A Proposed Solution to the Index Fund Free Rider Problem
- by Maurice M. Lefkort
An in-depth examination of the benefits of pro rata voting
The thesis behind index investing is the efficient market hypothesis, which trusts in the power of the market to accurately price all securities. Index funds buy a basket of securities corresponding to an underlying index with the goal of achieving the market rate of return for the least cost. Assuming that all competing index funds accurately track the underlying index, an index fund that spends money to improve the corporate governance and/or performance of its investments will be at a cost disadvantage to its competitors. This creates the “Index Fund Free Rider Problem” discussed in my previous post. As a result, large blocks of stock that can determine the outcome of corporate elections are held in the hands of index funds who are disincentivized from expending time and resources on shareholder votes. This creates a voting deadweight enabling management to entrench themselves at the expense of shareholders and market efficiency.
Proposed Solution: Pro Rata Voting
It seems anomalous to say that an index fund can use a “dumb algorithm” (such as weighting in a published index) to determine its investments, but then has to spend money to “vote smartly” in the companies chosen by the dumb algorithm. The solution to the index fund free rider problem is to trust in the market for voting securities, the same way that the index fund relies on the components and weighting of the underlying index to determine its investments. Thus, index funds (and perhaps all shareholders) should be given the option to have their votes cast pro rata with all other shareholders (“gross pro rata voting”). A further enhancement would be to permit pro rata voting, but exclude the shares controlled by the issuer’s officers and directors (“independent pro rata voting”). Independent pro rata voting would allow a true market guide for voting by an index fund and eliminate the pro-incumbent overhang in corporate elections. The index fund would, of course, retain the right to vote whichever way it wanted, but with gross pro rata voting or even independent pro rata voting (collectively, “pro rata voting”), it would have no need to unnecessarily expend funds on corporate governance matters unless it chose to do so.
How Pro Rata Voting Would Work
In a typical public company stockholder vote, stockholders are mailed a proxy card and asked to vote for/against/abstain on the matters submitted to stockholders (for election of directors, “against” is often replaced with “withhold”). In a pro rata voting regime, the proxy card would give the stockholder the ability to “check a box” that would direct the proxy to vote the shares in accordance with the applicable algorithm: In the case of gross pro rata voting, pro rata with all other shareholders voting in a non-pro rata fashion, and in the case of independent pro rata voting pro rata with all other shareholders (excluding officers and directors) voting in a non-pro rata fashion.
Example of Pro Rata Voting
The following example illustrates the effect of pro rata voting in the case of a shareholder proposal opposed by insiders, assuming that Insiders control 15 percent of the vote, index funds control 30 percent of the vote, and other institutional and retail investors (“Other SHs”) control 55 percent of the vote.
|Insider and Other SH’s||For||Against||Not Voting|
|Active Inst. and Retail||29%||15%||11%|
|Observation – Before index fund voting, the proposal is “behind” due to overwhelming insider opposition, even though favored by a 2:1 margin by the other SHs.|
|Scenario 1 – Anecdotal Status Quo – Index Funds Vote with Insiders|
|Observation: With the index funds voting with the insiders it is virtually impossible for a proposal opposed by the insiders to pass.|
|Scenario 2 – Gross Pro Rata Voting|
|Observation: Because the index fund shares are voted in proportion with the shares that are voted, the vote is much closer, although the proposal still fails.|
|Scenario 3 – Independent Pro Rata Voting|
|Observation: Because of the overwhelming other SH support, the resolution passes.|
Implementing Pro Rata Voting
Any corporate issuer could voluntarily implement pro rata voting today. All that would be required is adequate disclosure in a proxy statement, and if independent pro rata voting is implemented, a requirement that officers and directors disclose how they vote on the shares that they control. However, given the evidence of pro-incumbent voting tendencies of index funds, it is unlikely that pro rata voting would be voluntarily implemented by a public company.
To implement pro rata voting, three pieces of SEC regulation would likely be required:
- First, corporate issuers should be required to place the option for Pro rata voting on their proxy card.
- Second, officers and directors of a public company issuer would be required to disclose how they voted the shares that they controlled in a corporate election (“Insider Voting”) (this is necessary to enable independent pro rata voting).
- Finally, corporate issuers are currently obligated to publicly disclose on a Form 8-K the results of shareholder votes. That disclosure would be enhanced to also disclose the voting by shareholders not utilizing pro rata voting, insider voting, the allocation of the gross pro rata votes, and the allocation of independent pro rata votes.
These regulatory changes would, at minimal cost, both enable pro rata voting and facilitate validation of the pro rata votes.
Pro rata voting is not a panacea to the index fund free rider problem, but it is a market-based solution to the large blocks of stock that now serve as a pro-incumbent dead weight in many corporate elections.
Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, please note that this post may constitute attorney advertising.