The Future of Disclosure ESG, Common Ownership, and Systematic Risk

Abstract

The U.S. securities markets have recently undergone (or are undergoing) three fundamental transitions: (1) institutionalization (with the result that institutional investors now dominate both trading and stock ownership); (2) extraordinary ownership concentration (with the consequence that the three largest U.S. institutional investors now hold twenty percent and vote twenty-five percent of the shares in S&P 500 companies); and (3) the introduction of ESG disclosures (which has been driven in the U.S. by pressure from large institutional investors). In light of these transitions, how should disclosure policy change? Do institutions and retail investors have the same or different disclosure needs? Why are large institutions pressing for increased ESG disclosures?

This Article will focus on the desire of institutions for greater ESG disclosures and suggest that two reasons underlie this demand for more information: (1) ESG disclosures overlap substantially with systematic risk, which is the primary concern of diversified investors; and (2) high common ownership enables institutions to take collective action to curb externalities caused by portfolio firms, so long as the gains to their portfolio from such action exceed the losses caused to the externality-creating firms. This transition to a portfolio-wide perspective (both in voting and investment decisions) has significant implications but also is likely to provoke political controversy. In its final hours, the Trump Administration adopted new rules that discourage voting based on ESG criteria and thus by extension chill ESG investing. This controversy will continue.

As more institutions shift to portfolio-wide decisionmaking, there is an optimistic upside: externalities may be curbed by collective shareholder action. For entirely rational reasons, the new “universal” shareholders who now dominate the market will resist even large public companies who might seek to impose externalities on other companies. Owning the market, the “universal” shareholder will protect the market. Still, this process of resistance may produce frictions, and the disclosure needs of individual investors and institutional investors will increasingly diverge. Of course, not all institutional investors are indexed or even diversified, but those that remain undiversified (for example, hedge funds) logically have the perspective of an option-holder and favor greater risk-taking. Across the board, retail investors have different perspectives and preferences than do institutional investors.

Above all, the combination of high common ownership and institutional sensitivity to systematic risk makes disclosure a far more powerful force. If disclosure was once Brandeis’s best disinfectant, it is now becoming a force that can effect significant social and economic change without the need for judicial or agency intervention.