Spring Awakening: Notes from This Year’s CII Meeting

The theme I heard most often at the annual spring meeting of the Council of Institutional Investors was ESG: environmental/social/governance risks and investment opportunities. The issues of how best to understand ESG and factor it into assessing investment risk and return and how to respond as investors through proxy voting or engagement came up in a number of contexts. Other issues that were raised more than once included voting rights, crypto-currencies and initial coin offerings, and international investments and investors.

Some of the highlights of the official and member-hosted side meetings:

Why Asset Owners are Integrating ESG: Investment Case and Practitioner Insights

MSCI attracted a standing-room-only crowd for a panel on ESG. All panelists agreed that the accessibility and usefulness of ESG data had dramatically improved over the past 3-5 years, and all emphasized that the old idea of a trade-off of returns for some undefined social benefit was outmoded, as was the idea that ESG criteria restrict diversification.

“The old idea was that it will cost you something. The current idea is that it will gain you something,” said Tracy Stewart, Senior Corporate Governance Analyst of the Florida State Board of Administration (the state pension fund). According to MSCI’s recent paper, a low ESG rating for a security means that the company is 3 times more likely to have a significant economic drawdown, and they see ESG as an essential element in mitigation of systemic risk. On the return side, it can be a positive addition, a better risk adjusted return. “If we can cut beta and idiosyncratic risk, that’s beautiful.” Stewart noted that, “Problems in compensation are one of the key indicators of risk. Pay is how companies communicate how they feel about us as investors.” She said ESG as a factor in securities analysis and asset allocation has reached a tipping point, and outside managers have to understand that. “We will bring it in-house if it is not offered.”

June Kim, Director of Global Equities, CalSTRS, said that the 21-point checklist their fund has used for all investments for many years is now being revised to reflect ESG priorities. Outside fund managers must show how they apply these criteria to qualify for CalSTRS, updating those showings annually. They are also running a low-carbon portfolio internally. Kim made two important caveats: first, the rapid improvement in data and analysis has all occurred in an exceptionally strong market. CalSTRS will watch carefully and readjust their metrics as we see how ESG factors play out in a down market. Also, the access to information and compliance with ESG factors varies sharply in other markets. For example, too many companies in some countries miss weights on diversity. “We don’t want to end up with big mis-weights,” she said, “No more than two deviations.”

Stewardship Lessons for US Investors from Corporate Governance Scandals in Brazil, Germany, and Japan

Hermes EOS made a presentation on international corporate governance problems and scandals: Brazil’s Petrobras corruption, Germany’s Volkswagen emissions tampering, and Japan’s not-always successful adaptation to its new governance code, especially its emphasis on more independent oversight.

Alicia Ogawa of Columbia Business School said the problems recently revealed in Japanese companies are the result of “the old system coming into contact with the new system.” A survey of Japanese executives asked who the most important corporate stakeholders were. The top three answers were customers, staff, and employees. Shareholders, banks, and other financial partners were near the bottom. While companies are now required to have at least two outside directors, “external directors are paid peanuts” and the talent pool is “small and tired.” The consensus-based culture makes it difficult to challenge the insiders. Former top executives, even as many as 50 at a time, continue to have offices and salaries, making it extremely difficult to revise any of their past decisions and practices. She attributes the inability to adapt strategies to this problem at several companies with global investors and customers.

Mauro Rodrigues da Cunha, Associação de Investidores no Mercado de Capitais told us that one problem in changing corporate culture in Brazil is that fewer than one percent of the population has equity investments. Twice as many are invested in Bitcoin. He also pointed out that US investors were able to get $3 billion in settlement of shareholder litigation but that option is not available to investors from other countries (unless they bought their stock via the NYSE).

Dr. Hans-Christoph Hirt, Hermes EOS pointed out that the stock of Volkswagen is near where it was the day before the emissions scandal was made public. There were a number of warning signs, from smaller scandals to the wife of one of the executives on the board.

Tim Goodman of Hermes EOS, which invests directly and acts as engagement liaison for 40 institutional investors around the world, says that their primary focus is on the independence and quality of the board. They are less focused on exporting Anglo-US models than finding something that works for the culture and legal system of each country. But change must come. As Ogawa said, “The companies that are not changing are going to have their lunches eaten by activists.”

Jay Clayton, SEC Chair

Former SEC Chair Elisse Walter interviewed her successor, Jay Clayton, whose genial manner, lack of specificity, and “both sides” rhetoric did not disguise his unwillingness to commit to pursuing institutional investor priorities on arbitration, shareholder proposals, and universal proxy. He revealed his priorities not in talking about the substance of the issues but in dismissing those he does not consider important as “not a priority” or “not worth our time and bandwidth.” Clayton said that he supports transparency but believes that “verbiage” can be reduced, without any discussion of what he might want to jettison, just, “Keep the content; reduce the bulk.”

Asked about ESG, he said he thought G was already pretty well taken care of, with E he wanted “more of what the investor needs to know, less on macro topics,” and with S “it is hard to get a consensus on metrics.” On the idea of the universal proxy, the questions he raised were operational, not policy: limited solicitation aspect is the problem. How do you deal with ambiguities, as when the incumbents could overrule a vote and how would a process that has more than one step work? He was willing to say he was not sure what the role of the SEC should be with regard to lesser-voting stock, but expressed more interest in possible regulation of proxy advisory firms. On one hand, he appreciated the “market need for generic analysis” but on the other, “that’s a lot of power.”

He supports better coordination in overseeing entities that may be governed by five or more regulators: the SEC, FINRA, DOL, and state securities agencies. And he was perhaps most explicit in his concern about Initial Coin Offerings, saying, “I don’t like what I’m seeing.” And he supports the idea of more disclosure in the MD&A about deployment and return on intangible assets. Oddly, when asked about shareholder proposals he seemed to suggest that it was boards of directors who needed more support in presenting their views, despite the fact that unlike shareholders, they have no word limit in the company’s proxy.

Henry Fernandez on Index Funds

MSCI’s Henry Fernandez says that ESG “indexes” are the fastest-growing segment of their business. He laughed that this has him being called a socialist by some on Wall Street. As someone who escaped a communist revolution in Nicaragua, he considers himself a full-on capitalist and that what he is doing is the ultimate preservation of the free enterprise system: allocating capital based on market-based assessments. “You distort the flow of capital if you don’t address these issues.”

MSCI is looking at the challenges of multiple classes of voting stock, including adjusting the weights to reflect the voting rights. He solicited comments on their recent paper, calling it “a very important issue in our free markets today.”

Question: With index funds being sliced so many different ways, aren’t they really becoming more like managed funds?

Corporate Culture and Board Culture

Corporate board members Elizabeth Duke, Robert Herz, and Ruth Ann Marshal gave their perspective from the boardroom and recommended the report from the National Association of Corporate Directors, Culture as a Corporate Asset. “Conduct risk” is something boards must take very seriously.

Duke, now chair of the Wells Fargo Board, talked about the “shock” of learning about the fraudulent account scandal and how the board responded. She said the problem was not the incentives, as many people have concluded, but “sales management” that set unreasonable goals. We might argue that this is another way of saying incentives (keeping your job or getting a promotion is an incentive after all), but we understand the systemic nature of the problem and appreciate her use of the term “echo at the bottom” as parallel with “tone at the top” and the many measures they are using to achieve and measure it at every level, including the board. She praised the “first responder mentality” of Wells Fargo’s new directors.

Marshal said that she is her own “mystery shopper” of the companies on whose boards she serves, as a customer at the B to C companies and visiting trade shows to check out her company and the competition for B to B companies. Her priorities include employee engagement surveys, and diversity in the C-suite and on the boards. Board member must be courageous, must do their homework, and must be representative of the marketplace. “If not, shame on us.”