HLS Forum: Shareholder Activism and ESG: What Comes Next, and How to Prepare

[Gunnar Larson]

https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/

Shareholder Activism and ESG: What Comes Next, and How to Prepare

The recent successes of shareholder activists against Big Oil [1]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#1>
this
proxy season are one of many signs of mounting and effective pressure from
investors on public companies to enhance their performance and disclosures
on environmental, social, and governance (ESG) criteria. As ESG rises in
prominence among investors, activist shareholders have at their fingertips
new and potent themes from ESG’s repertoire of concepts and criteria to use
in campaigns to change control and strategy at companies. By integrating
criticisms of ESG failures into campaign narratives, activists may gain
additional traction with institutional investors at the ballot box. This
article provides background on the potential for increased integration of
ESG in shareholder activism campaigns and offers practical guidance for
companies to preempt ESG-themed shareholder activism.
The Promise of ESG

Investors increasingly view corporate attention to ESG criteria as closely
linked with business resilience, competitive strength, and financial
performance. The world’s largest institutional investors and pension funds
have stated their faith in the potential of ESG to unlock shareholder value
and to make companies and markets more sustainable. Their support has
afforded ESG investing and operating principles added legitimacy and
credibility.

Institutional investors have, in turn, developed ESG-themed investment
products, although comparable products have been in the market with lesser
fanfare for many years. 2020 saw a record influx of investor capital in
ESG-themed funds, bolstered by the moral prospects of ESG investing in
light of the COVID-19 pandemic and positive financial results reported by
media organizations and researchers. [2]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#2>
It
was reported that “sustainable equity funds finished 2020 with a clear
performance advantage relative to traditional equity funds.” It was further
noted that in the same period, “three out of four sustainable equity funds
beat their Morningstar Category average” and 25 of 26 ESG equity index
funds followed by Morningstar “beat index funds tracking the most common
traditional benchmarks in their category.” [3]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#3>

Institutional investors have intensified engagement with public companies
to advocate for ESG- oriented policies and disclosures. They have also
adjusted their proxy voting policies correspondingly. Investor support for
ESG-themed shareholder proposals has generally increased in the past five
years. [4]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#4>
Investors
have meanwhile lobbied governments and regulators — in the U.S.,
particularly Congress and the Securities and Exchange Commission (SEC) —
requesting that they impose further requirements on companies to expand
their ESG disclosures and deepen their commitments to ESG-oriented
operating principles. [5]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#5>
Since
the arrival of the Biden administration, the SEC and other federal
regulatory agencies in the U.S. have given clear signals to the public that
they intend to follow suit by issuing regulations and other guidance to
facilitate the integration of ESG commitments and disclosures in the
market. [6]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#6>
Reasons for the Integration of ESG in Shareholder Activism

Shareholder activists may deploy ESG concepts in their campaigns for
various reasons. An activist investor might genuinely believe that greater
attentiveness to environmental and social factors de-risks operations,
makes business more sustainable, and creates opportunities. An activist
could believe in a specific ESG value thesis, for example, that a carbon
transition plan is necessary for a given company to enjoy sustainable
growth. Depending on the fund’s priorities, policies, and agreements with
its investors, a fund could be required through contractual obligations to
integrate ESG into its investment strategy. In some circumstances, the
activist investor may claim to perceive an ethical duty to integrate an ESG
concept into its campaign. [7]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#7>

Activist investors also understand that certain institutional investors may
find an ESG-themed campaign difficult to resist at the ballot box.
Activists recognize that certain clients of institutional investors are
demanding ESG integration into investment platforms and that institutional
investors have in various cases committed to ESG stewardship through their
investments. [8]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#8>
For
an institutional investor to turn its back on an ESG-themed activism
campaign could, in some circumstances, mean running the risk of being
criticized for disregarding the financial and ethical priorities of its
clients. There is also a public relations dimension at work. Historically,
the general public has seldom noticed when a household name institutional
investor declines to support an activist campaign that was calling for a
sale of the company, changes to capital allocation, or the termination of a
CEO. But it is possible that in coming years, the general public will pay
attention when the same institution declines to support a campaign that is
calling for greenhouse gas reductions emissions targets or another
ESG-oriented improvement.

There are also unknowns and potential pitfalls for the integration of ESG
concepts into shareholder activism. It remains to be seen which ESG themes
will resonate with investors at the ballot box when factored prominently in
an activism campaign. It is not clear yet whether activists will
incorporate ESG themes as a core pillar of their campaign or if such themes
will mainly serve as a supporting campaign theme and a tool to be used when
convenient to support a larger purpose, much like calls for declassifying
the board alongside of a campaign to replace directors. Activists could
potentially harm their campaigns if investors perceive that the integration
of ESG themes is disingenuous. Perhaps most significantly, there are open
questions as to how shareholder activists can reconcile their relatively
short-term investment horizons with ESG theses, which characteristically
involve long-term value propositions. [9]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#9>
New Themes in Governance Best Practices

Proponents of ESG-conscious operations are elaborating new standards and
“best practices” related to corporate governance. Most prominently,
ESG-conscious investors are looking into how boards and management teams
oversee environmental and social performance, how ESG oversight is
allocated among board committees, and whether a board has sufficient
expertise in environmental issues and social issues. It is often
incorrectly said that the “G” in ESG, for governance, is old news for
shareholder activism. This observation is correct insofar as certain
governance themes have been present in activist campaigns for a decade or
more. Such themes include calling for enhanced director independence,
separation of the CEO and board chair roles, declassification of the board,
and other measures to increase shareholder rights. The observation is
incorrect, however, insofar as part of the “G” in today’s ESG thinking
focuses on the governance of environmental and social aspects of a business.

Certain ESG rating organizations are observing how ESG oversight is
allocated among the board and its committees and whether a dedicated
committee has been established for this purpose. As another illustration of
this trend, a recent memo by BlackRock concerning its proxy voting policies
stated an expectation that directors on a board will “have sufficient
fluency in climate risk and the energy transition to enable the whole board
— rather than a single director who is a ‘climate expert’ — to provide
appropriate oversight of the company’s plan and targets.” [10]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#10>
This
type of expectation for corporate governance, rooted in ESG thinking, is
new and far-reaching compared to shareholder activists’ more traditional
governance demands.

Establishing board and management oversight of ESG to keep up with investor
expectations involves a certain amount of chasing a moving target. Investor
expectations and company practices around corporate governance are evolving
relatively rapidly along with other ESG- related trends. Companies and
investors are converging, nevertheless, around certain practices and
expectations. Among other things, boards and management teams are
increasingly expected to ensure that ESG is a component of strategic
decision-making, identify key ESG risks and opportunities, understand
differences between the ESG priorities of shareholders and stakeholders,
oversee ESG-related disclosures, and determine how board oversight of ESG
will be allocated among the board and its committees. There is evolving
discussion around the particular appropriateness of audit committee
oversight of particular ESG-related matters, such as the identification of
material ESG factors and oversight of disclosures and disclosure controls
and procedures. Boards are also being expected to appreciate and focus on
those aspects of ESG- related oversight that only a board can perform, such
as oversight of management, setting executive compensation, and supervision
of auditing and internal controls.
Possibilities Ahead

The new age of ESG may bring other innovations in shareholder activism.

Additional corporate disclosures on environmental and social issues can
provide shareholder activists with a substantial amount of new material to
use in their campaigns. Successive editions of sustainability reports
issued by companies over a course of several years will provide investors
with an ability to compare ESG performance of individual companies over
time and to compare companies’ performance. Over 90% of S&P 500 companies
and 65% of Russell 1000 Index companies already produce a sustainability
report. [11]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#11>
The
SEC has signaled that it will likely develop additional requirements for
ESG-related disclosures of public companies. [12]
<https://corpgov.law.harvard.edu/2021/05/29/shareholder-activism-and-esg-what-comes-next-and-how-to-prepare/#12>

While environmental and climate-related topics are currently the most
likely among ESG topics to be integrated into activist campaigns, a further
stage in ESG-themed activism is the incorporation of social- and
social-justice-related concepts into activism strategies. 2020 was a major
year in the United States and worldwide for bringing matters of social
justice and public health to the foreground of public interest. These
developments led to a burgeoning of discussions regarding the direction of
social aspects of ESG, particularly as they relate to diversity and
inclusion. Prominent institutional investors have advocated for companies
to disclose workforce diversity statistics, California and other states
adopted legislation to require or promote gender and racial diversity on
boards, and the Nasdaq Stock Market has proposed listing standards designed
to increase board diversity. Throughout 2020, leading institutional
investors highlighted research showing that diversity in the boardroom and
the workforce contributes positively to a company’s performance. Meanwhile,
the current direction of the Biden administration indicates that it is
becoming a business risk for companies to not have processes in place to
monitor and ameliorate disproportionate effects of their carbon footprint
on minority communities. It may be expected that related themes will be
integrated into future activist campaigns.

Another potential ESG-driven innovation would be for shareholder activists
to avail themselves more frequently of the right to solicit proxies at
shareholder meetings for their own business proposals. In the United
States, the vast majority of shareholder proposals are made pursuant to
Rule 14a-8 under the Securities Exchange Act of 1934, which imposes topical
limitations on proposals. In contrast, shareholders who solicit proxies for
their own proposals have a comparatively free hand to make proposals on the
topics of their choice and to say want they want to say about their
proposals. Additionally, coupling a proposal to elect dissident directors
with an environmental or shareholder proposal could increase the
probability that a shareholder activist’s proposal to replace incumbent
directors would succeed.
Practical Guidance for Public Companies

Pursuing ESG-related goals may have various benefits for a company, among
them that good ESG performance creates a line of defense against
shareholder activism. Boards of public companies should be establishing
oversight of ESG issues as a priority matter, mindful of practices of
industry peers and expectations of investors and stakeholders. Companies
should review their ESG-related disclosure practices and take steps to
ensure that investors or ESG ratings organizations do not deem them
laggards. Companies deemed ESG laggards create low- hanging fruit for
activists looking for opportunities to work ESG themes into their campaigns
to change corporate policy and control.

Recognizing that public companies are variously situated in their
approaches to shareholder activism preparedness and ESG policies and
disclosures, the following practical guidance is additionally provided for
consideration:

   - *Public companies should treat activist shareholders with ESG-themed
   inquiries and criticisms respectfully, just as they would treat “regular”
   institutional investors seeking routine engagement on ESG topics*. While
   there may come a time to push back, companies should expect to be in
   “listening mode” for the first meeting.
   - *Companies should work ESG concepts and talking points into their
   emergency plan for shareholder activism preparedness*. The need to be
   respectful of investors does not mean companies should be unprepared to
   respond to criticism, particularly if made in a surprise press release.
   While finer points can be ironed out once specific criticisms are made, a
   company should be ready to speak at a high level about material areas of
   its ESG program in order to respond to public criticism in the same news
   cycle. If a company does not have any emergency plan for shareholder
   activism preparedness, it should be in touch with experienced activism
   defense counsel that has experience with ESG.
   - *Companies should be additionally cautious when making changes to
   governance or policy against the background of an ESG-themed activist
   campaign*. Boards facing demands to admit dissident directors commonly
   appoint directors of their own choosing or adopt new ESG-related policies
   or measures, prior to the annual meeting and without previewing these
   actions with the activist. These measures, often calculated to have some
   defensive value because they address ESG-related concerns of the activist,
   are often justified because, among other reasons, a company was already in
   the process of making changes before a dissident campaign arose. In the
   context of an ESG-themed campaign, however, these measures can backfire.
   Even if without basis, the activist can portray changes to leadership and
   policy made against the backdrop of an ESG-themed activist campaign as
   reactive, hasty, insincere, and incomplete.
   - *Companies should have shareholder activism defense counsel review
   their ESG disclosures*. The focus of a review of the company’s ESG
   profile from the standpoint of shareholder activism preparedness is
   distinct from a wide-ranging review of the company’s overall ESG profile.
   If a company is already advanced in its ESG policies and disclosures, the
   goal of this review is not to reinvent the wheel or second-guess existing
   programs that may be substantial and sophisticated. Rather, the goal is to
   identify and prepare to preempt ESG themes that may be exploited by an
   activist campaign, even if (and especially if) the company has addressed
   those themes through its existing operations and disclosures.
   - *Public companies should continuously improve ESG initiatives,
   oversight, and disclosures as well as ratings with ESG data collection
   ratings and services.* Most companies are well aware that good
   performance in these regards helps to avoid unwanted pressure from
   institutional investors and can create a path to higher liquidity and a
   lower cost of capital. But ESG scores and reports from the leading ESG data
   and ratings providers are also roadmaps for activists searching for
   weaknesses in a company’s ESG profile. To the extent these initiatives are
   lagging, they should be stepped up specifically in the areas that are most
   susceptible or vulnerable to ESG-themed activist criticism.
   - *Companies should stay near the curve, or at least their peers, in
   making voluntary disclosures in line with one or more voluntary disclosure
   regimes while being mindful of disclosure-related preferences and demands
   of leading institutional investors*. ESG data collection and ratings
   services are effectively monitoring the extent of companies’ alignment with
   voluntary disclosure regimes such as the Task Force on Climate-Related
   Financial Disclosures, the Sustainability Accounting Standards Board, and
   the Global Reporting Initiative. As mentioned, disclosure laggards may
   become easy targets for ESG-themed criticism.
   - *Companies should be cautious about internal initiatives to integrate
   environmental and social information from voluntary reports into regulatory
   filings*. The coming years are likely to see increasing pressure on
   companies to integrate information from their sustainability reports into
   filings with regulators, such as annual reports and proxy statements filed
   by U.S. public companies with the SEC. The inclusion of ESG-related
   information from sustainability reports and other thematic ESG reports in
   regulatory filings creates legal risks and should be pursued only after
   close coordination within the company among appropriate departments (e.g.,
   the legal department and sustainability team) and in consultation with
   counsel specialized in securities law and ESG disclosures.

-- 
*Gunnar Larson - xNY.io <http://www.xNY.io> | Bank.org <http://Bank.org>*
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