By Glyn Holton | March 8, 2007
During the past 100 years, capitalism has been transformed. No longer are corporations owned by Morgans, Rockefellers, and Carnegies. They are owned by average people through mutual funds, pension plans, and direct stock ownership. This is called "democracy of capitalism," but something is missing. For democracy to work, people must vote.
In the democracy that capitalism has become, individuals do not vote the shares they own. Most lack the time, expertise, or resources to adequately research votes, and individual holdings are too minuscule to justify much research anyway. Also, investors who beneficially own shares through mutual funds, pension plans, and other intermediaries aren't permitted to vote those shares.
To reassert control over the corporations they own, shareholders must overcome these obstacles. They can do so by implementing a novel "proxy exchange" that allows them to conveniently secure, transfer, aggregate, and exercise voting rights.
A Simple Change
Imagine a woman who is a successful employee, an investor, and a mother. Between the demands of work and shuttling her kids to sports practice, she cares about her world. She worries about damage to the environment. She is troubled by explicit sex and violence portrayed on television—and the impact it has on children. Paradoxically, she owns the companies that pollute the environment and the media. During a successful career, she has accumulated savings, which she has invested in equity index funds. The woman owns a slice of the corporate pie—and there are a million other moms like her. Collectively, they have the economic clout to shape corporate behavior. But this is hypothetical.
Scrambling from a planning meeting to soccer practice, the woman doesn't think such thoughts. On the car radio, an announcer describes the latest indictments in the latest corporate scandals—more names to join Enron, WorldCom, Tyco, etc.
Let's change this picture. Let's make one minor modification to the woman's world and see where it leads us. Suppose the woman receives a letter from her mutual fund company reminding her that her mutual funds vote the shares they hold on her behalf. She has never had a choice about this, but the letter now offers her one. She can have the mutual funds continue to vote the shares, or the voting rights can be assigned to an organization of her choosing—perhaps a charity involved in environmental or children's issues.
The letter goes on to explain that her fund company, cooperating with other institutions, has established a "proxy exchange." This is like any other exchange except that it is not for trading stocks or futures. It is for transferring voting rights. Use of the exchange is free, and the woman can access it through a secure website. She can transfer her voting rights to anyone she chooses—anyone willing to accept them.
What will the woman do? If she and a million moms like her choose to transfer voting rights to charities, professional associations, investment advisers, advocacy groups, and other organizations, what will happen? What will those recipients do with their new economic power? How will capitalism be transformed?
The agency problem has existed as long as people have allowed others to act on their behalf. In corporations, it arises between shareholders and managers, and this was one of the reasons Adam Smith (1776) denounced corporations. Commenting on managers, he complained:
…being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners of a private copartnery frequently watch over their own. (1)
Writing 150 years later, Berle and Means (1932) noted a fundamental change in the agency problem. Stock ownership of large corporations was becoming widely dispersed. This was democracy of capitalism, but it meant that individual holdings were shrinking. Shareholders were losing influence over managers. Berle and Means wrote:
Under such conditions, control may be held by the directors or titular managers who can employ the proxy machinery to become a self-perpetuating body, even though as a group they own but a small fraction of the stock outstanding. (2)
Berle and Means were witnessing the beginnings of a phenomenon called "managerial capitalism." In Adam Smith's day, shareholders still held sway over managers, and the agency problem was a matter of managers not exercising "anxious vigilance." Under managerial capitalism, shareholders have lost control of managers, and the agency problem is one of managers enriching themselves to the extent applicable laws allow.
In parallel with managerial capitalism, another phenomenon has emerged that we might call "fiduciary capitalism." This is ownership of equities by intermediaries, such as mutual funds, pension plans, and insurance companies. By inserting themselves between corporations and investors, these institutions further isolate managers from those investors. As large shareholders, institutions could challenge managers for the benefit of investors, but few engage in such shareholder activism.
A Proxy Exchange
To understand how a proxy exchange would work, let's return to the woman who just received the letter from her mutual fund company. Intrigued, she decides to assign her voting rights to a particular charity that is involved in children's issues. At her computer, she locates the website of the proxy exchange. After entering identifying information, she is taken to her own account page. The account has already been established for her by her mutual fund and brokerage firms. Those firms have the legal right to vote shares that they hold on her behalf, but they have placed the voting rights in her account. She can do with them as she pleases. If she is so inclined, she can access relevant shareholder materials online and actually vote her shares through the exchange. The exchange has an advanced set of screens that will allow her to do precisely that. More basic screens allow the woman to simply transfer all her voting rights to a third party.
Using those screens, the woman searches for her charity and confirms that it is willing to accept voting rights. With a single mouse click, she transfers all her rights to the charity. Her selection is not permanent; she can change it at any time. Until then, the charity will continue to receive all rights deposited into her account.
What will the charity do with the rights? Actually, it is in the same position as the woman. It has an account with the exchange, and voting rights are being deposited into it—from the woman's account and perhaps from a thousand other accounts. If the charity receives a large volume of rights, it may devote resources to voting them. If not, it can transfer them on to a trusted third party. Through the exchange's intermediate-level screens, the charity has even more options. For example, it might choose to vote shares of companies whose activities affect children but transfer the rest of its rights to another charity.
Rights may pass through many hands before they end up in the account of a party with sufficient rights to justify the effort to constructively vote them. The entire process will be one of aggregation. Through an exchange, small blocks of rights will be aggregated into medium blocks, which will be aggregated into large blocks. Large blocks will be voted through the exchange.
Four classes of participants can be identified:
- assigners: institutions such as mutual funds, brokerages, and pension plans that legally assign proxy rights to the exchange;
- beneficiaries: the beneficial stock owners—primarily individual investors—on whose behalf those rights are assigned to the exchange;
- aggregators: anyone willing to accept rights from beneficiaries or other aggregators through the exchange; and
- voters: parties who ultimately make voting decisions.
Transferring, aggregating, and/or voting rights could be done by anyone who chooses to—charities, professional associations, trade unions, advocacy groups, investment advisers, faith-based organizations, retirees who do so as a hobby—anyone. An online community may develop. Tips and ideas would be exchanged. Upcoming votes would be discussed. Referrals would be made, as in, "You want to unload your IBM? Give ‘em to Joe. He knows the company inside and out, and he thinks the way you do. Check out his record."
In its operations, a proxy exchange will have to balance competing needs for disclosure and privacy. For example, a trade union might—with entirely good intentions—encourage its members to assign their voting rights to the union. Union members who did not comply might not want the union to know of their decision. For this and similar reasons, the exchange should not disclose to aggregators who is transferring rights to them.
Larger aggregators' voting records should be disclosed with both summary reports and details of individual votes. An aggregator might add comments to its record explaining individual voting decisions. If an aggregator transfers voting rights to another aggregator, its record can reflect how the votes were ultimately cast.
No regulatory impediments preclude the launch of a proxy exchange. Legally, the exchange will be nothing more than an organization that makes itself available to serve as a proxy for others. Exchange rules and technology for transferring rights among participants do not need to be immediately implemented. They might evolve as the exchange grows.
A nominal exchange could be launched by activists who simply instruct their stock brokers to assign their proxy rights to the exchange. The activists could then "transfer" voting rights among themselves over hot chocolate in someone's living room. At that point, voting decisions would matter less than the fact that those decisions were actually being made through the exchange. As a novel concept unanticipated by existing regulations, such a proxy exchange would quickly introduce itself into gray areas of corporate governance regulations. It could become a useful vehicle for spawning legal test cases and highlighting the unfortunate state of shareholder rights under managerial capitalism.
There are many avenues by which a fully automated proxy exchange might be implemented. A foundation or wealthy philanthropist might donate money to launch an exchange. There are various for-profit and not-for-profit organizations involved in proxy issues and corporate governance. If they pooled their resources, they could form an exchange. A for-profit firm might launch an exchange as a business venture, earning income by charging fees from assigners. If regulators conclude that the marketplace has failed to develop a mechanism to facilitate the free granting of proxy rights, they might encourage financial institutions to form a proxy exchange.
Still another avenue would be for mutual fund companies to serve as a proxy exchange for their own clients. This would be easy, since the funds already hold the proxy rights. Legally, such a proxy exchange would be nothing more than a formalized vehicle for the funds to solicit clients' advice on how to vote shares—and then act on that advice. This would be simple and inexpensive to implement. Any mutual fund company that wants to distinguish itself from competitors would be shortsighted not to implement it.
Clearly, there are many avenues for implementing a proxy exchange. If several initiatives develop, they can compete with and learn from one another. When they mature, and operations become standardized, they might merge to achieve economies of scale.
Recent market crashes and financial scandals are symptomatic of a capitalism in which shareholders have lost control over the corporations they own. Law recognizes shareholders' right to exercise control through a proxy of their choosing. Because there has been no practical means to facilitate it, shareholders have been denied this fundamental right.
A proxy exchange will be a new market for corporate control—a market more efficient and far less costly than hostile takeovers or traditional proxy fights. Through competition, a proxy exchange will do a better job of minimizing agency costs and maximizing shareholder value than the "self-perpetuating body" of managerial capitalism ever can.
This article was adapted from a longer version that originally appeared in the Financial Analysts Journal. For more information on the legal issues and other nuances of implementing a proxy exchange, please see the full article.
(1) Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations, Book V, ch. I, part III, article 1 (Edinburgh: 1776).
(2) Berle, Adolf A., and Gardiner C. Means. The Modern Corporation and Private Property (New York: MacMillan 1932): p. 8.
Copyright 2006, CFA Institute. Reproduced and republished from the Financial Analysts Journal with permission from CFA Institute. All rights reserved. This article originally appeared in the November/December 2006, volume 62, number 6 issue of the Financial Analysts Journal. The FAJ can be found online at www.cfapubs.org.
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