Andrew M. Clearfield
July 24, 2018
Re: Charles M.
Nathan, Institutional Investor Engagement: One Size Does Not Fit
The errors in logic
in the attached piece are, unfortunately, manifest.
Mr. Nathan is
purporting to develop a logical argument, but his argument is based
upon several non-sequiturs:
1. It does not
follow that having a “relatively small group” (does the author mean
five? twenty?) charged with governance engagements should have any
particular relationship to the "huge number of worldwide company
[proxy] votes they [i.e., the same fund manager] cast in a year.” It does not follow that if this
number is less than some large number that all of a fund manager's
votes—or even merely those involving a company subject to a
governance engagement—would be miscast.
2. A focus upon
“the big picture environmental social, and governance issues” does
not necessarily mean that the investor will have a list of fixed
criteria to be applied to all proxy votes.
3. Nor does it
mean that a dedicated governance team can or will dictate that all
(or any) votes are cast solely in accordance with fixed global
4. And further,
the existence of governance teams does not necessarily mean that
they become involved with “company
specific issues of strategy design and implementation, capital
allocation, M&A opportunities, and operational and financial
—In actuality, my experience has
been that governance teams do not pass judgment on most or any
of these matters, but solely upon those issues falling more
specifically under the headings of corporate governance, and/or
social and environmental impact.
In short, the
author is creating a straw man, in order to criticize the use of
dedicated teams specializing in governance. Large investors do
reserve both evaluation of and final judgments upon ‘company strategy,
capital allocation, proposed mergers or acquisitions, and financial
performance’ to securities analysts and fund managers. Governance teams are expected
to make recommendations or give advice regarding the sorts of things
quantitatively-oriented portfolio managers usually ignore.
proposed, and supposedly new, engagement paradigm is the one which has
been used for decades: leave everything up to the numbers people. These are unfortunately least likely (especially when the numbers are
particularly mouth-watering) to pay attention to even the most obvious
problems with: the ownership structure, lack of a succession plan if
the indispensable CEO gets run over by a truck, the ability of a board
to dilute any hostile bidder to death (a feature sometimes found in
the most widely followed ‘bidding target stories’!), lack of board
independence, risk of enormous fines for egregious social or
environmental malfeasances, perverse pay incentives, and so forth.
That’s why dedicated governance professionals were created in the
first place—to pay attention to risk factors that most investors were
likely to overlook by focusing upon financial statements and listening
to sales pitches.
Moreover, he mixes
up two kinds of investors: indexers, who cannot, and will not, pay
attention to company-specific issues (therefore meaning there are
no portfolio managers to follow the aforementioned
company-specific issues), and active managers, who (a) almost
certainly do not give their governance teams carte blanche to overrule
portfolio managers’ decisions, and (b) are only likely to be involved
in governance engagements with a relatively few key companies—either
major holdings or companies that are otherwise in their radar.
I would, however,
agree most strongly with his conclusion that governance should be
closely integrated with portfolio management, although the two should
not be integrated such that one is totally subordinate to the other.
Fund management is always ultimately about investing to earn returns
for clients (within whatever designated parameters), but governance,
to provide useful input, must be capable of independent judgment.
Nonetheless, these two functions should always be on the same page,
and know what the other is saying and doing. The mistake here is in
assuming both that most fund managers are likely, capable, or willing
to pay close attention to non-quantitative matters, and that fund
management firms would otherwise be foolish enough to view good
corporate governance as an end in itself. In actuality, the problem
usually comes, not when there are trivial box-checking reasons for
ruling out the investment in a company, but when analysts and managers
get so carried away by the potential returns promised by an exciting
story that they ignore sizeable risks posed by its fundamental flaws
in governance. Whether the risks are economic or reputational, fund
managers should at least always be going in with their eyes open.