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SBC Hearing on the Index Fund Voting Process

Senate Committee on Banking, Housing, and Urban Affairs

Considering the Index Fund Voting Process

Tuesday, June 14, 2022

Topline

  • Brown opposed and Toomey indicated support for the INDEX Act.
  • Questioning focused on proxy voting, disclosure, and the influence of large firms.

Witnesses

Opening Statements

Chairman Sherrod Brown (D-Ohio)

In his opening statement, Brown highlighted the need to understand who should exercise the market share that index funds have gained, and how we can hold corporate executives accountable and make sure they are thinking about the long-term value of their companies. He introduced the issue of a growing population that opposes index fund managers’ voting and expressed his fear of this being the new reality under the bill of Sen. Sullivan (R-Alaska). He explained that fund managers not voting company shares unless instructed by the investor sounds democratic, but does not consider the cost, the complexity, or the number of votes involved. He maintained that when seeking to improve transparency and accountability for fund managers, it is integral to consider areas for reform without undermining index funds as a low-cost way to diversify savings and investments. He closed by stating that the current system is far from perfect, but moving to a system that suppresses voting is not the answer either.

Ranking Member Pat Toomey (R-Pa.)

In his opening statement, Toomey argued that Congress needs to address the problem of consolidation of voting power and voting other peoples’ shares for the largest asset managers. He said the INDEX Act is a solution to this problem and would prevent asset managers from abusing voting power of index fund investors to advance their own agenda.

Testimony

The Honorable Dan Sullivan, United States Senator, Alaska

In his testimony, Sullivan said the impetus for this legislation stemmed from ongoing frustration with America’s largest banks and insurance companies that undertook policies to blackball oil and gas investment and development in Alaska and took extreme exception to these companies investing in Chinese communist activities while blackballing American energy workers. He stated that the INDEX Act is neutral at its core and that it requires investment advisors of passively managed funds to vote proxies in accordance with the instructions of fund investors and the American people, not at the discretion of the advisor. He added that the bill would return voting power back to beneficial owners of the shares and that it would neutralize unsettling power that the largest investment advisors have amassed and empower the real beneficial owner of these shares. He closed by saying the INDEX Act would foster a healthier and more competitive and democratic corporate governance system and said all action must be taken in a bipartisan manner.

Professor John C. Coates IV, John F. Cogan, Jr., Professor of Law and Economics, Harvard Law School

In his testimony, Coates stated that index funds have provided more benefits to American people through low fees and diversification, competitive pressure, and that it requires almost no monitoring for people who put money in the fund. Thus, Coates believes this is not a problem to solve, but a tradeoff to manage. Coates stated that legislative intervention would harm the functioning of index funds while achieving minimal benefits. Coates argued the cost of pass-through voting will be large because there would be thousands of votes and hundreds of thousands of investors. He believed the cost will be imposed on everyone and that most would not use these rights yet would still have to bear such costs even if not used. Coates stated that the fallback to mirrored voting or not voting would be worse for everyone, including management, because it shifts voting power to institutions like proxy advisors and activist hedge funds depending on their relative voting power and dramatically increases the unpredictability of voting. He also noted that fund investors should be encouraged to take instructions from investors but that this will take pilots and experimentation to ensure it is done in a cost-effective way.

Professor Caleb Griffin, Assistant Professor of Law, University of Arkansas School of Law

In his testimony, Griffin explained each of the four key points of his testimony. He said that our corporate governance system is based in large part on empty voting, which distorts incentives, the best interest standard, which currently governs index fund voting, is insufficient, pass-through voting solves the empty voting problem and restores agency to investors, and finally, that pass-through voting is the lowest cost approach that will meaningfully address this problem. He stated that index funds vote in a way that is untethered from their investors’ interest and that the best solution to this problem is to transfer some of the power of fund managers to individual investors. He added that this would allow investors to not only set their own instructions on voting issues, but also instruct fund managers to vote their shares in alignment with a third-party representative.

Question & Answer

Proxy Voting

Brown asked Coates to describe logistical and practical concerns with trying to manage pass-through voting. Coates stated that managing pass-through voting would be costly, time consuming, and error prone because the current system of voting at the corporate level is still a work in progress, and the bill would add more layers to the complexity. Brown asked Griffin if the solutions to get input from fund investors proposed in the INDEX Act have any potential. Griffin responded that they do and said that outsourcing the voting process and using third-party expertise would reduce the separation of ownership and control and reduce the harm of empty voting. Sen. Chris Van Hollen (D-Md.) asked if anyone would be looking out for his best interest if an investment management company chose to simply not vote at all and opt out. Coates said there would be no one looking out for his best interest and that it would lead to less voting by the longest-term investment funds that exist today. Van Hollen asked if that would mean more relative voting by hedge funds and other short-term investors. Coates said yes, it would. Van Hollen asked if the bill would require an investment management company to send an investor their voting material for each of the constituent companies that underly the index fund. Coates said yes, it specifically talks about each proxy statement for each company it has in the index fund. Sen. Steve Daines (R-Mont.) asked Griffin whether it is too difficult to allow individual investors to vote their own shares held in index funds. Griffin replied he does not believe so because individual investors have the ability to utilize tools.

Van Hollen asked Coates if he could choose to directly invest in the underlying companies if he wanted to do so. Coates told him yes, he could. Van Hollen asked if this bill would allow an investment management company to opt out and thus not vote at all on the individual investors’ best interests. Coates stated that the bill has some ambiguities, which is a separate issue, and that he does not think an investment management company could provide an opt-in or -out option. Sen. Jack Reed (D-R.I.) asked Coates how this bill would affect investment managers’ reliance on proxy advisory firms. Coates replied that proxy advisors will get more power because of this bill. Van Hollen asked Coates if in return for his investment, an investment advisor has a duty to look out for his “best interest” in return. Coates said that is correct.

Disclosure

Sen. Menendez (D-N.J.) asked if Coates believes that corporate political spending is material information that should be disclosed to investors. Coates said on average, yes, and that he is a supporter of the DISCLOSE Act and of getting rid of micromanagement of the Securities and Exchange Commission (SEC). He added that political involvement of some companies is clearly their first order of strategy and that it would therefore be a mistake to not force them to disclose this spending. Menendez asked if Coates believed disclosure of political spending is useful to investors. Coates said he does because individual investors will lean into their rights and use them to make governance choices, and they can only do that if they have all the information. Menendez asked Coates how disclosures regarding votes that have been taken can be made more informative and digestible for investors. Coates said the SEC has a rule pending that if adopted will help because it favors big index funds reporting more frequently and having more real time disclosure would let markets work rather than having law direct the operations of companies. Menendez asked Coates if shareholders of companies that make public pledges should expect their companies to act in a manner consistent with the stated company policy. Coates said yes, they should. Sen. Thom Tillis (R-N.C.) asked Griffin if institutional investors should be required to disclose their analysis proving that their votes were in the best economic interest of their shareholders. Griffin believes seeing this analysis could be beneficial, since more disclosure usually is.

Reporting

Reed asked Coates if it would be an advantage for public companies that have left the public sector to be reporting some basic information. Coates said that index funds provide massive capital, but it is only one entity who buys the shares through an index fund and that there is currently a different reality for what is considered a public company than when the securities laws were first written. He added that the thresholds built into the Securities Exchange Act of 1934 should be revisited because index funds make it possible for most companies to amass enormous amounts of capital but stay below the threshold of 300 shareholders.

Costs and Concerns of the INDEX Act

Van Hollen asked Coates to say more about the costs that this bill would impose. Coates said that one significant cost would be for the funds to trace out through brokers and other intermediaries and find who the investors are. He added that the bill does not allow them to do it in a differential way because it is all or nothing and said that experimentation is necessary. Van Hollen asked if a money manager can opt out entirely because of the costs that this bill may impose. Coates said yes, they would be permitted to simply not vote at all. Tillis asked Griffin to speak on the merits or concerns he has on the INDEX Act. Griffin argued that pass through voting is the best and lowest cost option, and that the root of the problem is the concentration of power in very few hands. He is concerned about the two-year window in the bill and recommends the window to be extended to three years. Griffin stated he is sensitive to these concerns but that pass-through voting is exceptional. Toomey asked Griffin to comment on mechanisms spoken about to try to address inherent complexity in the share scale of this challenge. Griffin stated that because of the 1% cap, the INDEX Act would only apply to the largest funds, which helps balance proposals only on funds that could bear the cost. He also questioned whether it is feasible for a large number of companies to vote on a large number of questions. He noted that there were two methods for voting instructions: (1) a categorical vote that the company would apply on a blanket level for all firms in a portfolio, and (2) only one decision from the investor who assigns a specified third party or fund their voting power. Griffin believes the INDEX act would provide a neutral platform for third party recommendations, which could further lead to competition and a diversity of view.

Sen. Kevin Cramer (R-N.D.) noted that some states, such as Virginia, passed laws similar to the INDEX Act and may be more aggressive using state funds. He is concerned about the federal government having one agenda and the states having a conflicting one. If this were the case, he asked Griffin what the consequences would be. Griffin stated this would result in increased costs and further politicization at the state level, which would be difficult for fund managers to navigate. He said there is desirability for a unform standard and federal action. Cramer also discussed no action requests, specifically the SEC granting or denying them. He asked Griffin whether there is a risk of less than even handling of no action requests regarding index funds. Griffin said there is variability within the SEC due to the diversity of views on what is appropriate. He also mentioned that there are recent changes on what can and cannot be excluded for no action requests, and in respect to index funds, it is not a major issue for proxy voting.

Transparency and Accountability

Daines asked Griffin if allowing shareholders to participate in the proxy process would decrease woke outcomes from asset managers or corporations. Griffin stated that this is not clear with respect to why asset managers or corporations are exercising voting power the way they do, but it may be the problem. He mentioned that some people view it as pure compliance cost and others view it as a way to market undifferentiated commoditized products.

Influence of Large Firms

Toomey asked Griffin if three individual firms can determine the board of directors on a company, whether that gives them enormous influence over any matter of their choice because of the implicit backing of their request in the form of a change in composition of the board. Griffin stated the ultimate source of power is the voting right because big firms exercise their power through electing directors and standard setting processes. He noted that according to academic studies, when the big firms announce their corporate governance position, their positions are quickly adopted by other companies. Coates was asked to comment by Toomey, which Coates responded that there could be a reduction in predictability, but currently large companies are doing what their shareholders are telling them to do. He also mentioned that this could be less beneficial because it essentially creates a one-size-fits-all corporate governance culture that could be detrimental. Daines asked Griffin his thoughts on what happened to Exxon when a .02% investment suddenly replaced three Exxon board members with climate activist board members. Griffin said this demonstrates the power of big firms because they have the ultimate decisional power in corporate law controversies, which is a dangerous situation and harmful to corporate governance.

For more information on this hearing, please click here.

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