This brief column will assert that three developments that seem unrelated are in fact closely related and may soon impact U.S. corporate governance with the force of a freight train. This column summarizes a longer article just posted by this author on SSRN.[1]

Development No. 1: Stock ownership in the U.S. has now reached an extraordinary level of concentration. The Big Three — BlackRock, Inc., State Street Global Advisors, and Vanguard Group — now hold collectively over 20% of S&P companies, vote 25% of the shares voted, and, according to Lucian Bebchuk, will eventually hold 40%.[2] They also have allies among other diversified institutional investors, so that de facto control on a proxy vote is easy to assemble.

Development No. 2: The American retail investor has shifted from amateur stock picking to indexed investing (which largely explains the growth of the Big Three). Although the Big Three and similar firms are heavily indexed and historically passive (seldom divesting firms in order to hold the entire market), they have increasingly exercised their voting rights and supported insurgents in proxy contests. As they become more powerful and demanding, the question arises whether institutional and retail investors have the same or different disclosure needs.

Development No. 3: Institutional investors are insisting on a new type of disclosure: ESG disclosures (which cover environmental, social, and governance issues and increasingly disclosures relating to climate change). In Europe, governments are pushing for ESG disclosures and asking companies to incorporate such criteria into their decision-making, but in the U.S., the SEC has maintained a “hands-off” policy of neutrality, and the Department of Labor has become more skeptical of shareholder activism and has backed off its earlier insistence that trustees vote the shares they hold.[3]

Who then is pressuring NYSE-listed companies on the need for ESG disclosures? The short answer is large, diversified asset managers, including the Big Three. Why? Economic logic explains why diversified institutional investors want more ESG disclosures and are even actively seeking to impose ESG restrictions and deadlines on major corporations. Put simply, the Capital Asset Pricing Model (“CAPM”) posits that diversified investors are primarily interested in “systematic risk,” because diversification protects (and even immunizes) them from unsystematic risk.[4] Systematic risks are essentially risks that diversification does not protect against: for example, a national banking crisis, a pandemic, or sudden and irreversible climate change. Such risks do not create classes of winners and losers, so that the diversified investor remains exposed to the risk.

What has not been adequately recognized, however, is that much ESG disclosure overlaps heavily with systematic risk. The major institutions appear to see this and are acting upon it. A fascinating illustration arose in 2018 when Royal Dutch Shell announced that it was radically changing its emissions reduction targets so as to reduce its carbon footprint 20% by 2035 and 50% by 2050. Previously, it had fiercely opposed these targets, calling them “onerous and cumbersome.”[5] What caused this sudden conversion — the equivalent of Saul on the road to Damascus? The short answer is a coalition of diversified institutional investors that, having coerced Shell into submission, then turned to ExxonMobil, Chevron, and BP.[6]

Above all, such an example is proof of the power of common ownership. This term “common ownership” came into public view when a number of bright antitrust scholars raised the prospect that high common ownership might lead to shareholder pressure on firms in concentrated industries not to compete.[7] Even if true (which remains empirically unresolved), the flip side of this coin is that high common ownership might similarly lead shareholders to behave more as angels than villains. That is, common owners might rationally resolve to curb externalities created by some firms in their portfolio, at least if the losses to them from such shareholder-induced restraints were exceeded by gains to other firms in their portfolio. In short, the rational diversified institutional investor might adopt a portfolio-wide perspective and net the gains and losses on the firms in its portfolio from a specific shareholder action or actions. A literature predicting this dates back to the 1980s, but it only became realistic recently with the sharp rise in common ownership.[8]

There are now multiple examples where diversified institutions have taken collective action (generally by voting or pressuring management with respect to climate change).[9]  Arguably, they are making a portfolio-wide decision (i.e., “we think this will hurt two companies in our portfolio, but help six”), but the evidence is less clear that they have made such a calculation (although they have acted collectively). To be sure, institutional investors regularly do make portfolio-wide decisions (i.e., “let’s reduce the percentage of our portfolio in social media companies from 10% to 7%”).

Nonetheless, this idea of netting the gains and losses from shareholder activism (and determining to vote for an externality-reducing measure if there is a net gain to their portfolio) is fundamentally new. Interestingly, it could provide an answer to a dilemma faced by institutions that wish to engage in “ESG investing” — namely, using ESG factors, often as a screen by which to exclude some companies that fail such criteria. Here, they face a legal problem. Under both ERISA and the common law, trustees and fiduciaries owe their clients a duty to act (both in investing and voting decisions) solely to advance their clients’ interests (and not for other collateral purposes, including ethics or morality). This is known as the “sole interest rule,”[10] and it means that the trustee cannot be influenced by ethical or moral considerations that might produce “collateral benefits.”

How then is ESG investing possible? In the 1990s, clever lawyers rebranded “socially responsible investing” (which had lead many institutions to avoid investing in companies then doing business in South Africa), converting it into “ESG investing” based on the argument that corporate governance factors did legitimately relate to firm value and implied superior returns.[11]

Still, there remains some doubt about how easily ESG investing can be justified on this basis. In a comprehensive article, professors Schanzenbach and Sitkoff have recently concluded that ESG investing can be justified, but only if the fiduciaries can identify some governance or similar factor that has been “mispriced” and that should lead to a profit if the fiduciaries invest.[12] Even in this case, the fiduciaries must subtract trading and other costs. Although their test purports to approve ESG investing, their proposed standard is heroically high. Thus, I have suggested that this test would prove to be a “wolf in sheep’s clothing.”[13]

But what then is the answer? One cannot credibly answer that corporate governance factors are automatically mispriced or that, even if mispricing is discernible, it is likely to correct and produce significant price reversals in the foreseeable future. In my view, there are two plausible answers to professors Schanzenbach and Sitkoff. First, they are focusing on fiduciaries who are still making judgments about individual stocks only. But if fiduciaries are making a portfolio-wide decision, the analysis may be easier. Hypothetically, consider a group of institutional investors requesting coal producers to cease to market high-sulphur coal (or they will begin a proxy contest to replace directors, which they seem likely to win, given their 40% ownership). The institutions realize that this will cause a stock price decline at the coal producers (estimated at 15%), but they expect benefits at other portfolio companies that exceed this loss. Further, the institutions have hired proxy advisers who have prepared detailed reports supporting this conclusion. Overall, such a strategy seems to comply with the “sole benefit rule,” because it seeks and expects a profit, whereas a policy of divesting tobacco companies or companies lacking board diversity would not (because such a policy seems at least as much based on ethical considerations as financial considerations).

But, even if ESG investing on such a portfolio-wide basis avoids legal problems, it will likely still encounter intense political ones. A group of institutions that pressures a board of a portfolio company to adopt environmental restraints (or to advance the data of carbon neutrality) knows that it is causing a very likely stock price decline at this target company. Is this fair to the undiversified retail investors in this company? Presumably, the institutions do not owe a fiduciary duty to the other stockholders of this target and do not hold control. Retail shareholders (who, being undiversified, will not similarly benefit) may be outraged. Finally, directors who yield under the threat of a proxy contest and act to decrease their own stock value may be sued.

A second (but riskier) strategy would be for diversified asset managers to argue that their beneficiaries necessarily have both financial and non-financial interests. For example, shareholders in a company would not rationally want that company to pollute their immediate environment or cause irreversible and damaging climate change, at least not for only a small increase in the share price. Arguably, when the fiduciary acts to promote the non-financial interests of its beneficiaries, it is complying with the “sole benefit rule.” Some highly respected economists have argued precisely this, claiming that fiduciaries should seek to maximize overall shareholder welfare rather than stock value.[14] Still, lawyers can argue that the fiduciary may only consider the financial interests of its beneficiaries, as any broader standard creates a serious agency cost problem.[15]

For all these reasons, the major diversified asset managers are likely to be reticent participants in campaigns to curb externalities through collective action. Such collective action may be easier to justify to the public on moral or ethical grounds (i.e., “saving the earth is part of our job”). But fiduciaries may still need to tell (and demonstrate to) their own clients that they are benefiting them on a financial basis through their actions. The result may be much politically correct double speaking, but the trend towards greater ESG investing seems irreversible.

ENDNOTES

[1] See John C. Coffee, Jr., “The Future of Disclosure: ESG, Common Ownership, and Systematic Risk,” https://papers.ssrn.com/abstract_id=3678197 (2020).

[2] See Lucian Bebchuk and Scott Hirst, The Specter of the Giant Three, 99 B.U. L. Rev. 7, 21 (2019). These authors predict that this 20% figure will eventually rise to 40% within 20 years. For example, just six shareholders now control 24% of ExxonMobil and 26% of Chevron and have used such power to pressure for “climate change” restrictions on emissions. See Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1, 10-11 (2020).

[3] For a review of the SEC’s equivocal stance on ESG, see Thomas L. Hazen, Social Issues in the Spotlight: The Increasing Need To Improve Publicly-Held Companies’ CSR and ESG Disclosure, https://papers.ssrn.com/abstract_id=3615327 (June 29, 2020). While the SEC has been neutral regarding ESG, the Department of Labor (which administers the ERISA statute) has been increasingly hostile. On August 31, 2020, the Department of Labor proposed a rule that would “clarify” that ERISA trustees are not always required to vote, a proposed rule that seems intended to discourage shareholder activism.

[4] For the original statement of the CAPM, see William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk, 19 J. Finance 425 (1964) For a concise summary, see Richard Brearley, Stewart C. Myers, & Franklin Allen, PRINCIPLES OF CORPORATE FINANCE, 168-179 (10^TH ED. 2011).

[5] See Condon, supra note 2, at 2.

[6] Id. at 2, and 11-12.

[7] See, e.g., Einer Elhauge, Horizontal Shareholding, 129 Harv. L. Rev. 1267 (2016). This very active debate continues but will not be summarized here.

[8] For possibly the first suggestion that collective action by shareholders to curb externalities made economic sense, see Robert Hansen and John M. Lott, Jr., Externalities and Corporate Governance in a World with Diversified Shareholder/Consumers 31 J. Fin. & Quantitative Analysis 43 (1996). For the most recent and fullest statement of this argument, see Condon, supra note 2.

[9] See Condon, supra note 2. However, almost all these examples involve shareholder activism in the field of climate change or environmental action.

[10] For the most recent scholarly analysis of this rule, see Max M. Schanzenbach and Robert H. Sitkoff, Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee, 72 Stan. L. Rev. 381 (2020).

[11] For an excellent description of the “rebranding” of “socially responsible investing” into “ESG investing,” see Schanzenbach & Sitkoff, supra note 10, at 388-399.

[12] Id. at 451.

[13] See Coffee, supra note 1, at 23.

[14] See Oliver Hart and Luigi Zingales, Companies Should Maximize Shareholder Welfare and Not Market Value, 2 J. L. Fin. & Acct. 247 (2017).

[15] See Fifth Third Bancorp. v. Dudenhoeffer, 134 S. Ct. 2459, 2471 (2014); see also Schanzenbach & Sitkoff, supra note 10, at 451-453.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.