The Agency Costs of Sustainable Capitalism

The Agency Costs of Sustainable Capitalism 55(2) UC Davis Law Review 875-954 (2021) Presented by: Anna Christie (Assistant Professor of Banking, Corporate & Financial Law Edinburgh Law School) Date: April 4, 2022 Summary of Paper Problems: 1. Big Three asset managers - assuming role of sustainable capitalists 2. New agency costs theory of sustainable capitalism a. Rational Reticence b. Rational Hypocrisy 3. The agency costs of sustainable capitalism Solutions: 1. Activist Hedge Funds as ESG arbitrageurs - Mitigating problem of rational reticence - Appealing to the sustainable capitalism of Big Three - Nominating climate directors to corporate boards  Activist hedge funds have significant expertise in nominating board members  Big Three have shown willingness to support board changes 2. Responsible Activists - Portfolio-wide ESG issues - shareholder proposals - Target activism at Big Three themselves The Passive Index Investing Revolution Corporation (by market value) ExxonMobil Corp Chevron Corp ConocoPhillips Marathon Petroleum Corp Occidental Petroleum Corp Hess Corp Devon Energy Corp Apache Corp BlackRock Percentage of Stock Held Vanguard State Street 6.71% 8.43% 5.17% Big Three collectively 20.31% 6.98% 8.05% 11.27% 8.50% 8.41% 9.95% 6.35% 5.12% 5.77% 21.83% 21.58% 26.99% 5.97% 9.97% 5.46% 21.22% 6.77% 6.69% 10.02% 9.86% 5.10% 6.30% 21.89% 22.85% 6.08% 8.90% 5.72% 20.70% From Agency Capitalism to Sustainable Capitalism Agency Capitalism  Institutional Investors (e.g. Active Mutual Funds & Pension Funds)  Rational Reticence - Will only respond to proposals of others rather than pursue an activist monitoring role themselves  Solution: - Activist Hedge Funds- "governance arbitrageurs" Sustainable Capitalism  (Big Three) Asset Managers (diversified index investors & ESG funds)  Rational Reticence + Rational Hypocrisy  Solution? - ESG Hedge Funds? - Responsible Activists? Rational Reticence: - Portfolio-wide initiatives (less pronounced)  - c.f. board gender diversity Firm-specific monitoring (more pronounced) Rational Hypocrisy: - Discrepancies between public statements on climate and actions in practice Solutions? - ESG Hedge Funds? - Responsible Activists? Activist Hedge Funds 1. Swarms of locusts 2. Preying on corporations 3. Hit and run activists 4. A disease that affects American business Activist Hedge Funds As Governance Arbitrageurs Activism 1.0 - Financial engineering / balance sheet activism - E.g. increasing leverage, returning cash to shareholders Activism 2.0 - Activist Directors - Long-term strategic & operational plans - Filling gap left by lack of firm-specific monitoring by institutional investors Activism 3.0? ESG Hedge Funds - First boardroom battle to focus on climate change - Engine No. 1 successfully replaced ¼ of Exxon's board Exxon / Engine No. 1 - Tiny new hedge fund – 0.02% - Proxy contests are expensive – cost Engine No. 1 $30 million (with a $50 million stake) - Support from other shareholders  - Pension funds: CalPERS, CalSTRS, NY State Common Retirement Fund Big Three asset managers – over 20% of shares ESG Hedge Funds as ESG Arbitrageurs Mitigating the Agency Costs of Sustainable Capitalism? 1. Environmental and social campaigns can parallel the types of campaigns in Activism 2.0 2. Activist hedge funds can nominate specialist directors to corporate boards Activist Strategies – Climate Directors - Portfolio-wide -v- firm specific - Nominating climate focused or specialist energy transition directors to corporate boards  Proxy contests or settlements Other Responsible Activists Role as ESG arbitrageurs in the sustainable capitalism framework? 1. Mainly address portfolio-wide ESG issues 2. Propose fairly standardized shareholder proposals 3. May mitigate portfolio-wide rational reticence 4. But overlap with Big Three engagement Rational Hypocrisy - May require a different approach - Activism targeted at the Big Three themselves