Will ‘Portfolio Primacy’ Throw a Monkey Wrench in Elon Musk’s Plans to Acquire Twitter?

Assuming Elon Musk doesn’t withdraw his current offer to buy Twitter, is the Musk takeover really a done deal? In a recent interview with Brook Fox of ProMarket, Oliver Hart, the Nobel prize-winning economist, claimed that the fiduciary duties of investment advisers to index funds, such as BlackRock, Vanguard, and State Street (the Big Three), would compel them to vote for Elon Musk’s offer to buy Twitter given his willingness to pay a significant premium over market price. Professor Hart made his claim based on his understanding that their fiduciary duties require them ‘to act in a way that maximizes financial return’.

Even though I share Professor Hart’s understanding of the fiduciary duties of investment advisers, I respectfully disagree with Professor Hart’s claim and argue that the fiduciary duties of the Big Three and other investment advisers to mutual funds and exchange traded funds (EFTs) allow these advisers to vote ‘no’ on the Musk transaction. This can be done based on a maximization approach to fund investing called ‘portfolio primacy’.

The Fiduciary Duties of Investment Advisers

According to the Securities and Exchange Commission (SEC) in its ‘Proxy Voting Rule’, investment advisers to mutual funds and exchange-traded funds (ETFs) owe each of their clients (the funds they manage and their beneficial investors) ‘duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting’. Moreover, these duties require the shareholder voting authority delegated by these funds to their investment advisers to be executed ‘in a manner consistent with the best interest of its client and must not subrogate client interests to its own’.  

The wording used by the SEC uses to describe this fiduciary duty is broad and does not mention the requirement of maximizing the financial interests of clients when voting. I have found this broad language disconcerting and have argued that this guidance allows investment advisers to act opportunistically and needs to be tightened up. Nevertheless, if an investment adviser like Vanguard correctly determines its legal obligation to be one of value maximization, this still does not require the Big Three and other investment advisers to vote to approve Musk’s takeover of Twitter.

Portfolio Primacy

This is because an investment adviser who manages a stock fund should be managing the fund based on an approach that attempts to maximize the financial value of the entire stock portfolio at any point in time, not just the value of any individual stock investment. This approach is referred to as ‘portfolio primacy’.

For example, consider how an investment adviser to a S&P 500 index fund could utilize portfolio primacy in deciding how to vote on Musk’s $54.20 share offer for Twitter. The S&P 500 index is a market-value weighted index. When a fund is based on this index, it will have in its portfolio approximately 20 times more in dollar holdings of Tesla stock versus Twitter stock. This means that any change in market value in Tesla stock is much more important to the total market value of the S&P fund than a change in market value of Twitter stock.

Moreover, let’s say that the investment adviser to the S&P 500 fund comes to the conclusion that a Musk takeover of Twitter will so distract Musk from his duties at Tesla that it will lead to a significant reduction in the market value of Tesla’s stock. Because the S&P 500 fund has so much more in terms of dollar holdings of Tesla than Twitter, this expected reduction in the market value of Tesla stock could easily outweigh whatever positive value the fund derives from Musk purchasing Twitter.

It is important to note that focusing on this issue should be important not only to investment advisers to index funds, such as the Big Three, but also to any portfolio manager who holds large dollar amounts of Tesla stock in portfolio relative to Twitter stock. This makes it reasonable for the investment adviser to consider spending the time and resources necessary to coming to a determination on this issue.

Conclusion

In sum, the fiduciary duties of investment advisers to mutual funds and ETFs should not be an impediment to those advisers voting against the Musk acquisition of Twitter. Moreover, for those investment advisers who make the determination that the expected harm to the value of Tesla stock far outweighs the increase in value that the Musk acquisition would create for the fund, voting against the acquisition would be a reasonable action to take. 

An earlier version of this post was published by Pro Market on 12 May 2022.

Bernard S. Sharfman is a Senior Corporate Governance Fellow at RealClearFoundation, and a Research Fellow with the Law & Economics Center at George Mason University’ s Antonin Scalia Law School.