The New Separation of Ownership and Control: Institutional Investors and ESG

In recent weeks, the Securities and Exchange Commission (SEC) has devoted considerable attention to environmental, social and governance, or ESG, matters. It has requested public comment on climate disclosure proposals, appointed a senior policy advisor for climate and ESG, and announced that its 2021 examination priorities will include climate-related risks. Taken together, these developments indicate the SEC may be poised to mandate ESG-related disclosures. A recent post on this blog discussed the SEC’s interest in climate disclosures.

In a new article, “The New Separation of Ownership and Control: Institutional Investors and ESG,” forthcoming in the Columbia Business Law Review, we urge the SEC to proceed with caution. It has neither the expertise nor the political accountability to pursue climate, diversity, and other public policy goals. By appearing to take sides in contentious policy disputes, the SEC risks eroding public trust in its capacity and willingness to serve as an apolitical, technocratic regulator of the capital markets. Moreover, ESG disclosure mandates that go beyond current requirements to disclose known company-specific material risks are unlikely to help, and may harm, the Main Street investors who are the SEC’s primary constituency.

Several other scholars have examined the evidence that asset managers can use ESG factors to generate excess returns and concluded that it is mixed at best. We focus, by contrast, on the divergence in interests between asset managers and their investors. While the separation of ownership and control between corporate managers and shareholders has generated an enormous body of literature, the “new” separation of ownership and control between institutional investors and their beneficiaries has received less attention.

Several prominent institutional asset managers argue that mandatory ESG disclosures will better inform them about financial risks and that their support is accordingly a matter of risk and return, not policy preferences. In evaluating those arguments, however, the SEC should recognize that an institutional asset manager that sponsors retail mutual funds and advises employer-sponsored retirement plans must declare that it is acting in its beneficiaries’ best interests or it would be violating its fiduciary duties. The relevant question is not what institutional investors say, but whether they have presented a persuasive case that their own investors would benefit from a new disclosure mandate.

In our view, notwithstanding their (obligatory) claims that they are focused on financial risks, it is more likely that the institutional investors that demand more ESG-related disclosures and other policy actions are motivated by social goals. The herding behavior of the top fund managers toward ESG-informed investing is puzzling if they are interested only in uncovering and profiting from risks that the market hasn’t yet priced. It makes perfect sense if the objective is to redirect their beneficiaries’ capital in socially motivated ways.

The conflicts are particularly acute in the case of public pension funds. Some of their trustees are elected or appointed officials who are sensitive to local policy preferences. Their beneficiaries are largely a captive audience with defined benefit entitlements that do not vary with investment returns. For these trustees, market discipline is weak and political discipline is strong. Not surprisingly, some public pension funds have adopted investment and voting policies that are aligned with local policy preferences but are hard to reconcile with beneficiary interests.

There is also evidence that private asset managers exercise voting rights on ideological grounds. This is unsurprising given the pressure they face from peers, politicians, activists, and their own employees to use their control of (beneficiary) resources to address climate change and other social problems. Through investment and voting decisions, these managers can impose a private cost on greenhouse gas emissions in substitution for a government-imposed price.

Proponents of ESG mandates might argue that the magnitude of the social problems justifies institutional investor activism even at some cost to beneficiaries. This is a corporate social responsibility argument once removed. In other words, it expresses the view that corporate managers owe a duty to act in socially responsible ways and therefore asset managers should pressure their portfolio companies to do so.

The argument against delegating the solutions to social problems to asset managers rather than the political process turns on issues of competence, legitimacy, and conflicts of interest. Shareholder primacy is in large measure a rule about the allocation of responsibility in a market-oriented democratic society. Law and regulation impose constraints on corporate and asset managers, permitting them to act, within the constraints, as faithful agents of their principals while still serving society’s interests as mediated through the political process. Asset managers are not selected on the same basis as political leaders and have neither the skills nor democratic legitimacy to make the sensitive tradeoffs necessary to craft public policy. In practice, managers’ appeals to the interests of other constituencies have often been self-interested.

The SEC should also recognize that expensive, politically driven mandates may encourage companies to remain or go private. Congress and the SEC have taken steps to make it easier for privately held firms to go public. ESG disclosure mandates will push in the opposite direction, potentially reducing investment opportunities for retail investors and making it harder to address wealth inequality. We therefore argue that the SEC should not adopt ESG disclosure mandates unless it concludes that they would benefit households whose retirement, college, and other savings are in the hands of asset managers.

The SEC may continue to pursue its longstanding mission of investor protection, with an emphasis on protecting unsophisticated investors from fraud and agency costs. Alternatively, it may cast its lot with the institutional investors and political activists who aim to promote their favored public policy objectives without subjecting them to the transparency and compromises inherent in the normal substantive policy-making process. Fairly or not, the latter path may lead investors and the broader public to conclude that the SEC caters to Wall Street rather than Main Street.

This post comes to us from professors Paul G. Mahoney and Julia D. Mahoney at the University of Virginia School of Law. It is based on their new article, ““The New Separation of Ownership and Control: Institutional Investors and ESG,” forthcoming in the Columbia Business Law Review and available here.