The Risk Hypothesis of Shareholder Activism

The following post comes to us from Virginia Harper Ho, Associate Professor of Law and Docking Faculty Scholar at the University of Kansas School of Law. It is based on her recent paper, “Shareholder Activism & the Risk Hypothesis,” which is available here.

Over the past decade, a seismic shift in U.S. corporate governance toward shareholder empowerment has occurred at the same time as new regulatory mandates focused on risk management and risk oversight. Many of these reforms have been motivated in part by the risk hypothesis of shareholder activism – the view that shareholder empowerment promotes greater corporate accountability and therefore more effective risk management.

However, the proposition that investors can and will motivate appropriate levels of corporate risk-taking is contested on a number of levels. Critics raise reasoned objections about investor short-termism[1] and observe that the most visible (and powerful) activists are hedge funds, whose business model drives them to favor high-risk, high-return strategies.[2] Other key objections come from corporate governance and standard finance theory, which recognize investors’ role in pushing managers to take risks in the pursuit of growth, innovation, and ultimately higher returns. At a practical level, the intermediated nature of modern capital markets – what Ron Gilson and Jeff Gordon have called “agency capitalism”[3] – disincentivizes most investors from directly engaging portfolio firms.

My recent article, Shareholder Activism & the Risk Hypothesis, recently posted to SSRN (available here), responds to these arguments. While sympathetic to the limits of the risk hypothesis, I argue that some forms of shareholder activism – activism directed at indirect financial risks, such as environmental, social, and governance (ESG) risks – can be harnessed to complement, not counter, external regulatory demands and internal management trends, such as enterprise risk management (ERM).  The question is, can they go far enough to make a difference?

The article begins by presenting the rationales for risk-related activism, which have been largely overlooked in the debate over shareholder power. Drawing on a substantial and growing body of evidence in the finance literature, it observes that active owners who incorporate ESG factors into their investment strategies, voting policies, selection of investment professionals, and even direct engagement with portfolio firms increasingly do so because they are seeking alpha or are looking to preserve value by taking account of risks that have been shown to affect firm value and portfolio performance. Therefore, the incentives of some leading investors and investment intermediaries are in fact aligned with the risk hypothesis of shareholder activism.

The article then addresses the mechanisms for ESG activism and its potential impact. It draws on other work by Gilson and Gordon[4] arguing that hedge fund activists play a positive role in the capital markets as “activist arbitrageurs” who facilitate voting by the larger class of rationally apathetic institutional investors. However, I challenge their conclusion that no comparable mechanism exists to “arbitrage” the exercise of investor governance rights directed at long-term performance in the absence of hedge fund initiative.

Instead, I argue that ESG-oriented shareholder activists can and do facilitate the exercise of investor voting rights, in part through the use of shareholder proposals, which backstop direct engagement with portfolio firms. In fact, proxy access, say on pay, and other regulatory innovations got their start as weakly supported shareholder proposals. However, a focus on voted proposals and voting results often discounts the success of behind-the-scenes ESG engagement, causing commentators to further underestimate the link between ESG factors and firm value.[5] The lines between governance and social proposals have also blurred in a way that standard reports of proxy season trends fail to capture. While the impact of ESG activism may be less readily quantifiable than hedge fund activism, it is no less real.

A new study by NASDAQ OMX Advisory Services (available here) has recently hailed the power of a wide range of active owners to transform how companies think about value and ESG risks, calling it a “Silent Revolution”. The study finds that institutional investors committed to incorporating ESG criteria into investment decisions currently account for over 50 percent of all global assets under management, and their presence is critical to the success of new investor and asset manager stewardship codes already enacted by several countries, including the U.K.[6] and, most recently, Japan.[7]

Ultimately, the validity of the risk hypothesis depends on the influence active, ESG-oriented owners have in the market. Recognizing that institutional investors have increasing market power to drive ESG integration by fund managers and investment professionals, the paper concludes by suggesting steps boards, regulators, and investors themselves can take to better align shareholder activism in its many forms with other external and internal drivers of long-term risk management and oversight.

 

[1] Lynne L. Dallas, Short-Termism, The Financial Crisis & Corporate Governance, 37 J. Corp. L. 265 (2012); William W. Bratton & Michael L. Wachter, The Case Against Shareholder Empowerment, 158 U. Pa. L. Rev. 653, 716-23 (2010).

[2] Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Colum. L. Rev. 863 (2013).

[3] Ronald J. Gilson & Jeffrey N. Gordon, Agency Capitalism: Further Implications of Equity Intermediation (February 1, 2014). European Corporate Governance Institute (ECGI) – Law Working Paper No. 239/2014; Stanford Law and Economics Olin Working Paper No. 456; Columbia Law and Economics Working Paper No. 461. Available at SSRN: http://ssrn.com/abstract=2359690.

[4] Gilson & Gordon, supra note 2.

[5] See, e.g. James R. Copland, Special Report: Shareholder Activism by Socially Responsible Investors, Proxy Monitor 2014 (“in contrast to . . . corporate governance, [socially responsible] shareholder proposals . . . have only an attenuated connection, if any, to the company’s financial interests”).

[6] Fin. Reporting Council, The UK Stewardship Code 6 (2012), available at https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Stewardship-Code-September-2012.pdf.

[7] Principles for Responsible Institutional Investors (2014), http://www.fsa.go.jp/en/refer/councils/stewardship/20140407/01.pdf.