The Shareholder's Conflict

Introduction The modern shareholder is not always an individual investor. An increasing number of corporate America is owned and controlled by massive investment institutions which accumulate the capital of millions of investors. Entities such as BlackRock, Vanguard and State Street can own substantial stakes in hundreds of different public corporations, and wield tremendous power over matters such as candidate elections, executive compensation, mergers and corporate policy.

This raises an obvious but troubling question: Can a shareholder always make an independent decision when it has another type of business relationship with the company it owns?

Harvard Business Law Review has noted that institutional investors may both provide retirement-plan services to a corporation and simultaneously own shares in that same corporation. Such an institutional shareholder could potentially have conflicting interests as an owner and as a service-provider to the corporation, creating the possibility that the investor's duties as a shareholder may sometimes be at odds with its incentive to maintain a lucrative business relationship.¹

The Rise of the Institutional Shareholder

Voting by shareholders is an important feature of corporate governance. Shareholders are typically empowered to elect the board of directors, approve certain major transactions, and vote on other governance issues affecting the way in which the corporation is managed.

An individual who owns a few shares is unlikely to have much influence. An institutional investor which owns a controlling interest in a public company can be a kingmaker of sorts, possessing the ability to appoint key directors and approve or disapprove of major corporate actions, even if the owner itself does not directly control the corporation's day to day operations.

This is a significant power since a public company's shares are often widely dispersed among investors.

While the management of a public company may retain control of the enterprise, institutional investors may own enough of the stock to determine the outcome of board elections and major corporate decisions, representing the interests of millions of investors who do not possess comparable power.

An institutional investor, then, has an unusual position in corporate governance. It is an outsider to the company, yet it may be able to exert considerable influence over the corporation's affairs.

The Retirement Plan Problem

The problem arises when an institutional investor has other business relationships with the corporation whose shares it owns.

An institutional investor may both own a public company and provide services to that company through an affiliate. As a shareholder, the investment firm may want to take advantage of a proxy fight to depose poorly performing management. As an employee benefits consultant, the firm may want to ensure that the client relationship continues to flourish.

The investor's interests are not necessarily irreconcilable in this situation, since a well run company is likely to be good for the business relationship as well as the shareholders.

However, it can be legally difficult to square the interests of an institutional investor who has competing roles as owner and servicer of a corporation. The potential for conflict is most acute when the institutional shareholder believes that it should oppose management, but doing so may jeopardize the firm's position as a service-provider to the corporation.

The Problem of Passivity

This dilemma may help to explain why some institutional investors are accused of being "passive" when it comes to exercising control over the companies in which they own shares. The Harvard Business Law Review article notes that there has been an ongoing debate about the "passivity" of institutional investors in exercising their voting rights.¹

There are a variety of possible explanations for this alleged passivity. An institutional shareholder may genuinely believe that management is doing a satisfactory job. An institutional investor may determine that it is more profitable to avoid fighting with management and instead focusing on other investments. An institutional shareholder may believe that it is more effective to deal with management privately rather than through a public proxy fight.

Any of these factors could contribute to an institutional investor's decision to avoid a conflict with corporate management.

Not every situation in which an institutional investor supports management is necessarily a case of a conflicted investor advancing its own interests at the expense of the shareholders it is supposed to represent. Sometimes, it really is in the best interests of the shareholders to leave management in place, despite any personal preferences the institutional investor may have on the subject.

The real problem arises when an investor's business relationship with a corporation affects the fiduciary or contractual duties it owes to its own shareholders.

Who Does the Investor Serve?

One might ask who the institutional investor serves when it votes. A mutual fund manager, for example, may have certain duties to the fund and its shareholders. Pension fiduciaries have duties to the pension fund beneficiaries. Investment advisers can owe fiduciary duties to their clients depending on the circumstances.

The corporation in which the institutional investor owns shares is not its client just because it has another business relationship with the investment firm. There is a subtle but important distinction between the source of revenue for an investment adviser and the source of its fiduciary duties.

An investment adviser may receive compensation from the corporation for providing retirement-plan services, but the adviser's fiduciary duties may extend to the fund shareholders who own the shares in the corporation.

The law must ensure that a commercial relationship does not subtly affect the duties owed by an institutional investor to its own shareholders.

Corporate Democracy

Institutional investors are important players in the corporate world. They are shareholders in many public companies, and therefore have the power to vote on major corporate decisions.

A shareholder vote can affect the composition of a board of directors, which in turn can affect almost every major decision facing a corporation. Boards of directors can decide whether to pursue mergers and acquisitions, and can determine whether to keep incumbent executives in office or replace them with new management. Because of this power, a shareholder's votes can sometimes be equated with economic power. Institutional investors that are shareholders in major public companies can have tremendous influence over the corporate world, and their decisions can reverberate throughout the economy. When institutional investors own significant stakes in public companies, the potential for conflicts between owners and managers is magnified.

While an individual shareholder may be conflicted in its voting due to a business relationship with the corporation, this dilemma is magnified when it is applied to institutional investors, since institutional shareholders often have similar relationships with hundreds of different corporations.

The 401(k) Connection

Retirement funds present a particular dilemma since employees who fund them through a payroll deduction may have little or no awareness of how their votes are being cast.

Many employees have retirement funds that are administered by employers, and these funds may be invested in large part through an institutional investor that votes the shares on behalf of the fund. An employee who has no direct contact with the corporation in which his or her retirement fund is invested may nonetheless have an indirect but very real economic interest in the outcome of a shareholder vote affecting that corporation.

An employee holds the capital; an institutional investor holds the voting power. In this respect, the investor serves as an intermediary between the economic beneficiary and the corporation. While such an intermediary position is useful in some respects, it also introduces the possibility of conflicts that a direct investment by the employee would not present.

The Cost of Passivity

A passive institutional investor is not necessarily a bad institutional investor. An institutional investor may prudently decide that it is better to avoid a fight with management.

Challenging management can be very expensive. It can distract an institutional investor from more important matters. Institutional investors that manage a diverse portfolio may not have the time or resources to thoroughly research the issues facing every company in its portfolio. It is sometimes the most prudent course of action for an institutional investor to vote with management.

Passivity can become a problem when a shareholder fails to hold corporate management sufficiently accountable for its actions. If major shareholders never challenge directors, the directors have less to fear from the shareholders, reducing the accountability of the board and the motivation to take necessary steps to increase accountability.

Shareholders may lose confidence that voting is an effective means of controlling management.

The Conflict of Interest Solution

One way to address this conflict is by promoting transparency. Institutional investors could be encouraged to disclose situations in which they have significant commercial relationships with portfolio companies whose shares they own. Institutional investors could also provide information about the extent to which those business relationships factor into their voting policies and procedures.

By making this information available to investors, other institutional investors and regulators, it should be possible to determine whether an institutional shareholder's voting record is consistent with the interests of its shareholders.

While this solution may not always be practical, it nonetheless fits within a larger trend in securities law and regulation that encourages increased transparency when a conflict of interest cannot be avoided.

Despite the value of increased transparency, it is possible that a situation may exist in which an institutional investor is aware of a conflict, but has sufficient incentive to take advantage of the conflict.

Revealing the existence of a conflict of interest is only part of the solution. Shareholders, institutional or otherwise, also need to ensure that the proper controls and procedures are in place to ensure that a conflict of interest is not exploited.

The Problem of Concentrated Voting Power

A concentrated ownership position can also raise some unique issues. If a relatively small number of institutional investors own large amounts of stock in many public companies, decisions made by those institutional investors can have an impact far beyond the companies in which they directly own shares.

In circumstances where a significant number of shares are owned by an institutional investor, the policies of that institutional shareholder can affect governance at thousands of different companies. This can be a good thing.

An institutional investor can provide valuable expertise to shareholders of a corporation facing a particularly difficult governance issue. A single institutional shareholder can provide the kind of due diligence on director qualifications, executive compensation and shareholder proposals that individual shareholders would not be able to provide.

Having this much voting power can be good, but it can also be very bad. A new kind of corporate power has been created in which a single corporate power can affect the governance of many different companies without directly controlling them.

The law traditionally focused on the relationship between a shareholder and the corporation it owns. Institutional investors complicate this relationship by virtue of their size and their ability to serve as an intermediary between millions of investors who purchase securities and the corporations in which those securities are purchased.

Why It Matters

The Investor's Conflict is really about the question of what shareholders can or should do with their voting power.

If voting is one of the chief ways in which shareholders can control management, then shareholders need to be provided with sufficient incentive to do so in a manner that benefits all of the shareholders, including those that are not as well informed or as well resourced.

Institutional investors can enhance corporate governance by contributing expertise, but can also undermine it by virtue of the fact that they also have business relationships with the corporations in which they own shares. It is important to promote appropriate controls and ensure that institutional investors are held accountable even if they have other incentives.

Conclusion

Modern ownership structures have created an unusual situation in which the people who are affected by corporate decisions do not always make those decisions.

Millions of investors may ultimately own the assets of a corporation, but a small group of institutional investors may vote those shares on behalf of everyone else. Institutional investors play an intermediary role between the shareholders and the corporation, and may have other business relationships with the corporations they own.

This is not necessarily a problem, but it does present a dilemma that corporate law should be prepared to address. When an institutional shareholder has a stake in the company it owns, there is a question about whether the vote is really for the benefit of the shareholders or for the benefit of the business relationship the institutional investor has with the corporation.

Corporate law should ensure that voting power is used for the benefit of those for whom it is intended.

The institutional investor may own the shares, and the corporation may own the contract, but the people whose money is invested have the most to lose. The greatest shareholder should not become the greatest conflict.

1. Natalya Shnitser, "The 401(k) Conundrum in Corporate Law," Harvard Business Law Review, Vol. 13, Issue 1. This article addresses the implications of the increasing ownership positions of institutional investors such as BlackRock, Vanguard and State Street, and the potential for business relationships with portfolio companies to affect institutional shareholder behavior.