Risk-related activism: the business case for monitoring nonfinancial risk.

• Author: Ho, Virginia Harper

1. INTRODUCTION II. SHAREHOLDER ACTIVISM AND RISK A. Understanding Risk 1. Firm-Specific Risk 2. Portfolio Risk 3. Systemic Risk 4. ESG Risk B. The Activist Toolkit III. THE RATIONALES FOR RISK-RELATED ACTIVISM A. Risk Management as Good Governance B. Fundamental Financial Performance C. The Financial & Nonfinancial Risk Link D. Information Asymmetry E. The Risk-Return Link F. A Word About Short-Termism & Risk III. BEYOND PASSIVITY: THE MEANS OF RISK-RELATED ACTIVISM A. The Passivity Challenge B. Activist Arbitrageurs 1. Activism Without Blockholders 2. The "Other Arbitrageurs" 3. Blurring the Lines C. Beyond Activism: ESG Integration 1. Understanding ESG Integration 2. Breaking Down Structural Barriers IV. ASSESSING IMPACT A. The Metrics of Activism 1. The Limits of Financial Metrics 2. Evidence From Returns 3. Evidence From Withdrawn Shareholder Proposals 4. Evidence from Corporate Practice B. Anticipated Objections 1. The Agency Cost Challenge 2. Special Interests and Investor Heterogeneity 3. Beyond the Bottom Line V. THE FUTURE OF FIDUCIARY CAPITALISM A. Reorienting Corporate Boards B. Reorienting Investors VI. CONCLUSION APPENDIX: ESG METRICS I. INTRODUCTION

   In 2014, New York City's public pension funds kicked off a "Boardroom Accountability" campaign targeting 75 major public companies and seeking shareholder approval for proxy access--corporate bylaw changes that would open certain board seats to candidates nominated directly by shareholders. (1) In 2015, over 70% of these proposals were approved by at least a majority vote, creating new momentum for proxy access among leading firms. (2) As an example of shareholder activism, the campaign represents the results of over a decade of market and regulatory shifts that have increased the ownership concentration of public corporations and put greater voting power and influence into the hands of fewer investors. (3) These changes have revived expectations that institutional investors, like mutual funds and public pension funds, which now hold most of the publicly traded equity in the United States, (4) will play an active monitoring role for public corporations.

   At the same time, the pension fund campaign challenges much of the received wisdom about how shareholders actually behave. The campaign's stated objective--to "ensure that companies are managed for the long-term" for the benefit of diversified investors--is quite conventional. (5) Yet the campaign is backed by Ceres, a coalition of investors who advocate sustainable business practice, and its supporters see proxy access and board accountability to shareholders--corporate governance reform--as a way to make boards more responsive to investors' views on board diversity, executive compensation and climate change, all topics generally considered to be "social" goals of niche investors. Taking the campaign's goals at face value therefore raises interesting questions about how nonfinancial issues can drive long-term value for target firms and their shareholders and how shareholders should use their power.

   As it happens, part of the answer has to do with risk. Of course, risk matters to all investors because firm profitability and investment returns depend on the associated risk. (6) However, the board accountability campaign has targeted firms because of broader risk concerns, specifically, the perceived "risks associated with climate change, board diversity, and excessive CEO pay." (7) In fact, the pension funds are engaging in "risk-related activism"--the exercise of shareholder governance rights to motivate firms to effectively monitor, manage, and disclose risk, including nonfinancial environmental, social, and governance (ESG) risks. The term "ESG" is now widely used by institutional investors and investment professionals to refer not only to sustainability measures or to environmental, social, or governance practices specifically, but to all nonfinancial fundamentals that can impact firms' financial performance, such as corporate governance, labor and employment standards, human resource management, and environmental practices. (8) Consistent with emerging international standards discussed below, this Article defines risk-related activism to include investor engagement with portfolio firms that (1) urges companies to adopt sound governance practices, including effective risk management; (2) encourages corporate boards to effectively identify and manage both financial and nonfinancial, or ESG, risks; or (3) seeks to improve the quality of financial reporting and voluntary disclosures related to risk. Activism to achieve goals that increase the target firm's risk exposure or undercut prudent risk management are not included.

   Risk-related activism is not a new concept. Indeed, in the wake of the financial crisis, many policymakers and other advocates of shareholder power saw better alignment between corporate boards and shareholders as a way to constrain excessive managerial risk-taking and prevent future corporate governance failures by public companies. (9) It is therefore no accident that the reforms expanding shareholder voice in corporate governance were adopted in tandem with regulatory mandates for public corporations that focused on firm risk management and oversight. (10)

   The potential impact of broader risk factors on investment risk and return also drive many of the emerging regimes that seek to promote investor monitoring of portfolio firms. For example, the United Nations' Principles for Responsible Investment (UNPRI), whose signatories now account for over half of all publicly traded equities globally, (11) commit institutional investor signatories to engage portfolio firms around ESG performance and to encourage investment intermediaries to do the same. (12) The complementarity between shareholder governance rights and the primary responsibilities of corporate boards and managers to monitor and manage risk also informs international corporate governance codes, such as the International Corporate Governance Network's (ICGN) Global Governance Principles and its 2013 Statement of Principles for Institutional Investor Responsibilities, (13) the Organization for Economic Co-Operation and Development's (OECD) Principles of Corporate Governance, (14) and responsible investment or investor stewardship codes adopted by governments around the world since 2011, including the United Kingdom, Canada, Australia, Japan, and the European Union. (15) Recognizing the power investors wield in modern capital markets, these codes direct institutional investors to promote better firm governance and risk management through the exercise of voting and other governance rights and through investor influence over asset managers. They also seek to hold institutional investors accountable for how they use their power.

   Critics have cautioned, however, that these measures simply will not work because institutional investors lack the incentives and the ability to play a monitoring role. (16) Although the New York board accountability campaign claims to push systemic market reform, from this perspective it is exceptional, since most public pension funds prefer passive investment strategies. (17) Looking to shareholders as a source of corporate accountability may also be misguided because shareholders are perhaps as much to blame as corporate boards for the excessive risk-taking that fueled the financial crisis. (18) The controversy over shareholder empowerment has deepened with the rise of hedge fund activism, which has sparked debate over whether those most likely to use their power are short-term investors whose strategies will cause firms to take on more risk and jeopardize long-term firm value. (19) What is undisputed is that investors have diverse preferences, that investors' goals do not always align with effective risk management or maximizing long-term firm value, and that most institutional investors do not actively monitor portfolio firms.

   The New York pension fund campaign therefore points to two of the central challenges raised by shareholder power. The first is how to motivate more shareholders to use their power to play a monitoring role, and the second is how to ensure that those who engage in activism do so in a manner that is transparent and promotes long-term firm value and prudent risk-taking. Whether risk-related activism like the board accountability campaign suggests a useful response to the first challenge or demonstrates the urgency of the second depends largely on its economic justifications.

   This Article presents the business case for risk-related activism. It argues that risk-related activism represents a re-alignment of investor power with the core regulatory goals that motivated shareholder empowerment in the first place and that it has the potential to advance market transparency and stability. However, broader shareholder and board support for risk-related activism and consideration of new models to promote accountability for activists themselves have been impeded by outdated understandings of the goals and tools of risk-related activism as incompatible with shareholders' economic interests. Drawing on a substantial literature largely overlooked in current corporate governance debates, this Article challenges these conceptual barriers by presenting the economic rationales for risk-related activism. It demonstrates that activism directed toward these goals can generate long-term firm value that benefits shareholders as a class and satisfies the fiduciary duties that institutional investors owe to the individuals who are their ultimate beneficiaries and clients.

   This Article also presents evidence that risk-related activists have the ability to serve as active monitors of portfolio firms using the standard tools provided by corporate law and federal proxy regulation, primarily through direct dialogue with firms, backed by shareholder-sponsored proposals. This Article shows...