LAWRENCE — Since the financial crisis of 2008, debate has raged over how to prevent the next one. A University of Kansas professor has published a study arguing that institutional investors, like mutual funds and pension funds, need to be part of the solution.
Virginia Harper Ho, associate professor of law, Docking Faculty Scholar and Webb Hecker Jr. Teaching Fellow at the KU School of Law, has published “Risk-Related Activism: The Business Case for Monitoring Nonfinancial Risk” in the Journal of Corporation Law. The article calls for leading investors to engage in risk-related activism — the use of shareholder power to promote firm management, mitigation and disclosure of risk.
Harper Ho argues that there are potential economic payoffs to investors, firms and capital markets when leading investors pay closer attention to nonfinancial or “environmental, social and governance” (ESG) risks, like those associated with executive compensation practices, global supply chains and climate change. Financial risks are typically hedged, but many of these nonfinancial risks may not even be on companies’ radar screens.
A recent example of risk-related activism cited in the paper is the “boardroom accountability” campaign kicked off in 2014 by New York City ’s public pension funds. The campaign targeted 75 major public companies and pushed for proxy access — corporate bylaw changes that would open certain corporate board seats to candidates nominated by shareholders. Its backers hoped shareholder nominees might take their concerns about ESG risks more seriously, and the campaign has been a clear success. During the 2015 proxy season, more than 70 percent of proxy access proposals were approved, creating momentum for more companies to adopt proxy access this year.
Although large institutional investors haven’t played a real monitoring role historically, Harper Ho argues that New York City’s campaign and others like it show that they can and many already do. In fact, Harper Ho says, asking whether investors should play a role or not in monitoring corporations is the wrong question. The reality is that in “the post-financial crash landscape, investors have more power to influence corporate practice not just because of their voting power but because Congress has given them more of a voice,” she said. “The real question now is how investors should use that power.”
Her article goes on to argue that more investors should push for better risk management and oversight from the firms they invest in. As Harper Ho writes, enterprise risk management, known as ERM, and risk oversight is already a top priority for publicly traded firms, and many recognize the importance of looking at risk broadly, but she notes “investment advisers and the legal community will remain skeptical, or even hostile, toward risk-related activism and related responsible investment practices so long as they believe them to be value-depleting, risk-enhancing or otherwise at odds with investors’ fiduciary duties and economic interests.”
Harper Ho’s article responds by countering potential objections from conventional finance theory and presenting evidence that institutional investors can improve and protect portfolio value if they pay more attention to nonfinancial risk. For example, she points to a wide range of studies showing that lowering ESG risks can lower companies’ cost of capital and also protect portfolio value in volatile markets. The business case for ESG investment strategies, she argues, also explains why more investors might reap financial rewards from engaging in risk-related activism or voting in favor of those who do.
Harper Ho also outlines steps institutional investors and policymakers can take to reorient how corporate boards address nonfinancial risk, but she acknowledges that market-driven investor oversight alone cannot prevent excessive risk-taking by corporate managers. She argues instead that a sustainable financial system, in every sense of the word, will also mean taking seriously how institutional investors’ own behavior contributes to excessive risk-taking by corporate managers and may even pose systemic threats to modern financial markets.
Her article points to steps the United Kingdom, the European Union and other leading markets are taking to improve investor monitoring of portfolio firms, and she calls for regulators in the United States to adopt similar policy guidelines. Such measures could encourage institutional investors to monitor the companies they invest in and would also have the added benefit of requiring greater accountability from investors for how they use their power.
“Although this article offers starting points that could facilitate risk-related activism, ESG integration and better institutional monitoring, the real barriers to these reforms are not regulatory, but conceptual,” Harper Ho writes. In the end, simply realizing that nonfinancial risks are real, and that they matter to investors, might be a great place to start.