The following is an edited comment letter that was submitted by Bernard S. Sharfman and James R. Copland to the U.S. Department of Labor with respect to the Department’s proposed rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (RIN 1210-AC03)
The Employee Retirement Income Security Act (ERISA) requires a fiduciary to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and . . . with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” The Department first took the position, in the “Avon Letter” back in 1988, that the fiduciary act of managing plan assets includes the management of voting rights (as well as other shareholder rights) appurtenant to shares of stock. We find it appropriate that the proposed rule would clarify the Department’s position in formal rulemaking. However, we strongly, but respectfully, disagree with the Department’s approach. Specifically, for purposes of this comment letter, we object to the Department’s treatment of investment advisers to funds, as delineated in paragraph (d) of the proposed rule. The Department’s approach does not reflect how dramatically the rise of large investment advisers to mutual funds and exchange traded funds (“ETFs”) has changed the control of voting authority in the U.S. stock markets.
The New Controllers of Shareholder Voting Authority
The U.S. equities markets are now dominated by five investment advisers: The Vanguard Group, Inc., BlackRock, Fidelity, American Funds, and State Street Global Advisors. As of July 2021, Vanguard was reported to have under management $6.8 trillion in U.S. equities, BlackRock $2.65 trillion, Fidelity $2.4 trillion, American Funds $2.2 trillion and State Street $970 billion. In total, the Big 5 investment advisers managed approximately $15 trillion in U.S. equities, or roughly 30% of total U.S. stock market value.
Along with this concentration of equity assets under management has come a parallel concentration of shareholder voting in the hands of these investment advisers. This concentration has come about because of the industry practice of mutual funds and exchange traded funds (ETFs) delegating their shareholder voting authority to the investment adviser that has been contractually hired to manage its portfolio. This “decoupling” or “unbundling” of voting interests from economic interests in the context of shareholder voting is referred to as “empty voting”—here, the empty voting of investment advisers on behalf of equity mutual funds and ETFs. In this case, unless the investment adviser has purchased shares or some other interest in the fund itself, it has no economic interest in the underlying equities owned by the fund.
These large investment advisers, like all investment advisers, contract with their mutual fund and ETF clients to manage their investments. However, with both investment and shareholder voting power delegated to them, and no economic interest in the underlying securities, they can be understood in economic terms as agents working on behalf of their principals—their mutual fund and ETF clients and their respective beneficial investors. Like all agents, these investment advisers may be tempted to act opportunistically, utilizing their large amounts of delegated voting authority as a means to maximize the value of their own entities or the utility of their executive management, and not necessarily the value of the index funds they manage.
For example, just prior to voting in GameStop’s 2020 proxy fight, BlackRock, Vanguard, and Fidelity held roughly 40% of GameStop shares. However, as a result of their ability to lend out GameStop stock at extremely high short-term fee rates, 80% to 190% based on the value of the shares on an annualized basis, it was reported that only a small number of these shares were actually eligible to be voted at the annual meeting. In sum, in exchange for enhancing their fee income, these investment advisers gave up the opportunity to vote an overwhelming portion of their GameStop shares.
The Issue under ERISA
When a plan manager utilizes index mutual funds and/or ETFs for its portfolio or offers them as selections in self-directed individual accounts, the plan has delegated away its voting authority to the investment advisers of those funds. These investment advisers, as long as they do not participate in managing an ERISA plan, do not have fiduciary duties under ERISA. Therefore, the issue becomes whether an ERISA plan manager, investing in investment funds where the delegation of voting authority has occurred, either directly or through self-directed accounts, has a fiduciary duty to investigate the investment adviser’s shareholder voting and engagement with portfolio companies?
This is the issue addressed in Mr. Sharfman’s recent law review article, The Conflict Between BlackRock’s Shareholder Activism and ERISA’s Fiduciary Duties. The issue has not been extensively examined in the academic literature, but the concentration of shareholder voting power in the hands of a small number of investment advisers makes it ripe for study.
Plan Manager Duties Under ERISA
Mr. Sharfman’s article takes the position that a plan manager has a fiduciary duty, the duty of prudence, to investigate BlackRock’s shareholder voting and engagement with portfolio companies. This duty applies not only to the BlackRock mutual funds or ETFs that an ERISA plan invests in, but also to those BlackRock fund selections that it makes available to its participants and beneficiaries in self-directed accounts. The fiduciary objective in this investigation is to ensure that BlackRock is utilizing shareholder activism consistent with a plan manager’s duty of loyalty under ERISA; that is, “solely in the interest of the participants and beneficiaries” and for the exclusive purpose of providing financial benefits to them. If that is not happening, these funds should be excluded from an ERISA plan.
Given this fiduciary duty of investigation, Mr. Sharfman’s paper also argues that if a plan manager were to investigate BlackRock’s shareholder activism, it would find this use to be in conflict with the plan manager’s fiduciary duties. For example, the paper finds that one objective of BlackRock’s shareholder engagement is to increase the marketing of its investment products to millennials. Another objective is to appease shareholder activists who threaten to attack the business decisions, procedures, and objectives of its own corporate management. In both cases, shareholder voting and engagement are not being executed solely in the interest of its beneficial investors, including those beneficial investors who are participants and beneficiaries of an ERISA plan. As a result, those BlackRock-managed funds where its investment stewardship team has been delegated voting and engagement authority should not be allowed to become part of an ERISA plan until remedial action is taken.
While the focus of Mr. Sharfman’s paper is on BlackRock’s delegated voting authority and associated shareholder activism, it is meant to apply to any investment advisers who attempt to leverage their delegated voting authority for purposes of engaging in opportunistic voting and engagement with portfolio companies. In addition, the Department should provide guidance to plan managers on when to exclude the investment products of investment advisers with delegated voting authority.
Implications for Judicial Review
The Administrative Procedure Act (APA) calls upon courts reviewing agency rulemaking to “decide all relevant questions of law, interpret constitutional and statutory provisions, and determine the meaning or applicability of the terms of an agency action”—as well as to review all “findings” and “conclusions” and reject those deemed to be “arbitrary,” “capricious,” or “an abuse of discretion.” The Supreme Court has long determined to give agency rulemaking a “hard look,” under State Farm,though it has traditionally deferred to agency interpretations of ambiguous statutory language under Chevron. Regardless of which review standard courts adopt here, we are very concerned that the Department’s final rule may not address the issue as stated above. Given how significant and important the delegated voting authority of investment advisers to investment funds has become, we believe that not addressing the issue may be found by a reviewing court not to be “acceptable reasoning” and therefore “an abuse of discretion” under the APA. As such, we believe the Department must address this issue or face a potential court challenge.
While the voting authority of an investment adviser on behalf of a mutual fund or ETF does not come under the fiduciary duties of ERISA, it is doubtful that the intent of the Avon Letter and all subsequent guidance in this regard was meant to absolve a plan manager of any fiduciary duty associated with the shareholder voting of shares that it now owns indirectly through its share ownership in mutual funds and ETFs. The result would be an abdication of fiduciary duties in the context of shareholder voting and would lead, in many cases, to the absurd result that the plan manager has totally abdicated its fiduciary duties in this respect.
In sum, an ERISA plan manager cannot simply delegate away its fiduciary duties when delegating its shareholder voting authority to an investment adviser. The plan manager’s duty of prudence requires it to investigate an investment adviser’s shareholder activism to see what financial impact it will have on its participants and beneficiaries. Therefore, we would like to see the proposed rule modified accordingly.
Bernard S. Sharfman is a Senior Corporate Governance Fellow with the RealClearFoundation and a Research Fellow with the Law & Economics Center at George Mason University’s Antonin Scalia Law School. The research associated with Mr. Sharfman’s contribution to this writing was supported by a grant from the Manhattan Institute.
James R. Copland is a senior fellow with and director of legal policy for the Manhattan Institute.
The opinions expressed here are the authors’ alone and do not represent the official position of the RealClearFoundation, the Law & Economics Center, or the Manhattan Institute.
The full comment letter, including footnotes, is available here.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.