A Hard Look at Portfolio Primacy Theory As a Financial Rationale for SEC-Mandated ESG Disclosure

Amanda M. Rose is Professor of Law at Vanderbilt University Law. This post is based on her article forthcoming in the Columbia Business Law Review. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? (discussed on the Forum here) both by Lucian A. Bebchuk and Roberto Tallarita; Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; The Limits of Portfolio Primacy (discussed on the Forum here) by 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.

The Securities & Exchange Commission (“SEC”) is poised to adopt a controversial set of new disclosure mandates related to climate change, and pressure is on for the SEC to adopt additional ESG disclosure mandates. Given limitations on the scope of the SEC’s rulemaking authority, ESG disclosure advocates—which include many of the largest traditional asset managers—often argue that ESG disclosure mandates would serve the interests of purely financially motivated investors, and the SEC has explicitly justified its proposed climate-related disclosure mandates in terms of their financial significance to investors. Some allege that this is subterfuge, that in fact those calling for SEC-mandated ESG disclosures are motivated by a desire to promote other policy objectives, or to advance their own personal financial interests rather than those of investors. In my forthcoming article, A Hard Look at Portfolio Primacy Theory as a Financial Rationale for SEC-Mandated ESG Disclosure, I sidestep this heated, and increasingly partisan, question, and instead subject one popular financial argument for SEC-imposed ESG disclosure mandates to much-needed analytical rigor.

Financial arguments in favor of ESG disclosure mandates come in at least three different permutations. The first is traditional—ESG information would be important to a financially-motivated investor or prospective investor in the disclosing firm because the information is likely to significantly impact the disclosing firm’s future expected cash flows. To call this argument traditional does not, of course, answer whether it is convincing in application. Its strength as a justification for mandatory ESG disclosure will depend on, inter alia, the specific piece of ESG information at issue and the plausibility of the contention that such information is likely to be valuation relevant. The second argument is more novel. ESG information might be thought of in terms of its relation not only to firms’ future expected cash flows but also in relation to firms’ contribution to, or sensitivity to, systematic risk in the economy, in which case disclosure might improve the market’s understanding of the level of, and specific firms’ sensitivity to, systematic risk. Whether the SEC should be in the business of mandating disclosures designed to promote more accurate pricing of systematic risk is an interesting question. While the benefits of this sort of disclosure are easy to articulate, so too are the costs, particularly as it concerns placing meaningful boundaries on the SEC’s authority.

The third argument, which is the focus of my article, builds on a theory that has become popularized recently in both academic literature and in asset manager discourse. The theory, which has been referred to as “portfolio primacy theory,” proceeds from a clearly correct premise: financially motivated diversified investors want to maximize the risk-adjusted value of their portfolio as a whole and are not independently concerned with the performance of any given portfolio firm. In familiar economic terms, this means that such investors would, all else equal, want their portfolio firms to internalize the costs their activities impose on other portfolio firms, leading those firms to conduct business in a way that leads to Kaldor-Hicks efficient outcomes at the portfolio level. From this solid premise about the desired end of financially motivated diversified investors, portfolio primacy theory makes a contestable claim about the means by which such investors would wish to pursue it—namely, that they would want to use their influence as investors over portfolio firm managers to cause those managers to pursue portfolio value maximization, even at the expense of firm value maximization. Because the vast majority of diversified investors are passive investors in index funds, this translates into a claim that financially motivated diversified investors would want their index fund managers to wield their funds’ influence in this way. I refer to this as “portfolio-focused stewardship.”

The idea that financially motivated diversified investors would want their index fund managers to engage in portfolio-focused stewardship might justify a more expansive set of SEC disclosure mandates than would be called for if such investors preferred their fund managers to focus more narrowly on issues affecting individual firm value. For example, ESG disclosures about how a firm’s activities affect the broader economy might help index fund managers identify and, through stewardship, force the internalization of intraportfolio externalities. Such externalities would include, but are potentially much broader than, a portfolio firm’s contributions to unpriced systematic risk, distinguishing this argument from the second. There is another, more fundamental, distinction between this and the second argument: whereas the second assumes that investors will use the enhanced disclosures to inform their investment decisions, the third posits that index fund managers may use the enhanced disclosures to inform their stewardship decisions. It is the effect of portfolio-focused stewardship on the behavior of firms that may cause the risk-adjusted value of the portfolio as a whole to increase, not just the impact of the information on trading decisions that improve share price accuracy. Indeed, portfolio primacy theory presumes diversified investors whose portfolios are fixed and thus for whom “exit” is not an option.

In my forthcoming article, I argue that financially motivated diversified investors would prefer the path of portfolio-focused stewardship as a way to limit intraportfolio externalities, and thus enhance risk-adjusted portfolio value, only if two conditions were satisfied. First, the benefits of that path must be expected to exceed the costs—that is, net of fees and other costs, it must be expected that such stewardship would in fact lead to an increase in risk-adjusted portfolio value. Second, the expected net benefits of such stewardship must exceed the expected net benefits of pursuing alternative methods available to diversified investors for causing portfolio firms to internalize intraportfolio externalities, such as advocacy for legal change, unless the alternative(s) and the stewardship together would be expected to produce more net benefits than the alternative(s) alone. The article carefully interrogates the likelihood that each condition is met.

The analysis produces a set of criteria for evaluating specific stewardship interventions, and it leads to some general conclusions about the types of portfolio-focused stewardship interventions that rational, financially motivated diversified investors would—and would not—be likely to support. The analysis suggests that these investors would not generally support portfolio-focused stewardship interventions by index fund managers designed to directly regulate portfolio companies’ externalizing activities (“command and control regulation”), but that under certain conditions they might support stewardship interventions that force portfolio companies to disclose information about intraportfolio externalities (“disclosure regulation”). Importantly, disclosure regulation would not be supported because it would assist index fund managers in crafting future command-and-control style portfolio-focused stewardship interventions (which, again, is something financially motivated diversified investors would generally want their index fund managers to avoid), but rather because it might prod other actors (including, e.g., non-index investors, consumers, labor and environmental organizations, regulators, legislators) to take actions that would lead portfolio firms to internalize their intraportfolio externalities.

By identifying the narrow band of portfolio-focused stewardship interventions that financially motivated diversified investors might rationally support, the article offers guidance to index fund managers seeking to fulfill their fiduciary duties to fund investors. It also has significant implications for the contemporary debate over SEC-imposed ESG disclosure mandates. The idea that disclosure of ESG information—if made more consistent and credible through SEC mandates—would assist index fund managers in future portfolio-focused stewardship efforts seems consistent with the materiality standard set forth by the Supreme Court in TSC Industries, Inc. v. Northway Inc. That case provides that information is material if there is “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” 426 U.S. 438, 449 (1976). But my analysis suggests that financially motivated diversified investors would not rationally want their index fund managers to use the information in this way. Instead, they would view the information as potentially valuable only insofar as it might catalyze other actors to take actions that would result in portfolio firms’ internalization of intraportoflio externalities.

To the extent such mandates were expected to catalyze more informed trading by financially-motivated non-index investors, portfolio primacy theory would add nothing to the first two financial arguments for SEC-imposed ESG disclosure mandates discussed above. The upshot is that portfolio primacy theory potentially provides an independent financial justification for SEC-imposed ESG disclosure mandates only if the SEC may mandate disclosures designed for consumption by audiences other than financially motivated investors (assuming those audiences are expected to respond in ways that may lead to an increase in the risk-adjusted value of a diversified portfolio). This is a novel and expansive understanding of the SEC’s regulatory authority, one many—including the Court of Appeals for the D.C. Circuit—are likely to reject.

The complete paper is available for download here.

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