Monday, May 2, 2022

To say they are shareholders only begins analysis.

I recently posted (here) a link to, and brief overview of, a letter from twenty-two of the nation’s leading professors of law and finance urging the SEC to withdraw its climate disclosure proposal. Brett McDonnell submitted an interesting comment to that post, highlighting a potential tension between espousing views that prioritize shareholder wealth maximization while at the same time rejecting the calls of some of the world’s largest shareholders for greater climate-related disclosures. (Please be sure to read his full comment.) In response, Lawrence Cunningham suggested I post an additional excerpt from the letter, which addresses this issue in more detail. You’ll find that excerpt below. However, this all reminded me of a recent article by Amanda Rose, and so I’ll start my excerpts with a quote from that article.

Traditional asset managers claim their commitment to ESG is motivated by a desire to improve long-term fund performance for the benefit of investors. But agency costs offer an alternative potential explanation: embracing the ESG movement may help asset managers curry political favor, enabling them to fend off greater regulation of the industry; it may advance the personal sociopolitical commitments of those who ran them; or it may offer a way to attract investors to fund offerings without imposing any meaningful limitations on how a fund is managed.

Amanda M. Rose, A Response to Calls for SEC-Mandated ESG Disclosure, 98 Wash. U.L. Rev. 1821, 1824–25 (2021).

Now, on to the letter (the full version is here):

A.  Investor Varieties: Diverse Institutions and Individuals

    The investors demanding climate-related information are overwhelmingly institutional asset managers who are managing other people’s money, not their own. This raises the obvious question whether their advocacy is prompted by concern for their beneficiaries’ returns or their own profitability. Two of the SEC’s current major rulemaking proposals relating to private fund advisors each contain dozens of references to potential conflicts of interest between private advisors and their sophisticated clients. Yet this Proposal makes not a single reference to potential conflicts of interest between retail asset managers and their less-sophisticated clients, instead taking it as given that what is good for the asset manager is good for the beneficiary.

    To determine whether adopting the Proposal will protect investors, the SEC must explicitly consider the conflicts that arise between large asset managers and their beneficiaries and whether climate disclosure mandates will exacerbate them.  There is no indication that the SEC has attempted to assess, much less quantify, the potential losses to individual investors from self-interested voting or engagement by the asset managers to whom 160 million Americans entrust their savings. That fact alone is a fatal flaw of the Proposal.

1.    The Most Vocal Institutions.

    The Proposal refers to “investor demand” 54 times, with copious citations tied to one segment of the investment industry. The Proposal devotes five pages to introduce what it calls “growing investor demand,” mainly by listing six consortia of large global institutions along with reported assets under management.  The list starts with three groups of such institutions that have signed the United Nations’ policy advocacy documents urging countries to reduce climate risks.

    The United Nations is neither a business nor an investor and lacks any relevant expertise in either domain. It is a political institution coordinating international policies on contentious topics, including as an incubator of the concept of “ESG” and climate management that provide the backdrop for the Proposal.  The other three groups are avowed climate activists, reflected in their names: Net Zero Asset Managers Initiative, Climate Action 100+ and Glasgow Financial Alliance for Net Zero. The Proposal does not identify these investors nor indicate the portion of the reported assets invested in SEC registrants as compared to other investments around the world.  Aside from obvious member overlap in the first two referenced initiatives, the Proposal does not disclose overlaps in these numbers, except a vague general acknowledgement that “There is some overlap in the signatories to the listed initiatives.” 

    Nor does the Proposal disclose the proportion of the listed assets under management invested in SEC registrants that are actively managed versus passively managed. It does not delineate other important matters of investment style, particularly whether these investors follow traditional fundamental valuation analysis, conventional diversification based on modern portfolio theory, or fashionable indexing based on rankings of companies according to their climate-related practices. It does not delineate which of these investors invest for their own account or on behalf of clients or the breakdown of such clients between institutions or individuals.

    Such investor demographics and styles are essential predicates to determining whether there is a need for rulemaking along the lines stated in the Proposal. Such an understanding of which institutions are expressing such demand is particularly important for SEC disclosure regulations because these investor types demand different kinds of information and utilize it differently. For instance, traditional index funds do not select stocks by parsing SEC disclosure but rather formulaically buy and sell based on fluctuations in an index, without regard to such disclosure. Traditional stock pickers scrutinize such information carefully to ascertain business value, economic advantages, and investment trajectory.

    BlackRock, State Street, and other large index fund providers face a challenging competitive environment. Fees for index funds have been driven nearly to zero. Profitability therefore depends on spreading the managers’ fixed costs over a larger pool of managed assets. In attempting to attract investment inflows, large index funds compete against one another and with active managers. The latter have a built-in advantage in attracting socially conscious investors because they can offer non-indexed products specifically catering to ESG-focused investors.

    For the manager of an index fund that must invest in all or substantially all companies in the index, public statements that climate is a top priority across the entire portfolio can be an important competitive marketing tool. A recent academic article makes the point cogently:

[I]ndex funds are locked in a fierce contest to win the soon-to-accumulate assets of the millennial generation, who place a significant premium on social issues in their economic lives. With fee competition exhausted and returns irrelevant for index investors, signaling a commitment to social issues is one of the few dimensions on which index funds can differentiate themselves and avoid commoditization.

    While index funds may be interested in using climate-friendly voting and engagement as a marketing device, they cannot afford to incur substantial new costs to do so. A mandatory climate disclosure regime requiring publicly traded companies to bear the cost of producing and standardizing the climate-related information would save such funds costs while advancing their agendas. The Proposal fails to assess how its rules will affect different segments of the investment industry differently; it also fails to consider alternative approaches that would avoid favoring some sectors at the expense of others.

Stefan J. Padfield | Permalink


Post a comment