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The Department of Labor (“DOL”) recently proposed an update to its proxy voting rule for retirement plan fiduciaries. On the face of it, it’s not too different than the existing rules. It emphasizes that fiduciaries must always (and only) do what’s in the best interest of plan participants.
There is one part of the proposed rule, however, that can dramatically alter the mutual fund landscape. Consider this an example of the Law of Unintended Consequences.
When you think of voting proxies, you think of shareholder resolutions offered by publicly traded companies. These votes generally coincide with the company’s annual meeting. These resolutions range the gamut from electing new directors, approving executive compensation, approving various forms of corporate actions, etc… These resolutions can come from company management or from shareholders themselves.
Before the Securities and Exchange Commission (“SEC”) changed their rule on proxy voting, advisers chose to vote with their feet. If they didn’t like the direction management took the company, they wouldn’t bother voting the proxy to register their disagreement. They simply sold the stock.
To this day, if you survey professional advisers, they’ll tell you in nearly all cases proxies have little to no economic impact. (The exception that proves this rule is one that involves invoking a poison pill, which often serves the interests of company management and employees at the expense of shareholders.)
The SEC now requires Registered Investment Advisers to document and account for all the proxies they voted (including why they abstained, if they did). This only applies if the client has delegated this responsibility to the investment adviser.
Now, the DOL has introduced its own rule.
Here’s the dilemma: what the DOL is requiring makes perfect sense. The regulator doesn’t want fiduciaries to incur costs that do not have an “economic impact on the plan.” In fact, it prohibits fiduciaries from voting proxies that do not have an economic impact.
What could be wrong with that? You don’t want plan service providers needlessly wasting your retirement savings, do you?
If you look at the investment options of your 401(k), you’ll rarely see individual securities. Your options are mainly mutual funds. As such, it doesn’t appear that proxy voting has much relevance.
But for one very important exception, you’d be right. Unlike the individual stocks that you trade, mutual funds (technically, they’re called “registered investment companies”), have fewer requirements when it comes to mandated shareholder voting. That means you don’t often see proxies for mutual funds.
Among the times you will see a mutual fund proxy is when it comes to the election of directors. The SEC requires that at least two-thirds of all mutual fund directors must be elected directly by shareholders.
That’s no different than what you see in other companies. Except for one very important difference. More on that in a moment.
Returning to the DOL’s proposal, if it becomes effective, many professional fiduciaries feel there’s a greater risk in voting proxies than in opting out of voting. If they vote a proxy, they’ll need to prove there’s an economic value, and that economic value exceeds the cost associated with documenting, processing, and archiving each and every vote.
This poses an interesting quandary for certain mutual funds that cater exclusively to retirement plans.
What happens if all retirement fiduciaries conclude the cost of voting proxies is too costly and therefore decide to no longer vote?
That’s right. Assume 100% of retirement plans will not vote their proxies.
In science, this is called a “Boundary Condition Test.” You might think of it as a stress test. It’s not assuming what is likely. It’s merely taking a look at the worst possible scenario to see what happens. If it’s nothing, then the concept you’re considering passes the stress test. On the other hand, if things blow up, the stress test fails.
Here’s what this test is about: electing mutual fund directors.
Remember, at least two-thirds of all mutual fund directors must be elected by shareholders in either a special meeting or at the annual meeting. In order to conduct these meetings, the bylaws of the mutual fund require a minimum percentage of all outstanding shares must be present to achieve a quorum. Without a quorum, the meeting cannot be held, no votes can be taken and the directors cannot be elected.
Take a look at the stress test in the case of retail mutual funds. Some retirement plans utilize funds that are also available to non-retirement plan shareholders. If no retirement plans vote, it’s still likely enough retail shareholders will vote in order to achieve a quorum.
In this case, the Boundary Condition Test passes.
Now consider the fate of institutional mutual funds. The bulk, if not all, of the shareholders in these funds are retirement plans. If none of those plans vote their proxies, these funds will likely not achieve the quorum necessary to hold a meeting to elect directors. No meeting, no directors.
The SEC might have a problem with that. In the worst case, the fund becomes non-compliant and the SEC can, for all intents and purposes, shut it down.
In the case of institutional mutual funds, the Boundary Condition Test fails. Dramatically.
All because the DOL doesn’t want retirement plan fiduciaries to waste money that belongs to retirement savers and the SEC wants to make sure mutual fund shareholders don’t get taken advantage of.
Can either the DOL or the SEC fix this?
Not really. The DOL can’t require fiduciaries to act in a way that potentially harms plan participants (through incurring costs that cannot be economically justified).
And while the SEC can temporarily allow mutual funds to continue out of compliance, this is not a permanent solution.
How might this situation be mitigated?
Not very easily. It would require an act of Congress to either allow the DOL to veer from its currently defined duty to protect retirement plan participants or permit the SEC to place fund shareholders at risk.
Alternatively, the mutual fund industry can limit its risks by folding institutional funds into retail funds.
Most of this, however, is unlikely to come to pass. It’s also unlikely the boundary condition will even occur.
Just as it’s unlikely index funds will capture a critical mass of all investors; thus, destroying the integrity of the capital markets.