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

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 20% and vote 25% of the shares in S&P 500 companies); and (3) the introduction of ESG disclosures (which process 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. Indeed, the Trump Administration has proposed new rules that would discourage voting based on ESG criteria and thus would by extension chill ESG investing. As institutions shift to portfolio-wide decision making, the disclosure needs of individual investors and institutional investors diverge and serious conflicts can arise. As an equity investor, institutional investors have the perspective of an option-holder and favor greater risk-taking, while typically the undiversified retail investor tends to have the opposite perspective and preferences.


INTRODUCTION
How should the norms of corporate governance and disclosure policy change (at the SEC and elsewhere) in light of new market conditions and a changing population of shareholders? So framed, this may seem a fairly narrow question, which assumes that one accepts the need for a mandatory disclosure system. 1 Yet, once over that first hurdle, a second question logically follows that is broader and more nuanced: Do all investors have the same informational needs and goals? Or do some have distinctive needs and preferences? This article will suggest that individual and institutional investors have different needs (largely based on their level of diversification) and that conflicts can arise between them, particularly as institutional investors come to make voting and investment decisions on a portfoliowide basis (instead of on a stock by stock basis). Indeed, viewed in light of the growth in index investing and the high level of common ownership among such indexed investors, we may be moving from a system of corporate governance that is premised on a "shareholder primacy model" to a system that is premised on a "portfolio primacy model." 2 That is, in the future, our largest institutions may knowingly accept and even cause losses at some firms in their portfolio if they expect that those losses will be outweighed by correlative gains at other portfolio firms.
One cannot assess this topic without recognizing that we have moved far away from the environment in which the SEC grew up. In fact, three distinct and important transitions are in progress, but each is at a very different stage: First and most obvious, the "institutionalization" of the market has now been fully realized. Historically, the SEC has always seen its interests as closely aligned with those of the retail investor. 3 It has proclaimed itself "the investors' advocate," 4 and public investors have in turn recognized and applauded the SEC's efforts. This mutual alliance gave the SEC relative political immunity that assured it reasonable budgetary appropriations, despite major swings in policy and times of great stress for other agencies over recent decades. 5 2 This idea of a "portfolio primacy model" should not be confused with a "stakeholder primacy model," which has been supported by many commentators who want boards and managers to balance the interest of other stakeholders in the corporation with those of shareholders. A focus on maximizing the value of the portfolio is quite different from a focus on sustainability or wealth transfers to stakeholders (even though the two perspectives may overlap). 3  This phrase also appears regularly on the SEC's website. 5 I do not mean that the SEC always got what it wanted (or needed), but in comparison to other "consumer protection" agencies, including the Commodities Futures Trading Commission and the more recent Consumer Financial Protection Bureau, it has done relatively well. I attribute this not to uniformly brilliant leadership at the SEC, but to the fact that Congressmen know the SEC is popular with individual investors (and voters) in their jurisdiction. Here, it is also noteworthy that institutional investors do not vote.
But that is past. The era in which retail investors "owned" companies or moved the trading markets is long gone and "deader than disco". Today, retail investors account for only a modest minority of the ownership of large, publicly traded companies and probably only around 4% of the trading in NYSE-listed companies. 6 Stock ownership is now dominated by institutional investors, who are increasingly diversified and often indexed. 7 The second transition involves the more recent and extraordinary concentration in stock ownership, with the result that as few as five to ten institutions today may be in a position to exercise de facto control over even a large public corporation. The Big Three of institutional investors --BlackRock, Inc., State Street Global Investors, and the Vanguard Group --now hold over 20% of the shares in S&P 500 companies (and vote approximately 25%) and are projected to vote over 40% by 2038. 8 Potentially, this might suggest that retail investors are exposed to domination 6 The level of institutional ownership increases with the size of the company's market capitalization (as institutions desire liquidity and thus concentrate on large cap stocks). Thus, if we look at the market value of all outstanding, publicly traded equity securities in the United States, institutions have owned over 62% for a number of years. See In 2020, the percentage of trading by retail investors has seen some increase as the result of market strategies adopted by Robinhood Markets, Inc. and other online brokers, but it remains to be seen whether this is more than a short-term phenomenon. 7 "Indexing," or "indexed investing" refers to a passive investment strategy under which the investor invests in a broad market index (such as, for example, the S&P index), seeking not to outperform the market, but only to match it. As later discussed, much empirical research strongly suggests that retail investors cannot outperform the market and that they lose money systematically when they attempt to do so. Indexed investing also reduces trading costs, as it is a "buy and hold" policy, which can minimize tax liabilities. 8 This difference between 20 and 25% reflects the fact that many shares are not voted. For these percentages and for their prediction that the votes cast by the Big Three will rise eventually to 40% or more, see Lucian Bebchuk and Scott by institutional control groups, 9 but such a thesis still seems premature. At first glance, little conflict is apparent between diversified institutions and retail investors (as indexed institutions are not seeking control), but a potential conflict may be developing: as diversified institutional investors, utilizing their power of common ownership, begin to make decisions on a portfolio-wide basis (deliberately pursuing strategies that boost the stocks of some firms in their portfolios while depressing the stocks of others, to achieve a net gain), they will be taking actions contrary to the interests of undiversified investors in those firms that experience losses. Eventually, this conflict will trigger controversy and may necessitate new and enhanced disclosures.
Meanwhile, retail investors have moved their investments from "actively managed" (or "stock-picking") mutual funds to more passive index funds. 10 Hirst, The Specter of the Giant Three, 99 B.U. L. Rev. 721, 724 (2019). To give an example of activism in action, just six shareholders control 24% of ExxonMobil, and the same six control 26% of Chevron, and they have pressured both companies regarding emissions and climate change. See Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1, 10-11, 24 and note 116 (2020). These six included the foregoing Big Three and Northern Trust, Bank of America, and Capital Research Global Investors. Id. at 10 note 38. The stock in publicly held companies (in terms of asset values) that is held by the ten largest mutual funds (not all of which are index funds) rose from 46% in 2005 to 61% in 2019, and the corresponding percentages held by the five largest such funds grew from 35% in 2005 to 51% in 2019. See The Investment Company Institute, INVESTMENT COMPANY FACTBOOK at 46, fig. 2.14 (60 th ed. 2020). 9 Much of the literature that is concerned about the growing concentration of shares in the hands of a limited number of institutional owners has focused on the danger that such concentration will be anticompetitive, leading to shareholder pressure in some industries for firms not to compete. See Einer Elhauge, Horizontal Shareholding, 129 Harvard L. Rev. 1267 (2016); Jose Azar, Martin Schmalz and Isabel Tecu, Anticompetitive Effects of Common Ownership, 73 J. Fin. 1513 (2018). However, the flip side of this coin is that institutions can use their collective power to induce their portfolio companies to behave in a more socially responsible manner (at least when it will benefit their portfolio on a net basis). In particular, concentrated owners can balance the gains caused to some companies in their portfolio by shareholder activism that restricts or discourages externalities that injure them against the losses experienced by the externality-causing firms in the same portfolio. Although it cannot be assumed that the potential gains will necessarily exceed the potential losses, when they do, it is good business policy to force the internalization of the externalities by the firms causing them. See Condon, supra note 8, at 10-11. 10 In 2019, index funds (i.e., mutual funds that track a broad market index) for the first time exceeded traditional stock picking funds, holding $4.27 trillion in assets as compared to Collectively, retail investors seem to have finally recognized that they are poor stock pickers who systematically lose money when they trade actively on their own. 11 As a result, they have migrated in large numbers to invest in highly diversified institutional intermediaries (led by the Big Three), thereby further increasing ownership concentration. 12 Finally, the third important transition involves a new demand among investors (particularly among diversified institutional investors) for a new category of information, known as "ESG" disclosures (ESG is an acronym that stands for "environmental, social, and governance"). 13 Investors who pursue "ESG investing" tend to focus heavily on the environmental and social impact of the firm and on its human capital (including the level of racial and gender diversity at the firm). 14 Although it may be clear why social activists want to encourage such socially relevant disclosures, it puzzles many why diversified institutional investors have been the Passive Investors, 168 U.Pa. L. Rev. 17 (2019). 11 The simple truth is that only a small minority of actively managed funds have outperformed passive index funds. . Although there may be pressure (particularly in the case of public pension funds, which are politically accountable), this article will assert that sound economic reasons better explain why fiduciaries at large diversified investors favor ESG principles, and thus ESG investing is likely to increase for reasons unrelated to political pressure. Interestingly, journalists report that while European oil companies have been pressured by their governments to incorporate ESG criteria into their decision-making, the pressure on U.S. oil companies for the same outcome has come exclusively from large institutional investors (and not at all from the government). See Stanley Reed, "Europe's Oil Titans Ramp Up Transition To Cleaner Energy," The New York Times, August 17, 2020 at B-1, 3. 14 For a similar description of ESG investing, see Schanzenbach and Sitkoff, supra note 13, at 388. strongest proponents of increased ESG disclosure. 15 This article argues that this development is neither strange nor the product of the political sympathies of individual fund managers, but is the consequence of a fundamental economic logic.
Put simply, their interest in ESG disclosures flows directly both from the Capital Asset Pricing Model ("CAPM" 16 ) and from the just-noted fact of their high common ownership in portfolio companies. Both these factors imply that diversified investors should rationally concentrate on systematic risk and generally disregard idiosyncratic risk. Indeed, the best evidence that these diversified investors are conforming to economic logic lies in a new pattern under which they are actively voting and lobbying public companies in common, primarily on ESG-related issues. 17 Given high common ownership across a broad portfolio, it becomes rational and predictable that diversified institutional investors will increasingly make both investment and voting decisions on a portfolio-wide basis (rather than simply trying to maximize the value of individual stocks). Proposals made by a diversified institutional investor to the firms in its portfolio will likely produce some winners and some losers, particularly for proposals relating to climate change and other ESG issues. If netting these gains and losses produces a positive result, the indexed investor profits in a way that the undiversified investor cannot duplicate. These 15 Anecdotal evidence is abundant that diversified institutional investors, including the Big Three, are placing significant pressure on many companies, particularly including energy companies to expedite their dates for "carbonneutrality" and on all companies to achieve greater board diversity. See Condon, supra note 8; Reed, supra note 13. 16  How should the SEC respond (if at all) to these transitions? Some will argue that the SEC should keep the protection of the retail investor as its first priority, but this article is premised on the belief that the migration of retail investors to indexed investing has been salutary. In fact, the SEC should encourage (and even gently push) retail investors to diversify, shifting their retirement savings to diversified (and generally indexed) institutional intermediaries (i.e. mutual funds and pension funds).
Still, this preference leaves unanswered our initial question: How do the informational needs of institutional investors and retail investors differ? How should the SEC respond to their differing needs?
This question has been approached by others, but not directly answered. A dozen years ago, Professor Donald Langevoort focused on the transition from retail to institutional markets at the time of the SEC's 75 th Anniversary. 19 His recommendations seemed to suggest that the U.S. market would likely become more like the European securities market, which, as he accurately observed, was characterized by (1) "light touch" enforcement, (2) a lesser disclosure burden emphasizing principles-based disclosure, and (3) considerably less reliance on ex post 18 What is new here is that large institutional investors can profit by deliberately causing losses to some firms in their portfolios if doing so results in greater gains to other firms in their portfolio. Although non-controlling shareholders have never owed a duty of loyalty to the corporations in which they invest, it is hard to think of any comparable instance in which causing losses to some could benefit them. 19 See Langevoort, supra note 4. litigation to enforce disclosure norms. Others challenged him, 20 but the greater problem with Professor Langevoort's thesis was his unfortuitous timing. Shortly after he wrote, the 2008 financial crisis broke and, in response, even the U.K. abandoned "light touch" regulation. While differences in enforcement intensity still separate the U.S. and Europe (and will likely continue), 21 a greater consensus exists today over the need for stronger enforcement and a mandatory disclosure system. This article will therefore skirt the topic of enforcement and instead focus on where the disclosure needs of retail and institutional investors may differ and where they are not being addressed. Here, other transitions in securities law practices are also relevant. Increasingly, private offerings, which are exempt from the Securities Act of 1933 (the "1933 Act"), have come to rival public offerings as a means for issuers to raise capital. Indeed, in recent years, the number of private offerings and the total capital raised in them has exceeded the corresponding figures for public offerings subject to the 1933 Act. 22 Because these exempt offerings require little disclosure (at least as a legal matter 23 ), this might seem to imply that institutional investors need less information. Yet, a confounding fact interferes with this simple conclusion: the 20 See Evans, supra note 6. 21 For a detailed examination of relative enforcement intensity between the U.S., the U.K., and Europe, see John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156 U. Pa. L. Rev. 229 (2007). 22 The principal exemption for private placements is Regulation D (17 C.F.R. §230.500 to 508). The number of "Reg D" offerings has exceeded the number of public equity offerings by a 30 to 1 margin. See Coffee, Sale and Henderson, SECURITIES REGULATION: Cases and Materials (13 th ed. 2015) at p.368. The aggregate amount raised in private markets has also exceeded that raised in public markets in some years. For example, in 2012, $1.7 trillion was raised in private markets versus $1.2 trillion in public markets in registered offerings. Id. 23 Under Rule 502(b) of Regulation D (17 C.F.R. § 230.502(b)), the issuer need not provide information to purchasers when selling to "accredited investors." Typically, such offerings are as a result limited to "accredited investors," which term is defined in Rule 501 of Regulation D to require only a modest $1 million net worth or an annual income for the two most recent years equal to or exceeding $200,000. See Rule 501(a)(5) and (6). With inflation, this test has become much more permissive and now includes millions of investors. As a generalization, the purchasers in Reg D offerings are generally individuals and smaller institutions, and the disclosure they receive tends to be quite modest.
character of the disclosure actually provided in offerings done pursuant to Rule 144A (the exemption from registration preferred by large public issuers 24 ) closely resembles the character of the information in a registration statement filed pursuant to the 1933 Act. In particular, the issuer's disclosures in a Rule 144A offering typically follows the same standardized format. Although no precise metric exists that proves that the same quantum of information is present in both exempt and registered offerings, institutional investors as a group appear to want (and implicitly demand) at least the same information as other investors, and they prefer it presented in the same standardized format. Particularly as they come to make decisions on a portfolio-wide basis, diversified institutions will increasingly want to know and compare the likely impact of ESG-related policy changes on all firms in their portfolio. In contrast, undiversified shareholders, lacking common ownership, are not in a position to implement similar portfolio-wide policies.
This article will offer a number of conclusions that are brief and blunt; to be brief, it is necessary to be blunt. Organizationally, Part I of this article will focus on the informational needs of institutional investors (and particularly, the fully diversified institution). How do their needs and priorities differ from those of the retail individual investor? Relying on the CAPM, it will suggest, first, that institutional investors are more concerned with "systematic risk" than are individual investors 25 and, second, that ESG disclosures address systematic risk to a much 24 See Rule 144A (17 C.F.R. §230.144A). This rule permits private sales to institutional buyers that own and invest at least $100 million in securities of unrelated issuers (in short, the profile of a large institutional investor). The volume and quality of the disclosure in Rule 144A offerings is much higher than in Reg D offerings to smaller investors, suggesting that large institutions are demanding more information based on their market power. 25 The claim here is not that individual investors disregard or ignore systematic risk, but that they are unable to do greater degree than the SEC has recognized. Part II will then return to the individual retail investor, who certainly remains on the scene and is the dominant investor in smaller companies that offer less liquidity. What new needs (and fears) might the retail investor reasonably have in the contemporary investment environment? Here, a partial answer will be that, although diversified institutions tend to be tolerant of risk, individual investors rationally have the reverse preference. Finally, Part III will turn to the growth of ESG disclosures. Although such disclosures are now becoming It is traditional to begin any discussion that relies on "law and economics" with the mandatory observation that "one size does not fit all." Not all institutional much about it. Lacking high common ownership, they cannot take meaningful collective action. Although portfolio firms may face different degrees of systematic risk, the retail investor also has choices with regard to a vast range of companies with differing idiosyncratic risks and thus have less reason to focus disproportionately on systematic risk. 26 The SEC has not implemented any mandatory ESG disclosure requirements, leaving them entirely voluntary. investors are alike. Some mutual funds and many hedge funds are "stock pickers;" they engage in active trading and believe they can outperform the efficient market.
Generally, they are wrong, but not invariably (which could be explained by the fact that some may have access to private information). Today, highly diversified institutional investors owe more assets under their management than do institutions engaged in "actively managed" stock picking. Typically these highly diversified investors do not attempt to outperform the market (but rather to mirror it cheaply).
Given their dominance, it is prudent to ask what kinds of information does the fully diversified investor want? Here, one needs to turn to the CAPM, and its most relevant teaching for our purposes is that diversification reduces "idiosyncratic" risk, but not "systematic" risk. 27 Idiosyncratic risk (or non-systematic risk) is that risk that is unique to a company or industry; for example, a company's (or an industry's) technology may be outdated or outperformed by a new emerging technology (e.g., natural gas or solar power may become cheaper than oil or coal-based power). But some risks affect all companies: inflation may increase; a banking crisis may disrupt finance and cut off credit across the economy; or, more recently, a pandemic may require all companies to curtail or suspend operations. Diversification does not offer satisfactory protection from these risks.
The CAPM assumes that the capital markets ignore unsystematic risk in pricing the value of a financial asset (including corporate stock) because diversified investors do not bear non-systematic risk. Because diversification is easily achieved with little cost or effort for investors, the price of a stock, according to this model, is set by diversified investors, who need only consider the company's systematic risk. In effect, if two companies have the same expected return, the fact that one has higher non-systematic risk will not affect their relative valuation to the extent the market price is set by diversified investors who do not bear this risk. Put differently, investors cannot demand a higher return for bearing non-systematic risk that they could have easily diversified away.
The key implication here is that the price of a financial asset will be determined by the asset's systematic risk compared to the risk of the market as a whole. To be sure, the CAPM has been much criticized and may overstate. 28 But, even its critics believe that it points in the right direction and is roughly accurate. 29 The CAPM's immediate implication for our topic of disclosure policy is that, as the market becomes increasingly populated by diversified investors, these investors will focus primarily on systematic risk. Individual investors may have some concern about systematic risk, but it does not dominate their intention because there is little they can do about it and they have a range of other choices. Unsurprisingly, the SEC, as an agency that has always served the retail investor, has never addressed systematic risk in anything approaching a comprehensive manner.
Let us assume that the CAPM makes assumptions that many will regard as overstated. 30 But, even if we need to take it with a substantial grain of salt, the CAPM still legitimately implies that the SEC needs to modernize its disclosure policy and focus more seriously on systematic risk. This does not mean that the SEC should ignore non-systematic risk (because many investors will remain less than fully diversified), but it does suggest that diversified investors who constitute a majority of the market have an unmet disclosure need.
What has the SEC done to this point with regard to ESG disclosures? The short answer is very little. In 2018, institutional investors representing over $5 trillion in assets under management submitted a rule-making petition to the SEC requesting it to mandate ESG disclosure standards for public companies. 31 More than 60 governments and international organizations, including the United Nations and the International Organization of Securities Commissions, have promulgated ESG standards, 32 but the SEC has resisted these pressures (probably motivated by countervailing pressures from corporate issuers). The SEC's principal expressed concern has been the danger of information overload that would inundate investors with low-quality information and often inconsistent metrics and rankings. 33  This activism of diversified institutional investors on ESG issues contrasts sharply with their general passivity on firm-specific business issues, and this disparity can only be explained in one way: diversified institutional investors are deeply concerned about systematic risk but generally indifferent to idiosyncratic risk.
Not only can they ignore non-systematic risk, but they may waste resources in seeking to respond to it. 36 Climate change probably presents the clearest example of systematic risk.
Although it will not affect all companies the same (i.e., the risk is heterogeneous), 34 In 2020, the SEC "modernized" its requirements with respect to Items 101, 103 and 105 of Regulation S-K, but required only very general "principles-based" disclosures. For example, with respect to Item 101 (which requires a description of the issuer's business), it did address the "social" component of ESG, but only in a minimal way by instructing issuers to provide: "A description of the registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the registrant's business and workforce, measures or objectives that address the development, attraction and retention of personnel)." See Securities Act Release Nos. 33-10825, 34-89670 (April 26, 2020). This brief statement was the SEC's only reference in this Release to the goals of diversity and affirmative action. Thus, although Item 101 now at last addresses the social component of ESG, it does so in an extraordinarily minimal way. Not surprisingly, some observers have found that public corporations are not responding to this invitation to discuss their policies on human capital. [add citation] 35 For a description of a forceful intervention by a group of six large institutional shareholders (including the Big Three) that succeeded in causing both ExxonMobil and Chevron to support climate change reforms that these firms had previously opposed, see Condon supra note 8. Not only are broadly diversified institutions seeking more ESG disclosures, they are also acting upon them as well, sometimes by suing portfolio companies. See Alexander Platt, Index Fund Enforcement, 53 U.C. Davis L. Rev. 1453 (2020). 36 For example, if a diversified institutional investor expended money and effort to cause a given firm to improve its performance on some specific business issue, it might profit with respect to that stock, but lose money on the stock of a rival company that loss market share to the company that improved its performance. Being fully diversified implies that efforts directed at improving a single firm in the portfolio could be counterproductive. Also, index funds chiefly compete with other index funds that are also matching the same indexes; thus, if one index investor intervenes to improve the earnings of a portfolio firm, it benefits its rivals as much as itself (while bearing all the cost). That is not a successful competitive strategy.
investors cannot escape it through diversification. That is, there is no obvious class of companies whose stock will go up as the result of global warming so as to compensate diversified investors for those other stocks that go down.
Given that they are unavoidably exposed to this risk, diversified investors rationally want disclosures that enable them to estimate its impact on their portfolios. Further, they may want to take actions (either by voting, litigation, or persuasion) to induce changes that reduce such risk (even if it causes losses to some companies in their portfolio, so long as the action taken implies greater gains than losses to the portfolio). A clear indication of this new activism came in January, 2021 when BlackRock's CEO, Larry Fink, wrote to the CEOs of major public corporations, asking them to commit to a "goal of net zero greenhouse gas emissions" by 2050. 37 This is a costly change that will adversely impact earnings at many companies (but it is designed to benefit other firms in BlackRock's portfolio even more and thus to result in a net benefit for BlackRock).
Another example of a systematic risk that has concerned both institutional investors and the SEC involves the Covid-19 pandemic. Here, the SEC has been actively seeking increased disclosure, asking all public companies to explain how the pandemic is affecting them. 38 Obviously, pandemics represent a form of systematic risk because diversification again cannot protect an institution's portfolio. 37 See Larry Fink, "Letter to CEOs," Harvard Law School Forum on Corporate Governance, January 30, 2021. This letter went on to describe several metrics that BlackRock would use in evaluating whether their portfolio companies were in compliance and a "heightened scrutiny model" that its actively managed funds would use in dealing with noncomplying portfolio companies. Id such disclosures relate to systematic risk disclosure. Yet, over the long-run, these disclosures arguably relate to the potential viability of our corporate system. If our corporate system cannot offer inclusiveness and promote diversity, it may subject itself to a political risk that capitalism (or, at least, contemporary corporate governance) will be politically challenged and could conceivably yield to a more staterun system of corporate governance. To some degree, such a transition seems to be already occurring in Europe and the U.K. 39 Again, diversification could not protect investors against this risk of political upheaval, which could directly threaten the traditional investor's goal of shareholder wealth maximization.
One last point about "systematic risk" needs to be underscored: for diversified investors, systematic risk overlaps heavily with securities law's bedrock concept of materiality. Because systematic risks cannot be diversified away by investors, information about such risks is more material to diversified investors than information about "idiosyncratic" risks, both because institutional investors are in theory exposed only to "systematic risk" and because they (and, as a practical matter, overview, see "Updating Public Traded Company Disclosures for Covid-19," LAW360 (March 20, 2020). 39 Nations can be located on a corporate governance continuum ranging from "shareholder-centric" systems (of which the U.S. is the leading example) to "stakeholder-centric" systems (into which category most European nations fall). In Europe and the U.K., there has been recent movement towards increasing the rights of, and duties owed to, stakeholders. One step in this direction has been the recent popularity of "stewardship codes" for investors. See only they) may be able to take corrective action to minimize such risk. 40 Indeed, as later discussed, the major diversified institutions have begun to take direct action on a coordinated basis (through litigation, proxy fights, or the threat of exit).
Ultimately, the informational needs of the diversified institutional investor depend on the role that it is willing to assume. For some time, commentators have presented the diversified investor as being "rationally reticent" and willing to act only on issues framed and presented by non-diversified activist investors. 41 Understandable as this view was, it no longer conforms with the current reality in which the Big Three (and others) are taking a leadership role in pressing portfolio companies for systematic risk-related changes. BlackRock, for example, showed little "reticence" in insisting that its portfolio companies adopt a "net-zero" emissions policy by 2050. Thus, it is necessary to recognize that, within the boundaries set by systematic risk, indexed investors can indeed be activists--even (because of their greater scale) more effective activists than the hedge funds.  44 Retail investors tend to be "buy and hold" investors (who do not trade actively) probably because they face higher trading costs than institutional investors who, because they trade in volume, receive quantity discounts. 45 The taste for risk is subjective and individuals differ. Thus, although a hypothetical 5% stock market gain might induce some (or even most) investors to accept the increased risk associated with increased leverage or reduced diversification, it may not please all shareholders. Also, the increased risk may not be evident to many retail shareholders (who see only the increased stock price). This conclusion will be regarded as heresy by neo-classical economists who assume that all shareholders favor policies that increase the share price. See Frank H. Easterbrook & Daniel Fischel, THE ECONOMIC STRUCTURE OF CORPORATE LAW, 69-71 (1991). This, however, ignores that rational investors will focus on the risk-return ratio and vary in their reactions. exercising the option). Presumably, they will make the choice that maximizes their own interests (possibly at the expense of creditors and other stakeholders).
The immediate relevance of this point involves the incentive effects on the option holder (i.e., the common shareholders). As option holders, they can be expected to act rationally so as to maximize the value of their option. What does that imply?
Under  Today, activist hedge funds have learned that if they propose a specific scenario for increasing risk (such as by following a riskier investment policy, selling off corporate assets that mainly provide unneeded diversification, or increasing leverage, buybacks and dividends), they will find it easy to sell this policy to institutional shareholders. This motivation to increase risk and reduce diversification did not begin with activist hedge funds. "Bust-up" takeover bidders did the same thing in the late 1980's. But these bidders were chilled by the poison pill, state takeover laws, and judicial developments. 50 The evidence is clear that activist hedge they do not deliver immediate gains. In contrast, corporate managers are conventionally assumed to have a longer term (and more risk-averse) perspective because of their locked-in human capital. 50  funds can today compel target managements to negotiate their demands and place the hedge fund's agents on the target's board. 51 More importantly, the activist fund spends far less, fares far better, and achieves results far more quickly than the traditional hostile bidder. As a result, the activist hedge fund has largely replaced the hostile bidder, but the implications for the undiversified retail investor remain the same: increased risk is generally contrary to their preferences.
Although the clear winners here are diversified shareholders and activist funds, the clear losers are not only creditors, managers and stakeholders. In addition, the undiversified retail investor is a bystander whose fate is less easily summed up.
This shareholder may sometimes win and sometimes lose, depending upon how much risk the shareholder is willing to accept. The bottom line then is that retail shareholders are effected much more than they realize, and they may bear more risk than they understand or want.
How (if at all) should the SEC protect these investors?
The long term answer may be that retail investors should be prodded (or at least encouraged) by the SEC to diversify. But the SEC's ability at investor education is open to doubt. 52  BlackRock has announced that it will push all its portfolio companies to comply with a "net-zero" emissions goal by 2050. 53 For companies engaged with fossil fuels (oil, gas or coal), this will be a considerable challenge that could imply a period of continuing losses (or at least greatly reduced earnings). Nor will BlackRock's challenge be the only one that many companies receive with respect to climate change. Other asset managers may assert challenges on social or governance issues (including diversity). Because indexed investors must remain invested in the indexes with respect to which they promised their shareholders they would conform, there is little possibility that these investors will "exit" and disinvest if disappointed with the portfolio company's response. By definition, index investors are there to stay, although increasingly they may have a hostile relationship with management.
Ideally, these policies will prove profitable for the asset managers who are asserting them, but there is every reason to believe that undiversified retail investors will be caught between the rock and hard place. intended to protect beneficiaries from fiduciaries who might subordinate the beneficiaries' financial interests to those of political or social groups with whom the fiduciary sympathized. Legally, the "sole interest" rule implied that the trustee had to prefer investments with superior risk-adjusted returns, regardless of the social impact of the corporate issuer. Nervous that they might run afoul of the law, many risk-averse fiduciaries shied away from SRI investing. 62 To bring SRI investing into the mainstream, something had to be done, and predictably clever lawyers devised an answer. Conceptually, they "rebranded" SRI investing and converted it into ESG investing by asserting that consideration of the "governance factors" associated with public corporations would enable the fiduciary to identify superior investments and enhance risk-adjusted return. 63 By adding governance to the mix, they argued, one not only did good (ethically), but one also did better (financially Necessity is often the mother of invention, and the modest claim here advanced is merely that the need to calm the fears of risk-averse trustees best explains the addition of "governance" factors to environmental and social ones in order to convert SRI into ESG. Whatever the motive, this rebranding seems to have worked and in a brief period brought ESG into the investment mainstream. As of late 2019, some This distinction between (in their words) "collateral benefit" ESG investing and "risk-return" ESG investing seemingly makes everything depend on the fiduciary's motive. Realists will, of course, recognize that, once risk-averse fiduciaries are properly advised as to the law, they likely will express the legally proper motive and deny the legally improper motive. (Hey guys, isn't that what lawyers are for?). Thus, under this approach, the practical risk of fiduciary liability seems relatively small. 72 The "sole interest" rule applies to fiduciaries under private trusts, at ERISA plans, and at charitable foundations, but does not normally apply to the directors or officers of mutual funds or hedge funds (unless they are serving as advisors to an ERISA plan). 73 See Gary, supra note 65. Professor Gary served as the Reporter for the Uniform Prudent Management of Institutional Funds Act, which alone makes her a significant voice in this field. The Principles for Responsible Investment (or "PRI") represents probably the leading statement of the necessity for fiduciaries to adopt ESG factors into their investment analysis. It has obtained over 1,900 asset manager endorsements of its statement of principles. Still, the test proposed by Schanzenbach and Sitkoff would actually require considerably more than just a proper motive. They would require the prudent trustee to conclude, before investing based on any special ESG factor, that the "capital markets consistently misprice the factor in a predictable manner that can be exploited net of any trading and diversification costs." 75 Although this test purports to permit ESG investing, it may well be a wolf in sheep's clothing. Its very demanding standard about mispricing may be much harder for ERISA fiduciaries to satisfy. In effect, the fiduciary must determine, first, that ESG factors relate to firm performance in the case of a specific company, and, second, that this factor has been sufficiently mispriced that the fiduciary can exploit this mispricing (net of trading and diversification costs). 76 Although I agree with them that ESG investing is not mandatory and that prudent trustees can reasonably conclude that they cannot outperform the market (as the Supreme Court has also observed in a relevant recent decision 77 ), the possibility still seems remote that any court, either state or federal, would second guess and hold liable trustees who do decide to engage in ESG investing in the belief that it will enable them to achieve a superior portfolio. Courts are not suspicious of professional trustees, and, absent a personal self-interest on the part of the fiduciary, they have little reason to apply any enhanced scrutiny standard. Nor is there any clear history of courts intervening in this private world to impose liability. 75 Id. at 451. 76  In fairness, the "sole interest" rule regulates only some institutional investors (principally ERISA plans, common law trusts, and charitable foundations) and does not apply to mutual funds or hedge funds, which are subject to SEC regulation. Still, pension funds account for nearly half of the assets held by the institutional investors and the "sole interest" rule (and a Department of Labor rule extending it) may greatly reduce the size of the coalitions that can form to take collective action on ESG issues.
C. The Impact of a Portfolio-Wide Perspective. What is the best way out of this quandary? Here, we need to recognize that the key development is the new high level of common ownership that enables diversified institutional investors to take collective action on a portfolio-wide basis. Professors Schanzenbach and Sitkoff do not discuss this possibility, but fiduciaries should be able to engage in ESG investing on a portfolio-wide basis in full compliance with the "sole interest" rule so long as they make a finding that their collective strategy should raise returns or lower risks. For example, suppose that ERISA plans were to join both mutual funds and hedge funds in a joint effort to push the major energy companies to adopt tighter standards on emissions and to advance the date on which they would become carbon neutral. Their justification might be that, although this would reduce the financial returns for some portfolio companies (i.e., coal companies), it would benefit other companies (for example, those who produced solar power, wind power or nuclear power). Such pressure has in fact been successfully applied to Royal Dutch Shell and others in 2018. 78 Economically, such interventions would make sense --if the losses to the 78 In late 2018, Royal Dutch Shell was pressured by a coalition of institutional investors to set emission reduction targets to reduce its carbon footprint by 20% by 2035 and 50% by 2050. It had previously opposed these targets and traditional energy companies were outweighed by gains to the other firms in the portfolio. As Madison Condon has framed it: "A rational owner would use his power to internalize externalities so long as its share of the cost to the externality-causing firms are lower than the benefits that accrue to the entire portfolio from the elimination of the externality." 79 In the past, even a large institutional investor could not hope to cause a shift in corporate policy at a portfolio firm. But in the new age, where the Big Three usually votes 25% of the shares voted just by themselves (and can reach out to their fellow institutions for more support), they seem able to enforce their will effectively.
Moreover, the firm managers that they will seek to pressure will typically be riskaverse and probably unwilling to jeopardize their careers by engaging in a contested proxy fight with these powerful institutions.
Of course, fiduciaries at an ERISA plan would have to make an informed judgment and compare the costs and benefits from such action to their portfolio. But this is exactly where consultants will predictably be hired to perform such an analysis. 80 Possibly, my cynicism is showing, but these consultants will usually be able to justify the requisite findings that their clients want. Indeed, this could become described them as "onerous and cumbersome," but once approached by this institutional coalition, it yielded quickly. See Condon, supra note 8, at 2. Thereafter, this same coalition next approached ExxonMobil, Chevron and BP. Id. 79 Condon, supra note 8, at 6. 80 For example, an environmental consulting firm, an accounting firm, or a proxy advisor might compare the loss to a major oil company (such as Royal Dutch Shell in our earlier example) from reducing its emissions or carbon footprint by a specified percentage to the benefits to other companies in its portfolio from achieving reduced pollution and postponing adverse climate change. Some asset managers appear to be making these estimates already. Schroders, a major asset manager, has calculated that a 4 degree increase (Centigrade) would produce "global economic losses" of $23 trillion over an 80 year period. See Condon, supra note 8, at 6. Because this is a short article, it will simply assert (and not demonstrate) that such calculations are difficult and tend to be error-prone.
a burgeoning growth business for accounting firms, proxy advisor firms, and other consultants.
This is also the juncture where the SEC could play a useful role. The SEC could require corporate managers to disclose data that they possessed about the costs of change (for example, the costs of reaching carbon neutrality by a given date). Such data (which increasingly exists at many large public companies) could be required to Conceivably, one could go even a step further: fiduciaries might also calculate the benefits to their beneficiaries, as individuals, from reducing pollution or slowing climate change. 82 Although under ERISA fiduciaries may be legally required to focus on the financial benefits to their beneficiaries, it may be possible to quantify those financial benefits on a portfolio-wide basis. Considering the personal financial 81 "Reporting companies," which term includes most exchange-listed companies, must comply with SEC Regulation S-K (17 C.F.R. §229) by filing certain mandatory periodic disclosures with the SEC. Item 303 of Regulation S-K ("Management's Discussion and Analysis of Financial Condition and Results of Operations") requires such a reporting company to "identify any known trend or known demands, commitments, events or uncertainties… that are reasonably likely" to produce material changes in the issuer's liquidity, capital resources, or results of operations. If there were even "uncertainties" about the costs of reaching environmental targets and costs could have a material impact on liquidity, capital resources, or results of operations, then disclosure would be required. The point here is that the SEC could clarify that such disclosure was required as to major ESG topics, such as climate change, and this would inform and motivate fiduciaries at the major institutional investors. 82 This idea that fiduciaries could serve the best interests of their beneficiaries by considering more than simply the impact of their actions on the individual stocks before them will worry some, as it could quickly lead down a slippery slope to very subjective judgments. For example, one could look even beyond the financial interest of the beneficiaries and add into the calculation their beneficiaries' personal interests as well (reducing pollution may enable the beneficiaries to live longer or better lives Already, many securities analysts prepare rankings of public companies in terms of ESG criteria. The problem with such rankings is a familiar one: "Garbage In, Garbage Out" --the "GIGO Effect." Today, ESG disclosure is incomplete and unstandardized, with rankings that are dubious and inconsistent. 85 Public disclosure of ESG data would at a minimum improve the quality of such rankings and ratings and give trustees greater confidence in relying on such data. The bottom line here is that more ESG data will likely produce more decisions based on ESG criteria --and also greater attention being given to systematic risk.  (2019). This "reasonable chance" standard was later marginally massaged into a "reasonable expectation" standard, as later discussed. investment decisions) 87 and that fiduciaries must constantly make voting decisions across their portfolios. As a result, for many years, both favored a rule of reason with regard to voting and shareholder activism. 88 Then, in December, 2020 in the concluding days of the Trump Administration, the Department of Labor dropped a bombshell, reversing its prior approach to shareholder activism. No longer endorsing mandatory voting of shares and dropping the prior "reasonable expectation" test, it adopted a rule under which a fiduciary subject to ERISA "must not vote any proxy unless the fiduciary prudently determines that the matter being voted upon would have an economic impact on the plan." 89 A prerequisite to voting by an ERISA fiduciary is thus a prior determination by the fiduciary that the vote will have an economic impact on the plan; a "no impact" The SEC followed several years later and similarly endorsed the duty of a fiduciary or investment advisor to vote the shares held by a mutual fund or other investment company. See SEC Release No. 33-8188, 34-4703 (July 21, 2003). To sum up, both agencies agree that fiduciaries must vote their shares and must do so with the objective of increasing the value of the fund to their beneficiaries. 87 See Department of Labor, Employee Benefit Security Administration, Interpretive Bulletin 2016-1 ("Interpretive Bulleting Relating to the Exercise of Shareholder Rights and Written Statement of Investment Policy, Including Proxy Voting Policies or Guidelines") (12/29/2016). This revised bulletin adopted a "reasonable expectation" standard for when fiduciaries should engage in shareholder activism, with the expectation being that the plan's assets would be enhanced. However, in December, 2020, the Department of Labor withdrew Interpretive Bulletin 2016-1 and adopted a new final rule that significantly changed the standard for voting decisions to require that an ERISA fiduciary believe that voting shares in a particular case would enhance firm value. See text and notes infra at notes 88 to 89. 88 Even under President Trump, the Department of Labor continued to use a "reasonable expectation" standard until the final days of the Trump Administration. Although it cautioned that the objective of shareholder activism must be the enhancement of the plan's value (meaning that the fiduciary may not be pursuing political or social preferences), it did not alter significantly prior Department of Labor positions. See Field Assistance Bulletin No. 2018-01 (April 23, 2018). However, this position changed dramatically in December, 2020, as explained in the text and the next footnote. 89 See U.S. Dep't of Labor, "Fiduciary Duties Regarding Proxy Voting and Shareholder Rights," 85 Fed. Reg. at pages 81658-81695 (to be codified at 29 C.F.R. 2550.404a-1) (December 10, 2020). This rule became effective on January 15, 2021, just days before the end of President Trump's term. Before adopting this proposal on shareholder voting under ERISA, the Department of Labor a month earlier adopted a similarly restrictive rule on investments by an ERISA plan under ERISA's "exclusive benefit" rule. See U.S. Dep't of Labor, "Financial Factors In Selecting Plan Investments," 85 Fed. Reg. 72846 (November 13, 2020) (instructing fiduciaries that they "may not subordinate return or increase risks to promote non-pecuniary objectives…"). Id. at 72848. This provision was somewhat less surprising than the later rule on shareholder voting, because investments do involve greater costs and risks. Both may be reexamined by the Biden Administration. determination implies then that the shares may not be voted. This is a proposed rule of enforced passivity, which goes well beyond simply precluding votes based on moral or ethical considerations.
Consider what this does to ERISA plans that tend to vote affirmatively on ESG measures. Hypothetically, suppose that an ERISA plan would like to vote on a shareholder proposal favoring greater diversity on the board. Is it now barred from voting on this precatory (and entirely aspirational) measure? Must it conduct a potentially expensive study first (whose outcome is not automatically obvious)? Must it show that the market has "mispriced" this special factor? 90 The Department of Labor's new rule does seem to intend that such steps be prerequisites to voting, and it is quickly attracting a firestorm of criticism. 91 Three basic arguments call into question the legitimacy of this rule: First, voting is different from an investment or sales decision in that (i) loss of diversification benefits is less threatened by voting (whereas such benefits were threatened when investors sold off stocks of South African-based companies in the 1980's), (ii) the transaction costs of a voting decision are trivial (no brokerage fee is involved and no sale proceeds have to be re-invested), and (iii) the failure to vote can also result in loss to shareholders. That is, shareholders may suffer losses as much from the inability to vote as from "bad" voting decisions. Second, an ERISA fiduciary can make a voting decision on a portfolio-wide basis, and the rule should apply idea, because it does not involve fiduciaries subordinating economic returns to social welfare (as the proponents of "stakeholder capitalism" sometimes demand). Rather, fiduciaries are simply seeking to improve returns and reduce risk by responding to systematic risks that could depress the entire economy.
Nonetheless, it will likely arouse more controversy than modest concessions to stakeholders. Consider this hypothetical: five diversified index funds threaten a Coal's management closes its principal mine in Kentucky, with a resulting large layoff of miners. Employees are outraged, and a prominent Senator from Kentucky announces a senatorial committee hearing on the "arrogance" of the index funds.
Contemporaneously, the state legislature in Kentucky begins to draft legislation that would cancel the environmental changes just adopted, and corporate law firms develop a new form of poison pill that would bar the acquisition of more than 10% of a Kentucky company's stock by any group of mutual funds that is seeking (or later seeks) to pass or support specified shareholder resolutions.
The point here is not that this counter-reaction will succeed, but that counterpressure is predictable. Although I suspect that the threat of such political retaliation will incline many institutional investors toward no more than reticent participation in attempts to curb externalities through collective action, time will tell. At present, it is still premature to predict more than that controversy will surround collective action by institutional investors to maximize portfolio value.

CONCLUSION
Briefly and bluntly, this article has offered five basic conclusions: (1) Institutional investors logically have a greater interest in systematic risk than do undiversified investors (in part because only diversified investors with high common ownership can take effective action), and much of what ESG disclosures would provide relates primarily to systematic risk; (2) Individual investors (at least if undiversified) have reason to fear that portfolio-wide voting by diversified institutions will adversely affect them. Today, they are not adequately advised about the conflicts that arise between their interests and those of both diversified institutional investors and activist hedge funds; (3) Because of the high level of common ownership among diversified institutional investors, these investors can potentially profit on a portfoliowide basis by imposing constraints that seek to reduce externalities. But again, this aggravates the conflict between diversified and retail investors.
(4) Because ESG disclosures and high common ownership enable diversified institutions to make decisions on a portfolio-wide basis and potentially to reduce systematic risk, the advent of portfolio-wide decisionmaking (both as to investments and voting) may represent the most important contemporary change in institutional investor behavior.
Although it appears to be logically consistent with the "sole interest" rule, it will provoke continuing controversy.
(5) There is little need for a federal "sole interest" rule. No claim has been made that the states have failed to enforce their rules. Absent a showing that state law has failed or cannot be enforced, a federal rule is undesirable, as it may preempt sensible variations at the state level.
This article has not asserted that fiduciaries must favor ESG investing.
Decisions either to engage or not to engage in ESG investing should both be protected.
The real issues for the future are: (i) whether the Trump Administration's efforts to chill ESG voting decisions (and thus by extension ESG investing) should be reversed; and (ii) whether institutional investors are prepared to face significant political controversy and pushback if they pursue portfolio-wide voting policies. 95 For the SEC, this transition may force it to redefine itself. Since its creation, it has been an agency committed to serving "stock picking" individual investors. Such investors are, however, fading from the scene. This does not mean they should be ignored, but that greater attention must be given to the majority of individual shareholders who are today diversified (and often indexed). 95 It is not just institutional investors who are under attack; nor simply the Department of Labor that is leading this campaign. In 2020, possibly in response to their activism in assisting institutional investors, proxy advisors were subjected to new and burdensome SEC rules that will slow the process by which they can advise and assist their clients. See Michael Cappucci, The Proxy War on Proxy Advisors, 16 NYU J. L. & Bus. 579 (2020). My point here is only that this example may concern and caution institutional investors, who must realize that activism can produce political retaliation in their cases as well. To be sure, the major institutional investors have much greater financial resources than the proxy advisors.
Common ownership has both an upside and a downside, and to date little scholarly attention has focused on the upside. Shareholders have not been regarded as the "true owners" of the corporation, since Berle and Means announced the separation of ownership and control many decades ago. Yet today, shareholders have regained the powers of "true owners." Unlike their 19 th Century antecedents (for example, the railroad, oil and bank barons), however, the focus of institutional investors, as owners, will logically shift to maximizing portfolio value, not the value of individual stocks. One implication of this transition is that it may solve a problem that has frustrated legal scholars for decades. Over that period, many scholars have sought to find a strategy to make public corporations behave more virtuously. 96 Despite their gallant efforts, they have not fully persuaded most of us, and more conservative scholars have responded that reducing the externalities associated with corporate behavior was not the job of corporate law. 97 Now, without any change in corporate law, a real possibility has arisen that institutional activism may curb externalities and lead to a better (and not just more profitable) society.