Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance

Michal Barzuza is Nicholas E. Chimicles Research Professor of Business Law and Regulation at the University of Virginia School of Law; Quinn Curtis is Albert Clark Tate, Jr., Professor of Law at the University of Virginia School of Law; and David H. Webber is Professor of Law at the Boston University School of Law. This post is based on their recent paper, forthcoming in the Southern California Law Review. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here).

Our new paper Shareholder Value(S): Index Fund ESG Activism and The New Millennial Corporate Governance forthcoming in the Southern California Law Review documents and explains the increasing role of large index fund managers in promoting ESG issues at major companies. While often viewed as quiet on key corporate governance issues, we show that these asset managers aggressively press companies to address ESG concerns, especially board diversity and—more recently—climate change. Notably, we show that to promote ESG goals the big three challenged management by withholding votes from directors in uncontested elections, a channel of index fund activism that has not been examined in the existing literature.

We argue that index fund activism on ESG issues is a result of asset managers being locked in competition for the assets of the millennial generation. Millennials, more than their forebearers, integrate social values into their economic decisions. BlackRock CEO Larry Fink has said “[T]he sentiments of these generations will drive not only their decisions as employees but also as investors, with the world undergoing the largest transfer of wealth in history: $24 trillion from baby boomers to millennials.” Given the commodification of index funds and the inability to compete on returns, signaling commitment to ESG values provides an important competitive dimension to index fund operators. We analyze how this largely overlooked dimension influences index funds’ incentives and provide supportive data. Given the potential negative implications of being seen to lag on social issues among a generation in which cancel culture is predominant, the stakes for asset managers are extremely high.

Large index funds and their associated complexes are now the most important shareholders in the largest companies in our economy. BlackRock, Vanguard, and State Street own 25 percent of the shares of all S&P 500 companies, and this share is growing. Scholars have questioned how committed these passive investors will be to ensuring effective corporate governance. Though index funds are long term investors, they lack returns-based incentives to intervene to improve firms, and asset managers of these large index funds who also sell retirement plan services to these very same companies, might jeopardize lucrative business opportunities by aggressively confronting management. While there is disagreement about whether these underpowered incentives should be a source of concern, there is little disagreement that index funds should not be expected to wield their considerable power to confront management.

When it comes to ESG issues, index funds are far from docile. With respect to these salient social issues, we show that the big three confront problematic boards publicly, vote against their directors, compete aggressively with each other by escalating their ESG policies, and demonstrate vocal leadership in thought and deed—activities that are sharply at odds with the conventional account of index fund passivity. Importantly, index fund activism on these issues is not just cheap talk, rather, they targeted problematic firms systematically, voted against their board members and generated notable effects. In 2017, for example, after State Street announced its objection to all-male boards in its portfolio firms, the index fund voted against 400 of the 476 firms in its portfolio that did not have any female directors. By the end of 2018, more than 300 of these firms added a female director. Accordingly, that in July 2019 the last all-male board in the S&P 500 added a woman to its ranks reflects the outspoken and confrontational efforts of the big three, and BlackRock and State Street in particular.

Why does index funds’ behavior on ESG issues bear so little resemblance to their “don’t rock the boat” approach to conventional corporate governance? We argue that, while index funds might fear management retaliation, a more potent concern is on the horizon: the looming millennial customer base. The soon-to-accumulate wealth of the millennial generation is the prize sought by asset managers across the economy. To win the millennial generation, index funds have turned their attention not simply to share price—the conventional marker of shareholder value—but to the social issues that millennial investors care about: shareholder values.

When it comes to investment preferences, millennials are markedly different than their predecessors. Market research unanimously concludes that, compared to prior generations, millennials are less interested in investment returns and more interested in their investments reflecting their social values. It is no surprise that index funds are out front in the race to demonstrate a commitment to millennial social values: with prices for index funds already cut to the bone, and investment performance an irrelevant consideration for index investors, index funds must seek out differentiation in the market where they can find it. Using their voting power to promote their investors’ social values, and doing so publicly and loudly, is a way for these funds, which otherwise risk becoming commodities, to give millennial investors a reason to choose them.

That index funds are chasing millennial wealth explains their aggressive, competitive approach to ESG issues. First, we argue, it is in the interest of index funds to not only respond to existing shareholder preferences for social values, but to find new issues that can be made salient and become first movers on those as well. Second and relatedly, we show that funds caught flat-footed tend to respond with more aggressive policies than funds that acted earlier. Thus, after State Street scored a global sensation with its Fearless Girl statue on Wall Street and announced that it would vote against directors of firms with no female directors, BlackRock announced that it would expect all boards to have a minimum of two female directors. And it did not end there—State Street followed with more stringent voting policies, and BlackRock then responded with an even more aggressive approach, voting against boards at firms with which they had not previously engaged. Third, while funds must still be wary of management backlash, the Article shows that investors’ preference for social values is a critical factor that will act as a counterweight to those forces. Eventually, managers—who face pressure on social issues not just from index fund shareholders, but from employees and customers as well—will have to respond.

The result of these forces is a phenomenon new to corporate law: The major shareholders of our largest companies are pushing those companies to embrace social and environmental values. While corporate scholars are acquainted with theories of the firm that ask managers to subordinate shareholder value to the interests of other constituencies under some circumstances, the consequences of a world in which shareholders themselves have strong preferences for social responsibility and are positioned to act on those preferences through the traditional levers of corporate power are less explored.

The complete paper is available for download here.

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