Biggest Investor: A Computer Program’s Impact

In the realm of securities laws and governance in the United States, the primary aim is to safeguard the interests of shareholders. But what if the entity holding the largest stake in a company is not a traditional investor, but rather a computer program?

It’s a scenario that’s increasingly relevant, particularly with the rise of passive investing strategies. The Big Three—BlackRock, Vanguard, and State Street—now collectively own a substantial portion of the stock in S&P 500 companies. Despite their massive ownership, these passive asset managers often appear detached from critical governance issues, such as the selection of auditors, raising complex questions for both corporate management and regulatory bodies.

For chief financial officers (CFOs), the challenge lies in determining which investor or owner to engage with when developing business strategies. The conventional approach of catering to activist shareholders or institutional investors may need reevaluation when faced with the dominance of passive index funds.

Regulators, too, are grappling with the implications of this shift. The Public Company Accounting Oversight Board (PCAOB) and the Financial Accounting Standards Board (FASB) are among the entities questioning why major investors seem uninterested in policy consultations related to audit practices and financial reporting standards, respectively.

The relative disengagement of these major investors from detailed rulemaking discussions may have unintended consequences. For example, CFOs often devote significant attention to analysts during earnings calls, despite analysts not being actual investors. On the other hand, the Big Three’s passive investment approach means they will hold a company’s stock regardless, unless it is removed from the index.

This dynamic raises concerns about whether auditors are now more accountable to regulators, who drive rulemaking, than to the investors they are meant to serve. Negotiations over audit fees, for instance, typically occur between auditors and CFOs, with little input from passive index investors who are not actively involved in these discussions.

A similar issue arises with the FASB, where the absence of the real investor voice in regulatory deliberations calls into question the representativeness of financial reporting standards. The risk is that rules are crafted without considering the actual needs and perspectives of investors, potentially leading to standards that prioritize the interests of preparers and auditors over those of investors.

For the Securities and Exchange Commission (SEC), which investor group should be the focus when drafting regulations? Should the SEC cater to the preferences of the Big Three, who may prioritize long-term sustainability issues like climate change, or should it consider the views of more transient investors, such as mutual funds with shorter investment horizons?

These challenges are likely to persist and expand as passive investing continues to grow, not only in US markets but also globally and across different asset classes. As such, the fundamental question remains: in a world where your most significant counterparty is increasingly likely to be a computer program, how should companies, regulators, and investors adapt?