Scarlet Letters: Remarks before the American Enterprise Institute

Thank you, Ben [Zycher]. I will begin with the standard disclaimer. My remarks represent my views and not necessarily those of the Commission or my fellow Commissioners.

I will next address a question that is undoubtedly in the mind of at least one person in the audience. Did her parents really do that to her? Is she named after Hester Prynne, the main character in Nathaniel Hawthorne's Scarlet Letter? The answer is no; Hester is a family name, not a literary one. That said, I actually do not much mind the name or the question now that high school English class is a distant memory. Hester Prynne was a strong woman who accepted the consequences of her weak moment with quiet dignity.

Having a baby as the result of an extramarital affair in seventeenth-century New England and refusing to name her partner in crime brought hard-hearted, merciless condemnation from the legal and religious authorities and the society at large. The community's morality police did not bother themselves with much of an inquiry into the facts and circumstances and certainly did not consider whether a measure of mercy might be appropriate. These self-righteous authorities instead crafted a punishment designed to underscore the vast divide between their moral purity and Hester Prynne's obvious moral depravity. They ordered Hester to wear a scarlet letter "A" for "adultery." That letter, elaborately embroidered by Hester's own hand, served to facilitate social shunning, inspire incessant gossip, ensure that Hester never forgot her transgression, and inflict on its wearer deep pain and intense self-loathing. Her shame was emblazoned on her dress for all, including Hester's young daughter, to see.

As the story unfolded, it became very clear that the through-and-through immoral label was not appropriate for Hester. She conducted herself with great dignity. She worked hard to provide for herself and her daughter. She was a devoted mother to her daughter. She even drew from her meager resources to help to meet the needs of others in the community. She came alongside the suffering with a calm gentleness and expected nothing in return. Her actions stood in contrast to the actions of many of her fellow townsfolk. In short, the scarlet letter that marked her as morally depraved was affixed without taking into account the full character of the woman who was forced to wear it.

We are seeing a similar scarlet letter phenomenon in today's modern, but no less flawed world. In these remarks, I will focus specifically on the way in which corporations are being assessed according to Environmental, Social, and Governance (ESG) factors. Here too we see labeling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion to the consequences, which ultimately fall on real people. In our purportedly enlightened era, we pin scarlet letters on allegedly offending corporations without bothering much about facts and circumstances and seemingly without caring about the unwarranted harm such labeling can engender. After all, naming and shaming corporate villains is fun, trendy, and profitable.

E, S, and G tend to travel in a pack these days, which makes it hard to establish reliable metrics for affixing scarlet letters. Governance at least offers some concrete markers, such as whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. Even with these examples, however, people do not agree on which way they cut, and they may not cut the same way at every company.[1] In comparison to governance, the environmental and social categories tend to be much more nebulous. The environmental category can include, for example, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses.[2] The social category can include how well a company treats its workers, what a company's diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.[3] Not only is it difficult to define what should be included in ESG, but, once you do, it is difficult to figure out how to measure success or failure.

As Hester Prynne can attest, the affliction of shame is a group effort. It takes a village. Just as in Hester's day, in our modern corporate ESG world, there is a group of people who take the lead in instigating their fellow citizens into a frenzy of moral rectitude. Once worked up, however, the crowd takes matters into its own brutish hands and finds many ways to exact penalties from the identified wrongdoers. The motives are often noble, but the methods are not.

It is true that ESG issues may well be relevant to a company's long-term financial value. At a recent hearing before the Senate Banking Committee, John Streur of Calvert Research and Management testified that it is a "misconception" that using ESG investment strategies results in the investor sacrificing returns.[4] In fact, he said, research has found that "firms in the top quintile of performance on financially material ESG issues significantly outperformed those in the bottom quintile." Why, then, must the word "ESG" must be used at all? Of course, firms in the top quintile of performance on financially material issues outperform those on the bottom. If ESG disclosures mean disclosing what is financially material, there is little controversy, but the ESG tent seems to house a shifting set of trendy issues of the day, many of which are not material to investors, even if they are the subject of popular discourse.

Popular discourse has fueled the efforts of ESG instigators, which include developers of ESG scorecards, proxy advisors, investment advisers, shareholder proponents, non-investor activists, and governmental organizations. The problem perhaps begins with non-shareholder activists—the so-called stakeholders—who identify the controversial issues du jour. Other people quickly heed their call to action.

There is, for example, a growing group of self-identified ESG experts that produce ESG ratings. ESG scorers come in many varieties, but it is a lucrative business for the successful ones. The business is a good one because the nature of ESG is so amorphous and the demand for metrics is so strong. ESG is broad enough to mean just about anything to anyone. The ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences. Not surprisingly then, there are many different scorecards and standards out there, each of which embodies the maker's judgments about any issues it chooses to classify as ESG.[5] The analysis can appear arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason. Putting aside the analysis that produces the final score, some ESG scores are grounded in inaccurate information.

Some scorecard producers attempt to get information from the companies directly by submitting surveys to companies, the responses to which are then used to rate the ESG risk of the companies surveyed. A senior counsel from a major insurance company reported her experience at a recent Investor Advisory Committee meeting at the SEC.[6] Her company received approximately 55 survey and data verification requests from ESG rating organizations in the last year. By her company's estimate, it took 30 employees and 44.8 work days to respond to just one of these surveys. While this is just one company's experience with one survey, one could expect that some surveys will go unanswered because of lack of corporate resources.

Because many companies post sustainability reports,[7] producers of ESG ratings can draw from these reports without directly contacting the company. ESG scoring is often arbitrary because these reports are read and analyzed by machines. Illustrating this arbitrariness, Sarah Teslik, a consultant on ESG issues, recommends that companies "go look at the list of things they grade on and then disclose the way they talk. You may be doing something just right, but you called it a practice; you didn't call it a policy. And you only get credit if you call it a policy."[8] Perhaps it sounds inconsequential not to get credit for having policies, but the consequences can be serious. It can be the difference between a good rating and a bad. A bad rating, in turn, can mean investors shun your stock. When a company has engaged in actual misconduct, this may be the correct result; I am not arguing that any company should get a free pass. When ratings, however, are based on misinformation, the accountability mechanism does not work properly.

The errors in one ESG rater's assessment of Barrick Gold Corporation were apparently so severe that the company aired its grievances publicly. The company, in its words, called out the rater's "latest ESG Report, which we believe continues to be based on superficial research; inconsistent analysis based on a methodology that is not transparent; and a largely retrospective and controversy-based view of ESG performance. What results is a distorted and misleading assessment of Barrick's ESG performance."[9] Barrick then went on to provide several examples of allegedly erroneous or conflicting statements in the rating report, including a claim that it operated a mine that it did not operate.[10]

Even if the rating is not wrong on its own terms, the different ratings available can vary so widely, and provide such bizarre results that it is difficult to see how they can effectively guide investment decisions. For example, last year the electric car company Tesla received some lower environmental ratings than many traditional auto makers. This was not because of any substantive conclusion that there was non-green activity on Tesla's part, but simply because its disclosures were not viewed by the rating companies to be sufficiently robust.[11] For someone interested in gaining a perspective on actual environmental impact, rather than on the company's willingness to fill out paperwork just so, the environmental rating would have been sorely misleading.

These inaccuracies and inconsistencies matter because a growing number of investors pays attention to ESG scores. As Rakhi Kumar, head of State Street Global Advisors' ESG Investments and Asset Stewardship explained recently, "Investible ESG strategies are currently designed in ways that prioritize companies with higher ESG scores."[12] Not only is ESG determining where investment dollars go, but at what cost and on what terms. One important way ESG scores affect the flow of dollars is through their incorporation into indices, which can have a meaningful influence on the demand for a company's securities.[13] As part of the ESG trend, there are now many ESG-related indices and related funds available. The decision as to which companies to include in the indices is often guided by ESG ratings, which can substantially increase the ratings' impact on the market's allocation of capital. Improper allocations of capital matter to consumers, employees, communities, and society as a whole—the very groups that many ESG activists care about.

Why would anyone pay big bucks for experts selling precision in an area in which it is so elusive? These ESG experts sell their wares to, among others, investment advisers, who then rely on them to make decisions about how to vote or what to buy or sell.[14] It is not surprising that most investment advisers, in light of their fiduciary duty, want to focus primarily on maximizing the value of their investors' portfolios. However, they are courting investors, a vocal subset of whom are demanding that their money be invested in accordance with ESG principles.[15] According to one recent survey "ESG considerations [are] material in [the] day-to-day investment activities" of 70 percent of investment advisers in the Americas.[16] What that means in practice is unclear. Again, the nebulous nature of such principles allows great latitude to investment advisers. An adviser just needs to grab hold of something that allows it to show that it is managing according to ESG. A statement that you are an ESG manager may not require much to back it up. It may be enough to buy an ESG scorecard, hire a proxy advisor, or invest according to an index that incorporates an ESG filter. Although, of course, if you want to show how serious you are about ESG issues, there are any number of experts who will help you develop more complex (and expensive) means of demonstrating your bona fides.

Some advisers are turning more of their own attention and in-house resources to ESG. Some small advisers that formed around ESG principles dedicate considerable time to these issues. Many large investment advisers are setting up or expanding their own ESG teams and elevating ESG in their decision-making. State Street recently announced improvements to its ESG data and analytics capabilities.[17] According to the company's press release, these improvements will allow clients access to a tool that "calculates ESG scores through a combination of both human and machine generated data."

In addition to these concrete efforts to bring scoring in-house, large asset managers are signaling to companies that they will be assessed through an ESG prism. Last year, BlackRock CEO Larry Fink made waves when, in his 2018 annual letter, titled "A Sense of Purpose," he directed CEOs and their companies to "ask themselves: What role do we play in the community? How are we managing our impact on the environment?"[18] Earlier in the letter, he admonished boards to help their companies "articulate and pursue [their] purpose, as well as respond to the questions that are increasingly important to [their] investors, [their] consumers, and the communities in which [they] operate[]." "These stakeholders," he noted, "are demanding that companies exercise leadership on a broader range of issues." Investment advisers, who may be representing their own views more than those of their investors, are themselves among these "stakeholders." In any case, there is no reason not to believe that in the muddled ESG space, precision and comparability elude advisers too.

The government gave rise to another group of ESG experts by directing investment advisers' attention to proxy voting. Oftentimes, a company must address ESG questions because they have been included in the company's proxy statement to be voted at the annual shareholders' meeting. In 1988, the Department of Labor issued what has come to be known as the "Avon Letter," which took the position that managers of employee pension plans have a fiduciary duty to vote the proxies associated with the shares held by the plans.[19] The SEC, similarly, in 2003 emphasized proxy voting in a rule requiring investment advisers to adopt and disclose policies and procedures "reasonably designed to ensure that the adviser votes proxies in the best interests of clients[.]"[20] In response to concerns about the cost and magnitude of the task of voting proxies, the SEC staff issued two no-action letters that allowed advisers to rely on third parties.[21]

The recipients of these no-action letters were two of a handful of now powerful proxy advisory firms. Proxy advisors conduct research and provide guidance to shareholders, in particular, large institutional shareholders, on how to vote proxies. Without going into too much detail, the result of these no-action letters was to effectively entrench the use of proxy advisors. If an adviser followed a proxy advisor's recommendations for voting, the fund would be deemed to have made its decisions free from conflicts of interest, [22] and therefore to have fulfilled its fiduciary duty. A fund complex may hold the shares of hundreds of different companies, and therefore its adviser may make hundreds if not thousands of voting decisions every proxy season. The ability to outsource those decisions to a purportedly neutral third party, and in so doing reduce the risk of any vote being deemed contrary to the fund manager's fiduciary duty, makes the use of proxy advisory firms very attractive.

The SEC's Division of Investment Management withdrew both of these letters in September 2018, but proxy advisors, now heavily relied on by advisers, continue to wield great influence. Building on their influence, proxy advisors, who have focused a lot of attention on governance issues over the years, have recently made concerted efforts to expand into environmental and social issues.[23] Some investment advisers make a practice of following all or most of the proxy advisors' recommendations. Other advisers use proxy advisors' recommendations as a point of reference for their own analysis or defer to proxy advisors' recommendations on a subset of votes. The proxy advisors' recommendations therefore can substantially affect a company's proxy votes. One study, for example, found that a proxy advisor's "against" recommendation reduced favorable votes by 15 to 30 percent.[24] Another study, which specifically considered the effect of a recommendation on the so-called "say on pay" provision introduced by Dodd-Frank, found that a negative recommendation by proxy advisor ISS resulted in a 25 percent reduction in positive votes.[25]

Given the influential role of proxy advisors, companies started to realize that they needed to pay attention to proxy advisors' recommendations. For example, up to 70 percent of companies in a 2011 survey said that they consider the views of proxy advisors when developing their executive compensation plans.[26] Companies may align their equity compensation plans with dilution limits set by proxy advisors. [27] These limits, which determine whether the advisory service will recommend shareholder approval, are not publicly available, and so companies must pay proxy advisors for the information they will then use to ensure they are within the limits the advisors themselves will set.[28]

It has not been so easy for companies to get the proxy advisors to pay attention to them, which means that sometimes proxy advisors' recommendations are rooted in inaccuracies. Proxy advisors, which operate with skeletal staffs in comparison to the number of companies with respect to which they are making recommendations, will inevitably get it wrong some of the time. Proxy advisor Glass Lewis, for example, has only 360 employees, only about half of whom perform research, who cover more than 20,000 meetings per year in more than 100 countries.[29] Companies may not get an opportunity to correct underlying errors. According to one recent survey, companies' requests for a meeting with a proxy advisory firm were denied 57 percent of the time.[30] Companies submitted over 130 supplemental proxy filings between 2016 and 2018 claiming that proxy advisors had made substantive mistakes, including dozens of factual errors.[31] Proxy advisors ISS and Glass Lewis provide companies some opportunity to contest such errors, but access is not uniform for all issuers, and the process may not provide adequate opportunity for issuers to respond before proxies are voted.[32] The ramifications for the affected companies can be dramatic, as investment advisers, unaware of the error, vote their proxies in accord with the recommendation.

Proxy firms justify their interest in these issues as a reflection of shareholder interest. Recently, Glass Lewis announced that it may recommend a vote against members of the governance committee if a company choses to appeal to the SEC staff for permission to exclude a shareholder proposal from its proxy.[33] Indeed, shareholder proponents have pushed companies to focus on ESG issues. Even perennial favorites, such as executive pay, have received an overhaul and now shareholder proposals seek to tie compensation not to performance metrics such as share price, but to ESG metrics.[34]

The problem is that these active shareholder proponents are also a small group without the resources or time to make company-specific assessments. Over 40 percent of shareholder proposals in 2018 were submitted by just the top five investor groups.[35] Some of these groups are made up of only one small shareholder who has recruited a few family members or friends to join him.[36] A shareholder who has held just $2000 worth of stock in a company for at least one year can put forward a proposal for inclusion in a company's proxy.[37] A small number of very active shareholder proponents has taken this invitation to heart. In 2018, nine shareholders were responsible for almost half of the shareholder proposals.[38] Of these, half, or 24 percent of all shareholder proposals, came from just five individuals.[39]

Governments have added their voices to the ESG chorus. The strongest governmental pressure is coming from outside the United States. There have been considerable efforts in Europe and within international organizations to push for more ESG disclosures. In Europe, the revised Shareholder Rights Directive is taking effect this year.[40] The revisions include several express references to ESG matters, including a recommendation that director performance "be assessed using both financial and non-financial performance criteria, including, where appropriate, environmental, social and governance factors."[41] The fact sheet released by the European Commission in conjunction with the revisions, noted "Through increased transparency requirements, the new rules will encourage these investors to adopt more-long-term focus in their investment strategies and to consider social and environmental issues."[42] Earlier this year, the International Organization of Securities Commissions or "IOSCO," without the participation of the SEC, issued a statement "setting out the importance of considering the inclusion of environmental, social, and governance matters when disclosing information material to investors' decisions."[43] Although the statement mentions "materiality" throughout, and exhorts issuers to "consider the materiality of ESG matters to their businesses[,]" it seems that the statement envisions disclosures beyond what is traditionally viewed as "material." As the statement notes, "[j]urisdictions' securities laws generally require that issuers disclose material risks and any other material information[.]"

Some state and local governments have embraced ESG factors as drivers of investment choices.[44] The federal government has been more reluctant to jump on the ESG bandwagon. In fact, the Department of Labor recently backed off a position that made ESG considerations "proper components of the fiduciary's analysis of the economic and financial merits of competing investment choices."[45] As with private efforts in this area, government ESG initiatives are often rooted more in broad aspirations than in careful analysis.

As more investors, investment advisers, and companies embrace ESG, questions about what ESG means for returns are also gaining attention. Just yesterday, the Wall Street Journal ran an article entitled "Pensions Reconsider Linking Investing to Social Concerns."[46] While ESG advocates can point to studies that certain ESG policies serve companies well, the amorphous nature of such policies makes it hard to generalize. In any case, the research, even on discrete points, is mixed.[47] Other research has highlighted the cost of ESG investment strategies.[48] The ambiguity of ESG makes research inherently difficult.

Hester Prynne's scarlet letter became so customary that her daughter, a victim of the injustice perpetrated on her mother, did not want her to take it off. So too companies' shareholders are getting used seeing them wear their scarlet letters—ESG, not A—and even insisting that companies do so. As with the scarlet A, the ESG letters oversimplify complicated facts and thus may send companies scrambling to take actions that neither achieve the broader social goals of ESG proponents, nor serve their shareholders well.

People are free to invest their money as they wish, but they can only do so if the peddlers of ESG products and philosophies are honest about the limitations of those products. The collection of issues that gets dropped into the ESG bucket is diverse, but many of them simply cannot be reduced to a single, standardizable score. As beautifully simple as it is, a stark letter A does not always serve to convey the truth. The moral authorities of today, like their puritanical forebears, are motivated by a dream of a better society, but methods matter and so do facts. We ought to be wary of shrill cries from a crowd of self-appointed, self-righteous authorities, even when all they are crying for is a label.