Exit, Voice, BlackRock

Why Shareholder Democracy Isn’t

Shortly before he died, John Bogle, who created the index fund, had a premonition of overreach.

Someday, he warned, a “handful” of institutions might gain voting control over “virtually every large U.S. corporation.”

Someday came last month, when Engine No. 1, an environmentally committed hedge fund, nominated four dissident directors for the board of ExxonMobil.

Engine No. 1 owned only 0.02% of Exxon, but it skillfully solicited the three largest index funds—Vanguard Group, BlackRock and State Street, who together own 20% of the oil giant--and also the largest state pension funds.

Voila, three of the hedge fund’s nominees, heralding a greener future but offering few specifics other than that Exxon explore cleaner fuels and account for a lower oil price when evaluating drilling projects, were elected over company nominees.

The upset was cast as landmark of corporate democracy.  Anne Simpson, a managing investment director at Calpers, the country’s biggest public pension fund, in advance called the vote a day of reckoning for Exxon, whose share performance had been lagging, and for Wall Street. She said, “That is how capitalism is intended to work.”

Intended for whom would be a valid reply. Index funds serve as a conduit for millions of investors. It is these investors who put up the capital and who hold the economic interest. Yet it is BlackRock, et. al. who cast the votes.

As an index manager, BlackRock is not judged on Exxon’s (or any stock’s) performance. It does have a great public commitment to sustainable energy, and a reputational stake in coloring itself green. Like Calpers, it has lobbied American business to take action on climate change and called for a transition to a net zero economy.

Translating such beliefs into public policy is a first-order question for the U.S. Congress. The board of Exxon is hired to protect, and pursue, the economic interests of Exxon.

It may well be that oil and gas have such a problematic future that no drilling makes economic sense. (Engine No. 1, founded by an investor who formerly operated a coal mine and built petroleum storage facilities, made no such claim.) Or it may be that oil, a legal product for which the price is rising, will remain, within regulatory limits, permissible and profitable.

The question is who decides. The point is not just that a few institutional voices bear so heavily on the outcome. In Exxon’s founding era, control was wielded by one person (John D. Rockefeller, Sr.).

The problem is that the people casting the votes are policy-setters rather than economic owners. BlackRock notes that it has a fiduciary responsibility to vote in the long-term interests of its investors—but the rules defining its responsibility are sufficiently vague to render this duty meaningless.  

Ordinary mutual funds (I am a director of one) also cast proxy votes. Such funds differ in that they are chosen to actively manage portfolios. Index funds are useful administrative conveniences. They were chosen to be passive, to manage nothing. Their voting power is an accident.

The incentives are yet more troubling for the 4% of the market owned by public pensions, which are subject to overt political pressures. The New York State Common Retirement Fund has one trustee, an elected official. He has nothing to gain from a marginal appreciation in Exxon’s stock, and everything to gain from mollifying public opinion. Such funds routinely indulge in choreographed groupthink on public policy notwithstanding that many are chronically underfunded.

And yet--diagnosing flaws in corporate democracy, a parlor sport for 100 years, is easier than fixing it. The New Deal scholars Adolph Berle and Gardiner Means were first to observe that in the public corporation, management and ownership had been severed.[1] This produced an “agency” problem: how to ensure that the suits acted in the widows’ and orphans’ interests.

Michael C. Jensen of Harvard Business School argued that management incentives were so misaligned that public companies deserved extinction, i.e., should succumb to private buyouts.[2] Michael Milken and Henry Kravis did their best to oblige, but the “public” was, and is, where most of the capital resides.

Even at Exxon, with its 4.23 billion shares, about half of the company is held in retail accounts. They could elect the backfield of Notre Dame, if they so chose. But they don’t vote. According to Broadridge, retail investors vote 28% of their proxies; institutions, 92%. If BlackRock wields inordinate power, it holds it by default.

Public apathy was best explained by Albert O. Hirschman, an economist. In Exit, Voice and Loyalty (1970), Hirschman deduced that organizations offering “voice” to their members are less likely to suffer defections. On the flip side, ease of exit depreciates voice. Since selling stock is so easy, no one bothers with persuading, much less changing, management. (This is smugly expressed in the Wall Street rule: “Love it or Leave it.”)

Indexers such as BlackRock illustrate a converse truth. Since “exit” is foregone—indexers can never sell—they have become, contrary to predictions, models of engagement. BlackRock not only votes, it confers, frequently, with managements on governance and other questions. It has written, thoughtfully if self-interestedly, on issues surrounding proxy reform. It maintains a team of more than 30 professionals in “investment stewardship” who manage its participation in 160,000 ballot items per year.

Ordinary shareholders do none of this. And yet, for all its diligence, BlackRock’s statement that board directors are elected “to represent shareholder interests, among other things,” unintentionally exposes a gap between its perspective and those of its charges. What other things?

A small, Honolulu-based index fund, with the fitting ticker symbol “Index,” is experimenting with a reform: polling its shareholders for their preferences on proxy votes. In theory, this could transfer the franchise to investors, and the fund is marketing its innovation as a shareholders’ Magna Carta. For competitive reasons, it is not unthinkable that other indexers could adopt proxy polling. But so far, Index’s polls are only advisory (it can vote as it chooses). To truly give its investors the vote, Index would need SEC guidance and possibly legislation.

And there is another problem: few Index shareholders have shown much interest. It’s hard to perfect a democracy when the voters won’t be bothered.

[1]The Modern Corporation and Private Property, (1932).
[2] “Eclipse of the Public Corporation,” Harvard Business Review (1989).