The INDEX Act: A Ban on Free Reigning by Indexers
[Priyanshi and Simran are students at Institute of Law, Nirma University.]
The pioneer of passive funds, John C Bogle, had cited his fears against the increasing supremacy of index funds. He stated that index funds were successful at the time of their inception, but he had a strong hunch that down the lane, index funds may do too much for their good. The inflows from the active investments have been plunging while, on the other hand, passive investments have been progressing, accounting for 60% of the equity assets. However, the recent instance of fund investors missing out on Tesla’s appreciation depicts that buying the haystack has done no good to fund investors.
The three giant indexers in US, namely BlackRock, Vanguard and State Street, have not developed a level playing field and have gained control of the market. This concentrated corporate ownership has upended the voting powers of the fund investors.
Therefore, to deconcentrate the ownership and restore the voting powers of the fund investors, the INDEX (Investor Democracy Expected) Act (INDEX Act or Act) has been introduced in the United States. That said, how this will ever be brought to India, where the passive funds are still at the development stage, is still riddled with ambiguity. The authors, through this blog, juxtapose the growth of passive funds and the declining interest of the fund investors. To begin with, the authors list down the issues which have significantly helped in the inception of the INDEX Act in the US. Second, the authors seek to emphasize the above fallacy in the Indian context. Lastly, they state a few recommendations to address this problem.
The Advent of INDEX Act – A Saving Grace?
The backdrop of this Act resulted from two problems: firstly, there was significant concentration of power in the hands of a few indexers. The passive indexing caused the dispersed shareholding to be so concentrated that it began to distort the market. The studies have shown that the three indexers accounted for almost 1/4th of the total votes at the annual meeting, thus raising the level of influence in discussions. Secondly, the question about the casting of voting rights remained unvoiced. There was an interesting controversy; the index advisors of passive funds voted proxies as per their discretion and gave little regard, if any, to the fund investors, while the fund investor, who were the real owners, did not have any say in the voting decision. For instance, the American retirement funds have been used as per the whims of the indexers for a long.
Therefore, in one fell swoop, it is significant that indexers have failed to act as a steward. Together, these problems created an absurd paradox: the fund investors had no powers to change the corporate governance scenario; on the other hand, the indexers had too much control to turn the table in their favour. To remedy these issues, the INDEX Act was brought into force. The Act stipulates that the indexers have to dutifully pass through the vote to proxies only as per the instructions given by the fund investors and not as per their own choice.
More often than not, these indexers succumb to the pressure from the activists who do not have any vested interest in the issuer’s company and only under the guise of political agenda, try to fulfil their demands. Therefore, the Act will change the corporate governance framework initially governed by the shifting of the votes by three dominant players and take account of the unheard voices of the fund investors.
Additionally, implementation of “pass-through voting instructions” will be relatively easy as the proxies are usually part of the fund. Therefore, it could be established without any legislative and regulatory measures. The indexers can also conduct an issue-centric survey and record how the fund investors respond to each corporate governance issue. In this case, indexers will be hard-pressed to act as a steward.
In a nutshell, this Act will decrease fund investors’ apathy towards voting, make indexers more accountable to ultimate investors by way of a proxy voting system and mitigate the risk of concentrated corporate ownership. This will also extend the fundamental principle to index funds, that the principals and not the agents should vote. Moreover, since passive investment is all the rage today, it might overtake active funds. Therefore, it becomes all the more necessary than ever to account for the rights of fund investors at a time when some proposals seemed to have been blocked. This can be done by way of fund investors’ instructions and by allowing the voting mechanism to be solely governed as per the wishes of fund investors.
Indexers in India refrained from voting on almost 90% of issues before 2010. Mutual Fund absenteeism fell, and participation surged significantly after SEBI's rule in 2010 and a subsequent amendment in 2013 on voting. The proportion of those who do not vote has declined because of the SEBI’s proactive measures. During the 2014-2015 fiscal year, 20.9% of total votes consisted of absenteeism, according to data. During the 2018-2019 fiscal year, this figure decreased to 12.5%.
In the past, the majority of passive funds have "voted in favour" and expressed minimal issues in the majority of resolutions so far. It is rare for financial institutions to ignore management recommendations, even in extreme circumstances like the YES Bank’s fiasco. Consequently, the passive fund's stewardship function was underutilised. They, on the other hand, did not care about their stewardship responsibility until the Stewardship Code of 2020 came into effect. Though not mandatory, the stewardship code instilled a feeling of guilt in passive funds to actively engage in the governance of the firm they invest in to protect the rights of fund investors.
During the 2010 and 2013 mandates of SEBI, the passive funds were needed to document and report the basis for using their voting rights in corporations, but they were not obligated to vote. SEBI mandated that funds vote on all corporate resolutions on 5 March 2021. The regulator requires all schemes to be voted upon beginning on 1 April 2022, even if the company's equity shares are held passively via an index fund or exchange-traded fund (ETF). Now, indexers can cast votes at the scheme level if they disagree with a fund house's decision, which was previously limited to the fund house. Indexers are now required to certify to the fund house's trustees every quarter that the votes taken have not been influenced by any cause except the best interests of the fund investors. The public disclosure of the votes that funds cast on various resolutions provided by their investee corporations is also to be disclosed.
This indicates that Indian regulators have prioritised enhancing the voting participation of passive funds in the decision-making of investee companies. The new notification of SEBI has increased the voting power of fund management companies. Furthermore, high-weighting index funds in India's most important sectors and equities often lead to concentration issues. While several equities have rallied recently, the remainder of the index has been stagnant or declining. SEBI created new indices to reduce concentration concerns in ETFs and index products. Broad market indices should have no more than a 25% stock weight, whereas sector/thematic indexes should have a 35% stock weight. However, these guidelines still enable concentrated index fund portfolios.
Therefore, due to indexer’s right to vote and market concentration issues, India is likely to face asset management firms’ undue influence in the proxy voting patterns of these funds. The index fund market in India is in the developing stage and is vulnerable to face issues similar to the USA. The new guideline requires the management companies to work in the best interest of fund investors. However, the regulators must also consider “instruction-based voting” (similar to INDEX Act) to prevent fund management companies from prioritising their interests above those of the investors in future.
Recommendations for INDEX Act
INDEX Act has been a positive initiative in regulating proxy voting malpractices in business since its implementation. However, the following proposals should be included in the legislation to make it more effective.
At times the passive funds' ownership is extremely intermediated and dispersed, making it difficult and costly to identify shareholders. Indexers may also struggle to communicate directly with investors. These specific challenges raise costs for funds to carry out regulatory duties to get shareholder approval every time. When funds and advisors vote, it is challenging to secure vote confirmations due to the many intermediaries involved, from transfer agents to tabulators. Concerns over the precision and speed of vote confirmations may resurface. While legislators are obligated to solve these difficulties, they may incorporate intermediaries, such as transfer agents, to convey vote-confirmation information and utilise other ways utilising artificial intelligence to secure votes.
Index funds should have an independent supervisory board with full authority for all corporate governance-related decisions.
The Index Act shall include penalties for violations; otherwise, it would not be an effective measure.
Index funds shall do timely and complete public disclosure of their voting procedures and public record of each interaction with company executives. This would go a long way toward fostering a culture of openness and cooperation in government.
Globally, the market for passive funds is increasing due to a large number of individual investors. The abuses of proxy voting by the three largest index fund managers in the United States have caused several repercussions for industry participants. The introduction of the INDEX Act is a positive development, notwithstanding certain limitations. The legislation would serve as a model for other nations whose passive fund markets are developing. While India is seeing an increase in the engagement of passive funds in proxy voting, it would be prudent to learn from American reforms to minimise future inequities.