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Industry Voices

Commentary: Reforming a broken system

As clearly described in the news release announcing its formation, the Main Street Investors Coalition is a shareholder advocacy group formed through the joint efforts of the National Association of Manufacturers, the American Council for Capital Formation, the Equity Dealers of America, the Savings & Retirement Foundation, and the Small Business & Entrepreneurial Council. Also, as disclosed in the release, "The Main Street Investors Coalition was created to raise investors' awareness of how the system (shareholder voting and engagement) works and currently is being abused and advance a reform agenda designed to help fix it." Moreover, the Coalition believes — as do I — that climate change is real and poses a serious threat to our world.

I expect the coalition to become a leader in the field of shareholder advocacy. This is because it is the first organization trying to deal with a relatively new phenomenon that Ronald J. Gilson and Jeffrey N. Gordon would call the "agency costs of agency capitalism." This sounds very theoretical and sleep inducing, but it can be easily explained.

We now live in an investing world that is dominated by institutional investors. As the coalition notes on its website, "in 1950, retail investors directly owned more than 90% of the stocks issued by U.S. companies. Today, that number is closer to 30%, with securities markets these days increasingly being dominated by big, institutional and often passive holders." Moreover, we live in an era where retail investors who hold stock through their brokerage accounts are voting their shares in record low numbers. This is something that the American Business Conference is trying to rectify through its advocacy of advanced voting instructions, and I wish them luck.

The dominance of institutional investors — where the intermediary is the shareholder of record, not the retail investor who provides the funds — is what is meant by "agency capitalism." For the most part, agency capitalism has been very good for retail investors. For example, mutual funds provide unsophisticated and uninformed stock market investors with easy access to low cost portfolio diversification. But agency capitalism, like any other type of agency, also has a downside; it generates "agency costs."

Agency costs are generated when an institutional investor acts based on its own preferences, not the preferences of those who provide it with the funds to purchase securities. That is, there is a divergence between the objective of shareholder wealth maximization, the default objective of those 100 million-plus retail investors in the United States who invest in mutual funds either directly or through retirement accounts, or are the beneficiaries of public pension funds, and the preferences of institutional investors who manage those funds. The result is that these agency costs may significantly harm the efficiency of corporate governance and lead to lower returns for investors.

These agency costs include a public pension fund disregarding the preferences of its beneficiaries and approaching shareholder advocacy and voting through the lens of shareholder empowerment, not wealth maximization. Or, when an institutional investor uses voting recommendations from proxy advisers that are based on data errors, bias (simply making the recommendation based on what a type of institutional investor wants to hear), or are based on a one-size-fits-all approach. In addition, when a mutual fund adviser, in its desire to bring more public pension fund assets under management, supports and votes for proxy access proposals initiated by public pension funds. Or, in order to appease shareholder activists who are part of its own stockholder base, the mutual fund adviser may be more supportive of social responsibility proposals, such as those dealing with climate change, than they would otherwise.

It should not be surprising that the coalition's sponsor organizations and their members were the first to identify this growing problem and are trying to respond to it. Corporate law and common sense inform the board of directors and executive management that their fiduciary duties require them to act with the intent to maximize shareholder wealth. It also informs them that for such maximization to occur, investors must defer to the judgment of the board of directors and executive management. When activists demand that they do not do so and are successful, this in effect creates an obvious disconnect in the minds of management, sending up a slew of red flags.

For the coalition to mitigate the growing threat created by the agency costs of agency capitalism, it believes it must enlist the support of both the retail investors who directly or indirectly invest in mutual funds and the beneficiaries of public pension funds. And to correct any misunderstandings, while "mom-and-pop" investors, small-sum investors who invest minimally, are definitely included in the definition of retail investor, they are just a small subset of those 100 million-plus retail investors and public pension beneficiaries the coalition is trying to reach.

The coalition believes it has common cause with the retail investor because it assumes that the overwhelming number of retail investors simply want to earn the highest risk-adjusted financial return possible. Correspondingly, it believes public pension fund beneficiaries want their trustees to participate in shareholder advocacy and voting for the same purpose.

The coalition also believes this desire to earn the highest risk-adjusted financial return possible is shared by the overwhelming number of socially motivated investors who align their investments based on their moral or social values, even though they give up some risk-adjusted return in terms of portfolio diversification and might pay higher management fees for this customization. That is, these investors are willing to exclude certain stocks from their portfolios because they find them to be socially undesirable, but are still looking for the highest risk-adjusted return possible given their investment constraints.

For retail investors to earn the highest risk-adjusted financial return, and for public pension fund beneficiaries to have the best possible chance of receiving the payments they are entitled to, the efficiency of corporate governance must be maintained. The former cannot exist without the latter. For that to happen, the coalition must be successful in mitigating the agency costs of agency capitalism. I hope the coalition succeeds.

Bernard S. Sharfman is chairman, Main Street Investors Coalition Advisory Council and a member of the Journal of Corporation Law's editorial advisory board. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.