A recent article by Marcel Kahan and Edward B. Rock critiqued the sort of system stewardship we promote at TSC. While several correspondents have pointed to this article as taking a side against system stewardship, it is much more a tour of the landscape that highlights the challenges, both legal and practical, in achieving its goals. But the authors do not really question the idea that in some circumstances diversified investment fiduciaries would want to address the threat from portfolio companies that externalize costs to other investees:

BlackRock and other shareholders may legally adopt [a system stewardship] perspective in voting on precatory shareholder resolution. Indeed, as investment fiduciaries, they may even be required to do so.

The article begins by identifying three main concerns with system stewardship. First, the authors say individual companies that account for externalities may be overtaken by competitors that do not:

“[U]niversal owners would have to take into account the possibility that inducing some firms to reduce environmental externalities and mitigate risk will generate a competitive response that will eliminate the benefits from these actions for their other portfolio companies. If that were to happen, universal owners would be stuck with the losses without receiving any corresponding gains.”

This is not really an objection to system stewardship, but simply restates the problem it is trying to solve: if we measure corporate success by individual company financial returns, individual companies will be incentivized to engage in negative-sum behavior by externalizing social and environmental costs, because if any company fails to do so, a competitor will fill the gap. This is a classic prisoner’s dilemma. System stewardship attempts to introduce an enforcement mechanism designed to overcome this issue: the diversified investors who dominate the capital markets have both the incentive and the power to level the playing field, allowing shareholders to address the concern about competitive response. We identify related scholarship in our recent letter to the U.S. Department of Labor (DOL). That scholarship includes articles from two Columbia law professors, the book, Beyond Modern Portfolio Theory, and the recent study released by Freshfields, looking at fiduciary duty in 11 major global jurisdictions. The scholarship establishes the following relationship, which Rock and Kahan don’t dispute:

corporate social and environmental impacts ==> systemic health ==> global economic performance ==> beta ==> diversified portfolio performance

Second, the article argues that system stewardship may be incompatible with corporate and antitrust law:

“[C]orporate law, as it currently stands, has a strong ‘single firm focus’ (‘SFF’) that stands in sharp contrast to the potential ‘multi-firm focus’ (‘MFF’) of large portfolio investors. If universal owners were to work individually or together to protect their overall portfolios from systemic risk, it would clash with corporate law, securities regulation and potentially antitrust in a fundamental way that could create significant risks of liability and a significant potential for political backlash.”

This is not an objection to the ideas behind universal ownership, but rather a claim about current legal structures. The corporate law question is doctrinally interesting, and Kahan and Rock explore it in depth. But as a practical matter, it’s hard to imagine a court finding it a breach of fiduciary duty for a company to reduce its carbon footprint if that is what most of its shareholders want. And were that to happen, it’s hard to imagine a political consensus supporting that decision. Moreover, a company concerned with the liability issue could convert to a benefit corporation or migrate to a jurisdiction that had a constituency statute and then reduce its carbon footprint. Rick responded to some of the antitrust law concerns in a recent article, which responded to another article by Madison Condon about system stewardship in the Environmental Law Reporter.

The third objection the article raises is that the tradeoffs system stewardship necessitates would require asset managers to breach their fiduciary duties to concentrated shareholders:

“Third, universal owners typically manage a wide variety of different portfolios for different clients each of whom is owed fiduciary duties. A ‘trade-off’ strategy that would benefit some portfolios at the expense of other portfolios would conflict with these fiduciary duties as well as with the core multi-client multi-portfolio business model.”

But objecting to tradeoffs is not an effective argument for business as usual, which involves its own massive tradeoff: the focus on individual company financial return with no regard to systemic impact (the current system) creates the $2.2 trillion in annual negative-sum trade-offs documented in the Schroders Report discussed below; the only difference is that the current trade favors highly concentrated positions over the much larger group of actual beneficiaries whose portfolios are diversified in accordance with Modern Portfolio Theory. The real winners of what the article calls “single-firm focus” are the financial industry players who manage funds with concentrated positions and CEOs who get large rewards for creating “alpha,” even when the cost of that alpha is social and environmental damage that weighs down the economy and the returns of most real beneficial owners. As Rick said in the ELR article:

“The fact different beneficiaries have different interests in these issues cannot justify ignoring them, because ignoring the tradeoffs is itself a choice. If a company or portfolio manager maximizes company or portfolio value by externalizing costs, and if the ultimate beneficiaries of that company or portfolio have other financial interests, careers, people, and issues they care about affected by those costs, then the manager is trading off their interests for the interest of the hypothetical beneficiary whose interests are fully aligned with those of the company or portfolio.”

None of this is to say that the article does not include a subtle analysis of a complex issue; a careful reading of the most recent version of this working paper reveals Rock and Kahan don’t really challenge the ideas behind system stewardship. Instead, they’re suggesting it will be difficult to pull off and inconsistent with current corporate law.

While we agree there are certainly challenges, the risk of maintaining the status quo is existential. In our DOL letter, we establish the huge cost we pay by failing to make that shift. The Schroder’s Sustainex report shows that half the profits of all listed companies are matched by social costs those companies impose ($2.2 trillion in costs per year). Fully one-third of all listed companies are net value destroyers—their negative social costs exceed their profits. Something is very broken.

Other studies we cite show the economic costs of antimicrobial resistance ($100 trillion through 2050), inequality ($1 trillion annually in the United States alone), etc. Swiss Re has calculated that the cost of our current carbon trajectory compared to a Paris-aligned trajectory will be almost 10 percent of global GDP by 2050. These numbers are established and create strong headwinds for all portfolios. The social and environmental toll of individual company value maximization is ongoing and affects all investors who rely on a healthy economy.

Kahan and Rock suggest that the better answer to cost externalization is increased substantive regulation of corporate conduct. While we certainly support better regulation, the fact is that it’s not happening, in part because corporations use their power to pervert the system, as the news above regarding the ETF of heavy political influencers shows. Interestingly, Kahan and Rock end the article with an acknowledgement that system stewardship might be used as a tool to improve public policy:
The best argument in favor of systemic stewardship may thus be that it could act as a catalyst for political change.
We could not agree more.

Our shareholder proposals don’t deny the challenges of shifting to system stewardship. Instead, by proposing externalities analyses, we’re asking shareholders to communicate to companies that they care about the social and environmental costs companies externalize and that the companies should take that concern on board. If we can’t take that first step, we’ll never solve for the objections Rock and Kahan raise.