Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis. 2011. James P. Hawley, Shyam J. Kamath, and Andrew T. Williams, eds.
Reviewed by Martin S. Fridson, CFA
In August 2007, the head of AIG’s financial products division stated, “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar” in any credit default swap (CDS) transactions. Five months later, AIG disclosed that it had lost not $1.00 but $5 billion on its CDS exposure. This turn of events is just one example of sophisticated financial institutions’ hugely misjudging the risk of “financial weapons of mass destruction.” The reasons for their systematic failure deserve thoughtful and rigorous study.
Some clues emerge in Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis, a multi-author work edited by James P. Hawley, Shyam J. Kamath, and Andrew T. Williams. The book’s chapters derive from papers presented at a conference that the three professors of economics and business at Saint Mary’s College of California convened on the role of corporate governance in the financial crisis of 2008–2009. In particular, the volume’s editors are concerned with inattentiveness to financial risk on the part of the large institutional investors that have dominated corporate governance over the past two decades or so.
Before the financial crisis, many institutional investors had incorporated environmental, social, and governance (ESG) factors into their investment practices. None, however, had adopted screens or conducted analyses that might have signaled the impending financial crisis or, better yet, mitigated it. Although the institutions monitored the behavior of the companies in their portfolios, they did not apply corporate governance standards to the hedge funds and private equity firms they hired to select their investments. They relied on modern portfolio theory (MPT) in managing their holdings but paid little attention to the inadequacy of MPT in managing systemic risk, much less the troubling possibility that widespread use of MPT magnified systemic risk.
Corporate Governance Failures goes beyond the recent financial crisis to explore financial institutions’ investment practices across a broad range of ESG matters. For example, Claire Woods, a lawyer and University of Oxford doctoral candidate in economic geography, argues that fiduciary duty does not preclude addressing such nonfinancial issues as climate change. She cites a British case from 1925 in which a local government was found to have breached its fiduciary duty by paying women more than the market required in order to equalize their pay with that of men. In contrast, a 1983 case affirmed a local government’s fiduciary duty to taxpayers but also noted that it was entitled to ensure the welfare of its workers. Some readers will criticize the latter decision as judge-made law. To Woods, however, this bit of legal history demonstrates that what constitutes acting philanthropically (and, therefore, contrary to fiduciary duty) evolves over time.
Jennifer S. Taub of the University of Massachusetts advocates removing the sophisticated investor (SI) exception from many laws and regulations. Early securities legislation required extensive disclosures as a means of preventing retail investors from being flimflammed with complex instruments. For investments sold exclusively to investors deemed sophisticated, lawmakers thought that waiving those costly-to-comply-with requirements would promote efficiency.
The problem, says Taub, is that the criteria for establishing sophistication involve wealth, rather than experience or skill. Furthermore, even presumably sophisticated institutional investors cannot get a handle on today’s increasingly complex financial instruments. Some economists maintain that the simplest collateralized debt obligations are almost impossible to price, even when buyers are provided with all the relevant information.
Taub adds that automatically classifying institutional investors as sophisticated is questionable in light of an e-mail from Goldman Sachs investment banker Fabrice Tourre that came to light in hearings on the financial crisis. Tourre expressed disappointment with a target list of investors for a complex collateralized debt obligation, saying it “might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money.” The banks, Taub concludes,
understood that there are two types of SIs: (1) those with skills equal to their own, meaning the truly sophisticated, and (2) those institutional investors and real people who qualified under the law as “sophisticated” but who were quite easy to fool.
No less thought provoking is a chapter by Eric R.W. Knight, a lawyer and University of Oxford doctoral candidate, and Adam D. Dixon, a lecturer at the University of Bristol, that examines the role of investment consultants in integrating ESG considerations into pension fund decision making. In their view, consultants should be more proactive in focusing clients’ attention on ESG issues. Unfortunately, they find that some consultants are not even clear on the distinction between ESG and socially responsible investing. The former is concerned only with improving corporate valuation, whereas the latter is meant to achieve ethical objectives.
Knight and Dixon report that their survey of consultants elicited the following comment: “An increasing body of evidence exists to show that ESG factors can impact investment performance.” Some caution is warranted regarding this remark. A recent article summary in the CFA Digest that acknowledges “some research has shown that ESG alpha does exist” goes on to say,
The actual evidence of ESG alpha, however, is currently mixed. Because it can be difficult to disentangle the impact of ESG factors from other factors, more research and time are needed to explore the contribution of ESG factors to alpha generation. In equity markets, a demonstrable link between a corporation’s ESG characteristics and its share price has not yet been overwhelmingly proven.1
Corporate Governance Failures is well edited on the whole, yet a few errors escaped detection. One author writes of the advent of modern portfolio theory in the 1940s, even though another chapter correctly credits Harry Markowitz with introducing the foundations of MPT in 1952.2 The collapse of Long-Term Capital Management is erroneously placed in 1987 rather than 1998. George Soros’s concept of reflexivity is transmogrified into “reflectivity.”
Notwithstanding these imperfections, Corporate Governance Failures is a valuable and highly stimulating book. Along with many other sobering thoughts, it points out that in a highly competitive environment, as corporate and securities law attorney Bruce Dravis shows,
participation in a financial mania is a rational, and perhaps even necessary, strategy to be adopted by an informed board of directors, acting without self-interest and with due consideration, within the protection from liability afforded by the business judgment rule.
In that light, there would seem to be little justification for complacency regarding the possibility of another financial crisis as severe as, or more severe than, the last one.
1 Victoria J. Rati, summary of Thao Hua, “Special Report: Environmental, Social and Governance Investing,” Pensions & Investments, vol. 39, no. 2 (24 January 2011):1, 16, in CFA Digest, vol. 41, no. 2 (May 2011):8–9.
2 Harry Markowitz, “Portfolio Selection,” Journal of Finance, vol. 7, no. 1 (March 1952):77–91.