By Bernard Sharfman
Originally posted on the Oxford Business Law Blog at https://www.law.ox.ac.uk/business-law-blog/blog/2017/11/first-critique-framework-us-stewardship-and-governance
What’s not to like about a broad set of principles that guide investor stewards in their responsibilities to their pension fund beneficiaries or investors? For example, the Investor Stewardship Group (ISG), a group of leading institutional investors and mega-mutual fund advisors such as Blackrock, California State Teachers’ Retirement System (CalSTRS), Florida State Board of Administration, State Street Global Advisors, TIAA Investments, T. Rowe Price Associates, Inc., and Vanguard, have put forth what they called the Framework for U.S. Stewardship and Governance(‘Framework’). This Framework follows in the footsteps of many other such Stewardship Codes that have been proposed and implemented around the world since the financial crisis of 2007-2008. In my Internet searching, I have yet to find any criticism of the principles laid out in the Framework. However, if one looks closely at this Framework, one sees a glaring omission, the lack of any reference to wealth maximization as the objective of investor stewardship. Therefore, this writing presents the first critique of the Framework.
The Framework provides a set of basic principles of investment stewardship for institutional investors and corporate governance for public companies based in the United States. In regard to the objective of stewardship, Principle A of the Framework’s stewardship principles states the following: ‘Institutional investors are accountable to those whose money they invest.’ Principle A also comes with the following explanatory comments:
A.1 Asset managers are responsible to their clients, whose money they manage. Asset owners are responsible to their beneficiaries.
A.2 Institutional investors should ensure that they or their managers, as the case may be, oversee client and/or beneficiary assets in a responsible manner.
Being accountable appears to be synonymous with being responsible, but even so it does not provide an explanation of the stewards’ actual objective in managing the funds of their beneficiaries and investors. As stewards, the objective of such management must be wealth maximization. What other objective could be practically and logically applied to a U.S. public pension fund serving tens or hundreds of thousands of beneficiaries or a mega-mutual fund advisor contractually managing the savings of tens if not hundreds of millions of people at one time? The only reasonable path is for an investor steward to assume that the overwhelming majority of a very large number simply want the best return possible for the risk taken, resulting in the maximization of their wealth. Thus, every decision by these institutions, whether it involves how to investment the funds under the steward’s control, shareholder voting, or corporate governance advocacy, is to be guided by this objective.
Whether intentional or not, the Framework’s light and non-committal language of being accountable and responsible, instead of stating directly that their objective is wealth maximization, implies that the stewards who have signed onto the Framework are making the statement that they reserve the right to act opportunistically when they see fit. That is, they can take actions that may negatively impact the wealth of their beneficiaries and investors if it benefits them. For example, ‘it can be argued that mega-mutual fund advisors have been drawn into an alliance with the shareholder empowerment movement (‘movement’) on the issues of proxy access and dual class share structures… because of the business opportunity such an alliance represents. That opportunity is to attract or retain the business of public pension funds and union related funds (which control approximately $3 trillion in assets),’ the movement’s institutional leaders, ‘which are shifting their portfolios away from high cost, actively managed mutual funds and hedge funds to low cost indexed funds, the kind of funds that the top 10 largest mutual fund advisors dominate in terms of market share.’
To see how this alliance may harm mutual fund investors while at the same time enhancing the bottom line of mega-mutual fund advisors, it is important to understand that the objective of the movement is shareholder empowerment, not shareholder wealth maximization. The use of dual class share structures at public companies (Google, Facebook, Berkshire Hathaway, Comcast, Alibaba, etc.) negatively impacts the ability of the movement to achieve its objective, making their use intolerable even if wealth maximizing. This explains why the movement has zealously advocated, without exception, against dual class share structures in all their manifestations, including their listing on stock exchanges and representation in leading indices such as the S&P 500 and Russell 3000. Therefore, when mega-mutual fund advisors try to gain the business of public pension funds by allowing the movement to control its position on dual class shares, mega-mutual fund advisors are in essence substituting the objective of shareholder empowerment for wealth maximization. This cannot be good for mutual fund investors.
In effect, the result of the Framework is to both normalize and desensitize investors to the ‘opportunistic behavior’ of their stewards. This opportunistic behavior, when realized, can be referred to as the ‘agency costs of agency capitalism’. These agency costs are not acceptable.
Stewards, no matter how politically and economically powerful, are in essence only agents of their principals, their beneficiaries and investors. The interests of the principals’ come before those of the agents. It is not the other way around. This is something that seems to have been forgotten as we have moved into an investment world dominated by investor stewards with powerful voices, incredible amounts of delegated voting authority, and large market shares.
Wealth maximization should be a duty of all investor stewards. This should be explicitly stated in the Framework. Perhaps what is really necessary is for the courts to identify and require common law fiduciary duties for investor stewards that incorporate wealth maximization, but that discussion is better left for a future writing.
Mr. Sharfman’s recent article on dual class shares can be found here.
Bernard S. Sharfman is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, a visiting professor at the University of Maryland School of Law (Spring 2018), and a former visiting assistant professor at Case Western Reserve University School of Law (Spring 2013 and 2014).