The Future of Corporate Governance Part I: The Problem of Twelve

Dated Jan 23, 2021; last modified on Sat, 06 Nov 2021

The Problem of Twelve: In the near future, roughly 12 individuals will have practical power over majority of US public companies.

A Short History of Corporations

In the first stage, entrepreneurs get money from savings, “friends, family, and fools”, and VCs. Securities law restricts this to sophisticated investors only.

On generating revenue and stability, the entrepreneur takes the firm public (IPO) under oversight from the SEC. Ownership is separated from control, e.g. a board of directors accountable to shareholders. VCs start selling off their stake. Given the imposed restrictions, few investors would buy more than 5%.

Agency costs emerge with the new managers, but these are tempered by audits, disclosure, SEC oversight, board supervision, stock prices, and looming litigation and/or hostile takeovers.

The Emergence of Indexation

Coates also touches on the emergence of private equity and globalization, but doesn’t delve into them as much as indexation.

Indexation reflects a simple set of financial ideas: few investors can beat the market, and few among those who cannot can identify those who can, so buying a full array of stocks generally earns the highest risk-adjusted return, net investment costs like advisory fees.

Malkiel emphasizes this in A Random Walk Down Wall Street

Collective investments started in the late 18th century. There were no indexes to track, so the fund managers had to actually find and buy securities. The Great Depression of 1929 wiped out a bunch of them. This prompted the emergence of open-end mutual funds, legislation to exempt investment companies from “double” federal income tax, and more regulation (limits to borrowing, limited conflicts of interest, etc.).

True passive investing (tracking an index) did not arrive until the 1970s. Studies showed that funds were uncompetitive in fees, and Congress passed laws to combat that. Academics like Malkiel and Samuelson published seminal work on passive indexing. Vanguard launched the first indexed fund in 1974, promising the lowest advisory fees in the industry.

Indexed US mutual funds and ETFs are considered to hold at least 10% of total US equity markets. Foreign funds, pension funds, insurance company assets, and others are also likely to be indexed as well, adding to the 10%. Even active funds are partially indexed as they need to beat the index as a baseline.

The growth in index funds is fueled by institutional defaults, e.g. indexed funds in 401(k) plans; pension funds opting for indexing. Indexing will likely continue growing.

Coates actually posits that indexed funds will hold the entire US market by 2030. Bold!

Given the economies of scale, and the lack of meaningful margins for differentiation, it’s difficult for newcomers to break into the indexing market. Big Players: Vanguard, State Street, BlackRock, Fidelity.

Practical Implications of Indexing

Index providers lack the staff to oversee/understand what their portfolio companies are doing on a quarterly basis. Furthore, colluding would be cracked down by the SEC.

Because of the low index fees (~.0001/$), index providers have weak incentives to take actions to goad portfolio companies to increase their value.

Index funds publish their positions on issues like CEO compensation, board structure, disclosure of political activities, cost-cutting, technology investments, etc. Furthermore, voting is public, so index funds need not explicitly collude. Forming policy views on governance issues is mostly a fixed cost, so there are economies of scale too. Their staffers also meet reps of portfolio companies to discuss policies and approaches, wink.

Consider a large eclectic firm with a sole owner. In principle, the sole owner can countermand any decisions. However, the owner cannot know everythong, so they’d have to rely on agents to make most of the decisions. It’s unlikely that a dozen index fund managers would do worse, one average, than a sole owner.

CEOs of Fortune 500s enjoy significant polical success. Index fund managers may exploit their influence in this case as well.

Tentative policy analysis

Studies suggest that indexation creates antitrust harms, e.g. blunted price signals, transmission of non-fundamental shocks, and inflation of companies in the index relative to those outside the index.

Indexes could self-organize and adopt codes of conduct (or more impactfully have them as regulations), but encourages index fund managers to exert their influence.

Some argue that index funds shouldn’t vote in company matters as they’re uninformed. However, this boosts the voting power of other shareholders who may have distinct personal interests in control.

Capping ownership of any given portfolio company would lessen incentives of the index fund manager to monitor/improve the company value. Perhaps the activities of an index fund manager can be limited to the necessary ones.

Index fund agents could be banned from taking political or corporate office after retiring from the index funds.

Engagements can be regulated, e.g. Chinese wall between the index fund staff who attend the meetings, and the senior index fund managers.

References

  1. The Future of Corporate Governance Part I: The Problem of Twelve. Coates, John C.. Harvard Law. http://dx.doi.org/10.2139/ssrn.3247337 . Oct 3, 2018.
  2. The Modern Corporation and Private Property. Berle, Adolf Augustus; Gardiner Gardiner Coit Means. 1991 (original 1932).