On October 3, The Shareholder Commons and B Lab submitted their comment on a recent new rule (the “Proxy Proposal”) proposed by the Department of Labor (the “DOL.”) The Proxy Proposal would limit independent proxy voting by pension trustees. It is part of a series of rules recently proposed or adopted by the DOL and the SEC that tilt the scales against shareholders and in favor of management on disputes related to social and environmental issues. This post summarizes one of the critical arguments from our comment, which applies to this entire series of new rules meant to limit the voice of shareholders.
Against Engagement: The Proxy Proposal and Other Recent Agency Action
The Proxy Proposal threatens ERISA trustees with liability if they spend resources on voting. In particular, the proposal:
- Directs trustees to discount the value of engagement at companies that represent a small percentage of a plan portfolio;
- Creates a presumption against using third party proxy advisers;
- Encourages plans not to voting at all in order to reduce expenses;
- Provides a safe harbor for a policy of voting with management;
- Provides a safe harbor for a policy of only voting on certain matters related to questions important to company value; and
- Provides a safe harbor for a policy of not voting on matters at companies that comprise a small percentage of a plan’s assets.
Another DOL rule proposed earlier in the year raises the bar for fiduciary action on any environmental or social issue. A separate rule recently adopted by the SEC will actually make it more expensive for fiduciaries to use professional proxy advisers, especially if the advisers recommend votes against management, while a second SEC rule will make it more difficult for shareholders to even introduce environmental and social proposals at shareholder meetings.
Together, these rules create significant obstacles to institutional investors and other shareholders seeking to limit harmful social and environmental impacts of the companies they own. These rules represent a perverse form of anti-capitalist state corporatism: The federal government is preventing shareholders from managing their own capital in response to important social and environmental issues, at least where doing so might interfere with the wishes of corporate executives. In our comment, we explained why that is bad for shareholders and bad for the economy.
The DOL’s Essential Error
All of these rules are based on an assumption that proxy voting and related governance engagement only affect the value of the company at which the votes and engagement take place. This leads the DOL to favor management recommendations (which are presumed likely to align with company interests) and to posit that the percentage of a portfolio represented by a company is positively correlated with the importance of its decisions on that portfolio.
This assumption and the resulting conclusions are just wrong: Decisions made at any portfolio company can and do affect the performance of the economy and thus the value of other companies. Accordingly, company action that harms other companies is likely to harm its own shareholders as well, because the vast majority of shareholders are broadly diversified and will own those other companies in their portfolios.
In light of this, shareholders are fully entitled to ensure that the companies they own act responsibly on environmental and social issues so that their own capital is not used against their interests – that is how markets are supposed to work. As Milton Friedman explained in a famous essay, the responsibility of corporate managers to shareholders is “to conduct the business in accordance with their [shareholders’] desires.” (Friedman 1970.) The DOL’s interference with market forces will create inefficiency on a grand scale, as shareholders lose the ability to steward their own capital.
Portfolio Companies and Externalities
Sound investing practice mandates that fiduciaries adequately diversify their portfolios. This allows investors to reap the increased returns available from risky securities, while greatly reducing the risk from failure of individual companies; this is the insight that defines modern portfolio theory. This core principle is reflected in ERISA, which requires plan fiduciaries to act prudently “by diversifying the investments of the plan.”
Once a portfolio is diversified, the most important factor determining return will not be how the companies in that portfolio perform relative to other companies (“alpha”), but rather how the market performs as a whole (“beta”). Indeed, “[a]ccording to widely accepted research, alpha is about one-tenth as important as beta [and] drives some 91 percent of the average portfolio’s return.” (Davis, Lukomnik and Pitt-Watson.) The importance of beta to “universal owners” – the long-term shareholders who are invested essentially in the entire market – has been described as follows:
[Universal owners’] portfolio performance depends on the economic growth and social value that their investments, and therefore society, create in aggregate. Costs externalized by one set of investments onto society are likely to weigh down performance in other parts of the portfolio. By extension, ‘universal owners’ will only benefit when investments have positive social value. (Wood.)
In its release proposing the Proxy Rule, the DOL cited “mixed evidence” of whether corporate environmental and social corporate responsibility leads to increased returns. But this interpretation of the evidence derives from the lacuna in its analysis: The DOL assumes that the only relevant data would involve an increase in the value of the company at which the voting took place:
As discussed above, one factor prompting the rise in shareholder activities by ERISA fiduciaries was the belief that participating in such activities was likely to enhance the value of a plan’s investment in a particular security. Since that time, however, research regarding whether proxy voting has reliable positive effects on shareholder value and a plan’s investment in the corporation has yielded mixed results. (Emphasis added.)
The DOL is asking the wrong question. Prudent trustees should challenge corporate behavior that harms a diversified portfolio by externalizing costs whenever that harm exceeds the benefit the trustee would receive as a shareholder of the company in question. For example, if a company lobbies against emission regulations because its business model thrives on carbon-intensive practices, its shareholders may still insist that it refrain from such activity due to the overall burden of climate change on the economy and diversified portfolios.
Externalized costs include harmful emissions, resource depletion, and the instability and lost opportunities caused by inequality. The collective costs of such externalities are absorbed by diversified shareholders because they degrade and endanger the stable, healthy systems that corporate financial returns depend upon. Economists have long been aware that, while individual companies can “efficiently” externalize costs from their own narrow perspective (and the perspective of a shareholder of that single company), diversified shareholders pay these costs through a lowered return on their diversified portfolios. (Hansen and Lott). Legal scholars have more recently made the same observation in exploring the scope of duties of institutional investor trustees. (Coffee; Condon).
If a plan fiduciary focuses only on individual company performance, and not on the external environmental and social costs created by portfolio companies, the fiduciary may be sacrificing the 91 percent of potential return attributed to market return in order to optimize the 9 pecent that comes from alpha. Externalized social and environmental costs can play an outsized role in that 91 percent.
In support of this idea, our comment cites recent scholarship connecting climate change, inequality, and racial injustice to reduced GDP. It also cites evidence that more than half the profits of publicly listed companies around the globe are matched by costs that those same companies impose on the economy. The comment also discusses how PRI, an investor initiative whose members have $89 trillion in assets under management, issued a report detailing how the pursuit of profit by an individual company can reduce the return of diversified owners even if the company is included in their portfolio.
The DOL Misses the Point
Both the DOL and SEC entirely miss this point in their recent actions – indeed, the DOL’s most recent release expressly assumes that proxy voting on any matter broader than the economic value of the security being voted could not affect the value of the plan, positing a stark dichotomy between the two: “the type of proposal (e.g., those relating to social or public policy agendas versus those dealing with issues that have a direct economic impact on the investment).” But as the foregoing discussion illustrates, it would be imprudent for a trustee to ignore opportunities to increase beta through engagement with companies, whether or not related to social or public policy agendas.
Indeed, in the release describing the Proxy Rule, the DOL acknowledges that it is structured to encourage companies to create negative externalities, but fails to account for that cost anywhere in its rulemaking:
However, to the extent that there are any externalities, public goods, or other market failures, those might generate costs to society on an ongoing basis. For example, a fiduciary may vote for a proposal on a corporate merger or acquisition transaction to maximize shareholder value even though implementation of the proposal would bring about impacts in an affected geographic area that would be adverse for local businesses or residents.
Unsaid is the obvious truth that many of those externalities will harm other companies that make up the plan portfolio, as the PRI details in its work. The Proposed Rule and other agency actions by the DOL and SEC make it less likely that shareholders will be able to address these externalities, to the detriment of the very retirees and investors the DOL and SEC are supposed to protect.
John C Coffee, Jr., The Future of Disclosure: ESG, Common Ownership, and Systematic Risk (2020)
Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1 (2020)
Stephen Davis, Jon Lukomnik and David Pitt-Watson, What They Do with Your Money (2016).
Milton Friedman, Responsibility of Business Is to Increase Its Profits, New York Times Magazine (1970).
Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers, Robert G. Hansen and John R. Lott, Journal of Financial and Quantitative Analysis vol. 31, issue 1(1996).
Burton G. Malkiel, A Random Walk Down Wall Street (2015).
Schroders, Foresight (2020).
David Wood, What Do We Mean by the S in ESG?, in The Routledge Handbook of Responsible Investment, 553 (2016).
This post comes to us from Frederick Alexander, founding partner and chief executive officer of The Shareholder Commons.