We Three Kings: Disintermediating Voting at the Index Fund GiantsCaleb N. GriffinABSTRACTThe meteoric rise of passive investing has placed three large index funds in a newand pivotal role as the arbiters of corporate law controversies and the framers of marketwide governance standards. Collectively, the “Big Three” — Vanguard, BlackRock, andState Street — control a supermajority of index funds assets. The single largest investorin almost 9 out of 10 publicly-traded companies is one of the Big Three. As their growthis projected to continue unabated, it is difficult to overstate the centrality and importanceof these institutions for the future of corporate governance.Society is only just beginning to grapple with the implications of this concentratedeconomic power. On the one hand, there is potential for this power to be used for good.Index fund investors are uniquely concerned with long-term, sustainable economicgrowth and stability, and they are likely to be more representative of the averageAmerican investor than many other financial industry players, such as hedge funds.Concentrating the power of many dispersed “ultimate investors” through index fundvoting has the potential to better align corporate behaviors with the interests of a broadswath of American society. On the other hand, to the extent that this power is divorcedfrom the actual interests and perspectives of individual investors, index funds’considerable power may instead be used to advance the interests of index fund agents orother special interests in a way that is harmful to society at large.As it currently stands, individual index fund investors are utterly unable to expresstheir preferences in how voting decisions are made. They cannot rely upon index fundproviders to take their unique interests and values into consideration when deciding howto vote (or even to know what these interests and values might be). Further, index fundinvestors cannot even indirectly express their preferences by selecting a particular fundor a particular index fund provider that is more likely to vote in line with their interestand values, since the shares controlled by different individual funds are nearly alwaysvoted in the exact same manner and since the different index fund providers share verysimilar voting philosophies and priorities. As a result, a small number of individuals at ahandful of index fund providers wield increasingly dominant power with only very limitedaccountability.To address this problem, a number of corporate law scholars have recentlyproposed solutions that would limit index fund providers’ power in some way, whetherby requiring increased transparency, placing caps on index funds’ ownership of a givencompany or industry, or even going so far as to disenfranchise index funds entirely.Instead of these solutions, which generally rely upon regulators, auditors, or index fundadvisers themselves to promote better outcomes, this Article proposes a novel solutionthat would harness the voice of individual index fund investors in the decision-makingprocess. This approach builds off of the technological innovations that have permittedindex funds to streamline the process of deciding how to vote their funds’ shares. Itproposes using this infrastructure to overcome individual shareholders’ rational apathyinstead of using that infrastructure merely to simplify the work of index fund employees.The involvement of individual investors could take one of three forms. First, an “indirect1Electronic copy available at: 3365222

democracy” approach would allow individual investors to elect to have the votescorresponding to their indirect share ownership cast according to the recommendationsof a particular agent (such as the index fund provider, portfolio company management, aparticular proxy adviser, or another institutional investor). Second, a policy of “informeddiscretion” would entail solicitation by index fund providers of more information aboutthe characteristics and values of their investors, which they would use to better informtheir voting decisions. Third, “pass-through voting instructions” would give individualinvestors the opportunity to participate in shareholder voting by completing a general,issue-based survey about how they desired to vote on a number of key corporategovernance issues. The answers to this survey would effectively create basic proxy votingguidelines for a given investor’s shares, which would guide fund advisors in voting theproxies corresponding to the investor’s fund ownership. The uniting feature of all threeapproaches is that they would involve individual investors in the voting process to agreater degree, thereby diminishing the power of index fund agents, mitigating concernsabout the concentrated power of index funds, and reducing agency costs. The proposalsset forth in this Article set out to re-democratize shareholder democracy and to give voiceto individuals typically shut out of the corporate decision-making process. With passivelyindexed investments set to overtake active investments in the very near future, now is acrucial time to map the future exercise of funds’ corporate governance power.I.IntroductionThere is a fairy tale that goes something like this: Once upon a time, in thefaraway land of Sharetopia, there lived three powerful kings. They acted as stewardsof their citizens’ money (for a small fee of course), and their control over this moneygave them influence over large swaths of the land’s productive activities. As the powerof these kings grew until it dominated the whole of Sharetopia, the citizens began towonder whether the kings were ever tempted to use their power in their own selfinterest rather than in the interests of their citizens. When the citizens presented theseconcerns at an audience with the kings, the kings declared that it would take far toomany resources to figure out the actual interests of their citizens, even in very generalterms. Instead, the three kings promised that they would use their power in thecitizens’ “best interests,” although they reserved the right to define exactly what thatmight mean. When the citizens asked whether they might provide some thoughts aboutwhat their own "best interests" were, the kings politely declined. In any event, thekings noted, the very high barriers to entry for the position of king meant that, nowand for the foreseeable future, the citizens had few realistic alternatives. The citizenswent home pleased to have such a well-functioning democracy.As it currently stands, the index fund voting landscape — dominated by threemassive index funds — shares some striking similarities with the satirical Sharetopia.Index fund investors entrust their savings to index fund providers, who retain the powerto vote the fund’s proxies. In lieu of a true democracy where index fund investors wouldbe involved in voting decisions, index fund agents can vote shares representing theirinvestors’ economic stake in a given firm with only very limited constraints: first, indexfunds must disclose certain information about their voting policies and the votes they2Electronic copy available at: 3365222

cast.1 Second, index funds are required to vote “in a manner consistent with the bestinterests” of index fund investors.2There are some important problems with the “best interests” standard. The firstquestion begging to be answered is, whose best interests? One hundred percent ofinvestors? Fifty one percent? Should values and preferences held by only a minority ofinvestors be accorded any importance at all? A key problem is that fund investors arehuman beings, and, as human beings, they have diverse preferences and values.Currently, funds ignore the diversity of their investors while voting their shares,preferring to identically vote virtually all the shares they own.3 Second, even if fundswere clear on exactly whose interests the fund should be representing, and whether suchrepresentation should be winner-take-all or proportional, how do index funds discoveror discern those interests? Currently, they make no serious effort to do so. Interestingly,this obviates the need for them to answer the first question — simply ignoring thatdiverse preferences exist makes short work of them. Third, the vagueness of the “bestinterests” standard, and the lack of any mandate to discover any actual interests of theirshareholders, makes it difficult to hold fund management accountable for violating thisstandard, potentially increasing agency costs. Beyond a clear conflict of interest, itseems likely that the “best interests” standard would be satisfied by virtually anycolorable claim to that effect. This means that, for votes where a plausible argument canbe made for supporting either side, fund managers have near total discretion in theirvoting decisions, regardless of whether substantial amounts of their investors disagreeand without even attempting to discern whether they disagree. Thus, while the “bestinterests” standard is likely to prevent serious conflicts of interests, it is little more thana fiduciary fig leaf when it comes to promoting accountability and cabining the votingdiscretion of fund management.This Article analyzes the implications of index funds’ rise to power and theirincreasing dominance over corporate decision-making. Part II begins with a briefdescription of the index fund’s rise to power, moving in Part III to an analysis of theircurrent capacity to influence corporate governance. Part IV contains a detailed analysisof how index funds’ shares are currently voted. Part V examines the changes wrought byindex funds’ growing influence and discusses a number of key concerns engendered bytheir current scale and voting practices. In Part VI, this Article analyzes the strengthsand weaknesses of several proposed solutions and the reasons why they fall short. PartVII proposes an alternate approach, which disintermediates index fund voting byinvolving individual index fund investors in the process of setting voting priorities.Ultimately, this Article argues that this approach could re-democratize shareholderdemocracy and effectively reduce the power of the Big Three while obviating the needfor more drastic solutions.See generally, Disclosure of Proxy Voting Policies and Proxy Voting Records by RegisteredManagement Investment Companies, Securities Act Release No. 8188, Exchange Act Release No. 47,304,Investment Company Act Release No. 25,922 (Jan. 31, 2003) [hereinafter Exchange Act Release No.47,304], Id. (“An investment adviser voting proxies on behalf of a fund . . . must do so in a manner consistentwith the best interests of the fund and its shareholders.”).3 See Jan Fichtner et al., Hidden Power of the Big Three? Passive Index Funds, Re-Concentration ofCorporate Ownership, and New Financial Risk, 19 BUS. & POL. 298, 316-317 (2017).13Electronic copy available at: 3365222

II. The Rise of the Index FundA. Theoretical Origins of the Index FundA group of influential economists laid the foundation for the creation of the firstindex fund in a series of academic papers. In 1965, Paul Samuelson published a seminalarticle in which he demonstrated mathematically that future stock prices fluctuateunpredictably.4 That same year, Eugene Fama coined his Efficient Markets Hypothesis,which holds that it is difficult if not impossible to outperform the stock market giventhat market prices incorporate information quickly and efficiently.5 In 1967, MichaelJensen provided empirical proof to support Fama’s theory, showing that, over theperiod from 1945 to 1964, market indexes outperformed actively-managed funds.6 In1973, Burton G. Malkiel explicitly called for the creation of the index fund: “Fundspokesmen are quick to point out you can’t buy the market averages. It’s time the publiccould.”7 Specifically, he called for “a no-load, minimum-management-fee mutual fundthat simply buys the hundreds of stocks making up the market averages and does notrading (of securities).”8 In other words, he called for an index fund.B. Emergence of the Index FundEventually, the call of these economists came to fruition: a man named JohnBogle filed the Declaration of Trust for the first index fund, First Index InvestmentTrust, on December 31, 1975.9 Bogle, founder of the Vanguard Group, had successfullyconvinced his board to launch a fund that would attempt to simply mirror theperformance of the S&P 500 rather than attempting to outperform the market bypicking individual stocks.10 The emergence of this fund was met with great enthusiasmby Paul Samuelson and other economists, who lauded the fund for attempting to matcha broad-based index of the overall market, charging very low fees, having low portfolioturnover, offering high levels of diversification, and being available to investors ofmodest means — features that would serve as hallmarks of index funds going forward.11Despite the support of such economists, the initial performance of the fund wascharacterized by Bogle himself as “a complete flop.”12 The fund fell a whopping 95%short of its original goal for its initial public offering, achieving a paltry 11.4 million inassets rather than the 250 million initially envisioned.13 Given its limited size, the fundPaul A. Samuelson, Proof That Properly Anticipated Prices Fluctuate Randomly, 6 INDUS. MGMT. REV.41 (1965).5 Eugene F. Fama, Random Walks in Stock Market Prices, 21 FIN. ANALYSTS J. 55 (1965).6 Michael C. Jensen, The Performance of Mutual Funds in the Period 1945-1964, 23 J. FIN. 389 (1967).7 Burton Malkiel, A RANDOM WALK DOWN WALL STREET (1973).8 Id.9 John C. Bogle, The First Index Mutual Fund: A History of Vanguard Index Trust and the VanguardIndex Strategy, Bogle Financial Markets Research Center (1997) [hereinafter Bogle, The First IndexMutual Fund].10 Id.11 Id.12 The Index Fund Turns 40 - And Gets Its Reven

There is a fairy tale that goes something like this: Once upon a time, in the faraway land of Sharetopia, there lived three powerful kings. They acted as stewards of their citizens’ money (for a small fee of course), and their control over this money gave them influence over large swaths of the land’s productive activities. As the power of these kings grew until it dominated the whole of .