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 anjuran , 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 anjuran , 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 persoalan that can't take some time to sort out.
(How to start a fight in a libertarian kafetaria -- "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:
Update 2 here