The INDEX Act: A challenge to the voting influence of institutional investors that may yield unintended consequences

In May 2022, US Sen. Dan Sullivan (R-AK) introduced the Investor Democracy is Expected (INDEX) Act, which seeks to diminish the voting influence of large investment advisers like BlackRock, State Street and Vanguard, often referred to as the "Big 3" of passive investment funds. In July 2022, an identical bill was introduced in the House of Representatives by Rep. Bill Huizenga (R-MI) and Rep. Blaine Luetkemeyer (R-MO). The surging popularity of index funds has provided these managers with significant voting influence on behalf of their funds, which are the largest shareholders in many public companies. The Big 3 collectively manage approximately US$20 trillion in assets, hold on average more than 20 percent of any given S&P 500 company and cast approximately 25 percent of all votes at the annual meetings of US public companies. These funds typically delegate discretion to vote securities to the fund manager.

If enacted into law, the INDEX Act would require investment advisers of passively managed funds holding more than 1 percent of a company's shares to vote a proportionate number of those shares in accordance with voting instructions received from fund investors (which are primarily pension and similar funds holding shares on behalf of other entities and individuals), and would prohibit them from voting any other shares. The INDEX Act is co-sponsored by a dozen other Republican senators but has garnered no Democratic support, and without such support, the bill is unlikely to pass unless Republicans take control of both the House and the Senate in the November mid-terms.

Rationales for the Act

The INDEX Act is one of multiple challenges to the policies of the Big 3 on environmental, social and governance (ESG) issues. Each of the Big 3 has stated that they consider climate change to represent an investment risk and that they believe the energy transition process offers a prospect for significant returns. Larry Fink, CEO of BlackRock, the largest of the Big 3, has been the most vocal of the Big 3 in stating that ESG considerations will play a prominent role in BlackRock's investment decision-making process and related governance decisions. However, some pension fund managers who have placed money with the Big 3, as well as some (primarily) Republican state lawmakers from states that are dependent on the oil & gas industry, have opposed the ESG agenda (particularly a perceived anti-fossil fuel bias) of the Big 3 and have threatened to withdraw their investments as a result. These lawmakers assert these investment advisers have usurped the power from fund investors and leveraged this influence to pressure public companies to embrace progressive social and environmental stances by shaping the outcome of board elections and supporting related shareholder proposals.

Proponents of the INDEX Act insist the proposed bill is politically and policy-neutral and the unchecked influence of investment advisers should be a concern to both sides of the aisle. In their view, the INDEX Act corrects the disparity between how investment advisers and passive investment funds are treated compared to how broker-dealers are treated. They note that through the Dodd-Frank Act, Congress prohibited broker-dealers from voting in director elections without instructions from the beneficial owner of the shares. According to supporters, the INDEX Act is the next "logical step” to return voting power from fund managers back to the beneficial owners of the shares.

Key provisions of the Act

Under the Investment Advisers Act of 1940 (Advisers Act), a client may give an adviser the general authority to vote proxies on its behalf, without specific voting instructions. The INDEX Act would amend the Advisers Act to require investment advisers of passively managed funds holding more than 1 percent of a company's shares to vote a portion of those shares in accordance with voting instructions received from fund investors holding a proportionate number of securities or economic interests in the fund, and (subject to the Act's mirror voting provision discussed below) would prohibit them from voting any other shares.

The specific terms of the proposed INDEX Act include:

• 1 percent voting power threshold: The proposed voting rules would only apply if an investment adviser has voting control over more than 1 percent of a company's voting securities. This 1 percent threshold is intended to limit costs and avoid inundating fund investors with the need to cast votes at every portfolio company where they own even a minimal interest.
• Covered funds: The Act would apply to "passively managed funds.” A passively managed fund is defined as one that (A) is designed to track, or is derived from, an index of securities or a portion of such an index; (B) discloses that the fund is a passive fund or an index fund; (C) allocates not less than 40 percent of the total assets of the fund to an investment strategy that is designed to track, or is derived from, an index of securities or a portion of such an index; or (D) discloses that an allocation described in subparagraph (C) follows an investment strategy that is passive or based on an index of securities. The subtypes of "passively managed funds" covered by the proposed act include investment companies (as defined in the Investment Company Act of 1940), private funds, eligible deferred compensation plans, employer-sponsored retirement funds and defined benefit and contribution pension plans. 
• Routine matters exception: Investment advisers will be able to vote without instructions from fund investors on "routine matters," the most common of which is the ratification of the appointment of external auditors. This exception is intended to address concerns about satisfying shareholder meeting quorums. However, significant corporate matters—like the election of directors, shareholder proposals or changes of control—would not be considered routine under the proposed act.
• Mirror voting exception: For shareholder matters requiring the approval of a majority of all outstanding shares entitled to vote on the matter (as opposed to a majority of votes cast), an investment adviser may vote shares for which it has not received voting instructions in proportion to the votes cast by all other security holders. Mirror voting on proposals requiring the approval of a majority of all outstanding shares can be useful when a quorum is required and would be unlikely to be met otherwise without the vote of large institutional investors (i.e., if there is not otherwise a "routine" proposal on the agenda). However, mirror voting can inadvertently result in an interested minority determining the outcome of proposals requiring approval of a majority of the outstanding shares entitled to vote (i.e., notably, "say-on-pay" and Rule 14a-8 shareholder proposals, which many companies subject to the approval of a majority of outstanding shares entitled to vote).
• Disclosure and information obligations: Investment advisers would have to provide proxy statements and other proxy soliciting materials to fund investors. Investment advisers that provide vote recommendations must permit third-party recommendations on a non-discriminatory basis and on a wide range of views. 
• Cost burden: Expenses for implementing pass-through voting must be borne by the funds or their investment advisers, and not by the portfolio companies. 
• Safe harbor: An investment adviser can choose not to solicit voting instructions and thus avoid the costs of obtaining fund investor instructions. A safe harbor in the bill protects the decision not to vote from violating any duty under federal or state law. For non-routine proposals, this decision would lead to a "broker non-vote" under US national securities exchange rules. 

The broader political and societal context

The INDEX Act arrives at a moment of increasing resistance to ESG investing from lawmakers in politically conservative states who contend the Big 3 are forcing public companies to take positions that are unrelated to maximizing shareholder returns and inconsistent with the interests of certain pension funds and other residents of those states. Several Republican-led states have sought to restrain asset managers from ESG investing, and some have passed laws prohibiting state entities from doing business with financial firms that have reduced or cut investments in the oil & gas industry. In August 2022, a coalition of 19 Republican attorneys general sent a letter to BlackRock accusing the firm of pursuing a "climate agenda" in coordination with climate activists at the expense of the best possible returns of its investments. BlackRock pushed back on those accusations, and explicitly emphasized that as a result of launching Voting Choice, a program intended to increase institutional clients' ability to participate in voting decisions, state pension funds are now able to determine for themselves how to vote proxies. Voting Choice went live on January 1, 2022.

At a June 14 hearing before the Senate Committee on Banking, Housing, and Urban Affairs, Sen. Sullivan testified that the bill was motivated by his frustrations with the Big 3 investment advisers exerting pressure on banks and insurance companies in America to "black ball[] oil and gas development." He asserted that companies feel pressure from their largest shareholders (funds managed by the investment advisers) who wield "market dominance" by engaging in concert with company management and by voting with "complete discretion at thousands of shareholder meetings on behalf of millions of Americans." Sen. Sullivan argued these investment advisers steer the public markets toward their preferred policies, bypassing political accountability and pursuing policies disconnected from the interests of their investor clients.

Investment advisers defend their ESG initiatives as being rooted in their obligation to discharge their fiduciary duties to their clients by taking forward-looking positions on issues they believe present investment risk, such as climate change and workforce development. In recent years, there has been a marked increase in shareholder proposals concerning environmental and social topics. Major institutional investors publish annual proxy voting guidelines outlining their philosophy and policies on ESG matters. For example, the Big 3 have each set forth their expectations on ESG disclosures and board diversity, specifying when they may vote against a board nominee.

Notwithstanding these stated policies, the Big 3 curbed their support of environmental and social shareholder resolutions during the last proxy season. BlackRock and Vanguard stated that many of the proposals either unduly constrained management or were overly prescriptive (especially regarding the pace of energy transition plans and Scope 3 emissions-reduction targets) and may not promote long-term shareholder value.

Concerns and possible consequences

As a fiduciary, an investment adviser owes each of its clients a duty of care and loyalty for all services that it undertakes for them, including proxy voting. Under the Advisers Act, proxies must be voted in accordance with the client's best interests. At a Senate Banking Committee hearing to consider the INDEX Act, committee chair Sen. Sherrod Brown (D-OH) conceded that the INDEX Act sounded democratic but expressed skepticism, noting the logistical complexity and cost burden of soliciting "hundreds of thousands of clients about tens of thousands of corporate votes each year." Harvard Law School Professor John C. Coates, former Acting Director of the SEC's Division of Corporation Finance, expressed concern that in circumstances where the  asset managers receive relatively few voting instructions, the bill's mirrored voting provisions could magnify the voting power of other investors who do submit voting instructions, and possibly shift voting power to proxy advisers and activist hedge funds instead of empowering individuals. Professor Coates suggested fund managers should conduct pilots and experimentation to develop a way to communicate with and take cost-effective instruction from fund investors.

Even without the effect of the proposed INDEX Act's mirrored voting provisions, the inability of  large asset managers and other institutional investors to vote on behalf of their investors on non-routine matters could effectively shift control of key shareholder decisions—such as director elections (including contested elections), shareholder proposals and similar matters—to hedge funds and activist investors whose interests may be adverse to the same pension funds and lawmakers who support the bill. In addition, some of the most important matters that require a shareholder vote, including mergers and the sale of all or substantially all of a company's assets, would usually require the approval of a majority of all outstanding shares, not just a majority of votes cast. Accordingly, if a relatively low percentage of the investors who have invested in the Big 3's funds provide instructions as to how shares should be voted, and the fund's investment adviser does not elect to use the Act's mirror voting provision, this majority may not be achieved and even the possibility of achieving a quorum may be at risk. This may result in a failure to receive the requisite votes on matters that are in the best interests of the pension funds and lawmakers who support the bill. In addition, as investors in these funds may be inundated with dozens (if not hundreds) of voting instruction requests, they may either ignore some or all of the requests or ask not to be sent voting materials. Furthermore, tracking the custodial chain from the fund up to the ultimate beneficial owner may be problematic, exacerbating the practical ability of these beneficial holders to provide proper voting instructions. These factors may play a significant role in the willingness and ability of fund investors to provide the necessary voting instructions.

The INDEX Act is unlikely to pass before the November 2022 midterm elections. If Republicans regain a majority in Congress and the Senate after the midterms, the INDEX Act could advance in the legislative process. If it were to become law, the INDEX Act could have a major impact on corporate democracy in the US and lead to consequences that the Act's supporters do not anticipate—or desire.

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