The Law of Unintended Consequences: The Case of Proxy Advisory Firms
The SEC requires all institutional investors to vote on all matters put forth in proxy statements, or the measures voted on during shareholder meetings. For most institutional investors, keeping up with all of these issues is not feasible, so they turn to proxy advisory firms.
Proxy advisory firms help institutional investors wade through the overwhelming numbers of measures, and two proxy advisory firms, ISS (an arm of Genstar, a private equity firm) and Glass Lewis (an arm of the Ontario Teacher’s Pension Plan Board and the Alberta Investment Management Corporation) control 97 percent of the proxy advisory market.
The rule was supposed to protect shareholders’ interests but, as the SEC roundtable scheduled for today recognizes, the growing clout of proxy advisory firms has raised concerns that unintended, and adverse, consequences have resulted. The advice proxy advisory firms provide regarding environmental, social, and corporate governance (ESG) programs exemplifies the problems. The goal of ESG programs is to explicitly account for issues that some people believe are important and want to promote, which sometimes comes at the expense of financial returns.
Both ISS and Glass Lewis sponsor ESG programs; consequently, the firms have a preordained belief that pro-ESG proxy statements should be supported. Thus, their advice has clear bias on ESG issues that is not adequately disclosed. ESG criteria also raises fiduciary responsibility questions for institutional investors that the proxy advisory firms fail to fully appreciate.
From the perspective of the individual investor, voting in favor of specific ESG programs can make sense. Perhaps the ESG program will enhance profits, perhaps it won’t. Either way, individual investors know the constraints they are imposing, and bear the consequences from their actions.
This nexus does not hold for institutional investors, particularly public pension funds because pensioners typically have no other investment options – if you are a teacher in California, CalSTRS will manage your pension, you have no choice. Since public pension funds represent many individuals, it is inevitable that ESG policies and investing preferences will clash. For example, there is a growing push for CalPERS to divest from fossil fuel companies even though 67 percent of members surveyed by Spectrem Group in 2018 stated that the sector “is an essential element of a balanced, diversified portfolio”.
Further, many studies that have examined ESG (see here or here) have found that automatically screening out investment options, or imposing uneconomic constraints, harms financial results. SEC Commissioner Hester Peirce expressed these concerns at the 2018 Annual SEC Conference stating that: “the problems arise when those making the investment decisions are doing so on behalf of others who do not share their ESG objectives.…When a pension fund manager is making the decision to pursue her moral goals at the risk of financial return, the manager is putting other people’s retirements at risk.”
The large unfunded liabilities of public sector pension funds worsen these costs.
Take California as an example. As newly-elected CalPERS Board member Jason Perez estimated, the CalPERS ESG program toward tobacco cost the retirement fund $8 billion, which is sizable relative to California’s current unfunded liabilities of nearly $170 billion according to the Pew Charitable Trusts. The problem may even be worse than that. As I recently reported in my chart-book on California’s pension crisis, total public employee pension debt is really closer to $1 trillion using a more realistic market estimate.
The large fiscal hole leaves Californians with few good choices. If the state raises taxes, it would reduce overall economic prosperity, but if it fails to fully fund their pension obligations, then future public sector retirees will suffer greater economic insecurity. Given these difficult trade-offs, any policy that limits the public pension systems’ investment options, and costs potential returns, worsens California’s pension crisis.
Combining the potential investment losses with the diversity of opinions regarding contentious social issues, it is clear that ESG investing is inappropriate for public pension funds. However, it is unclear that either ISS or Glass Lewis account for the specific needs of public pension funds when advising institutional investors about ESG proxy statements. In fact, based on their own ESG programs, it is reasonable to conclude that both firms are biased toward supporting such programs despite the clear negative impact these policies have on public pension funds.
Without reforms that better align the interests of the proxy advisory firms and the interests of fund shareholders, these unnecessary costs will persist. To address the problems, several reforms are necessary.
For example, instead of assuming that the analyses of proxy advisory firms are objective, or allowing the proxy advisory firms to rely on their “general conflict of interest” statements, the SEC should require conflict of interest disclosures that are specific to the issue under evaluation. More relevant conflict of interest disclosures will help ensure that the investors relying on the proxy firms’ recommendations are aware of the proxy firm’s specific biases and potential conflicts of interest as it relates to the specific issue under consideration.
The SEC should also consider eliminating the requirement that institutional investors vote on all items on corporate proxy statements. Enabling institutional investors to focus on only those corporate proxy statements they deem material would reduce the artificial demand for the proxy advisory services, and therefore improve the competitive environment.
Without such reforms, while unintentional, the current proxy process will continue to create additional, and unnecessary, risks for investors.