Economist Channel

Todd Henderson and Dorothy Shapiro wrote me a thoughtful response to my post on non-voting shares. Todd and Dorothy:

Response to Cochrane

We are grateful for Cochrane’s thoughtful response to our op-ed in the Wall Street Journal. Space limitations prevent us from giving the necessary treatment to our ideas, but he is right to push us to be careful in our analysis, no matter the limits. We look forward to addressing his concerns and others in a forthcoming article.

In the meantime, here is a quick response to the thrust of Cochrane’s critique.

There is a logical inconsistency in Cochrane’s post—his “modest proposal” would require more legal change to accomplish than ours. (And we are the ones with a vested interest in more law!) For one, it’s not clear that companies would willingly issue non-voting stock in addition to voting stock (and in the right amounts)—this occurs very rarely in practice, if ever.

Second, even if the shares existed, Cochrane assumes that index funds would willingly buy them, although there’s no evidence to suggest that this would occur.

The hostile reaction from large passive institutional investors, including BlackRock and Vanguard, to the Snapchat IPO and other recent dual class stock offerings make it clear that passive funds wouldn’t buy non-voting stock willingly—institutional investors participated in those offerings under protest and have since been advocating for reforms that would prevent future non-voting offerings, even going so far as to lobby Russel FTSE to delist companies that have dual class shares.

It’s also unlikely that non-voting stock would be much cheaper than voting stock—empirical evidence has demonstrated that often, non-voting stock doesn’t trade at any discount to voting stock (such as when there's a controlling shareholder or the company is well run).

Even if passive funds could purchase non-voting shares at a small discount, it’s not obvious that they would have any incentive to do so. Index funds have the sole goal of replicating the performance of an index. Why would they want to get a different product for a lower price? This is especially true when doing so would cause them to give up power and influence over some of the companies that they invest in (for a small benefit that investors are unlikely to recognize).

So, under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them. Talk about a lot of law! (Read: coercion.) Not only would this be a more dramatic change than the one that we propose, it would surely lead to a worse world. As an example, there could be liquidity concerns—if passive funds wanted to sell en masse (as can happen when funds are tracking the same index), there would be no buyers. And, if passive funds instead wanted to buy, there would be no sellers (and in this situation, it's unlikely that the non-voting shares would really trade at a discount).

By contrast, our solution--encouraging (but not requiring) passive funds to abstain from voting—is much less intrusive. Rather than mandating the creation of a new market of non-voting shares, we advocate a voluntary legal change that would permit natural correctives to any corner solution. The concern seems to be that if index funds abstain, too much power will be vested in the hands of activists, not all of whom will be interested in long-term shareholder value. But if index funds are merely encouraged to abstain unless they have no strong interest in the outcome, then there is a natural, market-based corrective to this problem. If activists go overboard, then index funds will have a strong interest, and reenter the voting market at that time. In a sense, Cochrane’s critique is ironic: we are calling for less law. We want law to get out of the way, by letting index funds act naturally—to not vote when they have no interest in doing so, and where they have no comparative advantage in the process. (Our other alternative, a legal duty to vote in an informed matter, and not just blindly follow ISS and other proxy advisors, is a clear second best.)

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A little response-response clarification:

I do not envision any coercion!  So I  deny "under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them."

Index funds need to wake up and ask for non-voting shares, and then companies will issue them. The funds get a discount and absolution from legal trouble. Or companies need to wake up and offer non-voting shares to index funds. The companies get a new source of financing.

The non-voting shares I have in mind need do need a lot of smart lawyering and contract writing by people like Todd and Dorothy.  I accept the point that current non-voting shares are not as protected as they should be, that the promise ``you get exactly as much money as the voting shares, and you can sue as bondholders do if you don't'' needs teeth.

Indeed, the market is hostile to non-voting shares because current non-voting shares are designed to concentrate control with insiders, not to create a vibrant outside market for corporate control. That's the last thing insiders want, and a reason that companies will be slow to offer such shares unless funds start demanding them.

Sometimes the world hasn't arrived by itself at the optimum, just because nobody thought of it, not because there is a market failure, and not because law has not compelled it. We live in a time of legal and financial innovation, not just gadget innovation.

And index funds not voting aggressively is not a screaming problem that can't take some time to sort out.

(How to start a fight in a libertarian bar -- "You're advocating government intervention! No, you're advocating government intervention! I probably should have left that out of the original, and there is not much need to spend time on it in further discussion. Laws and contracts and courts are all on the menu at the libertarian bar.)

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Update:

This is a good point. Perhaps we just need some good intermediation/financial engineering for index funds to routinely lend out their shares around votes.

Update 2 here

Todd Henderson and Dorothy Shapiro Lund have an interesting OpEd in the Wall Street Journal, "Index funds are great for investors, risky for corporate governance." In brief, index funds don't participate heavily in monitoring companies, finding information about companies, or corporate control contests.

This point echoes larger complaints that with the spread of index funds there won't be enough active money to make markets efficient, and especially to make efficient the market for corporate control. One of the most important functions of a public market is, if you think that a company is mismanaged, you can buy up a lot of shares, vote out the management, and run it better. This is an imperfect system, to be sure, but note how many nonprofits (universities) and privately held companies, immune from this pressure, are run even more inefficiently than public companies.

Todd and Dorothy, law professors, after very nicely reviewing how funds currently deal with voting issues, seem to favor more law.

So how can the law ensure that these institutions make informed decisions about corporate governance? ... The first is to encourage them to rely on third-party corporate governance experts. It may be necessary... for the law to create incentives for institutional investors ...option three: encouraging passive institutional investors to abstain from voting altogether.   

Hmmm. When "the law," not a person or people, is the subject of a sentence, I get cautious. When the law wants "to encourage" people, my hackles rise.  The law "encourages" and "creates incentives" pretty bluntly. One example, though discarded, is a bit chilling,

 This could be accomplished by providing a legal cause of action to shareholders that are harmed by uninformed or conflicted voting decisions. But this would be a blunt tool for curbing abuse. 

Indeed it would.

But this is forgiveable. They are lawyers, so more law is the answer. We are economists, and law a necessary evil when contracts and markets fail. Is there not an economic solution, a Coasean way to slice the knot?

I think so. Companies should issue, and index funds should want to buy, non-voting shares.  Non-voting shares seem to be regarded as a little infamy of internet companies, used to keep control in the hands of founders. But a split between voting and non-voting shares seems ideally suited to a mass of indexing investors, and a few active, information-based traders and active corporate control investors. In this vision, most of those voting shares are in public hands, unlike the internet companies.  In fact, most corporate stock grants and options to insiders should be in the form of non-voting shares.

Non-voting shares are treated exactly the same for all cash flow purposes. They receive the same dividends, same rights in repurchase, same treatment in any reorganization. They just do not allow the right to vote.

Since index funds don't value the option to vote, they should want non-voting shares.


Would such shares trade at a discount? Yes, likely so. And that's a benefit, not a cost, a feature not a bug. Index funds could buy the same cash flow, which is what they want, cheaper, by giving up the value of their votes, which they're not interested in. Buying the same cashflow cheaper gives you a better return.

Todd  and Dorothy actually advocate a form of this idea, that the index funds voluntarily refuse to vote.  But then the index funds pay the cost of an option they do not use. By purchasing non-voting shares they do the same thing, and reap a financial reward.

This separation between voting and non-voting shares would make the market for corporate control more efficient. It is easier for someone who wants to buy the voting rights to buy them from other active investors than from passive mutual funds. It also separates the stock market price into guesses about cash flows and guesses about corporate control events. As a long-term investor I'm interested in the former and less in the latter.

Non-voting shares become a sort of state-contingent long term debt. Rather than guarantee payment by its fixed value, as in debt, payment is guaranteed by its equality with whatever other shareholders are paid, and similar rights in court as debt-holders have to enforce their right to be paid ahead of voting shareholders.

I've asked a few of my corporate finance colleagues about this idea, and their general reaction is that it won't work, because sooner or later the investors with voting shares find ways to screw the non-voting shares out of money, not just out of votes. The ability to vote is the ultimate guarantor of payment.

I'm still not totally convinced.  (I admit I did not follow all of the shenanigans they suggested to accomplish stealing money from voting shares.) If we're bringing in law here, and if we're designing a security, it seems not impossible to create a class of non-voting shares whose equal treatment in all cashflow related events is the same as those of voting shares, and who have strong rights to sue to guarantee those rights. Long-term debt works, after all, as the voting shares don't find a way to escape interest and principal payments. The contract design for that right seems easier than the legal means to "encourage" behavior that Todd and Dorothy imagine.

Update: See Todd and Dororthy's response and more discussion.