Ruminations 39: Responsible Investing And Market Behavior Beyond Principles and GAAP

Responsible investment is an important element of efforts to influence corporate behavior through assertions of consumer and shareholder power.  Responsible investing accepts the foundational framework of corporate organization--corporations are entities that must be run to maximize the welfare of the institution and its shareholders, for whom corporate interest represent property, the value of which they may maximize in accordance with their own interests.  But those interests may reflect values other than mere short term wealth maximization counted solely in money terms.   See Larry Catá Backer,  Values Economics and Theology: The Contribution of Catholic Social Thought and its Implications for Legal Regulatory Systems, 5(2) Economics, Management, and Financial Markets 17-56 (2010).  

(Pix from UNFCU, Spotlight UN PRI Movement ("Responsible investments by design build portfolios and investment products where certain securities are screened out or into an account based on specific criteria. Social investing works to achieve competitive returns in assets that also have a strong social aspect that appeals to a wide range of participants. To this end, UN PRI actively engages companies on environmental and social issues beyond classic corporate governance issues like board independence."))

But one wonders whether the development of an institutional structure for responsible investing by funds is invariably hobbled by its focus only on the disclosure and monitoring aspects problem of substantive based investment from the perspective of the investing entity.

Responsible investing (sometimes socially responsible investing) has a governance aspect.  As initiatives of NGOs  SRI has become a means of providing a framework for articulating a set of objectives grounded in values other than mere short term wealth maximization, sometimes understood as environmental social governance (ESG) issues. The international community has also been developing its own approaches to responsible investing, as part of a broader project of developing a framework for corporate governance and substantive values in economic behavior.  The U.N.'s six principles of responsible investing is one well known effort. These principles include:

1 We will incorporate ESG issues into investment analysis and decision-making processes.
Possible actions:
-Address ESG issues in investment policy statements
-Support development of ESG-related tools, metrics, and analyses
-Assess the capabilities of internal investment managers to incorporate ESG issues
-Assess the capabilities of external investment managers to incorporate ESG issues
-Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis
-Encourage academic and other research on this theme
-Advocate ESG training for investment professionals

2 We will be active owners and incorporate ESG issues into our ownership policies and practices.
Possible actions:
-Develop and disclose an active ownership policy consistent with the Principles
-Exercise voting rights or monitor compliance with voting policy (if outsourced)
-Develop an engagement capability (either directly or through outsourcing)
-Participate in the development of policy, regulation, and standard setting (such as promoting and protecting shareholder rights)
-File shareholder resolutions consistent with long-term ESG considerations
-Engage with companies on ESG issues
-Participate in collaborative engagement initiatives
-Ask investment managers to undertake and report on ESG-related engagement

3 We will seek appropriate disclosure on ESG issues by the entities in which we invest.
Possible actions:
-Ask for standardised reporting on ESG issues (using tools such as the Global Reporting Initiative)
-Ask for ESG issues to be integrated within annual financial reports
-Ask for information from companies regarding adoption of/adherence to relevant norms, standards, codes of conduct or international initiatives (such as the UN Global Compact)
-Support shareholder initiatives and resolutions promoting ESG disclosure

4 We will promote acceptance and implementation of the Principles within the investment industry.
Possible actions:
-Include Principles-related requirements in requests for proposals (RFPs)
-Align investment mandates, monitoring procedures, performance indicators and incentive structures accordingly (for example, ensure investment management processes reflect long-term time horizons when appropriate)
-Communicate ESG expectations to investment service providers
-Revisit relationships with service providers that fail to meet ESG expectations
-Support the development of tools for benchmarking ESG integration
-Support regulatory or policy developments that enable implementation of the Principles

 5 We will work together to enhance our effectiveness in implementing the Principles.

Possible actions:

-Support/participate in networks and information platforms to share tools, pool resources, and make use of investor reporting as a source of learning
-Collectively address relevant emerging issues
-Develop or support appropriate collaborative initiatives

6 We will each report on our activities and progress towards implementing the Principles.
Possible actions:
-Disclose how ESG issues are integrated within investment practices
-Disclose active ownership activities (voting, engagement, and/or policy dialogue)
-Disclose what is required from service providers in relation to the Principles
-Communicate with beneficiaries about ESG issues and the Principles
-Report on progress and/or achievements relating to the Principles using a 'Comply or Explain' approach
-Seek to determine the impact of the Principles
-Make use of reporting to raise awareness among a broader group of stakeholders (PRI, The Principles for Investment).

 The UN PRI is meant to provide context for incorporating ESG issues in investing (outside) as well as governance (inside) actions by stakeholders.

The United Nations-backed Principles for Responsible Investment Initiative (PRI) is a network of international investors working together to put the six Principles for Responsible Investment into practice.

The Principles were devised by the investment community. They reflect the view that environmental, social and corporate governance (ESG) issues can affect the performance of investment portfolios and therefore must be given appropriate consideration by investors if they are to fulfil their fiduciary (or equivalent) duty. The Principles provide a voluntary framework by which all investors can incorporate ESG issues into their decision-making and ownership practices and so better align their objectives with those of society at large.

The PRI Initiative was created after the launch of the Principles to help investors to implement the Principles. The Initiative is managed by the PRI Secretariat and supports investors by sharing best practice, facilitating collaboration and managing a variety of work streams. The Initiative is incorporated as a not-for-profit company limited by guarantee. The Initiative is funded by an annual subscription fee introduced for all signatories. This fee is on a sliding scale according to the relative size of the investor and their signatory type. (Principles for Responsible Investing Initiative, About Us).

The Forum for Sustainable and Responsible Investment tells us in its last report (2010 Report on Socially Responsible Investing Trends in the United States, Click here for executive summary) :  "Sustainable and socially responsible investing (SRI) in the United States has continued to grow at a faster pace than the broader universe of conventional investment assets under professional management."  (Executive Summary at 8). It points to the major drivers in socially responsible investment, this NGO suggests include:

• Money managers are increasingly incorporating ESG factors into their investment analysis, decision making and portfolio construction, awakening to the demand for ESG investing products and services from institutional and individual investors. Of the managers that responded to survey questions on their reasons for incorporating ESG criteria into investment management, more (85 percent) cited client demand than any other reason.
• Institutions—particularly public funds—are incorporating ESG criteria in part because of legislative
mandates. Among the institutions that responded to survey questions about why they incorporated ESG factors into their investments, more (52 percent) cited regulation or legislation than any other reason.
• Increasing numbers of institutional investors and money managers are addressing the crisis in the Sudan, whether through targeted divestment or active engagement with companies exposed to the risks of doing business in such a volatile, repressive regime. Indeed, Sudan-related investment policies have displaced tobacco as the most prevalent ESG criteria incorporated into investment management, affecting more than $1.3 trillion in institutional assets and nearly $450 billion across all investment vehicles included in the money manager phase of research.
• New products and fund styles are driving growth in ESG investment vehicles, especially among ETFs and alternative investment funds such as social venture capital, double- and triple-bottom-line private equity and responsible property funds.
• Environmentally themed investment products and services are rapidly emerging to meet growing investor desire to manage environmental risks and seize opportunities in clean and green technology, alternative and renewable energy, green building and responsible property development, and other environmentally driven businesses.
• Regulatory developments as well as the rise of various investor services have encouraged investors to take a more thoughtful approach to proxy voting. It is no longer uncommon for shareholder proposals on governance issues to receive majority support, or for shareholder proposals on social and environmental proposals to win the support of 30 percent or more of the shares voted.
• Several legislative and regulatory developments in 2009 and 2010 have set higher standards for corporate disclosure on ESG issues and could help make corporate managements and boards more accountable to shareholders and other stakeholders.
• A growing number of institutional investors and money managers are joining investor networks not only to coordinate their work on shareholder resolutions but also to advance their shareholder advocacy through public statements and other policy initiatives.
• The growth in community investing—as measured by the assets of community development depository institutions—has been fueled in large part by consumer demand. Community banks have grown rapidly by meeting the pent-up demand of communities previously underserved by mainstream banks. Community development credit unions have benefited from increased membership, assets and deposits from consumers dissatisfied with mainstream banks that had raised fees or cut back on credit when the recent US recession unfolded.
• A second factor in community investing institutions’ asset growth has been the capital they have received as US Treasury programs stepped up assistance to community development financial institutions in 2009 as part of economic stimulus and recovery programs.
• In addition, a number of campaigns, touting such concepts as “program-related investing” and “impact investing” have helped to increase awareness among foundations, other institutional investors and high-net-worth individuals of the high social impact associated with community investing strategies. (Executive Summary 10-11).

But is it possible that responsible investing is inevitably hobbled by its focus on the investing entity and not on the owners of the funds invested? Beyond the structuring of the obligations of investment managers there is little that touches on the relationships between the investment fund managers and the owners of those funds.    Thus, PRI speaks of  the design of the Principles

to be compatible with the investment styles of large, and often diversified, institutional investors that operate within a traditional fiduciary framework. The Principles apply across the whole investment business and are not designed to be relevant only to SRI products. However, the Principles do point to a number of approaches – such as active ownership and the integration of ESG issues into investment analysis – that SRI and many corporate governance fund managers also practise. (UN PRI, FAQs)

And UN PRI is careful to remind managers of the limits of SRI in the overarching fiduciary obligations of fund managers--to maximize the return of fund investors.  "The Principles are based on the premise that ESG issues can affect investment performance and that the appropriate consideration of these issues is part of delivering superior risk-adjusted returns and is therefore firmly within the bounds of investors’ fiduciary duties. The Principles clearly state they are to be applied only in ways that are consistent with those duties." (Ibid).

Thus, with respect to fund owners, the SRI obligations of fund managers practicing socially responsible investing can be reduced to transparency. Fund managers have gotten good at disclosing their history of investment and divestment.  They are also good at articulating the standards used to frame SRI based investment decisions.  All of this is done in the aggregate. One can understand this part of SRI as "what they said."

But fund managers do less well in another respect--beyond disclosure investors may find it harder to know how companies engaged with disclosed economic effect.  One can understand this as going to "what they did about it."  The Principles are vague on this.  It is clear one can make investment decisions based on SRI principles, and that investment permits active shareholder behavior. This goes more to the transparency of engagement. 

But more importantly, responsible investing remains a "personal" obligation.  There is little infrastructural efforts to sustain SRI markets.   A large omission in this respect are exchanges.  While SRI principles are targeted at funds and their managers, they are less well targeted at the exchanges where shares are listed for sale. And there is less effort to push exchanges into creating SRI environments.

Yet funds could move toward market supported SRI.  Consider the power to effect markets by supporting a principle of SRI that would limit SRI investment to qualifying companies whose securities are purchased only through exchanges that also practice SRI in the form of mandatory disclosure and reporting rules.  Backer, Larry Catá, From Moral Obligation to International Law: Disclosure Systems, Markets and the Regulation of Multinational Corporations. Georgetown Journal of International Law, Vol. 39:591 (2008). 

The barrier to greater movement, of course, is the foundation of corporate governance, and therefore of corporate investing: the principle of shareholder wealth maximization.   For fund managers and the markets on which securities are traded this basic principle privileges a certain sort of investment environment.  Combined with the presumptions of GAAP and the focus on financial over social, environmental and human rights reporting for value calculation, fiduciary obligation can serve as a limit on the logic of SRI. 

But that barrier may now be more porous. Markets are already moving in this direction.  Market segmentation may serve as a means to create SRI investment universes. The rise of special indexes through exchanges provides a good example.  "The FTSE4Good Index Series has been designed to measure the performance of companies that meet globally recognised corporate responsibility standards, and to facilitate investment in those companies. Transparent management and criteria alongside the FTSE brand make FTSE4Good the index of choice for the creation of Responsible Investment products." (FTSE4Good Index Series). The FTSE model has also migrated. FTSE Group has partnered with BME to create the FTSE4Good IBEX Index. The index comprises companies in the BME’s IBEX 35 Index and the FTSE Spain All Cap Index that meet described CSR standards.  In addition,

BM&FBOVESPA, the Brazilian Stock Exchange, announced this week that it will now recommend that its listed companies either state that they publish a regular sustainability report and where it can be accessed, or explain why they do not do so. According to BMFBOVESPA, the goal of the recommendation is to encourage the adoption of sustainability reporting by companies in advance of the United Nations Conference on Sustainable Development (Rio+20), to be held in Rio de Janeiro. (From Robert Kropp, Brazilian Stock Exchange Nudges Companies Toward CSR,  GreenBiz.com,  Jan. 9, 2012).

There has been little progress, though since the 2009 Report prepared for the World Federation of Exchanges by Dan Siddy, Selsus Limited, Exchanges and Sustainable Development (describing exchange directed sustainable investing in the Australian Securities Exchange, BM&FBOVESPA (Brasil), Bourse de Luxembourg, Bursa Malaysia, Johannesburg Stock Exchange, NYSE Euronext, Shanghai Stock Exchange, and TMX Group (Ibid., AnnexA).

At the same time, sustainable investment is slowly but surely rising up the agenda of other stakeholders who play a key role in shaping the investment climate: legislators, policy-makers, regulators, multilateral agencies, and the professional bodies that set accounting and auditing standards.
All of this translates into some important strategic and commercial questions for exchanges:
• How can an exchange help ensure that the market efficiently meets the new ESG-related information needs of investors, analysts and companies?
• Can ESG issues contribute to the badge of quality, integrity and transparency conferred on companies by listing on the Exchange and to the overall profi le of individual markets?
• Can the exchange help to raise corporate awareness and management practices among listed companies?
• Can the exchange add value by introducing investors and issuers to one another on theme of sustainability excellence?
• Can the exchange create new listing and trading products geared to specific sustainable investment niches?
• How can exchanges help to shape the way that regulatory conditions and reforms facilitate ESG transparency and sustainable investment flows?
The relevance of these questions to individual exchanges - and the decisions they take - clearly depends on each exchange’s specific business characteristics. In general, however, the sustainable investment strategies currently in evidence among WFE’s 51 members fall into three broad categories:
• Raising ESG awareness and standards among listed companies;
• Information products and services for sustainable investors; and
• Specialised markets for specific sustainable investment niches. (Ibid).

But that does not mean that there has been no progress.  The Shanghai Stock Exchange, building on the work of the Johannesburg Stock Exchange  requires sustainability reporting.  Larry Catá Backer, Business and Human Rights in China: Sustainability Reporting and Chinese Stock Exchanges, Law at the End of the Day, July 29, 2011.  See also  Sustainability Reporting Guidelines: Mapping & Gap Analyses for Shanghai Stock Exchange[PDF] 60 pages | © June 2011 IFC, Shanghai Stock Exchange.

 IFC and the Shanghai Stock Exchange (SSE) worked with SynTao on a study of existing sustainability reporting guidelines internationally and in China, comparing these with the existing SSE requirements. The study included interviews with key stakeholders and a review of the characteristics of 25 existing international and national frameworks. It confirms that, though sustainability reporting in China has increased in recent years, there is still much work to do to improve the quality and usefulness of environment,social and governance (ESG) information provided to stakeholders, particularly investors. The report was published in partnership with Canada. (Ibid).

 More importantly, even conventionally understood fiduciary duty may not be a bar. A duty of care and loyalty to beneficiaries does not require avoidance of limiting investment universe, including limiting an investment universe to SRI companies or to purchases from companies listed in SRI enhancing exchanges. What is clear, though, is that a single minded focus on the traditional model for SRI--one that places the burden on SRI on the fund manager (or otherwise on investors), does little to naturalize SRI within markets.  Beyond principles for investment, grounded in transparency between fund (investor) and their clients, principles of  active shareholding might be further developed and markets in which responsible investing blends financial, environmental and social welfare maximization ought to be encouraged.  The problem, in effect is not the "law" of SRI principles but the logic of GAAP.