Yearly Archives: 2022

On Index Investing

Posted by Jeffrey Coles, Davidson Heath, and Matthew Ringgenberg (University of Utah), on
Monday, August 15, 2022
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Jeffrey Coles is the Samuel S. Stewart, Jr. Presidential Chair in Business, David Eccles Chair, and Professor of Finance; Davidson Heath is an Assistant Professor of Finance; and Matthew Ringgenberg is an Associate Professor of Finance, all at the University of Utah David Eccles School of Business. This post is based on their recent paper, forthcoming in the Journal of Financial Economics.

Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen, and Scott Hirst; Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy (discussed on the forum here) and The Specter of the Giant Three (discussed on the Forum here), both by Lucian Bebchuk and Scott Hirst; and The Limits of Portfolio Primacy (discussed on the Forum here) by Roberto Tallarita.

The last two decades have seen a dramatic increase in the amount of capital invested in passive index funds. While these funds help investors earn benchmark index returns for relatively low fees, the increase in passive investing is not without controversy. Passive investors, by definition, hold portfolios that simply track an index. As a result, they do not do research—they free-ride on the research and analysis of active investors. This leads to a tension: Not everyone can index, some investors must be active for prices to incorporate information. The question is, does the rise of passive investing change information production in the economy? If so, how does passive investing affect informational efficiency, that is, the link between stock prices and fundamental value?

In our paper On Index Investing (Journal of Financial Economics, 2022), we examine these questions, both theoretically and empirically. We first develop a model that is a simple extension of the classic Grossman-Stiglitz (1980) model of information acquisition by investors. We then test the model’s predictions using Russell index reconstitutions as a shock to the mix of passive and active investors. Our findings suggest that passive investing does reduce information production, but perhaps surprisingly, it does not harm informational efficiency.

Existing theories disagree on the relation between investor composition and market efficiency. Some models predict that the rise of passive investing does alter price efficiency. For example, as passive funds replace active funds, there are fewer active funds doing research which could make prices less efficient.

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PE Firms Poised for Diversity Drive

Posted by Kem Ihenacho, Clare Scott, and Anne Mainwaring, Latham & Watkins LLP, on
Monday, August 15, 2022
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Kem Ihenacho is partner, Clare Scott is counsel, and Anne Mainwaring is an associate at Latham & Watkins LLP. This post is based on a Latham memorandum by Mr. Ihenacho, Ms. Scott, Ms. Mainwaring, Catherine Campbell, and Jennifer Cadet.

Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite (discussed on the Forum here) by Alma Cohen, Moshe Hazan, and David Weiss; Will Nasdaq’s Diversity Rules Harm Investors? (discussed on the Forum here) by Jesse M. Fried; and Duty and Diversity (discussed on the Forum here) by Chris Brummer and Leo E. Strine, Jr.

Diversity has become a key focus for every industry in recent years, and private equity, like many other parts of the financial sector, still has significant progress to make in terms of diversity and inclusion. Private equity lags behind others in the financial services industry across a range of diversity metrics—according to a report published by EY in December 2021, just 10% of private equity roles are held by women.

Amid a drive to boost diversity across the industry, PE funds are becoming more diversity focused in Europe, as investors and regulators demand change and sponsors seek a competitive advantage through diversity strategies.

LP focus

LPs are placing greater emphasis on diversity at GP manager and portfolio company level, and are asking for more information on diversity, equity, and inclusion (DEI) metrics. According to Private Equity International’s LP Perspectives 2022 survey, one in five LPs refused to invest in a PE firm due to the lack of diversity at GP level.

As PE firms strive to make progress, diversity-focused funds are now coming to market with specific mandates to select investments based on diversity criteria. Diversity criteria may be considered at both GP and portfolio level, for example, by setting minimum requirements for diversity of key people or carry recipients, or diversity of “C-Suite Executives” in portfolio companies.

Regulatory focus

EU regulation is placing greater emphasis on DEI, demonstrating growing appetite for change. For example, the EU’s Sustainable Finance Disclosure Regulation (SFDR) regime (which depending on structure, GPs are likely to be subject to, if based in Europe or marketing into Europe) requires consideration of metrics on board gender diversity and unadjusted gender pay gap in certain circumstances, including where investments are intended to meet the definition of “sustainable investments” under SFDR.

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What CEOs Must Consider When Wading Into Politics and Policy Discussions

Posted by Christine DiBartolo, Jackson Dunn, and Brent McGoldrick, FTI Consulting, on
Sunday, August 14, 2022
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Christine DiBartolo, Jackson Dunn, and Brent McGoldrick are Senior Managing Directors at FTI Consulting. This post is based on an FTI memorandum by Ms. DiBartolo, Mr. Dunn, Mr. McGoldrick, Elly DiLeonardi, Greg Mecher and Lindsay Kunkle.

Related research from the Program on Corporate Governance includes Corporate Political Speech: Who Decides? (discussed on the Forum here) by Lucian Bebchuk and Robert J. Jackson Jr.; The Untenable Case for Keeping Investors in the Dark (discussed on the Forum here) by Lucian Bebchuk, Robert J. Jackson Jr., James David Nelson, and Roberto Tallarita; and The Politics of CEOs (discussed on the Forum here) by Alma Cohen, Moshe Hazan, Roberto Tallarita, and David Weiss.

Increasingly, Americans are turning to the private sector for leadership as the boundaries between the political, social, and business arenas blur. Viewed in the best light, this is a search for value-based leadership. At worst, the forces of polarization have now crept into companies, which makes it particularly challenging for CEOs to determine how to engage on issues—particularly ones that can be seen as political—without creating new business risks.

In this post, we use our research of two of a company’s most important stakeholders—professionals and investors—to explore what CEOs must consider when wading into politics and policy discussions.

Demands on CEOs are being driven by the belief that businesses can influence the United States’ future

Investors and professionals see large businesses having real impact. In fact, they are perceived to have influence on the future of the country equal to—or even exceeding that of—federal, state and local government. This sentiment goes one step further in current times.

Investors and professionals look to businesses to partner with the government to help manage and overcome crises and major social change. CEOs are expected by stakeholders to take their responsibility to the country, not just their business, seriously.

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Should Your Company Go Private?

Posted by Mandy Wright, Directorship, on
Sunday, August 14, 2022
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Mandy Wright is senior editor of Directorship magazine. This post is based on an NACD BoardTalk publication.

Twenty-six public companies have gone private this year as of mid-May, totaling more than $121 billion in value. Compare that to 47 companies that did the same in all of 2021, the highest number of such deals in more than a decade, according to Dealogic.

Dry powder is partially fueling these transactions as private equity firms compete to buy the best companies at the best prices, pushing them to look at the public markets for inspiration. In an environment of volatile stock prices, now at lows not seen for almost a year and a half, public companies are looking like especially attractive—and cheaper—bets. On the flip side, public companies have found it less and less appealing to be public, with more stringent regulatory compliance and listing requirements. This also includes a responsibility to shareholders that, to some companies, inhibits research and development as well as risk-taking for the sake of innovation.

Going private is a growing a trend, and one that more boards might wish to evaluate. For public company boards helping their organizations consider going private, below are the three main steps.

Assess the Opportunity

With many workers back in the office and life returning to a semblance of normalcy—whether or not COVID-19 has actually made its retreat—this pandemic era presents transformational opportunities for companies and entire industries to rethink how they should do business going forward, taking into consideration all that has been learned about stakeholder wants, employee needs, and consumer habits during the pandemic.

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Statement by Chair Gensler on PCAOB Amendments to Strengthen Auditing Standards for Audits Involving Multiple Firms

Posted by Gary Gensler, U.S. Securities and Exchange Commission, on
Saturday, August 13, 2022
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Gary Gensler is Chair of the U.S. Securities and Exchange Commission. This post is based on his recent public statement. The views expressed in this post are those of Chair Gensler, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

Today, the Commission approved the Public Company Accounting Oversight Board’s (PCAOB) updated standards for audits that involve multiple auditing firms. I was pleased to support the amended standards because they will strengthen the requirements for lead auditors who supervise other auditors in an audit, helping to enhance audit quality and protect investors.

Over the years, the growing complexity and international operations of public companies has led auditors increasingly to rely on other auditors — working across different firms, countries, and even languages — in completing an audit. Last year, for example, 26 percent of all issuer audit engagements used multiple auditors, and more than half of large accelerated filer audits used multiple auditors.[1] Given the challenges that such multi-firm audits present, it is important that there be robust standards for how lead auditors supervise, communicate with, and coordinate with other auditors on the audit engagement.

The PCAOB’s updated standards make enhancements across two broad areas.[2] First, the amended standards specify certain procedures for lead auditors to perform when supervising other auditors. Second, they require lead auditors to prioritize their supervisory activities around higher-risk areas in the audit.

I thank the PCAOB for their work to update this auditing standard, the first adopted since the Board was newly constituted. I look forward to the additional standard-setting work the PCAOB will undertake to live up to its founding vision under the Sarbanes-Oxley Act. If Sarbanes-Oxley, signed into law 20 years ago, meets its full potential, trust in our markets can grow — and that benefits investors and issuers alike.

Endnotes

1See PCAOB Release No. 2022-002, available at https://pcaob-assets.azureedge.net/pcaob-dev/docs/default-source/rulemaking/docket042/pcaob-other-auditors-adopting-release-6-21-2022.pdf?sfvrsn=c3712668_2.(go back)

2See “PCAOB Adopts New Requirements for Lead Auditor’s Use of Other Auditors” (June 21, 2022), available at https://pcaobus.org/news-events/news-releases/news-release-detail/pcaob-adopts-new-requirements-for-lead-auditor-s-use-of-other-auditors.(go back)

Climate Disclosures: Not Quite as Easy as (Scope) 1-2-3

Posted by Lindsey Stewart, Morningstar, Inc., on
Friday, August 12, 2022
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Lindsey Stewart is Director of Investment Stewardship Research at Morningstar, Inc. This post is based on a Morningstar memorandum by Mr. Stewart and Hortense Bioy. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here), both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.

Executive Summary

Public policy advocacy is an important part of an asset manager’s active ownership strategy. Asset managers recently had a key opportunity to influence U.S. climate policy as the SEC invited comments on its proposed rule for corporate disclosures of climate-related information. Climate-related risks have increasingly become important for many companies within various industries and, as such, disclosures in this area are financially material and a key aspect of investor decision-making—a point emphasized in Morningstar’s own response to the SEC. Asset managers that have committed to addressing the climate crisis should be keen to engage with regulators like the SEC in setting guidelines for corporate disclosures on climate change, and they largely have been.

In this post, we analyze the responses of the 10 largest U.S. asset managers, including Vanguard, BlackRock, Fidelity Investments, Capital Group, State Street Global Advisors, T. Rowe Price, Invesco, JPMorgan, Dimensional, and Franklin Templeton. As our research shows, almost all of these 10 managers have engaged directly with the SEC on the proposed rule. They are generally supportive of the SEC’s efforts to mandate consistent disclosure from companies on climate risks, but they also have significant concerns in several important areas.

Key Takeaways

  • Eight out of the top 10 U.S. asset managers have responded to the SEC’s March 2022 call for comment on its proposed rule. The two exceptions are Invesco and JPMorgan.
  • Seven of the eight respondents favor mandatory climate change disclosures by all public companies. One manager, Dimensional, supports the disclosures only for public companies exposed to material climate risk.
  • All eight respondents agree on the need for mandatory disclosures of direct greenhouse gas emissions (Scope 1) and indirect greenhouse gas emissions from purchased electricity (Scope 2), where these are material.
  • Only one manager, Capital Group, favors mandatory disclosures of other indirect greenhouse gas emissions (Scope 3) at this time. The others are opposed to making such disclosures mandatory, citing a lack of maturity in measurement methods and an absence of materiality for many companies.
  • Most respondents’ support for the proposals is contingent on how materiality is defined. This is a key area of concern for most managers, who believe the SEC should clarify the definition in the proposals.
  • All respondents believe the SEC’s actions on climate disclosure should align with internationally accepted standards, particularly the Taskforce for Climate-Related Disclosures, and the emerging International Sustainability Standards Board.

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CSOs Have More Impact When Aligned To The CEO

Posted by Kurt Harrison, Sarah Galloway, and Emily Meneer, Russell Reynolds Associates, on
Friday, August 12, 2022
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Kurt Harrison and Sarah Galloway are co-head of the Global Sustainability Practice, and Emily Meneer is a Global Knowledge Leader at Russell Reynolds Associates. This post is based on their Russell Reynolds memorandum.

Businesses are more likely to hit organizational ESG targets when their sustainability leader reports directly to a CEO with a demonstrated commitment to sustainability.

Many organizations find it challenging to know where to start when adding a new Chief Sustainability Officer (CSO) role. Our recommendation is to provide them with a direct line to the CEO.

Russell Reynolds Associates’ (RRA) 2022 survey of more than 50 global sustainability leaders found that when CSOs report directly to the CEO, they are more likely to say their company is on track to hit organizational ESG targets than those who report to other business leaders.

In fact, the survey showed reporting structure is the primary differentiator of an organization’s likelihood to meet their ESG targets. Other factors, such as P&L ownership, company tenure, or past sustainability experience are far less indicative of sustainability performance.

CSOs who report to CEOs are 50% more likely to say their company is on track to meet their ESG targets than those at organizations with other reporting structures.

The rise of the “Empowered CSO”

Our analysis shows that just 34% of CSOs report to the CEO today. The vast majority report to other C-level executives or management below.

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Weekly Roundup: August 5 – 11, 2022

Posted by the Harvard Law School Forum on Corporate Governance, on
Friday, August 12, 2022

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This roundup contains a collection of the posts published on the Forum during the week of August 5 – 11, 2022.

Chancery Decision Expands the Court’s Approaches on Director Independence

Posted by Gail Weinstein, Steven J. Steinman, and Brian T. Mangino, Frank, Harris, Shriver & Jacobson LLP, on Friday, August 5, 2022
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SEC Expects to Issue Final Clawback Regulations by October ’22

Posted by Mike Kesner and John Ellerman, Pay Governance LLC, on Friday, August 5, 2022
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Amendments to Form 13F

Posted by Stephen P. Wink and Naim Culhaci, Latham & Watkins LLP, on Saturday, August 6, 2022
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Back to Basics: Board Committees

Posted by Natalie Cooper and Robert Lamm (Deloitte LLP), and Randi Val Morrison (Society for Corporate Governance), on Saturday, August 6, 2022
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SEC Proposes Narrowing Grounds for Excluding Shareholder Proposals

Posted by Richard Alsop, Harald Halbhuber, and Lona Nallengara, Shearman & Sterling LLP, on Sunday, August 7, 2022
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SEC Reverses Aspects of Proxy Voting Advice Regulations

Posted by Marc Treviño and Bob Downes, Sullivan & Cromwell LLP, on Monday, August 8, 2022
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Does ESG Negative Screening Work?

Posted by Robert Eccles (Oxford University), Shivaram Rajgopal (Columbia University), and Jing Xie (Hong Kong Polytechnic University), on Monday, August 8, 2022
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Welcoming the Universal Proxy

Posted by Kai Liekefett, Derek Zaba, and Leonard Wood, Sidley Austin LLP, on Monday, August 8, 2022
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Emerging Fraud Risks to Consider: ESG

Posted by Michael Brodsky and Amy Edwards, Deloitte, on Tuesday, August 9, 2022
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Hidden Gems: Do Compensation Disclosures Reveal Performance Expectations?

Posted by C. Edward Fee (Tulane University), Zhi Li (Chapman University), and Qiyuan Peng (University of Dayton), on Tuesday, August 9, 2022
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Delaware and Caremark: An Update

Posted by Theodore N. Mirvis, David A. Katz, and Sabastian V. Niles, Wachtell, Lipton, Rosen & Katz, on Tuesday, August 9, 2022
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Second Circuit on Stating a Claim for Scheme Liability

Posted by Israel David, Samuel P. Groner, and Harrison D. Polans, Fried, Frank, Harris, Shriver & Jacobson LLP, on Wednesday, August 10, 2022
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The Market for CEOs: Evidence from Private Equity

Posted by Paul A. Gompers (Harvard Business School), Steven N. Kaplan (University of Chicago), and Vladimir Mukharlyamov (Georgetown University), on Wednesday, August 10, 2022
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Twitter v. Musk: Plaintiff’s Response to Defendant’s Counterclaim

Posted by Anna Restuccia (Harvard Law School), on Wednesday, August 10, 2022
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Proposed Amendments to the Shareholder Proposal Rules

Posted by Marc S. Gerber, Richard J. Grossman, and Raquel Fox, Skadden, Arps, Slate, Meagher & Flom LLP, on Thursday, August 11, 2022
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Statement by Commissioner Uyeda on Proposed Joint Amendments to Form PF

Posted by Mark T. Uyeda, U.S. Securities and Exchange Commission, on Thursday, August 11, 2022
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Statement by Chair Gensler on Proposed Joint Amendments to Form PF

Posted by Gary Gensler, U.S. Securities and Exchange Commission, on Thursday, August 11, 2022
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Statement by Chair Gensler on Proposed Joint Amendments to Form PF

Posted by Gary Gensler, U.S. Securities and Exchange Commission, on
Thursday, August 11, 2022
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Gary Gensler is Chair of the U.S. Securities and Exchange Commission. This post is based on his recent public statement. The views expressed in the post are those of Chair Gensler, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

Today [Aug. 10, 2022], the Commission is considering whether to propose joint amendments with the Commodity Futures Trading Commission (CFTC) to Form PF, an important reporting tool that the Commission and the Financial Stability Oversight Council (FSOC) use, respectively, to protect investors and monitor systemic risk. I am pleased to support the proposal because, if adopted, it would improve the quality of the information we receive from all Form PF filers, with a particular focus on large hedge fund advisers.

In response to the 2008 financial crisis, Congress mandated the SEC and CFTC (the Commissions) to establish, after consultation with FSOC, reporting requirements for advisers to private funds. Congress felt it was necessary for there to be greater transparency for regulators into this field, which led the Commissions to adopt Form PF.

I had the privilege to serve as Chair of the CFTC when the Commissions jointly first adopted Form PF in 2011. As I said at the time, “With this final rule, regulators will gain transparency into an important sector of the financial marketplace to better assess risk to the overall system.” [1]

In the decade since, regulators have gained vital insight with respect to private funds through Form PF. Since then, though, the private fund industry has grown in gross asset value by nearly 150 percent and evolved in terms of its business practices, complexity, and investment strategies. [2] In response to the Commission’s years of experience with Form PF and the evolving private funds landscape, I asked the staff to recommend amendments to Form PF. We have considered these recommendations in two separate proposals.

In January 2022, the Commission proposed amendments to the SEC-only sections of Form PF. That proposal would, among other things, require certain advisers to hedge funds and private equity funds to provide current reporting of key events, and enhance reporting requirements for large private equity and large liquidity fund advisers.

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Statement by Commissioner Uyeda on Proposed Joint Amendments to Form PF

Posted by Mark T. Uyeda, U.S. Securities and Exchange Commission, on
Thursday, August 11, 2022
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Mark T. Uyeda is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on his recent public statement. The views expressed in the post are those of Commissioner Uyeda, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

Thank you, Chair Gensler. Who benefits from investments in private funds and alternative investments? In many cases, they are the pensioners in a retirement plan or a university student who benefits from an endowment. In other words, Americans of all types benefit from a robust market for private funds that is diverse and provides sophisticated institutional investors and their advisers with choices to address different risk tolerances, investment strategies, and time horizons.

Since the enactment of the Dodd-Frank Act, advisers to private funds have been required to file Form PF, [1] which was adopted in 2011 and amended in 2014. As the title of Section 404 of that Act indicates, the requirement was to facilitate the “Collection of Systemic Risk Data.” [2] Yet today’s proposed amendments to Form PF, which come on the heels of an existing proposal to amend Form PF issued earlier this year [3] — would impose additional and more granular disclosures, with effects that could potentially reshape an industry that is already dominated by large fund advisers [4]

Form PF is intended to assist the Financial Stability Oversight Council (FSOC) in assessing systemic risk in the U.S. financial system. [5] When we consider a rulemaking proposal, one of the key steps is to identify the need for the rulemaking and explain how the proposed rule will meet that need. [6] Although the 303 page draft release, encompassing 103,223 words, sent to the Commissioners on Monday evening references “systemic risk” a total of 118 times, plus two additional references to “system risk,” the release largely does not describe or define what is meant by that term. [7] Merely stating over and over that the proposed amendments will help to monitor and assess systemic risk and provide additional information does not make it so. This shortcoming makes it difficult to evaluate the appropriateness of the proposed disclosures.

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