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.)
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.)
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