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Anti-ESG Backlash Comes for Pension Plans that Force Beneficiaries into ESG Investments: Could Somebody Sue UCRP?

Kevin LaCroix reports that:

On June 2, 2023, an American Airlines pilot filed an ERISA class action lawsuit in the Northern District of Texas against American Airlines; the American Airlines Employee Benefits Committee; the company’s benefits plan administrator; and the company’s benefits plan advisor. The lawsuit purports to be filed on behalf of participants in the company’s employee benefits plan. A copy of the complaint can be found here.

The gist of the complaint is that the defendants “breached their fiduciary duties in violation of ERISA by investing millions of dollars of American Airlines employees’ retirement savings with investment managers and investment funds that pursue leftist political agendas through environmental, social and governance (‘ESG’) strategies, proxy voting, and shareholder activism—activities which fail to satisfy these fiduciaries’ statutory duties to maximize financial benefits in the sole interest of the Plan participants.” ...

He also reports that a similar lawsuit is pending against Delta.

Which leads me to a point of personal privilege. By virtue of my job I am obliged to participate in the University of California Retirement Plan. In pension plan terms, the rules under which my pension operates is an involuntary defined benefit plan. I cannot opt out and I have zero control over how my money is invested.

So what is UCRP doing with my money? UCRP's investment policy states that:

The Office of the Chief Investment Officer (“OCIO”) shall incorporate environmental sustainability, social responsibility, and governance (ESG) into the investment evaluation process as part of its overall risk assessment in its investments decision making. ESG factors are considered with the same weight as other material risk factors influencing investment decision making.

The policy statement further states that the plan must not hold tobacco stocks. UCRP is also in the process of divesting from fossil fuel companies.

So the answer to the question, "what is UCRP doing with my pension plan," is going big on ESG. 

Not only is the basic UCRP pension plan gone whole hog on ESG, but so have the voluntary 403(b) retirement saving plan options. Almost all of the choices are fossil fuel free because they are subject to the UCRP's ESG investment policies.

Eli Lehrer and Robert Eccles recently argued that employers should offer employees a choice between ESG and non-ESG funds. Specifically, they argue for legislation ensuring that "state employees in defined contribution plans can select non-ESG options."

Laws passed in decidedly red North Dakota and Idaho offer good models in this regard. North Dakota’s law defines “social investment” as “consideration of socially responsible criteria…for the purpose of obtaining an effect other than a maximized return” and requires the State Investment Board to “demonstrate a social investment would provide an equivalent or superior rate of return compared to a similar investment that is not a social investment and has a similar time horizon and risk” before making it. The Idaho law contains language with similar effect and allows that state-defined contribution plans offer employees socially-oriented investment funds only so long as they offer alternatives as well. Both policies are worthy of emulation.

I don't expect a deep blue state like California to consider mandating that state pensions offer non-ESG alternatives, especially with virtue signaller in chief Gavin Newsom as governor, but maybe we can get there by litigation? I understand that state university pension plans are exempt from ERISA. But surely a conservative public interest law firm could come up with a theory that relies on other fiduciary duty theories.

Do we really want to encourage more retail investor participation in corporate governance?

Ann Lipton posted a couple of weeks ago about proposals to encourage retail investor participation in corporate governance (I'm a little behind).

A while back, Jill Fisch proposed that retail shareholders be given access to the type of electronic tools available to institutional shareholders so that they could create standing voting instructions, allowing them to cast ballots in corporate elections automatically according to predefined preferences.  That vision appears to close to realization; today, there are new programs that make it easier for retail shareholders to cast ballots, including in accordance with preset preferences.  As I understand the Iconik service, for a monthly fee, you can set your preferences and have the app automatically vote them – or you elect to follow the instructions provided by a third party provider like As You Sow or Third Act.  If you do that, it’s free.

And of course, we know that mutual fund companies are proposing to give more voice to retail shareholders through various kinds of pass-through voting experiments.  There are now voting platforms being developed that allow automatic voting in this context, as well.

I am deeply skeptical. In the first place, there are lots of sound theoretical reasons to limit participation by all shareholders--retail or institutional--in corporate governance. See my article The Case for Limited Shareholder Voting Rights: https://ssrn.com/abstract=887789.

Second, retail investors have strong incentives to be rationally apathetic--i.e., to refrain from exercising their voting rights:

1. Lack of Information: Retail investors may not always have access to comprehensive and timely information about the companies they invest in. This can make it challenging to make informed voting decisions. Additionally, the sheer number of companies in which retail investors may hold shares can make it difficult to keep up with all the voting matters.

2. Limited Influence: Individual retail investors often own a relatively small percentage of a company's shares, which can lead to a perception that their votes may not significantly impact the outcome. As a result, some may feel that their vote will not make a meaningful difference.

3. Time and Effort: Voting requires time and effort, especially for retail investors who hold shares in multiple companies. Researching the issues, reviewing the proxy statements, and casting votes can be time-consuming, and some investors may prioritize other aspects of their investment activities.

4. Trust in Management: Some retail investors may trust the management and board of directors of the companies they invest in to make decisions in their best interest. They may believe that voting is unnecessary or that management will act in accordance with shareholder interests without their active participation.

Historically, retail investors have been apathetic. In 2017, for example, the NY Times reported that " 91 percent of the shares owned by institutional investors — but only 29 percent of those held by individuals — were voted." 

There are several reasons why we might want to let there sleeping dogs lie. First, as Ann points out, we are currently observing in real time retail investors in action--i.e., the objections being filed in connection with the proposed settlement of the AMC Entertainment litigation. (For background on that litigation see my posts AMC APEs, Retail Investor Rational Apathy, Blank Check Preferred Stock, Class Voting, and Blasius and Chancery Daily, AMC, DGCL 242, and the Delaware Legislature.) As Ann delicately puts it:

a lot of the comments are, well, uninformed, to put it mildly.  There are some fairly odd conspiracy theories floating around regarding AMC shares, and, in particular, something about an inflated share count and “synthetic” shares that are improperly voting.  Many of the objecting shareholders buy into those theories.  

I've read a lot of these objections and the vast majority do not inspire confidence in the knowledge or judgment of the objectors.

Second, as Ann also pointed out, many retail investors are now day traders and meme stock traders who are very different from the traditional perception of retail investors who are long-term shareholders. Research examining "how the influx of retail shareholders has directly affected the governance outcomes at the meme stock companies" concluded that "meme stock companies have experienced a significant decrease in participation by their shareholders with respect to voting. Shareholder proposals under Rule 14a-8 have also been extremely limited, with most meme firms seeing no proposals brought after the rapid increase in retail ownership." 

The same research also concluded that meme stock companies' "ESG scores have gotten worse subsequent to the meme surge.

Predictions that retail investors will "revolutionize corporate governance and make public companies more responsive to social concerns" thus seem unfounded.

Third, many retail investors are deeply engaged with social media and increasingly exhibit the pathologies associated with social media. In the AMC Entertainment litigation, for example, one of the two lawsuits challenging the plan was filed by an individual Usbaldo Munoz. The AMC Apes have been viciously attacking Munoz. Things apparently got so bad that Munoz has now ghosted his own lawyers, leaving them without guidance as to how to proceed.

Today, the WSJ reported that:

... the ticker MMTLP has become a rallying cry for people angry at the Financial Industry Regulatory Authority and, by extension, the entire financial system. Market veterans say the investors’ rage is misguided.

The episode is the latest example of how social media is a double-edged sword in today’s stock market. Online communities allow individual investors to connect and share trading tips, but they can also fan conspiracy theories and lead to disastrous investing decisions.

...

Some Finra employees and market veterans caught up in debate around MMTLP have received death threats. In one anonymous message to a market veteran seen by The Wall Street Journal, the sender alluded to mass shootings and vowed to come “piss on your casket.”

In sum, maybe it'd be best to leave things alone.

Senator Schumer's Misconceptions and Misrepresentations about ESG Investing

In today's WSJ, Senator Chuck Schumer argues that "Republicans Ought to Be All for ESG." There's a lot of misinformation in it. He claims, for example, that:

America’s most successful asset managers and financial institutions have used ESG factors to minimize risk and maximize their clients’ returns.

True, sort of. A lot of investment managers do use ESG. But not successfully. In my book The Profit Motive I review the data on ESG investing and point out that:

If socially responsible firms are superior performers, one should see evidence that investment portfolios weighted towards such firms outperform the market on a risk-adjusted basis. Yet, there is little evidence that socially responsible investment funds outperform relevant market indices. ... In general, there is no evidence that SRI investment funds—standing alone—improve portfolio company performance on environmental or social metrics, probably because such funds prefer investing in firms that already score high on those metrics. ... A 2021 literature review of over 1,100 peer-reviewed studies and 27 published meta-analyses determined that the risk-adjusted financial performance of ESG investing was indistinguishable from that of conventional investing.

He then claims:

Investors and asset managers increasingly recognize that maximizing returns requires looking at the full range of risks to any investment—including the financial risks presented by increasingly volatile natural disasters, aging populations and other threats that the public doesn’t normally associate with financial modeling.

It's interesting timing for that claim, because on Monday in the WSJ we learned that Vanguard CEO Tim Buckley was backing his massive fund family away from ESG:

“Our research indicates that ESG investing does not have any advantage over broad-based investing,” Mr. Buckley said in a recent interview with the Financial Times. Matching word to deed, his comments came after he had withdrawn his firm from the $59 trillion Net Zero Asset Managers initiative, an organization that is part of the $150 trillion United Nations-affiliated Glasgow Financial Alliance for Net Zero. Both alliances are committed to restricting their investments over time to companies that are compliant with the Paris Agreement’s objective of net-zero greenhouse gas emissions by 2050. Mr. Buckley claims the financial world, swept up in climate-change fervor, can’t make such commitments without reneging on its fiduciary duties.

Next Schumer turns to the recent Department of Labor ERISA rule allowing investment managers to freely invest their client's money in ESG:

Nothing in the Labor Department rule imposes a mandate. It simply states that if fiduciaries wish to consider ESG factors—and if their methods are shown to be prudent—they are free to do so. Nothing more, nothing less.

The present rule gives investment managers an option.

But what if the investment manager's client don't want their money going down the ESG sinkhole? Presumably Schumer would say "change investments," but not all of us have that choice. As I discussed in an earlier post, the University of California unilaterally shifted my retirement money into portfolios that track ESG indices. Nobody asked my permission and I don't have any choice in the matter.

Vanguard backs away from ESG

In today's WSJ, Terrence Keely reports that:

Vanguard’s Tim Buckley is having a Copernican moment. Like the famous Renaissance polymath who challenged conventional wisdom about celestial movement, the 54-year-old CEO is challenging the asset-management industry’s environmental, social and governance orthodoxy.

“Our research indicates that ESG investing does not have any advantage over broad-based investing,” Mr. Buckley said in a recent interview with the Financial Times. ...

...What is it that Mr. Buckley knows that so many others don’t?

For one thing, he understands that it’s difficult for active managers to beat broad indexes, as most ESG funds promise.

... Mr. Buckley knows that the largest index manager in the world isn’t qualified to tell individual companies how to set their ESG priorities. “It would be hubris to presume we know the right strategy for the thousands of companies that Vanguard invests in,” he told the FT. 

It's almost as though he read my book:

The University of California Retirement Fund is Misleading and Shortchanging Beneficiaries

Some years ago, the University of California pension fund managers decided to embrace ESG investing. Nobody asked us beneficiaries. If they had, we might have pointed out that the fund managers are both misleading and shortchanging those of us who have entrusted them with our money.

Consider the example of the UC Domestic Equity Index Fund. This fund claims to be a Large Cap blend fund. But it also claims to track the performance of the Russell 3000 ex Tobacco ex Fossil Fuels Index. 

Problem # 1: The Russell 3000 is not really a large cap fund. If you wanted to track a large cap index, you'd probably want to track the S&P 500, which is widely regarded as the best means of tracking of Large Cap U.S. equities. But you would not select the Russell 3000, which contains about 98% of the US equity market. The Russell 3000 is large cap, mid cap, and small cap all in one.

Problem # 2: The Russell 3000 ex Tobacco ex Fossil Fuels Index has underperformed the Russell 3000 index on a YTD, 1 year, 5 year, and 10 year basis. It's done particularly badly in 2022, losing 11.65% compared to 10.80% for the non-ESG index. 

Kentucky Attorney General Holds ESG and Stakeholder Capitalism to be Inconsistent with Kentucky Law in Fiduciary Duties

Kentucky Attorney General Opinion OAG 22-05 notes the "increasing trend among some investment management firms to use money in public and state employee pension plans—that is, other people’s money—to push their own political agendas and force social change." The Attorney General is also concerned "that politically biased investment strategies have real costs and worsen outcomes for pensioners."

The Attorney General therefore addresses the following question:

Whether “stakeholder capitalism” and “environmental, social, and governance” investment practices in connection with the investment of public pensions funds are consistent with Kentucky law governing fiduciary duties.

The opinion reviews both ERISA and Kentucky statutes to conclude that:

While asset owners may pursue a social purpose or “sacrifice some performance on their investments to achieve an ESG goal,” investment managers entrusted to make financial investments for Kentucky’s public pension systems must be single-minded in their motivation and actions and their decisions must be “[s]olely in the interest of the members and beneficiaries [and for] the exclusive purpose of providing benefits to members and beneficiaries” .... In sum, politics has no place in Kentucky’s public pensions. Therefore, it is the opinion of this Office that “stakeholder capitalism” and “environmental, social, and governance” investment practices that introduce mixed motivations to investment decisions are inconsistent with Kentucky law governing fiduciary duties owed by investment management firms to Kentucky’s public pension plans. (Emphasis in original.)

I certainly agree that politics has no place in investment management. I have frequently written about that issue in connection with divestment campaigns, most notably in Those Divesting Presbyterians.

As I will be discussing in my forthcoming book, The Profit Motive: In Defense of Shareholder Value Maximization, I am also deeply skeptical that there is a business case for ESG and stakeholder capitalism.

Having said that, however, note that the Kentucky Attorney general's opinion has a gap; namely, it fails to address the question of whether there is a business case for ESG and stakeholder capitalism.

Proponents of ESG argue investing in employee welfare generates higher employee satisfaction and, as a result, productivity gains.[1] Improved corporate governance will discourage managers from actions that benefit themselves at the expense of shareholders and/or stakeholders. Likewise, investing in environmental enhancements will reduce long-term costs from climate change. And so on.[2]

Proponents will therefore argue that they are using ESG metrics in making investment decisions precisely for the required "purpose of providing benefits to members and beneficiaries." 

As I explain in The Profit Motive, I don't buy the proponents' argument. To the contrary, ESG is mostly about politics. 

But the Kentucky Attorney General's opinion basically ignores this critical issue. It says there is "some suggestion" that ESG's costs outweigh its benefits. In support of that rather weak claim, the opinion cites one op-ed from Barron's. This omission significantly weakens the opinion. As such, the opinion does the objection to ESG little good.

Recommended reading: Fisch's "GameStop and the Reemergence of the Retail Investor"

Fisch, Jill E., GameStop and the Reemergence of the Retail Investor (February 8, 2022). U of Penn, Inst for Law & Econ Research Paper No. 22-16, Boston University Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4049896

The GameStop trading frenzy in January 2021 was perhaps the highest profile example of the reemergence of capital market participation by retail investors, a marked shift from the growing domination of those markets by large institutional investors. Some commentators have greeted retail investing, which has been fueled by app-based brokerage accounts and social media, with alarm and called for regulatory reform. The goals of such reforms are twofold. First, critics argue that retail investors need greater protection from the risks of investing in the stock market. Second, they argue that the stock market, in term, needs protection from retail investors.

This Article challenges calls for broad-based regulatory reform. It argues that, although retail investing is likely to impact the capital markets, claims about the harms from increased retail investing are overstated. More importantly, the debate overlooks potential benefits from retail investing both to investors themselves and the capital markets. Regulators should not be clamping down on the conditions such as commission-free trading, gamified trading platforms, and the expanded use of social media, that have enabled a generation of new investors to participate in the capital markets. These innovations, through their ability to facilitate direct market participation by retail investors have the potential to democratize the capital markets and increase the connections between ordinary citizens and U.S. businesses. Regulators should instead be focusing on how to facilitate the effectiveness of that process.

The Article defends the reemergence of the retail investor and its potential promise in enabling citizen capitalism – providing ordinary citizens with a stake in the nation’s productivity while, at the same time, increasing the accountability of those businesses to societal interests. It explains that retail investment can reduce the increasing problematic power of institutional intermediaries. It also holds the possibility of increasing corporate consideration of stakeholder interests without the need for formal structural changes or heavy-handed regulation.

Critically, however, effective citizen capitalism requires retail shareholders to participate in the capital markets on an informed basis. Although the extent to which the GameStop frenzy reflected rational investing behavior is questionable, its effect has been to draw retail investors to the market, and there is evidence that retail investment and engagement will both continue and evolve. The Article identifies opportunities to improve the retail investing experience, including greater oversight of sources of investment information, limiting the manipulative use by brokers of customer information, and the extension of fintech innovation to mechanisms for improving financial literacy. Attention to these concerns, rather than heavy-handed efforts to discourage retail investing, will increase the effectiveness of the retail investor.

The War in the Ukraine Reveals Two Basic Flaws in ESG Investing

Flaw #1: Prior to the 2022 Russian invasion of Ukraine, ESG indices typically excluded defense contractors. Companies that sell ratings of corporate ESG performance likewise downgraded defense companies. In the wake of outbreak of war, however, many rating firms, ESG funds, and index suppliers are reconsidering the exclusion of defense companies. The Russo-Ukrainian war also raised questions about whether fighting climate change was more socially responsible than dealing with inflation and the impact of energy prices on the poor. James Mackintosh, Do Good Investing is Under Pressure, Wall St. J., Mar, 28, 2022, at B1. Trying to be socially responsible is exceeding difficult when the definition of what is socially responsible involves clashing goals and rapidly changing perceptions about what is pro-social.

Flaw #2: European corporations with major operations in Russia prior to the outbreak of the Russo-Ukrainian war typically had higher ESG ratings than those who were not operating in Russia. Doing extensive business in an increasingly authoritarian and militaristic apparently had little, if any, impact on the ESG industry’s perceptions of those companies. Perhaps even more instructively, however, is that companies with lower ESG ratings were more likely to divest or suspend any Russian operations than did companies with higher ESG ratings. Id. All of which tends to call into question the merits of the ESG industry’s claims to be socially responsible.

Alan Palmiter On Capitalism Healing Itself

Alan Palmiter has a new article out, with a handy summary on The CLS Blue Sky Blog:

A paradigm shift is underway: The corporation – much reviled as a cost-externalizing, short-termist, inward-focused, politically manipulative machine – is undergoing a fundamental change. This is good news. Corporations are beginning to confront the harm they created, allowing capitalism to start healing itself.

Alan argues there are three factors at work:

First, most large investment funds are either incorporating ESG into their investment decisions or tracking stock market indices. ...

The second powerful force at work is ESG.  Over the last several years, it has become clearer that corporations that seek to be aware of their environmental, social, and governance actions (ESG) have perform better financially. ...

The third powerful force at work is the (almost miraculous) communication and information advances of the internet. Investors learn in milliseconds what is happening with companies.

He concludes:

Here’s the takeaway.  Indexing, ESG performance, and the internet seem to have come together in a way that puts capitalism in a position to heal itself.

I'm a bit more skeptical, probably because I'm more cynical and pessimistic about human nature. But I like the project a lot anyway.

 

Nasdaq Board Diversity Quotas Challenged in Federal Court by the Alliance for Fair Board Recruitment

From their press release:

On August 9, 2021, the Alliance for Fair Board Recruitment (AFFBR), a nonprofit membership organization incorporated in the state of Texas, filed a Petition for Review in the United StatesCourt of Appeals for the Fifth Circuit seeking a review of the approval by the Securities and Exchange Commission (SEC) of the corporate board diversity quotas proposed by the Nasdaq stock exchange. ...

As AFFBR explained in a comment submitted to the SEC, Nasdaq's discriminate-or-explain rule also exceeds its role and the authority granted by federal securities law and also violates core Bill of Rights guarantees against compelled speech and discrimination based on sex and race by stereotyping all people of the same skin color or sex as being alike and interchangeable. Further, the rule will not deliver the promised benefits. As Harvard law professor Jesse Fried has explained, numerous studies have shown "that stock returns suffer when firms are pressured to hire new directors for diversity reasons."

NASDAQ offers a summary of the listing standard here. SEC Commissioners Lee and Crenshaw's statement in support of the standard is here. SEC Commissioner Peirce's statement in opposition to the standard is here.

Andrew Stuttaford comments here. In a comment on the original draft proposal, Stuttaford observed:

NASDAQ, a private institution, is, of course, entitled to set its own rules, just as (to quote the Journal) “banks and asset managers” are entitled to try to push their clients or portfolio companies to change their ways. Nevertheless, it is hard to miss the mission creep that is currently occurring across a wide range of institutions, some private, some parastatal (take a look at the effort centralbanks are increasingly making with regard to climate change) to impose different aspects of a “progressive” agenda on private companies without the bother of going through the usual democratic mechanisms.

In my view, this is a legitimate concern.

Asking corporate executives to take on governmental functions not only asks them to undertake tasks for which they are untrained and for which their enterprise is unsuited, it also subverts the basis of a liberal democracy. Government efforts to solve social problems are inherently limited by the checks and balances baked into the American political system. "Woke capitalism" bypasses those checks and balances by asking unelected executives to undertake solving social ills.

As Milton Friedman explained, back in 1970, liberals of that era argued that society was plagued by a host of ills that were "too urgent to wait on the slow course of political processes, that the exercise of social responsibility by businessmen is a quicker and surer way to solve pressing current problems.” Accordingly, Sixties-era liberals seized on using CSR as “a quicker and surer way to solve [these] pressing current problems.” 

Friedman rejected this line of argument as fundamentally anti-democratic:

What it amounts to is an assertion that those who favor the taxes and expenditures in question have failed to persua de a majority of their fellow citizens to be of like mind and that they are seeking to attain by undemocratic procedures what they cannot attain by democratic procedures. In a free society, it is hard for “good” people to do “good,” but that is a small price to pay for making it hard for “evil” people to do “evil,” especially since one man's good is another's evil.

Why was the challenge to the Nasdaq diversity rule Filed in the federal court of appeals instead of a district court? Keith Paul Bishop examines the question. https://t.co/5c2OO3v813

— Steve Bainbridge (@PrawfBainbridge) August 20, 2021

Cleary Gottlieb discusses Biden Administration Labor Department's refusal to enforce rules requiring ERISA fiduciaries to put plan beneficiary welfare ahead of woke policy preferences

Although I'm sure Cleary would not approve of my headline:

On Wednesday, March 10, after engaging in conversations with stakeholders, the U.S. Department of Labor’s Employee Benefits Security Administration issued an enforcement policy statement in which it declined to enforce two DOL rules put in place by the Trump administration in 2020.

I.e., stakeholders like Senators Sanders and Warren.

The first of these rules placed limitations on the ability of plans subject to ERISA to invest in environmental, social and governance (“ESG”) funds. In particular, it provided that a fiduciary’s duty of loyalty and prudence under ERISA would only be satisfied if investments were selected solely on the basis of pecuniary factors (defined as factors that have a material effect on the risk and return of an investment), and that ESG factors could only be considered to the extent they created economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. ...

A related second rule provided that ERISA plan fiduciaries could not harness plan assets to vote on policy-related, political or ESG issues in proxy resolutions that are not solely in the economic interests of plan participants and beneficiaries or likely to enhance the economic value of the plan’s investment. 

So if you're a beneficiary of an ERISA regulated retirement plan, for example, you'll no longer be able to rest confidently that the plan managers are putting your interests ahead of woke politics.

Larry Cunningham argues that "companies following ESG principles attract quality shareholders (QSs), the discerning minority of patient stock pickers, as opposed to the massive cohorts of passive indexers and transient traders"

In an editorial for MarketWatch my friend Larry Cunningham (GWU Law) argues that:

I compared two recent ESG rankings, by Barron’s and Investors’ Business Daily, with rankings of companies by QS density produced by the Quality Shareholder Initiative at George Washington University. The Quality Shareholder Initiative has presented evidence that high density of QSs in a company is associated with superior corporate performance. The ESG and QS data correlate: the vast majority (80%) of high-ranking ESG companies also rank in the top half for QS density. ...

ESG principles stress factors that enhance long-term shareholder value, an approach that concurs with history, law, and practicalities. As a result, ESG went mainstream.

Personally, I remain an unrepentant "passive indexer." But if you're an active investor, the linkage with ESG appears worth a look.

More evidence that banning short selling makes no sense

Alderighi, Stefano and Gurrola Perez, Pedro, What Does Academic Research Say about Short-Selling Bans? (April 29, 2020). WFE Research Working Papers, World Federation of Exchanges, Available at SSRN: https://ssrn.com/abstract=3775704

As a reaction to higher market volatility due to the global COVID-19 pandemic, in March 2020 some financial regulators imposed short-selling bans on equity markets. Their argument is that short-selling exacerbates downward price movements, thus being responsible for heightened volatility and reduced market confidence. This paper reviews the academic literature on short-selling and short-selling bans, comparing the arguments against banning short-selling with the arguments in favour. We find that the evidence almost unanimously points towards short-selling bans being disruptive for the orderly functioning of markets, as they are found to reduce liquidity, increase price inefficiency and hamper price discovery. In addition, short-selling bans are found to have negative spillover effects on other markets, for example option markets. According to the literature, during periods of price decline and heightened volatility, short-sellers do not behave differently from any other traders, and contribute less to price declines than regular ‘long’ sellers. As research has shown that short-selling bans are more deleterious to markets characterized by a relatively high amount of small stocks, low levels of fragmentation, and fewer alternatives to short-selling, emerging markets should be particularly wary of bans on short-selling

"Selling the stock market short"

Kevin Haeberle has a very interesting op-ed in The Hill on the social functions of the stock markets prompted by the recent GameStop frenzy (for lack of a better word). I particularly enjoyed his discussion of the market's function of facilitating "gambling." Recommended reading.

Are providers of market indices investment advisors?

Paul Mahoney and Adriana Robertson engage in some outside the box thinking and end up making a provocative and persuasive argument:

The rise of index funds has reshaped the modern American capital markets. Like mutual fund managers, indices now direct trillions of dollars of investor capital. Although it regulates mutual fund managers as investment advisers, the SEC has chosen not to treat the providers of market indices similarly.

In this Article, we argue that many index providers are not merely like investment advisers; under the relevant statutory and regulatory regimes, they are investment advisers. The SEC’s failure to recognize this fact reflects an inaccurate and antiquated view of the index fund market.

Having established that certain index providers are presently acting as unregulated investment advisers, we propose a regulatory solution. The SEC should create a nonexclusive, conditional safe harbor giving index providers guidance on what activities will and will not make them investment advisers. This would close the regulatory gap in a way that is consistent with the governing statutes and case law without unduly burdening market participants.

Mahoney, Paul G. and Robertson, Adriana, Advisers by Another Name (January 15, 2021). Virginia Law and Economics Research Paper No. 2021-01, Available at SSRN: https://ssrn.com/abstract=3767087

 

Recommended reading