stocks in the fund. The fund owns the stocks and
the fund's manager can decide to vote them. That gives the
managers enormous influence over companies, even though they
are voting shares purchased with other people's money.
This would be a problem even if this voting power were
dispersed. But it is not dispersed. The stocks held by index
funds are heavily concentrated with very few large asset
managers, making these entities disproportionately influential
with every large public company in America.
Collectively, BlackRock, State Street, and Vanguard are the
largest voting blocks in nearly 90 percent of S&P 500
companies. They derive much of their voting power from ordinary
Americans who buy index funds.
Even though this is not the managers' money, and they are
supposed to be investing this money passively, they are
nonetheless voting these shares. I would like to highlight two
problems that arise from this consolidation of corporate voting
power.
First, some asset managers are using their voting power to
advance their own political agendas. They are voting on
shareholder proposals and board nominees, and by virtue of this
power, they can apply pressure over companies even outside of
formal votes.
For example, last year, BlackRock, Vanguard, and State
Street all backed the effort of Engine No. 1, a small hedge
fund owning just 0.02 percent of Exxon's voting shares, to
install on the board of Exxon, America's largest energy
company, directors who are sympathetic to the fund's global
warming activism.
Engine No. 1's effort to install board members who want to
fundamentally remake a giant oil company succeeded only because
the Big Three agreed. Does anyone seriously believe that all of
the Big Three's investor clients actually want Exxon to
transition away from the very business that has made it a
remarkable success?
There are plenty of actively managed funds that investors
can choose, that will pursue the reforms, if those are the
things investors see fit. But passively managed funds are not
supposed to impose a strategic vision or agenda on firms. They
are supposed to neutrally follow the market.
Second, as I have noted, these asset managers are voting
shares purchased with other people's money, not their own.
Asset managers should not be using their clients' voting power
to pursue the political agenda of their CEOs or exercise
control over corporations.
Investors select index funds to track the market, not to
have the big asset managers change the market based on their
political views.
Congress needs to address the problems of the largest asset
managers voting other people's shares and their consolidation
of corporate voting power. In my view, the solution is to
return voting power to the true investors in a company, the
people who put their own money at risk.
Senator Dan Sullivan has introduced legislation, the INDEX
Act, to do just that. I am proud to cosponsor it and delighted
he is here today to discuss it.
The INDEX Act requires any asset manager of a passive index
fund with more than 1 percent of a company's voting shares to
vote those shares in accordance with the instructions of the
fund's investors, not at the discretion of the asset manager.
Or they could choose to not vote at all.
This means such asset managers, including for index funds
offered under 401(k) plans, ERISA plans, and the Thrift Savings
Plan for Federal workers and retirees, could no longer use and
abuse the voting power of their index fund investors to advance
their own agendas.
Importantly, the INDEX Act recognizes the reality that
index fund investors may want some guidance in deciding how to
vote their shares, since there could be a large number of votes
to cast. Researching and deciding on each of those votes
individually is not realistic for most average investors.
That is why the INDEX Act requires asset managers to permit
third-party vote recommendations on their platforms so that
investors can consult these recommendations. And asset managers
that provide third-party recommendations must do so on a non-
discriminatory basis that allows investors to consult a broad
diversity of views.
To make the voting process simpler and more efficient for
index investors, the INDEX Act would allow recommendations to
take the form of general voting instructions given in advance.
In other words, an investor could vote according to those
general instructions and not on a case-by-case basis.
I look forward to hearing from today's witnesses. In my
view, further democratizing investing and diminishing the
consolidation of corporate voting power are objectives that
members of both parties can, and should, get behind. I hope
that today's discussion will help us build bipartisan support
for legislation that will achieve these important objectives.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Toomey.
It is my pleasure to introduce my colleague from Cleveland.
Senator Dan Sullivan is in his second term in the Senate,
representing far-away Alaska. He will discuss his bill, the
Investor Democracy is Expected Act, the INDEX Act, which
addresses how index fund managers conduct proxy voting.
Senator Sullivan, you are recognized. Thanks for joining
us.
STATEMENT OF SENATOR DAN SULLIVAN OF ALASKA
Senator Sullivan. Thank you, Mr. Chairman, and I sincerely
appreciate the opportunity to testify here, and thank you for
holding this important hearing on this important issue. I want
to thank Ranking Member Toomey, in particular, for his
leadership and work with my team on the bill that has already
been described, Investor Democracy is Expected Act, or the
INDEX Act.
And I want to thank other members of the Committee-- there
are several here--who are also co-sponsors of this bill.
Mr. Chairman, I will be frank with you. You and I have
talked about it. The impetus for this legislation was due to my
ongoing frustrations with many of America's largest banks and
insurance companies that undertook policies to start black-
balling oil and gas investment development in Alaska, and in my
view, black-balling the proud American workers who do this very
necessary work for our country--we need energy--while at the
same time these financial institutions--banks and insurance
companies--were eagerly and continue to eagerly do business
with Communist China. Black-balling American energy workers, no
problem with investing in Chinese Communist activities.
Why are they doing this? Why were they doing this? Well, I
found out these financial institutions do this, in part,
because of pressure from their largest shareholders, he Big
Three investment advisors and their index funds.
In time, my Alaska-centric frustration uncovered a much
larger concern, that many of you have already described today,
about the sheer power that is consolidated among the three
firms that were already mentioned, and the massive distortion
in our public market that it creates.
Here again are the astonish numbers, that were already
mentioned by Senator Toomey, with regard to BlackRock,
Vanguard, and State Street. They manage around $20 trillion in
combined assets, are the largest owner shareholder in around 90
percent of the S&P 500, and cast nearly one- quarter of all
votes at annual meetings for public companies in America. These
numbers were even larger before the recent market correction.
In many ways, as you mentioned, Mr. Chairman, this is a
success story. Investors are benefiting from greater
diversification and lower fees. However, there have been
unintended consequences, especially the unprecedented
consolidation of ownership and voting power of these three
firms.
These companies wield this market dominance through behind-
the-scenes engagements with company management and they can
steer our public market toward policies that they or others
prefer, bypassing the political accountability of our
legislative process.
This should concern all of us, regardless of political
party. Some may like, or even applaud, the positions these
entities currently advocate for, but as we have all seen,
leadership at these kinds of firms can change. Just look at the
ongoing Twitter saga right now.
At its core, the INDEX Act is politically and policy
neutral, focused instead on the very real and unprecedented
power amassed by the Big Three investment advisors. That should
be a concern of us all. And I know this is becoming a concern
on both sides of the aisle. I have had discussions with many of
my Democrat and Republican colleagues. In fact, just a few
months ago Senator Bernie Sanders held a Budget Committee
hearing on these same issues.
In many ways, it is the next logical step in Dodd-Frank.
Before it became law, broker dealers were allowed to vote
shares held in street name even though the beneficial owner of
the shares were the clients.
The bill simply requires that investment advisors of
passively managed funds vote proxies in accordance with the
instruction of fund investors, the American people, and not at
the discretion of the adviser. It would return the voting power
back to the beneficial owners of the shares, not the index fund
managers. In many ways it is a logical next step that was
undertaken in Dodd-Frank. When broker-dealers used to be
allowed to vote shares they held in street name, the beneficial
owner was not allowed to vote those shares. That was changed by
Dodd-Frank.
Mr. Chairman, you mentioned already some of the
complexities, but Senator Toomey has also mentioned some of the
ways in which these complexities of implementation could be
addressed.
The INDEX Act would accomplish important goals. It would
neutralize the massive power that the largest investment
advisers have amassed and it would empower real beneficial
owner of these shares. It would foster a healthier, more
competitive, and democratic corporate governance system, which
is what we should want, and certainly what the American people
expect.
I will close with a quote from Jack Bogle, the founder of
Vanguard, and the father of the index fund, who voiced a
warning before his passing in 2019. He said, quote, ``If
historical trends continue, a handful of giant institutional
investors will 1 day hold voting control of virtually every
large U.S. corporation. Public policy cannot ignore this
growing dominance,'' unquote.
Mr. Chairman, this day is upon us. This prophetic warning
has proven itself out, and we need to act in a bipartisan
manner on this important issue.
I look forward to the rest of the hearing today and working
with all of you on this issue, and I would encourage all of my
colleagues to consider the INDEX Act as a bipartisan solution.
Thank you again to the Chairman, Ranking Member Toomey, for
the opportunity to testify today.
Chairman Brown. Thank you, Senator Sullivan. Thank you very
much for joining us.
The Chair calls up two witnesses today, Professor John
Coates IV. He is the John F. Cogan, Jr., Professor of Law and
Economics at Harvard Law School. In 2021, Professor Coates
served as Acting Director for the Division of Corporate Finance
and as General Counsel for the SEC. He previously served as
Chair of the Investor as Owner Subcommittee of the Investor
Advisory Committee of the SEC.
Professor Caleb Griffin is Assistant Professor of Law at
the University of Arkansas Law School. His research focuses on
corporate law and corporate governance with a particular focus
on the role large asset managers play in the governance
ecosystem. He served as a board member at Citizen Shareholder
International, as Chair of the Stakeholder Engagement
Subcommittee at the American Bar Association. Thank you for
joining us. Professor Griffin is a remote witness.
Professor Coates, if you would begin your testimony. Thank
you for joining us.
STATEMENT OF JOHN C. COATES IV, JOHN F. COGAN, JR., PROFESSOR
OF LAW AND ECONOMICS, HARVARD LAW SCHOOL
Mr. Coates. Thank you, Chair Brown, Ranking Member Toomey,
Members, for the invitation. The topic today, index fund
voting, is quite an important challenge. Index fund success, on
behalf of Wall Street and Main Street, has been so dramatic
that they have, in fact, created legitimacy and accountability
gaps.
As I have thought about this set of issues for many years
now, and I have written about it, however, I have come
increasing to the view that you should not really think of
there being a problem to be solved but rather a set of
tradeoffs, a dilemma, that has to be managed as best we can.
And what I mean by that is, has already been said, index
funds have provided and continue to provide enormous benefits
to American investors. They do it through low fees, low-fee
diversification, competitive pressure on other funds who have
had to lower their fees in response to the success of index
funds, and something that I think is directly connected here,
an additional benefit of index funds is that they require
almost no monitoring by the people who put their money in them.
They know what they are getting because there is an index. They
do not have to pay attention and use their time, which is, for
most Americans, better spent in their day jobs and managing
their children and doing other things, and tracking what their
managers are doing.
And that is different between index funds and other ways to
invest. Even an active fund with a lot of professionals in it,
they tend to turn over, and so you kind of have to keep track
of an active fund to see whether they are continuing to do well
for you, as they might have in the past.
So index funds provide all these benefits and, therefore,
for my sake, even though I agree the challenges are real, the
most important principle to bring to bear as you think about
legislative interventions is let us first do no harm. Let us
make sure that we are not going to dramatically impede the
ability of index funds to do what they have been doing.
Unfortunately, I believe the bill, while well intentioned
and an intuitive response to the challenges of governance,
will, in fact, do harm and achieve relatively little benefit to
offset that, even if your goal is for individuals to have more
influence over how their shares are voted.
The cost of a pass-through will be large. As has been
adequately, more than adequately, better than I can, stated by
Chair Brown. Thousands of companies, thousands of votes,
hundreds of thousands of investors. Data on existing individual
participation suggests not likely to be used by many, and yet
the costs will be imposed on everyone. Mutual funds--these are
mutual funds, which means costs are mutual. So you might have
some investors who would use these rights. My prediction is
most would not. And the ones who do not would still have to
bear the costs of the system put into place. That would make
index funds less attractive and overall impede the ability of
them to keep doing what they have been doing well.
There is a fallback, as mentioned, mirror voting or not
voting, built into the bill, and I think actually this would be
even worse for almost everyone, including people represented by
the business roundtable or management generally. It would
increase unpredictability in outcomes because it would
effectively shift voting power from the index fund to other
institutions, such as proxy advisors or activist hedge funds or
management, depending on relative voting power leading up to a
proxy fight that could change on a daily basis. And I have
talked to proxy solicitors about this, who do this for a
living. They think it would dramatically increase the
unpredictability of voting, precisely when it is the most
likely to be contested.
The bottom line is I think the goals here are good, but the
remedy needs to be more cautious, more conservative, if I can
use that word in an unpolitical way, more moderate, and more
experimental. So better transparency--I am all in favor of
that. Funds could do more to tell their shareholders about what
they are doing.
Better conflict management. Currently conflict rules are in
place at the fund level. They could be put in at the complex
level.
And I do agree they should be encouraged and given
authority to take instruction from their investors. That,
however, I think, is going to take pilots and experimentation
to make sure it is done in a cost-effective way.
And so with that I will stop. I have other comments but I
will stop there.
Chairman Brown. Thank you, Mr. Coates.
Professor Griffin, you are recognized, I assume from
Arkansas.
STATEMENT OF CALEB GRIFFIN, ASSISTANT PROFESSOR OF LAW,
UNIVERSITY OF ARKANSAS SCHOOL OF LAW
Mr. Griffin. Yes. Thank you, Chairman Brown, Ranking Member
Toomey, and Members of the Committee. I am privileged to
testify.
I wanted to make four key points in my testimony today.
First, we have a corporate governance system that is based, in
large part, on empty voting, which distorts incentives.
Second, the best interest standard which currently governs
index fund voting is insufficient.
Third, pass-through voting solves the empty voting problem
and restores agency to investors.
And fourth, pass-through voting is the lowest cost approach
that will meaningfully address this problem.
As has been discussed, index funds have assumed a new and
unprecedented role as the most influential players in corporate
governance. Particularly Vanguard, BlackRock, and State Street,
known as the Big Three, play a pivotal role. And we mentioned
that they cast about a quarter of the votes at S&P 500
companies. That is expected to grow to roughly 34 percent by
2028, and to over 40 percent in the following decade. So this
rise shows no signs of slowing down.
One of the great ironies of index funds is that while these
fund managers have become the most powerful governance actors
in the world, their investors are essentially powerless. It is
the fund managers rather than their investors who wield the
power to cast these votes.
And I view the present situation as an accident. If, given
the opportunity, no one would have designed a governance system
controlled by empty voting or a party has control rights but
lacks economic ownership. We need to explicitly recognize the
costs of empty voting, when we eliminated empty voting by
brokers more than a decade ago. And empty owners have interests
that are often poorly aligned with those of true owners, and
they are much more vulnerable to conflicts of interest. And yet
today we find ourselves facing a situation where virtually all
public companies will be controlled by empty voting.
There is essentially only one substantive legal constraint
that governs index fund voting, and that is index fund managers
are required to vote in the best interests of their investors.
And this constraint is surprisingly weak. To my knowledge, of
the millions of votes cast by all index funds, not a single
vote has been held to violate the standard.
As a result, I believe index funds vote in a way that may
be totally untethered from their investors' interests. I say
maybe because we simply do not know. Index funds are not
currently required to solicit any form of proxy voting input
from their investors, and for the most part they do not make a
meaningful effort to do so voluntarily. They may be guessing in
good faith about their investors' interests, or they may be
voting in their own self-interested, but I view either option
as much less desirable than simply getting input from
investors.
So what should we do? I believe that the best solution to
the current problem, where we have virtually powerless index
investors and an enormous, concentrated power in the hands of
index fund management, is to transfer some of that power to
individual investors. I believe that there are two primary ways
that we could do so.
The first is to allow individual investors to set their own
voting instructions. In order to streamline this process, I
favor what I call categorical pass-through voting, where
investors are able to give semi-specific instructions on common
categories of topics. For example, investors would be able to
instruct management to vote yes or vote no on all lobbying
disclosures every time that type of proposal came up at a
portfolio company. So one decision is applied many times.
The second approach I call vote outsourcing or indirect
democracy, and it is where investors could instruct management
to vote their shares in alignment with a third- party
representative. These may be institutional players, such as
management or even the index fund managers themselves, or they
may be third parties such as nonprofit organizations. So that
would be only a single decision made on the part of the
investors, saying who do I want to vote on my behalf, as
opposed to being forced into saying only my given index fund
will have my vote.
I believe that pass-through voting is the lowest-cost
approach that actually solves the problem. I think some
evidence of this fact is the fact that a number of parties,
including BlackRock, are already developing the technology to
institute pass-through voting preemptively, and I think that
this speaks to the affordability and the relative desirability
of this approach, even from the perspective of the fund
managers.
I believe that other solutions, including antitrust
remedies, like breaking up the Big Three or capping fund
complexes at a certain size, will be far more costly. I think
pass-through voting preserves the economies of scale of the Big
Three while addressing the root of the problem, that is
concentrated voting power in the hands of a small,
unaccountable group.
I see I am out of time. Thank you.
Chairman Brown. Thank you, Professor Griffin.
Let us start with you, Professor Coates. The idea of
passing through voting rights to fund investors sounds
appealing, as you have pointed out, but it is more complicated
than it seems. You talked about a process to be managed.
Describe, if you would, the logistical and practical
concerns with trying to manage that kind of process.
Mr. Coates. Sure. I will do my best to sketch a few of the
challenges. It is actually going to be far more complicated
than I can capture. The first thing to note is the scale of
investment at the fund level. We are talking hundreds of
thousands of investors who would have to be asked for
instructions.
Second, many of those investors are funds. They are other
institutions. So if you really wanted to achieve, as the bill
tries to, to push it all the way out to individuals, we are not
talking about one pass-through. We are talking about two,
three, four layers of funds. This is, you know, you might think
a little counterintuitive, but the way our market works there
are layers upon layers of institutions at work. Employee
benefit plans sit on top of funds, which in turn invest in
index funds. So that is a second kind of challenge.
A third kind of challenge is put-aside funds. A lot of the
individual investment in funds is through what are called
omnibus accounts, brokerage accounts that aggregate individuals
and purposefully shield from the fund the identity of the
actual individuals, for competitive reasons. So in order for
those individuals to instruct, the fund would have to provide
information to the brokerage firm and they then would have to
pass it through, reaggregate, pass it back down.
Now there is a lot more that could be said to unpack the
complexity here. The reason I am fairly confident this would be
costly, time-consuming, and error-prone is because our current
system of voting at the corporate level, the basic voting that
this is all going to be a part of, is still a work in progress.
This year alone, as I have extended more notes in my
written testimony, is the first time that the major players in
the basic voting system are trying to provide confirmations
back to investors about whether their voting instructions have
been followed. This is for people who have chosen to directly
invest. This is the first time in history they are going to be
able, possibly, to confirm their instructions have been carried
out, and the reason is the system is very complicated, even at
that level.
We are adding one or two orders of magnitude of complexity
on top of that with the way the bill approaches this.
So I think it is just not workable, even if you imagine
some large number of the fund investors wanting to take on the
challenge of providing instructions.
Chairman Brown. Thank you, Professor Coates.
Professor Griffin, your testimony suggests the INDEX Act
could allow for a variety of options to get input from fund
investors. Some fund managers you suggest are working toward
this. Do these solutions have potential, in your mind?
Mr. Griffin. Thank you, Chairman. I think they do have
potential. I think that passing through several thousand votes
for an individual would be, in many cases, unmanageable, but I
think outsourcing the voting process, or sort of decoupling
that and saying can use third-party experts, use of my chosen
third party as opposed to sort of being locked into a single,
whoever you happen to invest with. I think that actually sort
of reduces the separation of ownership control from a corporate
law perspective, and I think reduces the harm from empty
voting.
And I think that there are certainly some costs here. It is
not free. But I think it is important to view these costs in
context. I think we need to think about not just the costs of
facilitating pass-through voting, which I think are very
manageable, and I think that they are expenses that funds have
begun to undertake voluntarily--BlackRock currently offers it
to about 40 percent of its index clients, primarily
institutions--but to say that scaling that up is in no way
possible I think is a little bit unrealistic, given that they
are building it out, have built it out for institutions and
are, in my discussions with them, currently in the process of
building it out for retail clients.
I also think that the costs of having empty voting dominate
corporate governance for the economy at large could be very
serious. Misaligned incentives can lead to very significant
costs. Some academic fear monopoly effects. The common
ownership literature is still pretty nascent, and I am not an
antitrust scholar, but essentially they say it could lead to
price increases for consumers. One academic, Zohar Goshen, at
Columbia, even says essentially this type of governance
philosophy espoused by the Big Three is responsible for decades
of wage stagnation for employees.
And so I think when you are comparing the cost of a survey
and voting like investors say, I think it is clear that pass-
through voting is a feasible option.
Chairman Brown. Thank you. I have run out of time, but
Professor Coates, I would like you to respond in writing to
this. Your testimony suggests some potential improvements to
the current process. As the former Chief Counsel at SEC you
have great insight to this. If you would outline some steps
that SEC and fund companies could take to make sure public
companies and fund managers are more accountable and more
transparent, if you would put that in writing to us. Thank you.
Mr. Griffin. I will do that.
Chairman Brown. Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman. Professor Griffin,
let me just start with you here.
You know, it is easy to see the enormous influence that the
Big Three have when it comes to casting a proxy vote when they
control a plurality of the votes. But, in fact, that dynamic
alone is only the beginning of the kind of influence they wield
if you, as one of three individuals, can effectively determine
who sits on the board of directors of a company. Does that not
give you enormous influence over pretty much anything you
choose to exercise influence over, because there is this
implicit backing of your request in the form of changing the
composition of the board. Could you comment on that, Professor
Griffin?
Mr. Griffin. Thank you, Senator. Absolutely. I think that
the ultimate source of their power is the voting right, as you
mentioned, but it is only the beginning. So one way they
exercise their power is through, as you mentioned, being able
to elect directors, but also through sort of standard-setting
process, and this makes them almost a regulatory body, in a
sense, without sort of that accountability that we expect.
So when they announce their governance positions, or when
Larry Fink writes his annual shareholder letter, there are
academic studies that demonstrate these positions are very
quickly and effectively adopted by a number of companies. They
file 8-Ks that have not just the same positions but sometimes
the exact same language as Larry Fink's letter.
And so to Professor Coates' point earlier about
predictability, I agree that there may be a reduction in
predictability, but that predictability, the source of that
current predictability is that companies are essentially doing
what they are told by their largest shareholders. And I think
that may be less beneficial than we might assume because it
creates a corporate governance mono-culture. It is sort of a
one size fits all for the governance, per se. Everybody should
act in such-and-such a way, and these asset managers have
decided it and decreed it. And so it is predictable, but I
think it is detrimental.
Senator Toomey. So now let us go to the heart of what I
think is Mr. Coates' criticism, and I do not mean to speak for
you, sir, but it is the way it sounded to me, and that is the
challenge and complexity and cost of implementation. We all
realize that, of course, over the course of a broad- based
index you have many hundreds, maybe even in some cases
thousands, of companies, and the total number of votes is an
enormous number.
But as you, Senator Sullivan and I and others worked on a
variety of ways to deal with that complexity. BlackRock seems
to think that this is manageable. In fact, they have already
initiated this process.
Could you comment, Professor Griffin, on the mechanisms
that we have talked about to try to address the inherent
complexity and the sheer scale of this challenge?
Mr. Griffin. Absolutely. So first we have the 1 percent cap
which says, look, this is only going to apply to the very
largest funds, and I think that helps to balance this proposal
specifically only on the funds that could bear the costs, and I
think that with respect to whether it is feasible to vote this
many questions on this many companies.
I think the two methods that we outlined provide these
types of voting instructions, whether they are categorical of
every time you see such-and-such issue, do this, vote this way,
vote yes or vote no. Every time you see a lobbying disclosure,
vote yes to disclose or vote no to not disclose it, either way.
And then the company would apply that, at a blanket level, at
all, maybe 500 firms, let's say, in the portfolio.
The second one I think is even simpler and requires only
one decision from an investor, say I want my votes to be voted
according to this person. And so they specify the party. It
could still be the fund. Some people really like the way their
fund votes, and that is totally fine. Under this system they
would be able to designate them as the person to follow in the
voting process, to instruct, say, according to their
recommendations.
But I think under the bill it would provide a neutral
platform for third-party recommendations, and so that is one of
the requirements in this bill is to say if you do provide
voting recommendations you have to present it from third
parties on a neutral basis. And so I think that could actually
open up a lot of competition for differing perspectives to
enter, and a diversity of views in the proxy voting space, and
that would be beneficial.
Senator Toomey. Thanks very much. I will yield. My time is
about to run out. But I would just point out that for people
who think that this system works reasonably well or well
enough, they could select to continue with the status quo by
choosing to defer their votes to the asset managers.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Toomey.
Senator Reed, of Rhode Island, is recognized.
Senator Reed. Thank you very much, Mr. Chairman, and
welcome, gentlemen, witnesses.
Professor Coates, as you know and as you also indicated in
your testimony, many investment managers currently engage
outside proxy advisory firms for guidance. So how would this
bill affect investment managers' reliance on proxy advisory
firms?
Mr. Coates. Well, the pilots that have been alluded to by
Professor Griffin and Senator Toomey, that BlackRock is
undertaking, are a good illustration of how to answer your
question. They are focused on institutional clients. The
institutional clients who do not invest through index funds
often rely on firms like ISS and Glass Lewis for voting advice.
BlackRock's experiment is essentially extending that into the
index fund space for institutions. I want to emphasize both
that means they are going to be now not simply following the
decisions of the index fund managers but they are now relying
on proxy advisor personnel for their voting.
This is shifting from one institution to another. I am not
really sure that that is achieving the goal that is stated for
the bill.
I also would note that that is a vastly simpler pilot,
which is why BlackRock is starting with it, than passing
through to individuals the same kind of options, which is, in
fact, why, if you talk to each of the Big Three, they will tell
you, point black, it is 10, 100, 1,000 more complicated and
expensive to think about doing it for individuals, even if it
is just one time a year we want ISS or some other advisor.
The last thing I would say is it is not true that other
investors could just preserve the status quo and ignore this
because the costs will be borne by them, unless you do more
than is in the bill, which would allow the index fund sponsors
to charge a fee to those individuals who want to do something
beyond what is currently done now, on an individual account-
level basis.
I do not believe that would currently be permitted under
the '40 Act, and I do not think anything in this bill directly
addresses that problem. So I do not think actually that could
be accommodated under the current legislative language.
So in the end, just to come back to your question, I think
proxy advisors, who have been the subject of prior hearings and
conversations between Senator Toomey and me about this,
suggests that he is not entirely comfortable with the role that
proxy advisors play. They will get more power as a result of
this bill.
Senator Reed. One of the concerns I have, and I think it
goes to the assumption that we are operating on, is that
transparency, public companies with a direct connection to
their real shareholders, is really the model. But what we are
observing right now is public companies going dark. They want
to get out from underneath scrutiny and transparency. As a
result, we have a growing number of unusually significant, in
terms of financial power, companies that have left the public
sector and now, lacking all transparency. I do not think it
helps the markets.
So would it not be an advantage to have these companies
reporting some basic information, like their audited
financials, or if they reach a certain financial level? If it
is a $2 billion private company that has a lot of impacts in
our society. Any thoughts on that, Professor?
Mr. Coates. One thing that index funds have done that has
not been noted is that because they provide so much capital,
but it is only one entity, one record-holder who buys the
shares through an index fund, because it is a fund, the actual
number of record-holders of listed companies has fallen
dramatically over the past 20 years. In fact, most of the
companies that went public in 2021, when I was at the SEC, did
not go above the threshold requiring them to register with the
SEC.
As a result, we currently have a very different reality for
counting what is a public company than we did when the
securities laws were first written. And I do think there is
much to be said for revisiting the thresholds that are built
into the '34 Act, thinking about them in a different way, not
simply counting numbers, because index funds make it possible
for most listed companies to have fewer than 300 shareholders
and still amass enormous amounts of capital.
Senator Reed. Thank you very much. Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Reed.
Senator Cramer, of North Dakota, is recognized.
Senator Cramer. Thank you, Mr. Chairman, for calling this
meeting, and Ranking Member Toomey and witnesses, thank you.
I am a cosponsor of the INDEX Act, also a sponsor of
another similar relating to traditional lending, the Fair
Access to Banking Act. I am grateful to Senator Sullivan for
focusing so much on indexes. It is just really, really
important.
I wanted to ask you, Professor Griffin, about no-action
requests. So we see the SEC, we see the granting or denying of
no-action requests, and first of all, is there a risk of a
less-than-even handling of no-action with regard to indexes?
Mr. Griffin. I think, speaking broadly, there has been some
academic research that suggests it does matter somewhat, which
SEC staff member receives that no-action request, and so there
has been some academic research into that issue. And I think
that maybe is evidence of what you are speaking about, that
there is sort of personal variability within the SEC, maybe
diversity of views on what is appropriate and is not.
I would also note that there has been some recent changes
as to what can and cannot be excluded. So someone might be
asking to exclude a proposal from an upcoming meeting and
requesting an interaction letter on that basis. And I think
that we have changed some of the policy there and potentially
disturbed some longstanding positions.
But I think with respect to index funds, I would not say it
is particularly a major issue with respect to proxy voting.
Senator Cramer. Sure. Let me ask you about the role of
States, because we are seeing red State pushback, as they call
it. Obviously, not all States are created equal, but every
State, particularly their State funds, provide a lot. I mean,
there is a lot. And I think of a State like Texas, for example.
West Virginia is another one that recently passed State laws
similar to the INDEX Act. In some cases they might even be more
aggressive in terms of their own pushback guidance.
Do you see any concerns about the Federal Government doing
one thing or States doing their own thing, or what if we do not
do anything, what could be the outcome or the consequence of
States taking this on their own and having, if you will, a
maze?
Mr. Griffin. Thank you, Senator. I think that it will
potentially become further politicized at the State level and
then have sort of a difficult-to-navigate situation for these
asset managers, and I think that can increase costs as well. So
certainly it may be the best course of action for the States,
if their citizens desire it, but I do think that there are
risks to that approach as well, and the fragmentation that you
mentioned I think could be detrimental.
So I think that there is a desirability of a unified
standard and Federal action on this issue.
Senator Cramer. I almost never say that, but there are
situations. There are a couple of places in the Constitution
where they give the Federal Government some say, and I think
this might fit into interstate commerce a little bit.
The one thing I just sort of want to wrap up with, Mr.
Chairman, and you can certainly comment, Professor Griffin, if
you would like, has anybody come up with an index like a
reliable electricity index or reliable, low-cost energy index?
We pick these very political criteria in the energy sector with
very little regard for--we talking about long term. We have to
think of the long-term. Well, 2050 is a long way off, and 2030
is closer. But 2022 is on us. It is here right now. And
inflation is not a fantasy. It was not created by Vladimir
Putin, although he certainly has enhanced it with his behavior,
but we were heading this way already.
It just seems to me that if we are going to have indexes
based on political criteria they ought to be grounded in some
science, not just somebody's perceived or even real crisis that
is years off.
Anyway, no need necessary to comment. It is just my comment
as we wrap up. Let us be a little more realistic about
governance. Thank you.
Chairman Brown. Thank you. Senator Menendez, from New
Jersey, is recognized.
Senator Menendez. Thank you, Mr. Chairman.
Under current rules, public companies are not required to
disclose political spending to shareholders, and as result
corporate executives can spend investor money on political
causes without any consideration of shareholder views or the
company's public commitments.
Dr. Coates, should shareholders of companies that make
public pledges expect their company to act in a manner
consistent with the stated company policy?
Mr. Coates. Yes.
Senator Menendez. And we saw, in the wake of the January
6th insurrection, many public companies pledged to suspend to
reevaluate political donations to Members of Congress that
sought to stop the certification of President Biden's victory,
proving that these donations are a business decision that
affects the company's reputation and therefore their bottom
line. However, since then, many of these companies resumed
their political donations in direct contradiction to their
public pledges.
So, Dr. Coates, do you believe that corporate political
spending is material information that should be disclosed to
investors?
Mr. Coates. On average, yes. I am a supporter of the
DISCLOSE Act and have been since it was first introduced, a
long time ago, and I am also a fan of getting rid of the
micromanagement of the SEC, with the budget rider that has
forbidden the SEC from taking up this topic for the past 10
years. Clearly, for some companies, their political involvement
is first order to their strategy, and for them to not even be
possibly asked by the SEC to make some disclosures related to
that political strategy to me just seems like an obvious
mistake, from an investor perspective. It has nothing to do
with politics per se. It has to do with corporate strategy
connected to political involvement.
Senator Menendez. Well, I appreciate that, and I fully
agree. That is why I have been pushing for years to strengthen
the SEC's political spending disclosure rule. We have also
introduced the Shareholder Protection Act, to allow investors
to more directly influence the political spending of publicly
traded companies. But enhanced disclosure of relevant
information like this, in my mind, is another way to empower
investors.
The key to empowering investors, in my mind, is a strong
disclosure regimen that informs consumers and allows them to
vote with their wallets. When it comes to voting, many
investment fund managers voluntarily issue proxy voting
guidelines that outline, for investors, how the fund tends to
vote proxies as well as general principles that are considered.
So, Dr. Coates, do you think this type of disclosure is
useful to investors?
Mr. Coates. I do, and I think if you think about the
premises of this bill, as backed by the various co-sponsors, it
is that individual investors will lean into their rights, as
economic capital providers, and use them, presumably on an
informed basis, to make governance choices. The only way they
can do that, the only way this bill could possibly work, even
putting aside my worries about cost, would be if they actually
had full information about what they were voting on.
And if they cannot get information about what companies are
doing with their money--because remember, as capital flows down
to the index funds, which is the focus of this bill, but then
it flows down to corporations, so it is their money all the way
down. If you want them to have the ability to reasonably
exercise governance rights over their capital then you need
disclosure about how that money is being used, and that
includes political activity.
Senator Menendez. Thank you. To me, this type of disclosure
is exactly what investors need to make informed decisions,
while still maintaining the accessibility and cost
effectiveness of index funds. However, it is also important for
investors to be able to verify that the funds are actually
voting in line with these principles. How can we make
disclosures regarding votes that have been taken more
informative and digestible for investors?
Mr. Coates. Well, the SEC currently has a rule pending
that, if adopted, will help. It will improve the detail with
which funds have to disclose their votes. I am also in favor,
for the big index funds, the ones that are the focus of this
bill, to report more frequently than they are currently
required. Annually is all that is required now. They actually
do it quarterly, on a self-enforced basis. They choose to do
that. I think they could do it even more frequently because the
proxy season lasts for many months.
And I think having more real-time disclosure and better
disclosure would be the first place to start. That is how we
have markets work, rather than having law direct operations of
companies.
Senator Menendez. Thank you very much.
Chairman Brown. Thank you, Senator Menendez.
Senator Van Hollen is recognized, from Maryland.
Senator Van Hollen. Thank you, Mr. Chairman, and I want to
associate myself with the remarks Senator Menendez made
regarding the importance of disclosure by the companies for
shareholder purposes.
You know, I find the description or title of this bill,
Investor Democracy Act, to be a little bit upside down, and
here is why. I have some shares in Vanguard, mutual fund, and I
choose to make that investment. But, Professor Coates, I could,
if I wanted, choose to directly invest in the underlying
companies, right?
Mr. Coates. Yes, you could.
Senator Van Hollen. And at least in return, Vanguard has a
duty to look out for my, quote, ``best interests.'' Is that
right?
Mr. Coates. That is right.
Senator Van Hollen. All right. Now as I read this bill,
because of the costs that this bill may impose on a money
manager--Vanguard--they can opt out entirely. Is that right?
Mr. Coates. Yes. They would be permitted to simply not vote
at all.
Senator Van Hollen. Right. And so I do not know how that
advances the cause of democracy if now Vanguard, because of
additional costs, says, ``Well, I am going to opt out,'' then
nobody is looking out for my, quote, ``best interests.'' Is
that not correct?
Mr. Coates. That is correct. It would effectively, I think,
lead to less voting by the longest-term investment funds that
there are.
Senator Van Hollen. Right, and that means more relative
voting by hedge funds and other short-term investors, right?
Mr. Coates. Yes. This bill would boost the power of Carl
Icahn or Bill Ackman, or pick your other favorite hedge fund
activist, to come in and vote.
Senator Van Hollen. I think that is exactly what it will
do. And, you know, in my experience, I do not have any separate
stock holdings right now, but I had some small holdings. I get
these statements in the mail. I never have time to fill them
out and vote my few shares that I had. And that is what would
result, in my view, from this.
As I think has already been discussed, some of the bigger--
I think BlackRock has now made provisions for some of the
larger institutional investors. I think that is important. But
for retail investors, in my view, this is going to have exactly
the result that you are predicting, which is to essentially
have us not exercising our votes, even through a proxy like
Vanguard, and that just empowers the others in the system.
Can you talk a little bit more about the costs that are
imposed? Because one of the reasons people invest in these
index funds is because they are low cost. And so if they are
going to have to increase their costs, I am not going to want
to put any of my investments there. And so that will be an
incentive for them to exercise the safe harbor rule.
So can you talk a little bit more about the costs that this
would impose?
Mr. Coates. Sure. One of the things that I have done in the
past 20 years is first for the SEC and then for the Department
of Justice I have played a role in looking at how the back-
office functions of different investment managers function. And
at the SEC, a long time ago, in 2002, I helped distribute money
under a fair fund, back to the investors of mutual funds, large
ones.
It is an incredibly complex process simply to even identify
who the investors in a mutual fund are. Many of them do not
know. And the reason they do not know is because brokers bring
them clients, and the brokers do not want the funds to know who
their clients are.
So one of the major costs here would be simply for the
funds to trace out, through brokers and other kinds of
intermediaries, who are your investors, to get instructions
from. The bill does not allow them to do in a differential way.
It is all or nothing. And so I really believe, actually, when
you put up the costs, the fund advisors will say, ``Better we
do not do this at all for retail.''
I encourage--let me just go back to the vein--I think
actually there is something here, but it is going to take
experimentation and pilots. It is going to take SEC oversight.
It is going to take leaning in to figuring out what could be
cost effective. The kinds of things that Professor Griffin
sketches, I think, are nice ideas, but to make them really work
you are going to need some experimentation.
Senator Van Hollen. So under your reading of the bill would
it allow an investor in Vanguard to simply check a box and say,
``I want to opt out of this, Vanguard. You have got my proxy''?
Mr. Coates. So the bill has some ambiguities to it, which
is itself a separate issue that, of course, could be cleaned
up. I do not think, as it is currently written, Vanguard could
just provide an opt-in or opt-out option. It asks for pass-
through voting instructions for every fund investor, or none at
all.
Senator Van Hollen. So in your reading, as written, it
would require Vanguard to essentially send me my voting
material for each of the constituent companies that underlie
that index fund.
Mr. Coates. It specially talks about each proxy statement
for each company that is in the index.
Senator Van Hollen. So not giving me an option to opt out
seems to me to be very anti-democratic.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Van Hollen.
Senator Tillis is online from his office. Senator Tillis,
from North Carolina.
Senator Tillis. Thank you, Mr. Chair, and thanks to the
witnesses for being here today.
Index funds provide significant economic benefit to retail
investors. I think we all agree on that. It allows them access
to low-cost, diversified portfolios that do not require active
management.
However, since their creation, the concentration of these
funds has grown significantly. The share of assets managed by
the five largest firms rose from 35 percent in 2005, to a
majority, 54 percent, in 2021, while the share managed by the
ten largest firms increased from 46 to 66 percent.
So, Mr. Coates and Mr. Griffin, is it fair to say that the
concentration of assets under management by a handful of
institutions is an unintended development that the creators of
index funds and the ETS did not foresee?
Mr. Coates. Yes.
Senator Tillis. I am sorry. I----
Chairman Brown. Professor Griffin, your answer?
Mr. Griffin. Yes. Yes, it is.
Senator Tillis. Now the Big Three--BlackRock, Vanguard, and
State Street--currently collectively cast an average of 25
percent of the shareholder votes for the S&P 500 companies.
This is a significant bloc. However, I have looked at some
research, and I would like to get your feedback on it, that
indicates that if the current trends remain, the Big Three
could control as much as 40 percent of the voting power of the
S&P 500 companies within two decades. Do you agree or disagree
with those trend lines, and why, Mr. Coates and Mr. Griffin?
Mr. Coates. Yes, I believe that the likely share of index
funds in 10 years will be greater than now, in part because we
are talking principally about investment decisions by retail,
ordinary individuals, and they follow guidance and advice that
is hard to change. So even if we got to a point where index
funds were no longer the best thing, there would probably be
some inertia well past that point.
So I think, actually, index funds are likely to continue to
grow, and I think that is why the goal of the bill is a good
one, to look into how most cost-effectively to address the
accountability problems that their growth has created.
Senator Tillis. Thank you. Mr. Coates?
Mr. Griffin. Thank you, Senator. I absolutely agree. I
think that we are looking at about 34 percent by 2028, which is
not too far off, and in the next decade after that, by 2038,
the predictions by Lucian Bebchuk at Harvard are that
approximately 40 percent ownership. So there is a range of
values there. Obviously, we cannot predict the future, but the
trend of indexation shows no signs of slowing down.
Senator Tillis. Thank you. Mr. Griffin, in the time that we
have left, a select few institutional investors control an
outsized portion of voting rights. More and more, I hear from
companies that these institutions utilize their voting bloc to
force business decisions onto companies or otherwise coerce
them.
Mr. Griffin, should institutional investors be subjected to
due diligence requirements when backing shareholder proposals?
Mr. Griffin. I think that could be beneficial, and, you
know, it sort of speaks to what their duty of care may be in
this context. And I think that could certainly benefit from
being fleshed out, to an additional degree, with more due
diligence.
Senator Tillis. And similarly, should institutional
investors be required to disclose their analysis, proving their
votes were in the best economic interest of their shareholders?
Mr. Griffin. I think seeing their analysis could be
beneficial. I think more disclosure is usually beneficial.
Senator Tillis. Well, thank you.
Mr. Chair, I am proud to be a cosponsor of the INDEX Act. I
think it would begin to address the distortion of power in our
capital markets. This bill would return voting power back to
the individual investors and foster a competitive marketplace,
instead of promoting a system where individual investors can
crowd out everyday investors.
Mr. Griffin, could you speak a little bit more on the
merits or any concerns you have with the INDEX Act?
Mr. Griffin. Certainly. I think that pass-through voting is
probably the best and lowest-cost option that we are going to
find here. I think it addresses the root of the problem, which
is this concentration of voting power in very few hands.
I think that the fact that many of these funds are
developing the exact technology that we are looking at in-
house. I do agree with Professor Coates that pilot programs are
beneficial. I think BlackRock is effectively doing one right
now. And so perhaps there is a concern there is sort of a 2-
year window in the bill. Perhaps it may need to be extended to
3 years, or build in something like that.
So I think we should be sensitive to those concerns, but I
think ultimately pass-through voting is exceptional.
Senator Tillis. OK. Thank you. My time has expired. Mr.
Griffin and Mr. Coates, I may submit a question for the record.
I am specifically interested in the duopoly of the proxy
advisor firms, ISS and Glass Lewis. But out of respect for the
Chairman I will not ask for an answer now but would like to get
your opinions on that.
Thank you, Mr. Chair.
Chairman Brown. Thank you, Senator Tillis.
Senator Daines, from Montana, is recognized.
Senator Daines. Chairman Brown, thank you. I am very
pleased we are holding this hearing today on, I think, a very
important topic. I am very proud to join Senator Sullivan in
introducing the Investor Democracy is Expected, or the INDEX,
Act, which, as we discussed, would shift voting power away from
investment advisors to individual investors who already have
skin in the game and own the companies that are held in the
exchange trade of funds that they also own.
Passive investing through index funds has provided
tremendous benefits to investors, but woke investment managers
have created a downside of this style of investing. These asset
managers, namely BlackRock, State Capital, and Vanguard, are
using their clients' capital to advocate for viewpoints in the
boardrooms of corporate America that their own clients largely
disagree with. This should not be a political issue. This level
of concentration and power should be concerning to Democrats
who often talk about the problems with consolidation of power
in a few hands, and this is exactly what we have in this
situation.
Here is an example that has been discussed previously but
it is worth repeating, is the woke, hostile election directors
on Exxon's board in 2021. Engine No. 1--this is an activist,
environment, climate investment firm-- successfully leveraged a
0.02 percent investment to oust three Exxon board members in
favor of climate activist board nominees. This happened with
the support of BlackRock and Vanguard, Exxon's two largest
shareholders.
Following its victory in this proxy battle, Engine No. 1
pressured Exxon to reduce its oil production in October of
2021. They put out a statement celebrating the fact that Exxon
had reduced its oil and gas production as a result of a
takeover of three members of the board.
Fast forward to today. President Biden is begging oil
companies, including those in Venezuela and the Middle East, to
drill more to alleviate the energy crisis we are seeing both
here and in Europe.
This politicization of our financial system is part of the
reason I am planning to introduce a bill to codify a 2020
Department of Labor rule which would require plan fiduciaries
in retirement plans to put financial factors above all other
considerations when making investment decisions. This bill will
simply clarify what nearly all investors believe is already
happening, and that is that financial decisions on their behalf
are being made to make them money, not to further a particular
policy or political agency.
Turning to my questions. Professor Griffin, I have heard
some argue that it would be difficult to allow individual
investors to vote their own shares held in index funds. Would
you agree with that assessment?
Mr. Griffin. No, I would not, and I think there are a
number of tools to effectively involve individual investors.
Senator Daines. Do you think perhaps the issue might be
that allowing shareholders to participate in the proxy process
might wrest away control of the outcomes from woke asset
managers and corporations?
Mr. Griffin. I think, you know, it is not clear. I wish I
knew exactly what sort of was in the mind of BlackRock with
respect to why it exercises voting power the way it does. Some
people view it as a pure compliance cost that they would sort
of readily hand off if they could. Some people view it as a way
to market what are essentially undifferentiated, commoditized
products. One index fund has very little difference from
another. So in that regard that may be what you are speaking
to.
Senator Daines. So what are your thoughts when you saw what
happened at Exxon--0.02 investment ousted three Exxon board
members? I think if I am investing in an energy company like
Exxon, I am assuming they are trying to find ways to increase
oil and gas production, not decrease it. What do you think
about what happened there, where you had some climate activist
board members then suddenly take over part of Exxon?
Mr. Griffin. Well, I think it illustrates the power of the
Big Three. Essentially, you have, as you mentioned, a very
small owner, a very small hedge fund, with pretty minuscule
ownership, traditionally no say. But they are almost lobbying
these large index funds, particularly the Big Three, and the
Big Three are almost sitting there with a thumb and saying, you
know, vote up or vote down, and say they have the ultimate
decisional power. They are sort of the arbiters of corporate
law controversies.
And I think that is a dangerous situation, and I do not
think it is good corporate governance.
Senator Daines. All right. Chairman, thank you.
Chairman Brown. Thank you very much, Senator Daines.
To the two professors, thank you, Professor Coates, thank
you, Professor Griffin. Thank you for testifying today.
For Senators who wish to submit questions for the hearing
record those questions are due 1 week from today, on Tuesday,
June 21st. To the witnesses, please submit your responses to
questions for the record within 45 days from the day you
receive them.
Thanks again for your testimony. The hearing is adjourned.
[Whereupon, at 11:14 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN SHERROD BROWN
My colleagues and I often say the U.S. markets are the envy of the
world. Our strong and diverse economy and the rule of law benefit
families and workers saving for the future.
The breadth of our markets allows many workers to plan for the
long-term and to take advantage of low-cost, diversified investment
funds.
Whether investing for retirement or for college tuition, low-fee,
broad-based index funds have been an essential resource for millions of
families.
That's become more important over the last few decades, as
corporations have cut or eliminated pension plans, and fewer and fewer
workers have a union to fight for their retirement security.
For all the benefits index funds provide, they draw criticism for
everything from being Marxist, to promoting anticompetitive business
behavior, to being too active in the affairs of the companies they own
. . . or too passive in the affairs of the companies they own.
Many academics, including our witnesses here today, have considered
aspects of these questions. And, we'll hear from Sen. Sullivan, who
recently introduced legislation that addresses his concerns.
To be sure, there are important questions to consider, given how
important index funds are for pensions and retirement accounts.
Today's hearing considers how index funds vote on company shares,
and whether fund investors should be able to vote on the shares held
and managed by the fund adviser.
In some ways this issue boils down to one question--who should
exercise the market share that index funds have gained?
The law professors testifying today can tell us how corporate and
securities law grants power to the fund directors and fund managers.
Critics say that puts too much power in the hands of too few people
at the largest fund companies.
Some skeptics say that fund companies have too much influence over
corporate America to pursue activist social policies. Other critics say
fund companies should be doing more to hold public companies
accountable.
We know index funds are long-term investors that need to think
about long-term results.
To me, this debate is about how we can hold corporate executives
accountable, and make sure they are thinking about long-term value of
their companies.
It means putting at the center the workers and communities that
make those companies work-not just the next quarter's profits.
That's just common sense.
Sometimes the long-term success of a company means voting in favor
of policies that consider climate risk or workforce diversity or human
capital management. And now, all of a sudden, there are people who
don't want index fund managers to vote.
I'm afraid that is what would happen under Sen. Sullivan's bill.
As we will hear, the INDEX Act strives to achieve democracy for
fund investors. It starts by singling out index funds--taking aim at
the biggest firms, but potentially capturing even smaller fund
companies.
The bill says fund managers can't vote company shares unless they
get directions from the fund investors. It's an idea that sounds
democratic, but doesn't consider the cost or complexity or sheer number
of votes involved.
For popular, widely held index funds, that could mean reaching out
to hundreds of thousands of clients about tens of thousands of
corporate votes each year.
Industry data tells us that savers who own stock on their own-not
through any kind of fund-vote only 30 percent of the time.
It's hard to imagine that someone who specifically picked a
professional to invest their money for them would want to become an
expert in corporate proxy voting and be forced to keep track of
hundreds of corporate meetings.
It's an obvious problem--so the INDEX Act solves for it by telling
fund managers they don't have to vote, even though current law requires
them to.
The Act would then leave Americans whose money is invested in these
index funds with two bad outcomes-either to have no voice, because the
bill protects fund managers when they don't want to ask for directions
on voting, or to be inundated with votes on thousands of corporate
issues.
To complicate things further, the INDEX Act could give more power
to short-term investors or large foreign investors. And smaller
companies could be worse off, because the bill would make it more
expensive and time consuming to reach out to stockholders.
Index funds are targeted in part because of their success.
But if we are really trying to improve transparency and
accountability for fund managers and public company management, it is
important to consider potential reforms in this area without
undermining the clear benefits index funds provide-low-cost access to
diversified savings and investments.
The SEC is working to improve the process of corporate voting and
increase transparency. And market participants are developing
technology solutions to improve the voting process.
The current system is far from perfect. But moving to a system that
would suppress voting, or potentially give more influence to short-term
interests, is not the answer either.
I look forward to hearing the testimony today. We'll hear some
criticism, but also some solutions. I think it is important to start
this conversation.
______
PREPARED STATEMENT OF SENATOR PATRICK J. TOOMEY
Thank you, Mr. Chairman, for holding this important hearing.
Over the last 25 years, there's been democratization of our capital
markets. Today, retail investors have access to investment products
more easily and at lower costs than ever before, through zero
commission trading, tighter bid-offer spreads, and convenient and user-
friendly interfaces.
Retail investors have access to countless low-cost, or even zero
expense, passive index funds and ETFs. And it turns out, investors
particularly like low-cost, diversified funds that track an index like
the S&P 500.
At the end of 2021, index funds held $12.5 trillion in assets.
Index funds have been a tremendous boon for retirement savings.
However, their tremendous growth presents a problem.
A retail investor who buys an index fund technically doesn't own
the stocks in the fund. The fund owns the stocks and the fund's manager
can vote them. That gives the managers enormous influence over
companies, even though they're voting shares purchased with other
people's money.
This would be a problem even if this voting power were dispersed.
But it's not dispersed. The stocks held by index funds are concentrated
with a few very large asset managers, making these entities
disproportionately influential with every large public U.S.
corporation.
Collectively, BlackRock, State Street, and Vanguard, are the
largest voting blocks in nearly 90 percent of S&P 500 companies. They
derive much of their voting power from ordinary Americans who buy index
funds.
Even though this isn't the managers' money, and they are supposed
to be investing this money passively, they're nonetheless voting these
shares. I'd like to highlight two problems that arise from this
consolidation of corporate voting power.
First, some asset managers are using their voting power to advance
their own political agendas. They're voting on shareholder proposals
and board nominees. By virtue of this power, they can apply pressure
over companies outside of formal votes.
For example, last year, BlackRock, Vanguard, and State Street
backed the effort of Engine No. 1, a small hedge fund owning just 0.02
percent of Exxon's voting shares, to install on the board of Exxon
directors who are sympathetic to the fund's global warming activism.
Engine No. 1's effort to install board members who want to
fundamentally remake an oil company, succeeded because the Big Three
agreed. Does anyone seriously believe all of the Big Three's investor
clients actually want Exxon to transition away from fossil fuels as
Engine No. 1 wants them to?
There are plenty of actively managed funds that investors can
choose from that will pursue reforms and changes at companies if those
investors see fit. But passively managed funds aren't supposed to
impose a strategic vision or agenda on firms. They are supposed to
benignly follow the market.
Second, as I've noted, these asset managers are voting shares
purchased with other people's money. Asset managers should not be using
their clients' voting power to pursue the political agenda of their
CEOs or exercise control over corporations.
Investors select index funds to track the market, not to have the
big asset managers change the market based on their political views.
Rather, they choose an asset manager based on factors like fees,
returns, and the index a fund tracks.
Congress needs to address the problems of the largest asset
managers voting other people's shares and their consolidation of
corporate voting power. In my view, the solution is to return voting
power to the true investors in a company-the people who put their own
money at risk.
Senator Dan Sullivan has introduced legislation--the INDEX Act--to
do just that. I'm proud to cosponsor it and delighted he's here today
to discuss it.
The INDEX Act requires any asset manager of a passive index fund
with more than 1 percent of a company's voting shares to vote those
shares in accordance with the instructions of the fund's investors, not
at the discretion of the asset manager. Or they could choose to not
vote at all.
This means such asset managers, including for index funds offered
under 401(k) plans, ERISA plans, and the Thrift Savings Plan for
Federal workers and retirees, could no longer use and abuse the voting
power of their index fund investors to advance their own agendas.
Importantly, the INDEX Act recognizes the reality that index fund
investors may want some guidance in deciding how to vote their shares,
since there could be numerous votes to cast. Researching and deciding
on each of those votes could be incredibly time consuming for the
average investor.
That's why the INDEX Act requires asset managers to permit third-
party vote recommendations on their voting platforms so that investors
can consult these recommendations. And asset managers that provide
third-party recommendations must do so on a non-discriminatory basis
that allows investors to consult a broad diversity of views.
To make the voting process simpler and more efficient for index
investors, the INDEX Act would allow recommendations to take the form
of general voting instructions given in advance. That means an investor
could vote according to those general instructions, not on a case-by-
case basis. For example, an investor could choose to always support
management's position on votes, unless the investor decided otherwise.
I look forward to hearing from today's witnesses. In my view,
further democratizing investing and diminishing the consolidation of
corporate voting power are objectives that members of both parties can,
and should, get behind. I hope that today's discussion will help us
build bipartisan support for legislation that will achieve these
important objectives.
______
PREPARED STATEMENT OF SENATOR DAN SULLIVAN
Senator of Alaska
June 14, 2022
Thank you Chairman Brown for holding this hearing on this important
issue.
And thank you Ranking Member Toomey for your leadership, and for
your work and support on the INDEX Act.
Additionally, thank you to my other friends and colleagues on the
dais who cosponsored this important bill.
At the outset, I want to acknowledge that the impetus for this
legislation was due to my ongoing frustrations with America's largest
banks and insurance companies black balling oil and gas development--
specifically in my State--while at the same time eagerly doing business
in China and propping up the CCP.
These companies feel the need to do this, in part, because of
pressure from their largest shareholders--the big three investment
advisers and their index funds.
However, this Alaska-centric frustration uncovered a broader
concern about the sheer power that is consolidated within these three
firms, and the massive distortion in our public market that it creates.
I'm sure you are all familiar with the numbers. The Big 3--
Blackrock, Vanguard, and State Street, who:
Manage around $20 trillion in combined assets;
Are the largest owner in around 90 percent of the S&P 500
companies; and
Cast nearly 1/4th of all votes at annual meetings.
These numbers were even larger before the recent market correction,
and they will only grow as more and more Americans move into passive
funds.
In many ways, this is a success story--investors are benefiting
from greater diversification and lower fees, however the unintended
consequence has been the consolidation of ownership and voting power
with these three firms.
These companies wield this market dominance through behind-the-
scenes engagements with company management and by voting with complete
discretion at thousands of shareholder meetings on behalf of millions
of Americans.
They can steer our public market toward policies that they prefer--
completely bypassing the political accountability of our legislative
process, and completely disconnected from the interests of their
massively diverse universe of investors.
This should concern all of us--regardless of political party.
For now, you may like some of the positions that these entities
advocate for, but leadership and positions can change at these powerful
investment advisers--look at the ongoing Twitter saga.
I know some of my Democrat colleagues have expressed concerns and
frustrations with these firms: primarily, that the big 3 are deferring
far too much to management.
In fact, just a few months ago, Senator Bernie Sanders held an
entire Budget Committee hearing about this problem.
At its core, my bill, the Investor Democracy is Expected Act (INDEX
Act) is politically neutral.
In many ways, it is the next logical step in Dodd-Frank. Before it
became law, broker dealers were allowed to vote shares held in street
name even though the beneficial owner of the shares were the clients.
Congress recognized then that shares should be voted to reflect the
wishes of the investor, not based on the wishes of intermediaries. The
INDEX Act is the same exact principle extended to index funds.
The bill simply requires that investment advisors of passively-
managed funds vote proxies in accordance with the instruction of fund
investors, and not at the discretion of the adviser.
It would return the voting power back to the beneficial owners of
the shares, not the index fund managers. And I think it is a little
condescending to say that the average American doesn't vote their
shares, which is true, so they shouldn't have the opportunity or power
to do it. Not voting is a vote in and of itself.
The big 3 recognize this, and some are already announcing steps to
increase investor choice on proxies--but obviously they are still
retaining significant discretion.
This issue requires Congressional action--just like it did in 2010
with Dodd Frank.
We know that there are complexities to implementing this kind of
pass-through voting mechanic, especially for retail investors. The bill
is not overly prescriptive on these mechanics, and it is only targeting
the largest firms who have with the necessary resources and
infrastructure to successfully implement a system like this.
The INDEX Act would accomplish two important goals: it would
neutralize the massive power that the largest investment advisers have
amassed, and it would empower real investors--fostering a healthier,
more competitive, and democratic corporate governance ecosystem.
I will close with a quote from Jack Bogle, the founder of Vanguard,
and father of the index fund, who voiced a warning before his passing
in 2019: ``If historical trends continue, a handful of giant
institutional investors will one day hold voting control of virtually
every large U.S. corporation. Public policy cannot ignore this growing
dominance''.
This day is upon us. This prophetic warning has proven itself out,
and we need to act in a bipartisan manner on this important issue.
I look forward to the rest of the hearing today and working with
all of you on this issue, and I would encourage all my colleagues to
consider the INDEX Act as a nonpartisan solution.
Thank you again to the Chairman, Ranking Member, and Members of the
Committee for having me today.
______
PREPARED STATEMENT OF JOHN C. COATES IV
John F. Cogan, Jr., Professor of Law and Economics, Harvard Law School
June 14, 2022
Chairman Brown, Ranking Member Toomey, and Members of the
Committee, thank you for inviting me to provide written testimony on
the index fund voting process. The rise of index fund ownership and its
effects on corporate governance are important, as I have written. \1\
As I continue to study the phenomenon, I now think of it not as a
``problem'' to be solved, but as a ``dilemma'' to be managed, to
balance economic and practical trade-offs. Any legislative intervention
should be cautious and provisional, giving the Securities and Exchange
Commission (SEC) the ability to adjust and refine how the law applies
over time, as markets respond and evolve.
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\1\ ``The Problem of Twelve'', Columbia Global Press (forthcoming
2022); ``The Future of Corporate Governance Part I: The Problem of
Twelve'' (Sep. 20, 2018). Harvard Public Law Working Paper No. 19-07,
https://ssrn.com/abstract=3247337; ``Thirty Years of Evolution in the
Roles of Institutional Investors in Corporate Governance'' (May 2014),
in Research Handbook on Shareholder Power (Jennifer Hill and Randall
Thomas, eds., Edward Elgar 2015).
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To state the dilemma: On the one hand, index funds provide huge
economic benefits to individual investors, in the form of low cost
diversification, which requires keeping regulatory burdens low. On the
other hand, their success has so concentrated ownership as to challenge
the legitimacy and accountability of customary delegated governance.
The rise in popularity of ``indexes'' also threatens to harm investors
through creation and marketing of bespoke and undiversified or
otherwise risky ``indexed products'' that lack the characteristics of
conventional indexes. Giving investors ways to better understand and
inform advisors about governance decisions and preferences are worthy
goals. To avoid degrading index funds' real benefits, any legislative
solution should be practical, cost-effective, and carefully designed to
avoid unintended consequences, in part by delegating implementation to
the SEC. It should enlist rather than try to supplant market forces.
As written, Senate Bill 4241 is not practical or cost-effective,
would create significant uncertainty in corporate governance, and would
not address the dilemma of indexation. As discussed more below,
depending on unpredictable and ever-shifting variation in ownership of
public companies, it would variably (a) entrench managers to
shareholders' detriment, (b) make it cheaper for hedge fund activists
to attack well-run companies, to the detriment of both corporate
managers and shareholders more generally, (c) boost the power of proxy
advisors, with some risk of harm to individual investors and in any
event only shifting and not improving the legitimacy and accountability
of corporate governance, and (d) likely result in less long-term
investor influence than at present. It would also create bad incentives
for funds or pension plans to adapt ``closet indexing'' strategies to
avoid the law's effects (resulting in no benefits and additional
costs).
Better would be a package of reforms that are more modest and
effectively targeted. Straightforward would be reforms that build on
the kinds of self-imposed disclosure and governance processes and rules
that index fund advisors have developed on their own, as they have
attempted to address the legitimacy dilemma of their success. For
example, low-cost quarterly or more frequent reporting is feasible for
large funds. Also worth consideration are specified qualitative
disclosures about how advisors develop, identify, assess, and take
voting positions on new issues as they emerge. It should be possible
for fund advisors to obtain information from their investors about how
they want indirect governance powers to be exercised, without
attempting to go so far as S. 4241. But the technology challenges and
costs of such investor input should not be underestimated, and patient
and persistent pressure from the SEC is likely to lead to better
outcomes than an attempt to micromanage consultations through
legislation.
Conflict of interest restrictions that exist at the fund level
could also be imposed at the advisor level. This would help insure that
the potential power that large fund advisors obtain from concentrated
ownership cannot be leveraged to benefit their other operations or to
harm any of their own investors. To insure this step does not create
unintended consequences, it should be done by authorizing and directing
the SEC to do so, with appropriate adjustments as the SEC may discover
are appropriate to protect investors.
Consistent with analysis and recommendations from former University
of Virginia School of Law Dean Paul Mahoney and Professor Adriana
Robertson, \2\ Congress could clarify authority for the SEC to oversee
index providers (such as S&P and MSCI), who provide the key input to
the index fund product (that is, indexes themselves), and do so with
enormous discretion and with light and incidental current oversight. As
to fund advisors, Congress could simplify the requirements for or
direct the SEC to use authority to provide exemptive regulatory or
liability relief necessary to enable large fund advisors to experiment
with practical, low-cost ways to obtain governance direction from their
investors. Finally, the SEC should also have at least as much authority
it currently has to review and approve new funds to also review and
approve investment products that use the ``index'' brand to partly
mimic conventional, low-cost diversified index funds, but lack their
all-in investor-friendly attributes, while being designed to avoid
conventional fund regulation, including collective investment trusts
sponsored by banks.
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\2\ ``Advisers by Another Name'', 11 Harv. Bus. L. Rev. 311
(2021).
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The rest of this written testimony builds on this introduction in
three ways: (a) the benefits of index funds are amplified, to
underscore how important it is not to unduly degrade them; (b) the
problems with the intuitive but ultimately impractical and even harmful
concepts in S. 4241 are explained, and (c) some alternatives for
improved regulation sketched above are discussed in more detail.
1. The Benefits of Indexation
Indexation and index funds provide enormous direct and indirect
economic benefits to Main Street investors. That is precisely why they
own a large and increasing share of U.S. public company stocks (as well
as other financial assets). ``At year-end 2021, index mutual funds and
index ETFs together accounted for 43 percent of assets in long-term
funds, up from 21 percent at year-end 2011.'' \3\ They continue to
increase their market share.
---------------------------------------------------------------------------
\3\ ``ICI Factbook 2022'', at 29.
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They continue to succeed because they are a cost-effective way for
individual Americans to invest in broadly diversified portfolios,
especially for the 99+ percent who lack the wealth required to hire a
full-time and trusted personal financial advisor. They provide better
risk-adjusted returns than if such investors tried to invest directly
in public company stocks, and on average better than through other
institutional channels. \4\ My first investment--at age 14 if memory
serves--was in a Vanguard index fund. I am not a financial advisor, but
I will continue to recommend index funds--to my children, for example.
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\4\ Fama, Eugene, and Kenneth French. 2010. ``Luck Versus Skill in
the Cross-Section of Mutual Fund Performance''. Journal of Finance 65,
1915-1947; Kosowski, Robert, Allan Timmermann, Russ Wermers, and Hal
White. 2006. ``Can Mutual Fund `Stars' Really Pick Stocks? New Evidence
From a Bootstrap Analysis''. Journal of Finance 61, 2551-2595.
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Still, to be clear, I am not one of those finance academics that
believes that no one can outperform the market, or that actively
managed funds are so incapable of doing that that they should be
banned. Many professionals can in fact generate ``alpha'' for their
investment clients--that is, they can select or weight stocks to
achieve greater returns than if they simply invested in standard
indexes. \5\ That is true on a net-of-fee and risk-adjusted basis, at
least for certain kinds of financial assets. \6\ In the limit, in
principle, doing so will become more feasible as indexation increases.
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\5\ Barras, Laurent, Olivier Scaillet, and Russ Wermers. 2010.
``False Discoveries in Mutual Fund Performance: Measuring Luck in
Estimated Alphas''. Journal of Finance 65, 179-216 (75.4 percent of
funds have some skill); Berk, Jonathan, and Jules van Binsbergen. 2015.
``Measuring Skill in the Mutual Fund Industry''. Journal of Financial
Economics 118, 1-20.
\6\ See K.J. Martijn Cremers, Jon A. Fulkerson, and Timothy B.
Riley, ``Challenging the Conventional Wisdom on Active Management: A
Review of the Past 20 Years of Academic Literature on Actively Managed
Mutual Funds'', 75 Fin. Anal. J. 1-28 (2019) (surveying studies).
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I come to the topic of index funds, then, not a quasireligious
supporter, or a detractor, but as one who sees their social and
economic benefits as well as the social and economic challenges they
create. Their rise has lowered the all-in costs of investment directly,
for their own investors. On an asset-weighted average basis,
conventional equity index fund expense ratios are six basis points; by
contrast, the median equity mutual fund charges 104 basis points, more
than 15x higher. \7\ Costs of directly investing in equivalent
diversified portfolios are vastly higher for individuals.
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\7\ ``ICI Factbook 2022'', at Figure 6.5.
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Index funds also have benefited all investors, through competition.
As they have grown their market share, their direct competitors--
actively managed funds--have lowered their fees, too, or else exited
the market, shifting assets to lower-fee funds, on average. \8\ By
making it easier to invest, they also induce more investment, which
increases liquidity, and lowers the cost of capital for all firms.
Their economic benefits, in other words, are general, and benefit the
market as a whole.
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\8\ Id. at Figures 6.2 and 6.3.
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Index funds not only charge lower fees, they also impose lower
opportunity costs on investors. It is vastly simpler for an individual
investor to designate and invest in a reputable low-cost index fund
than it is to invest directly. That is true even if a retail investor
invests in the same underlying securities, and even if they could do so
at the same out-of-pocket cost, which they cannot. That is partly
because the components of indexes are constantly changing, as companies
merge or otherwise drop out of the market, and new ones are added. An
individual investing directly would have to be continually engaged in
buying new stocks (along with record-keeping, tax reporting and other
``back office'' activities) to preserve their exposure to the same
diversified investments a single index fund provides.
Oversight of actively managed funds also takes more time than
oversight of index funds. Active strategies must evolve with markets,
and key members of good active fund portfolio management teams can
retire or exit their roles. Individual investors must thus devote more
attention to monitoring active funds than index funds. Importantly for
present purposes, governance itself--learning when shares need to be
voted, learning about the issues or people to be voted upon, and then
voting--is time-consuming and expensive. Few individuals will or even
could oversee the votes attached to the many thousands of companies
whose shares are held by the most successful index funds. Even
attempting such a task would approach a full-time job for an individual
investor.
Finally, index funds enjoy significant economies of scale, at least
if they primarily hold large company liquid stocks. Those economies of
scale are part of why they can charge lower fees. They use their large
scale to negotiate very low cost service contracts for back-office
functions and trading. Not only do these economies contribute to their
growth, but they also create greater concentration of ownership and
create the ``dilemma'' sketched in my introduction.
For thinking about legal change, it is important to note that law
and regulation contribute to economies of scale, by simplifying the
allocation of voting rights associated with assets held by index funds.
Fund investors, unlike direct investors, do not vote the shares owned
by the fund. Fund advisors do. This follows from basic organizational
law, long primarily a task for the States, not the Federal Government.
Because advisors can and have developed voting systems that can
accommodate multiple funds within a given fund complex, the per-vote
cost of governance for index funds is lower than for individuals, or
smaller funds and smaller complexes.
Given that they achieve all of the foregoing benefits, the most
important principle in thinking about how they are regulated is the
principle of ``first, do no harm.'' As I will sketch next, the voting
system underneath each index fund is more complex than it appears, just
as our sleekly designed personal laptops and phones contain intricate
systems inside. It would be a mistake to tinker with the insides of our
devices without expert help, or to do so quickly, or based on
simplified assumptions about how they work. The same is true for
corporate governance by index funds.
2. The Governance Roles of Index Funds and the Likely Effects of S.
4241
Index funds--like all mutual funds, pension funds, corporations and
trusts--have legal ownership of their investment assets, such as
shares. Fund investors own shares issued by funds, not shares owned by
funds. Fund investors do not have the right to direct how the fund
votes shares it owns. The fund board has that right, typically
delegated under a contract to the fund advisor.
The same is true of investors in a public company. They do not have
the right to direct how to vote shares of other companies that it may
own. For example, Exxon and Shell have a 50/50 joint venture called
Infineum. The shareholders of Exxon do not have a right to vote
Infineum shares, even 50 percent of them. Exxon, the corporation, has
that right, a right held by the Exxon board, typically delegated to
Exxon officers. In this way, index funds are treated under States
identically to other kinds of legal entities. To break from this
tradition, as proposed in S. 4241, would be a significant change--
suggesting caution, as such a change is likely to have unintended
consequences.
As S. 4241 recognizes, fund owners are themselves commonly other
legal entities, such as other funds or trusts or retirement plans. Not
reflected in the bill, fund owners can also be ``omnibus'' accounts at
brokerage firms, through which still other investors invest in the
fund, whose identities are purposefully shielded from fund advisors for
competitive reasons. Many fund advisors separately manage ``sleeves''
or separate accounts that own the same investments as a fund, in a
legally separate way, which would be unaffected by legal changes
applicable to index funds, yet which are included in the numbers
usually quoted (including by me) to show the rise of indexation.
Sometimes voting rights of assets held in such separate accounts are
retained by the investor, but sometimes they are delegated to the
advisor, as with a fund.
If this brief sketch seems complicated, it is in fact a gross
simplification of reality. A typical index fund will have some shares
owned by (for example) one or more other mutual funds, one or more
pension funds, one or more corporations, and one or more separate
accounts at an insurance company. Some of the assets of those entities
are typically owned in turn by retirement accounts, which are sponsored
in turn by (for example) an employer (e.g., a dentist office) for the
benefit of current and retired employees. If one were to drill through
all of the layers of ownership of a typical large index fund, one would
find not simply the thousands of shareholders that directly own fund
shares, but thousands more individual beneficiaries, separated by
varying degrees of legal ownership. Tracing the chains of economic
ownership up and back down is complex, time-consuming, and error-prone.
Even if a fund were ``flat,'' and simply had a 1,000 individual
shareholders, passing through portfolio level votes to its own
shareholders would be complex, time-consuming and error-prone. I can
assert this with confidence because of our experience with the current
portfolio-company-level voting system. When a company like Procter &
Gamble seeks a vote from its shareholders, many of those shareholders
own shares through brokers. Unlike individuals who own through funds,
individuals who own through brokers retain the right to vote. But the
process by which P&G seeks proxies from its shareholders, and brokers
seek instructions from their clients, is still a work in progress. Only
in the current--2022--shareholder meeting season is the industry--by
which I mean Broadridge (a major proxy services firm), along with
corporate transfer agents, the Depository Trust Company, and large
broker-dealers--after years of planning--finally testing a pilot system
to permit ultimate individual broker clients to ``confirm'' that their
voting instructions were carried out. \9\ In the past, many such
instructions have been imperfectly followed, at best. The result has
sometimes been lengthy and disputed vote contests, where weeks passed
before it was clear who won a given vote, and even then without those
involved from having any confidence that votes were correctly counted.
Put simply, the foundations of the current voting system are not yet
secure. Adding more structures on top of a shaky foundation is likely
to not achieve what is intended.
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\9\ See https://cdn.ymaws.com/stai.org/resource/resmgr/industry-
info/pilot-announcement-as-of-12.pdf. For background on vote
confirmations and other challenges in the basic portfolio-company
voting system, see https://www.sec.gov/spotlight/investor-advisory-
committee-2012/iac-recommendation-proxy-plumbing.pdf.
---------------------------------------------------------------------------
Senate Bill 4241 would magnify by many times the challenges of the
current voting system. Somewhat simplified, it would require covered
index funds to ``pass through'' votes on nonroutine matters to fund
shareholders. Because, as noted above, many fund shareholders are
themselves funds or other entities, it could require multiple pass-
throughs. But even one pass-through to the first layer of shareholders
at a major index fund would create enormous practical challenges, along
with expense, delay and error. Those costs would be borne by individual
investors in index funds. The increased costs would reduce the benefits
of index funds, and induce some investors to switch to fund options
that are less efficient for them.
Whatever benefits the system would create would be small, because
few individuals are likely to use the pass-through rights for most
votes. The costs are likely to be far higher, because the sheer number
of votes required each year for index funds, which are designed,
customarily, to invest in thousands of companies. Simply identifying
the choices and voting in thousands of companies' director elections
and shareholder resolutions and merger votes would overwhelm a typical
individual. I study voting outcomes as part of my job as a researcher
and teacher, and even have a taste for it, but I can barely keep up
with the aggregate numbers, much less individual votes. The result
would be that a tiny fraction of eligible votes would be cast, at what
would still be a significant cost (for the fund to communicate times
with its investors about the votes, and vice versa). It is tempting to
think modern technology would make such communications inexpensive.
That would be, in my experience, a mistake. The ``back office'' details
of such communication systems always turn out to be far more complex
that simple intuition might suggest. Remember that fund shareholders
move in and out of funds every day, so determining who is entitled to
instruct on a given vote is not simple. Voting instruction forms can be
imperfectly completed or interpreted or applied. Investors will want
confirmations, and will generate further costs as they dial in or
electronically attempt to change or undo prior instructions. They will
want to complain if they believe their instructions were not completed
properly. Any pass-through is not simply a one-time technology fix, but
an ongoing workstream requiring many full-time staff to implement. If
your intuition is that the cost of such a pass-through is X, I would
suggest the actual cost is at least 10X, and could well turn out to be
100X. And to repeat, that cost will generate relatively little actual
benefit, because most fund investors will not instruct on thousands of
voting choices per year.
This prediction is consistent with individual voter turnout in
corporate elections, where individuals have self-consciously chosen to
remain direct investors. In such elections, they vote at far lower
levels than is true for institutional shareholders. That is true even
in contested votes where both sides expend significant sums to
encourage shareholders to vote. The predictable passivity of
individuals who currently invest through index funds is even greater.
After all, they have chosen to use an index fund (rather than investing
directly) for reasons, which include cost reduction and minimizing the
need to monitor their investments.
To address the possibility that fund investors would not use the
pass-through voting rights, the bill would permit funds to engage in
``mirror voting.'' \10\ That is, they could vote uninstructed shares in
the same way that other investors vote. I put aside the challenges of
fund advisors obtaining information that would permit mirror voting
(often, particularly in close contests, many votes are made at the last
minute). Even if it could be made practical, mirror voting would
effectively magnify the power of a voting instruction given by other
investors. These other investors include activist hedge funds, funds
that are actively managed but are pursuing a variety of non-
representative and nonfinancial agendas, and funds that follow advice
from proxy advisors such as ISS and Glass-Lewis, as well as executives.
Mirror voting would effectively shift voting power from index fund
advisors to those other shareholders, with hard-to-predict outcomes.
While some of those other shareholders are individuals, those
individuals (as noted above) vote less frequently than institutional
shareholders. So instead of empowering individuals, the bill would
magnify the power of other institutions.
---------------------------------------------------------------------------
\10\ It also provides a safe-harbor for funds that simply do not
vote at all, which has effectively the same result as mirror voting,
except that it could mean many companies could fail to achieve a quorum
of shareholders voting, as required under varying States laws and
corporate charters.
---------------------------------------------------------------------------
I am fairly sure that what would result is not what is intended. In
a subset of public companies, the result would be to entrench managers
who own enough shares for the boost of the mirror voting of index funds
to move them from a non-controlling to a controlling position. For
those companies, it would be as if the law had transformed ordinary
voting structures into dual class structures, without any shareholder
involvement. This would increase agency costs and increase the risk of
managers pursuing non-shareholder goals.
In other companies, instead of fund advisor employees voting
shares, the shares would effectively be voted mostly at the direction
of other agents--not individuals. To take a simple example to
illustrate, suppose votes at a given company were distributed this way
on the record date used to determine voting eligibility:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
For this simple stylized example, I use numbers roughly based on
data from Innisfree, a proxy solicitor, building on their deep
experience analyzing corporate ownership and predicting likely voting
outcomes for corporate boards and other clients. Notice that the effect
of ``mirror voting'' or nonvoting by index funds (as permitted by S.
4241) is to boost the effective votes of other shareholders. However,
because managers often own so few shares, the boost is correspondingly
small, so small it does not change the percentage, due to rounding. For
clients of ISS and Glass Lewis, the boost is much larger--their likely
vote grows from 25 percent to 31 percent. Once one takes into account
the fact that individual shareholders commonly do not vote, even when
aggressively solicited in a voting contest, the effective votes of
hedge funds and proxy advisory clients moves to over 50 percent. Even
assuming only 80 percent of proxy advisory clients side with a hedge
fund activist and vote, mirror voting makes a hedge fund victory in a
control contest significantly more likely than if index funds could
vote, because index funds (on average) tend to vote more frequently
with management. But if the starting position of hedge funds was lower,
and managers or other institutions higher, the outcome could well be
different, and could even (as noted above) entrench managers (or
empower proxy advisor clients). One can vary assumptions in this simple
scenario, and produce outcomes that range widely in likely effect on
the ability of corporate managers to resist hedge fund activism, social
activist resolutions, or other contested votes.
This uncertainty across outcomes is not a minor flaw. The net
effect of the pass-through and mirror voting provisions would be to
increase significantly the challenges of predicting the outcomes of
many corporate votes, casting a shadow over all public companies. Many
outcomes would be bad for shareholders as a whole, on average. And the
uncertainty involved would induce more activist interventions,
management risk-aversion and settlements in which management gives up
control to a subset of institutional investors. That would not be good
for corporate managers or corporate governance as a whole, and
certainly not benefit the individual investors in index funds, on
average.
The bill would also create bad incentives for funds to adapt
``closet indexing'' strategies to avoid the law's effects (resulting in
no gains and additional costs), and for investors to avoid index funds
to avoid the associated costs. Index funds could avoid the effects of
the bill by modifying their approach to over- or under-weight
components of an index sufficiently to avoid the application of the
law. This is not easily fixed, because it is not a simple task to
identify whether a fund's investments have been chosen to track or be
derived from an index, or whether their risk and return characteristics
happen to be correlated with an index. On average, by construction,
stocks and other investable assets have a ``beta'' of one--they are
correlated with the market as a whole. In a diversified portfolio, many
companies' shares move in tandem, even if they are not part of an
index. The upshot is that the bill could be avoided, albeit with costs
and increased risk for investors. Alternatively, it could be rewritten
to cover all funds, but that would magnify its costs for little
marginal benefit.
In sum, the bill would generate significant costs--which would be
borne by Main Street investors. It would be likely to not generate
substantial new individual investor engagement. Instead, it would shift
voting power away from economic owners to unpredictable groupings of
other shareholders. And it would make the overall voting process more
complex, time-consuming, error-prone, and unpredictable. If I to be
asked by anyone with an interest in our corporate governance system--
managers, investors, fund managers, proxy advisors, proxy solicitors,
or activists of various kinds--the cost and risk are such that I would
advise them that they would be worse off as a result.
3. Alternative Suggestions Reforms Addressing the Index Fund Dilemma
If the rise of indexed funds presents legitimacy and accountability
challenges, as it does, and if Senate Bill 4241 would make corporate
governance worse, what are alternative suggestions for reform? What
would allow individual investors to better understand and inform
advisors about governance decisions, without degrading index funds'
real benefits?
First, reforms could build on the kinds of self-imposed disclosure
and governance tasks that index fund advisors have developed on their
own, as they have attempted to confront the legitimacy dilemma of their
own success. For example, low-cost quarterly or more frequent reporting
is feasible for large funds. A faster cadence of after-the-fact
electronic vote reporting is now cheaper than in the past, and would
not impose undue costs on fund investors. The costs of increased
frequency of fund reporting would be far lower than the costs of a
pass-through system would be, because more frequent reporting of fund
votes involve an existing system, the fixed costs of which have already
been incurred, and would consist of a presentation of facts funds must
already track. A pass-through system would involve new fixed costs in a
system that could elicit, process, validate, aggregate, implement, and
reporting back about thousands of voting instructions from thousands of
investors.
Advisors could also provide better qualitative disclosures about
how advisors develop governance understanding and voting positions on
new issues as they emerge. Currently, the only time that fund investors
learn about a fund advisor's inclinations on a given policy issue--
e.g., whether to vote to split the Chair and CEO roles across
companies--is after the fact, after votes on resolutions proposing such
issues have occurred. Better would be to inform fund investors
beforehand, so they would know that a new kind of governance issue has
arisen, and that the fund advisor is considering how to respond. Some
issues are too company-specific for advance disclosure to be feasible,
outside a specific vote, but often issues arise at one company only to
become the subject at votes at multiple companies over time. If
advisors were to proactively identify ``emerging issues'' for their own
fund shareholders, those shareholders would be better able to respond
(such as by selling fund shares, if they wanted, as they can do now)
based on how the advisor plans to respond to the issues. Market
discipline would be more effective with more complete advance
disclosure about how fund advisors evaluate new policy issues over
which they exercise delegated governance authority.
More ambitiously, it should be possible for fund advisors to obtain
some information from their investors about how they want their
indirect governance powers should be exercised, without attempting to
go so far as S. 4241. For example, funds might ask their investors for
their views on topics overall, or whether overall a fund advisor should
follow the advice of an existing proxy advisor, or a new one that might
emerge over time, which might take different positions from existing
proxy advisors. Or funds might give their own investors the ability to
set overall voting guidelines, as ISS's institutional clients already
do. Those views could be aggregated and used by a fund advisor to guide
it in making voting decisions for fund shareholders as a whole. While I
believe some such system may turn out to be workable, I emphasize that
imposing a simplistic requirement to provide such options may not be
best for index fund investors as a whole. That is because any such
option may only be used by a minor number of fund investors, but the
system to permit it would impose costs on all fund investors. Index
funds have a ``mutual'' component of shared costs, after all--that is
they are ``mutual funds.'' Individual investors electing to use the
system might be charged individually for the costs of such a system,
but such separate expense pass-throughs raise complex regulatory
questions under current law, and may require exemptive relief from the
SEC.
For both cost reasons, and because taking instructions in this way
is likely to be quite practically challenging, for reasons sketched
above, investors in and advisors to index funds are likely to benefit
from pilots and experimentation before finalizing any given method of
communicating with or eliciting governance information from fund
shareholders. It would be best to avoid trying to micromanage how it
will be done through legislation, and instead provide advisors with
flexibility to test whether and which such types of systems would
actually be used by investors. Directing the SEC to oversee pilot
programs proposed by advisors to accomplish these goals would be a
conservative (in the nonpolitical sense) way to pursue such a goal. The
SEC could also be given clear authority to provide regulatory relief
(from fiduciary duties under the Investment Advisers Act or other legal
duties) if needed by advisors to pursue such pilots, conditioned on
appropriate public-regarding conditions and investor protections.
Conflict of interest restrictions that exist at the fund level
could also be imposed at the advisor level. This would help assure that
the potential power that large fund advisors obtain from concentrated
ownership cannot be leveraged to benefit their other operations or to
harm any of their own investors. So that this step does not create
unintended consequences, it should be done by authorizing and directing
the SEC to do so, with appropriate adjustments as the SEC may discover
are appropriate to protect investors.
As you consider index funds, you should also consider index
providers (such as S&P and MSCI), who provide the key input to the
index fund product (i.e., indexes). The market for index creation is
highly concentrated, and some evidence exists that providers use market
power to charge substantial licensing fees. \11\ They wield enormous
discretion and have light and incidental current oversight. Famous
examples of companies like Tesla being taken out of the S&P ESG Index
are not due to choices by index funds, but by the index sponsor.
Increasingly, ``indexes'' are being created that consist of narrow
classes of assets, without meaningful economic diversification. Former
Virginia Law Dean Paul Mahoney and Professor Adriana Robertson have
argued that the SEC already has authority to regulate index providers
as ``investment advisers,'' but Congress could clarify this authority.
Doing so could stave off at least some kinds of predictable industry
court challenges, and the SEC could be given some direction as to how
index providers should be supervised in this respect. Through a public-
comment style process, they could be required to take input from
individual investors on how to manage and adapt existing indexes over
time.
---------------------------------------------------------------------------
\11\ Y. An, M. Benetton, and Y. Song, ``Index Providers: Whales
Behind the Scenes of ETFs'', Working Paper (Jan. 12, 2022), available
at https://www.law.nyu.edu/sites/default/files/
Matteo%20Benetton%20Paper%20Final.pdf.
---------------------------------------------------------------------------
Finally, before imposing costly new regulations on index funds
alone, some thought should be given to whether ``indexation'' is being
misused outside the context of the largest index funds. Collective
investment trusts sponsored by banks are currently beyond the reach of
the securities laws, as are commodity pools investing in index-linked
derivatives. It is not clear that giving responsibility for supervising
such vehicles to different Federal agencies makes sense, as they are
functionally much closer to mutual funds than to other types of
financial institutions.
More dangerously, many ``products'' are sold directly or through
brokers to investors as index-linked bonds or the like, and are
structured not to fall outside the SEC's jurisdiction altogether, but
outside of the Investment Company Act of 1940. As a result, they may be
marketed as ``index-based'' without having to comply with the
diversification, conflict-of-interest and custody rules applicable to
mutual funds, such as index funds. Many such products are increasingly
being built on bespoke, one-off indices, that utterly lack the economic
benefits of index funds. The SEC should also have at least as much
authority it currently has to review and approve new funds to also
review and approve such products, even if they are not formally
investment companies.
None of these suggestions will ``solve'' the ``problem'' of
increased concentration of ownership through index funds. They do have
promise, however, of mitigating the legitimacy and accountability
dilemma that such concentration creates. Most importantly, if carefully
crafted and accompanied by delegation to the SEC, they may achieve
benefits without destroying the basis on which such funds have provided
enormous economic benefits to Main Street investors.
______
PREPARED STATEMENT OF CALEB GRIFFIN
Assistant Professor of Law, University of Arkansas School of Law
June 14, 2022
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
FROM JOHN C. COATES IV
Q.1. Professor Coates, your testimony mentioned how activist
investors could benefit from diminished index fund voting.
Please discuss the general trends you have observed in voting
dynamics and what could happen if individual investors don't
participate and fund shares are not voted, or aligned voted
with the rest of the shareholders as contemplated by the INDEX
Act?
A.1. Shareholder activism is increasing over time. This
includes activism sponsored by hedge funds that do not
necessarily share the same time horizons or goals of other
shareholders. If the economic interests of individuals held
through index funds are deprived of votes, either because
individuals do not use pass-through rights or because index
fund advisors decide not to vote (as permitted by the INDEX
Act), this will increase the power of other shareholders, in
varying and unpredictable ways, likely induce more hedge fund
activism, and likely increase the number of activist
interventions that do not improve shareholder wealth overall.
Q.2. On June 15, 2022, the SEC issued a request for common with
respect to whether certain index providers, among other market
participants, should be regulated as investment advisers under
the Investment Company Act of 1940. Given the growth in the
types and specialization of index funds, how could such
regulation help protect investors? Please address the extent to
which improved disclosures, examinations and inspections, or
restricting conflicts could help transparency and investor
protection.
A.2. Regulation of index fund providers as investment advisers
would be a beneficial additional check on the risks of
conflicts of interest and manipulation in the design and
operation of indexes. Indexes are increasingly being developed
without characteristics (e.g., of diversification) that have
made index fund investing economically valuable for retail
investors. In general, index fund providers do not now have any
meaningful disclosure obligations about when and how they
develop and publish new indices, even when they are being paid
by index fund or ETF or other investment advisers to do so, or
even when they essentially partner with those advisers to
develop and market new index products. Even if there are no
current, undiscovered problems associated with index provision,
sunlight remains the best disinfectant, even as a prophylactic.
The SEC currently has authority in this area, under the
Investment Adviser Act and the Investment Company Act, but it
would be helpful for staff of the Committee to engage with SEC
staff about possible clarifications or augmentations of SEC
authority to regulate in this area. I would defer to SEC staff
on the details of how best to adapt traditional approaches to
investment adviser regulation and supervision to index fund
providers.
Q.3. Your testimony highlighted some other potential steps the
SEC and fund companies can take to make sure public companies
and fund managers are more transparent and accountable. Please
highlight any necessary or recommended regulatory or
legislative changes to achieve those goals.
A.3. The SEC could and should require funds to report portfolio
company voting on a more frequent basis than currently--several
large complexes are voluntarily reporting quarterly.
The SEC should require fund advisers to disclose in more
detail than currently required how they go about fulfilling
their fiduciary obligations to vote fund shares. These
disclosures should not only apply to index fund advisers, but
all advisers with sufficient assets under management as to
provide significant voting power over public companies. These
disclosures should include:
Descriptions of any procedures or processes they
use to develop standing voting positions on topics that
recur in voting on shareholder proposals or other kinds
of votes,
How they choose which companies with which to
engage, and how they do so,
What engagements they completed, and what topics
were discussed,
Whether they have any internal limits on who
performs those engagements,
From whom they seek advice or input when developing
voting positions, and
What conflict of interest policies and procedures
on voting they have, and how they are enforced,
Whether (and why) an adviser votes identically
across funds in a complex, or differently.
Such disclosures should be regularly updated, and be linked
to voting disclosures in a way that better allows fund
investors to understand how and why the voting power derived
from their investments is being used as it is. Such disclosures
should flag ``emerging issues''--shareholder proposal topics or
formulations that are materially different from prior proposal
topics or formulations--before the fund adviser has settled on
a voting position. A final possible type of disclosure
requirement would be for advisers to regularly engage with
their own investors in some structured way--whether through
online discussion forums, investor-specific portals, or by
posting possible voting positions on new topics for investor
comment, or some other means.
To the extent the SEC believes it needs more authority to
require any of the foregoing that it believes in the best
interest of investors, Congress should provide that authority.
To the extent that fund advisers can establish they need
more exemptive relief to engage in pilot studies that would
inform the best long-term method of providing information to
and getting information from their own investors about how the
advisers do and should vote, and using that information in
formulating their own voting positions, the SEC should provide
that relief, appropriately conditioned with regard to investor
protection. If necessary, SEC staff should inform Congress
about any needed changes in its own authority to permit such
pilots.
Congress should give the SEC full authority to impose on
fund advisers the same kinds of limits and controls imposed on
funds relating to conflicts of interest that may arise from
aggregations of voting power from multiple funds by a single
``complex'' adviser.
Congress should consider imposing the same fragmentation
requirements on complexes that are currently imposed by
securities law on ``diversified'' funds, and by tax law on all
funds that seek to avoid entity-level taxation. See Investment
Company Act Section 6; Internal Revenue Code Sections 851-852.
It may also make more sense to combine these fragmentation
provisions into a single statute, under the SEC's authority, to
facilitate greater tailoring of the requirements over time.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SINEMA
FROM JOHN C. COATES IV
Q.1. One provision of the INDEX Act requires costs for
implementing pass-through voting to be borne by the funds or
their investment advisers. If enacted, how substantial would
you expect these costs to be? How much of these costs would you
expect to be passed on to retail investors?
A.1. If the INDEX Act were adopted as current drafted, and
pass-through voting adopted by index fund advisers, I believe
the costs would be substantial, and nearly all of those costs
would be passed on to retail investors.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TILLIS
FROM JOHN C. COATES IV
Q.1. Following our discussion of the INDEX Act last week, I'd
also like to touch on other actions that may be necessary in
this space. I'm specifically interested in the duopoly of the
proxy advisory firms ISS and Glass-Lewis, and would appreciate
your thoughts on the matter.
What actions as it relates to the proxy advisory firms may
be helpful for policy makers to consider?
A.1. The SEC should actively monitor and report on whether
proxy advisory firms are complying with their obligations to
disclose conflicts of interest, how they are managing those
conflicts, and whether those conflicts are causing any
observable harm or bias in their advice. Congress should
provide the SEC dedicated funding to study and report whether
proxy advisory firms make objective, factual mistakes in their
analysis, as many companies allege are common, but which
current data suggests are extremely rare, especially when
benchmarked against analysis by other investment professionals,
such as research analysts.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SINEMA
FROM CALEB GRIFFIN
Q.1. One provision of the INDEX Act requires costs for
implementing pass-through voting to be borne by the funds or
their investment advisers. If enacted, how substantial would
you expect these costs to be? How much of these costs would you
expect to be passed on to retail investors?
A.1. The cost of implementing pass-through voting is in many
ways dependent on both the level of precision we require and
the liability standard we impose. I believe we should impose a
relatively low precision requirement and a relatively light
liability standard in order to minimize the costs associated
with pass-through voting.
With respect to the precision requirement, the core
question is how accurately asset managers must translate each
investor's voting instructions into firm-level votes. As
Professor Coates mentioned in his testimony, end-to-end vote
confirmation in the broader proxy voting space is still a work
in progress. \1\ With that in mind, we should be realistic
about the level of precision we can expect when translating
fund investors' voting instructions into actual, firm-level
votes. Particularly in the early stages of implementing pass-
through voting, regulatory flexibility with respect to
precision requirements would help ensure that burdens on asset
managers and investors remain low.
---------------------------------------------------------------------------
\1\ ``Considering the Index Fund Voting Process'', Hearing Before
the Comm. on Banking, Housing, and Urban Affairs (2022) (Testimony of
Professor John C. Coates IV).
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With respect to the liability standard, the central
question is what happens if an asset manager falls short of the
precision requirement in some respect. I believe that the
applicable liability standards should be relatively light. For
instance, a ``reasonable efforts'' standard or a ``good faith''
standard could be appropriate. As asset managers navigate the
process of implementing pass-through voting, it may be
appropriate to have an especially light liability standard
during this transitional period, perhaps imposing liability
only where there has been a ``systematic and sustained''
failure to adhere to investor input. Overall, the focus should
be on giving voice to investors and democratizing the proxy
voting process rather than creating new causes of action.
Provided that precision requirements and liability
standards are low, the main costs associated with pass-through
voting would involve establishing the infrastructure to solicit
and tabulate investor input. I estimate that those would be
quite manageable, especially given that index funds such as
BlackRock have already begun to develop such tools in-house.
In particular, BlackRock has already expanded pass-through
voting capabilities to institutional clients representing 47
percent of all BlackRock index equity assets. \2\ The ``most
popular approach'' among their clients is the option to
``select from a menu of third-party proxy voting policies.''
\3\ This is very similar to what I referred to in my testimony
as ``vote outsourcing''--rather than being locked in to an
asset manager's voting policies, investors could instruct that
their shares be voted in line with another third party of their
choosing. The fact that such technology is already in use is
perhaps the strongest argument for its cost-effectiveness and
feasibility.
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\2\ ``It's All About Choice'', BlackRock (2022), https://
www.blackrock.com/corporate/literature/publication/its-all-about-
choice.pdf.
\3\ Id.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR TILLIS
FROM CALEB GRIFFIN
Q.1. Following our discussion of the INDEX Act last week, I'd
also like to touch on other actions that may be necessary in
this space. I'm specifically interested in the duopoly of the
proxy advisory firms ISS and Glass-Lewis, and would appreciate
your thoughts on the matter.
What actions as it relates to the proxy advisory firms may
be helpful for policy makers to consider?
A.1. ISS and Glass Lewis collectively control greater than 90
percent of the proxy advisory market. \1\ Although concerns
about their market power have been present for some time, \2\ a
consensus on how to deal with that power has proven elusive.
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\1\ Paul Rose, ``Proxy Advisors and Market Power: A Review of
Institutional Investor Robovoting'', Harv. L. Sch. F. on Corp.
Governance (May 27, 2021), https://corpgov.law.harvard.edu/2021/05/27/
proxy-advisors-and-market-power-a-review-of-institutional-investor-
robovoting/.
\2\ See, e.g., ``Concept Release on the U.S. Proxy System'',
Release Nos. 34-62495, IC-3052, IC-29340 (July 22, 2010); ``Examining
the Market Power and Impact of Proxy Advisory Firms'', Hearing Before
the Subcomm. on Capital Markets and Government Sponsored Enterprises
(2013).
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One potential response is related to the proposals laid out
in the INDEX Act. I believe that, in addition to its other
benefits, pass-through voting represents an effective strategy
to mitigate the power of proxy advisors. This is because a
voting decision made by an individual investor typically
replaces a decision made by either a proxy advisor or an asset
manager. When pass-through voting transfers voting authority to
individual investors, it shifts it away not just from asset
managers, but also from the proxy advisors on whom asset
managers often heavily rely. Thus, by granting individual
investors a greater voice in corporate governance, policymakers
could reduce the concentrated power in the hands of many other
financial market actors, including both index fund managers and
proxy advisors.
In particular, ``vote outsourcing,'' or providing
individual investors with the right to select their own
representative who will vote on their behalf, has the potential
to diversify the pool of advisors shaping proxy voting
outcomes. If pass-through voting creates demand for such
services, I believe dozens of organizations and nonprofits
would provide voting recommendations, reducing the relative
power of ISS and Glass Lewis while providing individual
investors with a greater voice in the proxy voting process.
Additional Material Supplied for the Record
LETTER SUBMITTED BY KATHRYN FULTON, MANAGING DIRECTOR, BLACKROCK
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