With great power comes great responsibility: differences in EU and US legislation and its effect on passive investment managers’ incentives to engage on ESG

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Name : Maximilian Timothy Straatman Email: maxstraatman@hotmail.com Student number: 12917338 Study: Master Law and Finance Supervisor: Prof. Dr. Alessio M. Pacces Words: 12,692 Date: July 24, 2020

With great power comes great responsibility: differences in EU and US legislation and its effect on passive investment managers’ incentives to engage on ESG

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Abstract

This master thesis analyzes to what extent differences between EU and US legislation influence ESG engagements of EU and US passive investment managers. There are differences between the ESG engagements of such managers in the EU and the US. Passive investment managers can generally only rely on public and private engagement mechanisms to influence their portfolio companies. Regulation, including fiduciary duties and disclosure obligations, influences the incentives of passive investment managers to employ such engagement mechanisms. This master thesis posits the following arguments. The extent to which differences in fiduciary duties influence incentives is presumably negligible. Both the EU and the US lack a clear framework that provides for incorporation of ESG in fiduciary duties. However, there are interesting differences in disclosure obligations that might influence engagement activities. The magnitude of these differences depend on the extent to which EU law requires disclosure of private engagements and is subject to several caveats. A further investigation through a case study suggests that differences in disclosure obligations may indeed result in differences in engagements. Hence, it is suggested that disclosure obligations of engagements may result in differences in ESG engagements between the EU and the US.

Keywords: passive investing – engagements – ESG – fiduciary obligations – disclosure obligations

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Chapter 1: Introduction

“With great powers comes great responsibility.” – Uncle Ben in Spiderman

1.1 Introduction

Recently the extent to which financial market participants consider Corporate Social Responsibility (‘CSR’) or Environmental, Social and Governance (‘ESG’)1_{factors in their} strategies has come under increasing scrutiny (UNEP FI and the PRI, 2019, pp. 4-7). ESG might be “financially material” (Johnston & Morrow, 2016, p. 2). Perhaps for that reason, ESG has come to the attention of the European Commission (‘EC’) (European Commission, DG Environment, 2014). Furthermore, climate change might affect financial stability. Therefore, also the European Central Bank has taken note of ESG (European Central Bank, 2020). Simultaneously, there has been a large shift from active funds to passive funds. Passive funds replicate an index, whereas active funds seek to outperform the market. In the United states (‘US’) there are three large investment managers that predominantly provide such passive funds (‘passive managers’). These are Blackrock, State Street Global Advisers (‘SSGA’) and Vanguard, collectively called ‘the Big Three’. In the last decade, over 80% of money invested in investment funds was invested in funds of the Big Three. (Bebchuk & Hirst, 2019, pp. 1-2). Figures 1 (Blackrock annual reports 2015-2019) and 2 (SSGA annual reports 2015-2019) show that Blackrock’s and SSGA’s equity assets under management (‘AuM’) growth in the past 5 years is mainly driven by their passive funds.

Figure 1

1_{For the purpose of this master thesis, CSR and ESG are treated as equivalent.}

0.0 1.0 2.0 3.0 4.0 5.0 2015 2016 2017 2018 2019

Blackrock equity AuM in trillion USD

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5 Figure 2

The rise of passive investing draws attention. Especially, there is increasing academic debate about passive managers’ incentives to engage. Engagement relates to “how [investment managers] monitor, vote in and engage with portfolio companies” (Bebchuk & Hirst, 2018, p. 1). According to some authors, passive managers are incentivized to engage (Rock & Kahan, 2019). Other authors emphasize the agency relationship that exists between investors in passive funds and passive managers which could be subject to agency costs (Bebchuk & Hirst, 2018). Research shows that institutional investor ownership positively correlates with environmental and social performance. However, “independent institutional investors” such as mutual funds only affect performance if they are from countries with strong ESG norms. This provides for a difference between the US and EU countries (Dyck, Lins, Roth, & Wagner, 2019, pp. 694-695). The mechanisms employed the most to influence ESG are private engagements (Dyck, Lins, Roth, & Wagner, 2019, p. 703). Private engagements are expected to become even more important over time (Mallow & Sethi, 2016, p. 397). However, only 27.1% of US institutional investors use engagements to incorporate ESG information as opposed to 48.1% in the EU (Amel-Zadeh & Serafeim, 2018, p. 33). Also, EU investment managers have historically been less hesitant than US investment managers to challenge portfolio companies on environmental and social performance (Morningstar, 2017b, p. 14).

The inflow in passive funds and the importance of private engagements for influencing ESG in portfolio companies makes the incentives of passive managers to engage of high importance. Bebchuck and Hirst conclude that passive managers have insufficient incentives to engage portfolio companies. Furthermore, their paper provides an empirical analysis that suggests insufficient incentives to engage. Their analysis comprises US passive managers (Bebchuk &

0.0 0.5 1.0 1.5 2.0 2.5 2015 2016 2017 2018 2019

SSGA equity AuM in trillion USD

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Hirst, 2018, pp. 3,46). Given the differences between EU and US institutional investors, a comparison of incentives is relevant to further investigate such incentives to engage.

Bebchuk and Hirst identify two factors that limit passive managers’ incentives to engage, namely reputational concerns and fiduciary obligations (Bebchuk & Hirst, 2018, pp. 41-42). Disclosure obligations enable investors to assess passive managers’ adherence to fiduciary duties (Laby, 2017, p. 9) and provide the basis for reputational risk (Enriques & Romano, 2018, p. 15). Hence, incentives to engage depend on the regulatory framework. Building on these findings, this master thesis seeks to answer the research question: ‘To what extent does regulation influence differences in ESG-engagement activities of passively managed funds in the United States and the European Union?’. This question combines the debate on passive managers’ incentives to engage with the increasing importance of ESG.

This master thesis seeks to make four contributions. First, it seeks to contribute to the wider academic debate surrounding passive managers’ engagement activities. It does so by investigating the implications of differences in the regulatory framework on the engagements of passive managers. Second, it suggests possible causes for the differences between EU and US asset managers and engagements on ESG. Third, it seeks to contribute to Bebchuck’s and Hirst’s empirical enquiry into engagements of passive managers by including EU market participants. Fourth, this master thesis suggests an approach for comparing engagement activities that corrects for size differences between passive managers adding to previous standardizations of Bebchuck and Hirst (Bebchuk and Hirst, 2018, p. 57).

To that end, several chapters are put forward. Chapter 2 deals with the engagement mechanisms employed to influence ESG. Chapter 3 explains passive manager and fund structure. Chapter 4 explains the debate on passive managers’ incentives to engage. Chapter 5 and 6 explain differences in fiduciary duties and disclosure obligations between the EU and the US respectively. Chapter 7 suggests how differences in the regulatory framework impact incentives to engage. Chapter 8 provides for a case study on engagement activities that reflects on the incentive analysis in chapter 7. Chapter 9 provides an answer to the research question.

1.2 Scope

The scope of the research question is the following. First, the regulatory analysis is limited to fiduciary duties and disclosure obligations, because such legislation influences engagements in general. Little attention is given to other legislation. Second, the analysis is limited to the effects of legislation on passive managers’ general engagement activities. There will not be an enquiry

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into the engagements of passive funds domiciled in either the EU or the US. As will be explained, engagements generally take place at the manager level which makes fund analysis difficult. Therefore, EU legislation applies at the manager level (Section 6.3). US legislation applies at the fund level (Section 6.2), but is also disclosed voluntarily at the manager level (e.g. Principles for Responsible Investment, 2019b). Additionally, engagement reports do not often distinguish between activities of e.g. EU managers in the EU and the US. Managers engage on behalf of funds (see e.g. Section 6.2). Hence, differences in engagement activities of passive funds are found in differences between passive managers.

This master thesis relies on articles in law and finance journals and legal textbooks. The data is mainly obtained from the Principles for Responsible Investments’ (‘PRI’) Transparency Reports as well as from engagement reports and annual accounts of passive managers. Last, EU and US legislation is consulted.

Chapter 2: How can institutional investors influence ESG?

2.1 Introduction

This chapter deals with the mechanisms employed by institutional investors to drive ESG. These are divided into “exit and selection” and “voice”. The former entails institutional investors’ influence on portfolio companies through selling their investments or through only selecting companies compliant with ESG requirements beforehand. The latter means insitutional investor engagement with portfolio companies through e.g. exercising their shareholder rights. (Dyck, Lins, Roth, & Wagner, 2019, p. 702).

2.2 Exit and selection

Generally, few institutional investors exclude companies that do not meet specific requirements. Also, actively selecting companies does not appear to be a strong mechanism to influence ESG (Dyck, Lins, Roth, & Wagner, 2019, p. 702). The reasons are the following. Research has shown that there are costs associated with exit and selection. First, institutional investors give in on diversification benefits by excluding investment possibilities. However, this cost is small because the relative number of excluded companies is small. Second, excluded companies are sometimes “relatively cheap”, e.g. because of low P/E-ratios (Harrison & Kacperczyk, 2009, p. 16).

Institutional investors can be dinsguished between institutions subject to “public scrutiny” and institutions less subject thereto. Contrary to pension funds that are more subject to public

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scrutiny, mutual funds do not appear to distinguish as much between “sin” and regular stocks (Harrison & Kacperczyk, 2009, p. 32). This has legal implications. First, excluding companies due to ESG might conflict with fiduciary obligations to investors because such stocks have higher returns (Dyck, Lins, Roth, & Wagner, 2019, p. 702). Additionally, disclosure obligations are relevant, because mutual funds are generally less subject to public scrutiny.

2.3 Voice

Contrary to the foregoing, “voice” is important to influence ESG. This can take place through many channels, such as voting, discussions with companies or collaboration with other investors (Mallow & Sethi, 2016, pp. 392-393). Such engagements are divided into public engagements, e.g. voting and shareholder proposals and private engagements such as conversations with boards and management. The latter appears to be the most used channel of engagement in general (McCaherty, Sautner, & Starks, p. 1) and to influence ESG specifically (Dyck, Lins, Roth, & Wagner, 2019, p. 702-703). It is expected to become even more important over time (Mallow & Sethi, 2016 p. 397). Other research concludes the same. Public engagements, such as general meetings of shareholders, constitute 5.6% of the 3,000 interactions between a large EU investment manager and its portfolio companies. However, about 33% of the contact was by email and 18.5% by means of letters. In 10.9% of the contacts, meetings in person took place (Barko, Cremers, & Renneboog, 2017, p. 14). Hence, the importance of private over public engagements is undoubtedly exemplified.

The foregoing deals with ‘institutional investors’ in general. However, “equity ownership in its own right is not a determinant of ownership engagement.” The type of engagement may differ according to institutional investor type. The degree of engagement can also differ, which depends on business models and regulatory environments. For this thesis, the following features are relevant: the investment horizon, a passive or active strategy, political or social incentives, a concentrated or diversified portfolio, fixed or performance based fees and the regulatory framework (Çelik & Isaksson, 2014, pp. 104-105).

Several types of institutional investors, such as investment funds and hedge funds engage in different degrees. The remainder of this master thesis focuses on investment funds. There is a distinction between passive and active funds (Section 1.1). This distinction influences influences the abovementioned features. As will be explained, passive managers cannot use ‘exit and selection’ and there is discussion regarding their incentives to engage (Chapter 3 and

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4). Therefore, it is necessary to analyze the structure of passive managers and contrast these with active managers.

2.4 Conclusion

Of the mechanisms employed by institutional investors to influence ESG, voice is more important than exit and selection. Within voice, private engagements are more important than public engagements. The degree to which investment managers engage, depend on a number of features. As will be explained, features of passive management and fund structure raise the question if passive managers are incentivized to engage.

Chapter 3: What are passively managed funds?

3.1 Introduction

This chapter introduces investment fund structure. Subsequently, it explains the possible agency problems related to this structure. These might affect the level of engagement which in turn depends on whether the fund is actively or passively managed. Last, the structural differences between actively and passively managed funds and limitations on engagement are explained.

3.2 The relationship between investors and investment managers

Investors can buy securities directly themselves or through investment funds. An investment fund is a legal entity that trades in securities on behalf of investors. Investors buy shares or units in the fund. An investment manager manages the fund. The investment fund holds the shares for the investor, whereas an individual that directly invests holds the shares itself. Investment funds are divided into mutual funds or UCITS2 (Undertakings for Collective Investment In Transferable Securities) and ETFs. Both mutual funds and ETFs invest in securities, but they differ in the exit strategy for investors. Mutual fund shares are redeemable only at the end of each trading day, whereas shares in ETFs are traded on the financial markets themselves (Armour, et al., 2016, pp. 250-253).

Investment managers can pursue different strategies. First, active funds seek to outperform the index that functions as a benchmark for the fund’s performance. Conversely, passive funds replicate the benchmark through buying shares in the companies of which the index is composed. They buy proportional to the company’s stake in the index (Bebchuk & Hirst, 2018,

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p. 6). It is relevant to reiterate that both mutual funds and ETFs can be actively and passively managed. Figure 3 provides an overview of the abovementioned relationships.

3.3 Agency relationships

Agency problems occur when a principal relies on an agent to maximize the principal’s prosperity. Therefore, agents have to be incentivized to increase the principal’s welfare instead of their own. Typically there are three agency problems. First, a firm’s managers have to be incentivized to engage in conduct that is best for shareholders. Second, majority shareholders have to be motivated to not expropriate minority shareholders. Third, agency problems can arise between the firm and outsiders such as creditors (Kraakman, et al., 2017, pp. 29-31).

There is also an agency relationship between investors and investment managers. Investment managers are agents that have to be incentivized to maximize investment fund return which maximizes investors’ return. When investors invest through funds, the investment fund holds the shares and accordingly asserts the rights attached to the shares, whereas non-fund investors have shareholder rights themselves (Rock & Kahan, 2019, p. 3). This is a crucial difference that possibly results in another agency problem, namely one between investors in funds and investment managers (Jahnke, 2019, p. 3).

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3.4 Structural differences between active and passive funds

The foregoing is relevant for passive funds. ESG engagement can be value increasing for shareholders (Dimson & Karakaş, 2015, p. 34) which this thesis will assume. Generally, active funds have incentives to engage, since they seek to increase the value of the companies that they assume might outperform an index. This value increase benefits the investors in active funds (Rock & Kahan, 2019, p. 4). Conversely, passive funds replicate an index regardless of performance. This provides for structural differences between active and passive funds. First, passive funds are generally “locked-in” their investments because they track index. Thus, in principal they cannot sell their investments. Active funds can sell their investments. Second, passive funds hold the same investments if they replicate the same indices. Active funds compete based on performance of their idiosyncratic portfolio. Therefore, passive managers compete on the costs for index replication as opposed to outperforming other funds (Fisch, Hamdani, & Davidoff Solomon, 2020, p. 21). Third, the nature of stock picking differs. Active funds select potentially promising companies, whereas passive funds replicate an index. Fourth, passive managers lack information collected while trading and need to actively gather information compared to active managers. This makes engagements relatively costly for passive managers. Fifth, passive funds are subject to collective action problems. If passive managers engage, all passive managers benefit because they also hold investments in the engaged company in the same proportion (Lund, 2018, pp. 102-103). Active funds are also susceptible to collective action problems. However, active funds do not necessarily invest in the same companies and possibly attach different weightings to their investments. Therefore, the value captured by other funds differs (Lund, 2018, p. 108). Last, passive funds possibly have a long-term perspective because they are locked-in (Bebchuk & Hirst, 2018, p. 2). Though not necessarily a difference between active and passive funds, the latter hold large stakes in an abundance of companies (Bebchuk & Hirst, 2018, p. 15). Table 1 lists the differences between actively and passively managed funds and managers.

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12 Table 1

Feature Active Passive

Nature of stock picking Active analysis Track index

Exit Yes No

Competition Performance Fees

Information spillover Yes No

Collective action problem Minor Severe

Time horizon Short and long Long

The differences in features result in different expectations regarding incentives of passive managers to engage. Bebchuck and Hirst call these expectations “the value-maximization view” and the “agency-cost view”. The value-maximization view holds that engagements are mainly based on increasing the long-term value of the fund. Conversely, the agency-cost view entails that agency problems chiefly determine engagements (Bebchuk & Hirst, 2018, pp. 17-18). 3.5 Conclusion

The structure of passive funds results in differences between passive and active managers. Investment fund structure in general is subject to agency problems. However, there are several differences between active and passive managers that raise the question if agency problems are more severe for passive managers. Therefore, it is important to discuss whether passive managers have incentives to engage.

Chapter 4: Do passive managers have incentives to engage?

4.1 Introduction

This chapter sets out two frameworks to assess the incentives of passive managers to perform engagement activities. Bebchuk and Hirst support the agency cost view. On the other hand, Rock and Kahan support the value-maximization view.

4.2 The agency cost view

According to Bebchuck and Hirst, investment managers are motivated by agency problems for two reasons. First, investment managers are disincentivized to invest in engagements. Investors

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pay for the services of investment managers as a relatively low percentage of AuM. Engagements increase the value of the investments held by investors. Therefore, the investment manager’s AuM increase in value. However, only a small part of this increase is caught by the investment manager (Bebchuk & Hirst, 2018, p. 5). Furthermore, passive funds compete with each other and with active funds for AuM on the basis of relative costs. As mentioned, engagement with portfolio companies can increase value. The benefits of the engagement are shared with all investors in the index whereas the costs are incurred by the engaging investment manager. The investment manager is disincentivized to increase fees to pay for the engagements, because higher fees reduce a return that is equal for all passive managers. Therefore, competition between passive funds does not provide incentives to engage. Moreover, the increase in passive funds’ AuM is driven by the believe that index outperformance is difficult to achieve. If this drives the flow into passive funds, there is also no competition with active funds (Bebchuk & Hirst, 2018, pp. 25-28). Therefore, investment managers have less incentives to engage than is optimal for the investors in their funds. Second, investment managers’ private interests result in conduct deferential to corporate management. Investment managers have business ties to the managers of portfolio companies. They generate revenue through employee pension plans. Investment managers can assume that their revenues are affected by how corporate managers of pension plans perceive them. This results in “client favoritism” which entails that investment managers are less critical of portfolio companies with which they also have business relationships. Client favoritism can be addressed by splitting engagement departments from departments that manage pension plans. However, investment managers can also be deferential to corporate management through their policies and practices. Such “general management favoritism” means that all policies are applied in a non-critical way towards corporate management. This deference does not distinguish between portfolio companies with business ties and portfolio companies without business ties. There is evidence that supports this view, e.g. investment managers with strong ties to corporate managers are more likely to vote in favor of corporate management (Bebchuk & Hirst, 2018, pp. 31-35).

Furthermore, investment managers might hold positions of at least 5% of outstanding shares. In that case, article 13(d) US Securities Exchange Act prescribes that stockholders have to disclose certain information. There is a distinction between limited and extensive disclosure. The latter applies if the goal or effect of the investment is to alter control over the company. Bebchuk and Hirst note that several engagements are captured by this statute. Consequently,

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engaging investment managers have to disclose their holdings more often, which is time consuming and costly. Therefore, investment managers have incentives to stay out the gambit of this disclosure (Bebchuk & Hirst, 2018, pp. 35-36).

Last, investment managers consider the possible regulatory backlash that adopting a critical position towards corporate management could cause. Investment managers can wield large power through their shareholdings. There is historical evidence that legislation protective of management is enacted after corporate management’s interests are threatened. If investment managers critically exercise their power, they are subject to the risk that such legislation is enacted. Therefore, investment managers have incentives to reduce the scrutiny of corporate management (Bebchuk & Hirst, 2018, pp. 36-39).

4.3 The value maximization view

Rock and Kahan claim that the Big Three have “the best incentives” compared to fund investors, other retail investors and institutional investors. They identify three engagement areas, namely “high profile [proxy] contests”, “market wide governance standards” and “company specific […] issues.” The Big Three’s incentives differ according to the areas concerned, but remain positive. Therefore, it is better when the Big Three are not targets of policy proposals (Rock & Kahan, 2019, pp. 3-4).

Rock and Kahan identify several features that influence engagements. First, there are incentives to increase the value of companies. Fees are based on AuM as explained above. Thus, any value increase enlarges AuM which results in higher fees. Especially the Big Three hold large investments which makes the absolute value increase large. (Rock & Kahan, 2019, p. 13). Additionally, the Big Three are subject to reputational incentives, because they wish to be positively perceived by society. An example is the yearly letter of Blackrock’s CEO to portfolio companies. Rock and Kahan believe that reasons for this letter are the following. First, Blackrock seeks to avoid regulation by signaling its engagement activities. Second, Blackrock distinguishes itself by emphasizing the issues it considers as important. Consequently, it can attract investors with the addressed topics (Rock & Kahan, 2019, pp. 29-31). Interestingly, Rock and Kahan arguably arrive at the opposite conclusion of Bebchuk and Hirst. The latter argue that the Big Three do not engage because they do not want to alienate corporate managers for fear of a regulatory backlash (Section 4.2). Conversely, Rock and Kahan think that the Big Three do have incentives to engage, also for fear of regulatory backlash.

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The second feature deals with economies of scope. Rock and Kahan posit a distinction between company and topic specific information. The former deals with individual companies, whereas the latter applies market wide. The Big Three have an advantage with issue specific information because they deal with recurring issues at multiple companies. They lack company specific information because they do not generate information by actively trading. However, this disadvantage is alleviated because they also manage active funds resulting in information spillover and because a lot of company specific information is publicly available (Rock & Kahan, 2019, pp. 35-39). Third, active funds are subject to voting distortions because they identify companies whose stock prices differ from fundamental values. Consequently, they trade more short-term than passive funds and they can base decisions to sell on factors other than fundamentals. Conversely, passive funds replicate an index (Section 1.1). Therefore, such voting distortions might apply less to passive funds (Rock & Kahan, 2019, pp. 39-42).

The abovementioned areas of engagement are related to the structural features of passive managers (Section 3.4). First, the Big Three hold large stakes and can therefore decide on voting contests between activist shareholders and managers. Additionally, voting contests can significantly affect a company’s value. Thus, Rock and Kahan posit that the Big Three are incentivized to act on voting contests. Second, the Big Three’s large stakes and issue specific information generate economies of scope. This benefits the Big Three with governance standard engagements (Rock & Kahan, 2019, pp. 42-44). Last, the Big Three do not employ much analysts for performance related problems. They have to generate this information themselves and cannot rely on information spillover collected from trading. Therefore, Rock and Kahan assert that company specific engagements are costly for the Big Three. Conversely, they recognize that the Big Three have incentives to engage on governance, because there is spillover from market wide governance issues (Rock & Kahan, 2019, pp. 45-46).

4.4 Mitigating factors

There are factors that relate to both views. First, fiduciary norms can influence engagement activities. Fiduciary norms seek to ensure that investment managers act in the interests of investors (UNEP FI and PRI, 2019, p. 21). Second, reputational concerns can drive engagements (Bebchuk & Hirst, 2018, pp. 41-45). Both factors build on disclosure obligations. Disclosure enables investors to assess the extent to which investment managers meet their fiduciary obligations (Laby, 2017, p. 9). Furthermore, disclosure enables investors to form an opinion on passive managers’ engagements (Enriques & Romano, 2018, p. 15). Therefore, disclosure obligations are paramount for fiduciary norms and reputational constraints.

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16 4.5 Conclusion

There are two views regarding the incentives of passive managers to engage. The agency cost view believes that agency problems influence passive manager engagements. The value maximization view posits that passive managers have sufficient incentives to engage. Fiduciary norms and disclosure obligations can determine the degree of engagement expected of investment managers. The effect depends on the concrete obligation that a passive manager is subject to. Therefore, it is relevant to assess fiduciary obligations and disclosure obligations for investment managers in the EU and in the US and investigate the possible implications for engagement activities of passive managers.

Chapter 5: What are differences in fiduciary obligations for US and

EU passive managers?

5.1 Introduction

Section 4.4 established the relevance of legislation for the incentives of passive managers to engage. This chapter analyzes the fiduciary obligations of US and EU passive managers. First, a general overview of fiduciary norms is given.

Norms relating to ESG can be of a voluntary nature or can arise from fiduciary obligations. Most ESG norms are of a voluntary nature. However, specific topics, such as environmental concerns and bribery, are found in specific regulation (Williams, 2015, p. 13). There is no general fiduciary obligation for passive managers to engage on ESG (UNEP FI and the PRI, 2019, pp. 22-23). Therefore, it is difficult to assess whether fiduciary obligations for US and EU investment managers differ. Furthermore, the necessity of such obligations has been questioned. It has been suggested that ESG is “implicit in doing business” in stakeholder focused nations, e.g. the Netherlands and Germany. The opposite holds for shareholder focused nations, e.g. the US, where such obligations possibly need to be made “explicit” (Williams, 2015, p. 13).

Also, research shows differences in perspectives between US and EU institutional investors on ESG inclusion in fiduciary duties. Using a sample of senior personnel from several institutional investors of which 65% is qualified as “asset management company”, Amel-Zadeh and Serafeim find that 21.9% of US institutional investors believe that using ESG information when making investment decisions violates their fiduciary duty. Only 8% of the EU institutional investors believe the same (Amel-Zadeh & Serafeim, 2018, pp. 29-30). This is consistent with

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an EC consultation. A group of 131 organizations, comprised of e.g. institutional investors and industry associations responded. Of the 131 respondents, 120 were of an EU origin. When asked whether investment entities “should consider sustainability factors in their investment decision-making” two respondents did not have an opinion and only two respondents answered ‘no’ (European Commission, 2018). Therefore, a large majority indicated that ESG should be incorporated in investments.

Moreover, the United Nations (‘UN’) and the PRI have conducted extensive research into inclusion of ESG in fiduciary obligations for investment managers (UNEP FI & the PRI, 2019, p. 2). They posit that their “modern fiduciary duty” includes, among others:

1) Incorporating ESG criteria in accordance with the relevant timeframe;

2) Include ESG preferences of beneficiaries and clients irrespective of financial materiality;

3) Disclosure of how such preferences are incorporated; 4) The duty to behave as an active owner

These requirements are “sufficiently mature and underpinned by legislation and policy.” Therefore, ESG should be included in an institution’s fiduciary duty. (UNEP FI & the PRI, 2019, p. 21).

5.2 US fiduciary norms

In that respect, the US Department of Labor (‘DOL’) addressed ESG inclusion in fiduciary obligations of entities that manage pension plans. It held that fiduciary duties impede foregoing yield or assuming additional risk “to promote collateral social policy goals.” However, the DOL added that ESG considerations can be financially relevant by affecting risk and return profiles, but ESG must not too easily be considered as such (United States Department of Labor, 2018). Although this may be considered as a first step into ESG inclusion in US fiduciary duties of institutional investors, there was confusion among market participants (UNEP FI and the PRI, 2019, p. 51).

US academics also disagree on this subject. The issue is whether (Delaware) fiduciary duties are geared towards maximizing shareholder value or also towards other stakeholders. Williams points out that fiduciary duties are aimed at the company and shareholders. Shareholders’ financial wealth has to be maximized only in case they are “cashed out”. Otherwise, the company interests prevail in case of conflicts between shareholders’ “financial interests” and the long-term strategy of the company (Williams, 2015, pp. 46-47). The latter is arguably also

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beneficial for other stakeholders. Therefore, Williams argues that shareholders are important beneficiaries of fiduciary duties, but only if their interests are aligned with the company’s interests (Williams, 2015, p. 49). Conversely, Strine argues that fiduciary duties can only be enforced by shareholders. Also, shareholders are the only party with voting power. Therefore, it is contrary to the structure of corporate law if directors place shareholder interests below interests of other stakeholders (Strine, 2015, pp. 30-32). Strine argues that it is more fruitful to take the law as it is and amend it where necessary to encourage responsible behavior (Strine, 2015, p. 33).

5.3 EU fiduciary norms

EU investment managers are allowed to consider ESG criteria when making investment decisions. However, the legal framework on fiduciary duties is surrounded bys “legal uncertainty.” Institutions were only guided by financial considerations (Johnston & Morrow, 2016, pp. 2-3). The closest to an EU fiduciary duty is found in article 24(2) Directive 2014/65/EU (The European Parliament and the European Council, 2014) (‘Mifid II’) (European Commission, DG Environment, 2014, p. 27) . This article requires investment firms to act in the best interests of their clients. This is mainly achieved through the “suitability assessment” which requires information to be obtained in order assess such suitability (article 25(2) Mifid II). Suitability is mostly assessed by financial goals. “ESG-preferences” are often not considered. The EC beliefs that the suitability assessment encompasses ESG. Therefore, the European Securities and Markets Authority (‘ESMA’) has submitted amendments to the guidelines used to interpret suitability. They suggest that ESG should only be considered once suitability is determined by the other relevant criteria (Siri & Zhu, 2019, pp. 9-11). To my knowledge, the amendments still have to be finalized and accepted.

It appears that both EU and US fiducary duties are somewhat unclear on ESG inclusion. Possible reasons are the following. Fiduciary duties are traditionally understood as increasing shareholder value. It is unclear to what extent ESG is part of this duty to increase value, because long-term horizons are considered “as inferior to” reliable yield in the short-term (Jahnke, 2019, pp. 3, 9) (European Commission, DG Environment, 2014, p. 7). Furthermore, there appears to be a “responsibility vacuum.” It is unclear which party is responsible for incorporating ESG (Jahnke, 2019, pp. 18-19).

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5.4 Conclusion: differences

It is arguably clear that fiduciary obligations encompass ESG when relevant from a return or risk management perspective. Moreover, EU market participants seem to be more acquiescent towards ESG inclusion in fiduciary duties compared to the US. Also, ESMA is in the process of reviewing ESG inclusion in the suitability assessment of Mifid II. Despite these differences, in principle both the EU and the US seem to lack a framework that unequivocally determines whether and to what extent fiduciary duties include ESG.

Chapter 6: What are differences in disclosure obligations for US

and EU passive managers?

6.1 Introduction

Regulation that does specifically address engagements and ESG relates mostly to disclosure (Williams, 2015, p. 14). This chapter analyses disclosure of engagements of passive managers in the EU and in the US. As explained (Section 2.3), engagements are an important mechanism to influence ESG. This should especially be true for passive funds, given that they generally lack the option of exit and selection (Section 3.4).

6.2 US disclosure obligations

Regulation for engagement disclosure of US passive managers is found in the Investment Adviser Act (‘IAA’) and the Investment Company Act (‘ICA’). Investment managers are “investment advisers” which is defined in the IAA as “any person who, for compensation, engages in the business of advising others […] as to the value of securities or as to the advisability of investing in […] securities.” The clients of the investment advisers are the funds in which investors buy units or shares (see figure 3). The ICA defines the funds of an investment advisor as “investment company” which is “any issuer which […] holds itself out as being engaged primarily […] in the business of investing, reinvesting, or trading in securities.” (Committee on Capital Markets Regulation, 2020, pp. 4-5). Therefore, it appears as if passive managers are in scope of US disclosure obligations.

The investment advisor exercises voting rights of the investment company under an agreement between the investment advisor and investment company (Committee on Capital Markets Regulation, 2020, p. 8). US law requires granular disclosure of voting activities. First, an investment manager’s voting policies have to be disclosed. Second, investment managers have to publish a “voting record” including information on individual votes, such as: topic, portfolio

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company, whether and how the fund voted and whether the fund opposed management (Committee on Capital Markets Regulation, 2020, p. 11). The disclosure of voting is applicable at the fund level (Coates, 2019, p. 20).

Voting is a form of public engagement (see Section 2.3). Therefore, disclosure of public engagements is required by US law. However, the IAA and the ICA do not require passive managers to disclose a policy and record on private engagements. Private engagement disclosure in the US occurs entirely on a voluntary basis (Committee on Capital Markets Regulation, 2020, p. 11-12).

6.3 EU disclosure obligations

Disclosure of engagements in the EU is found in Directive 2017/828/EU (The European Parliament and the European Council, 2017) (‘SRD II’). It entered into force in 2017 (article 3) and in 2019 its implementation deadline expired (article 2).

An important caveat regarding SRD II applies. SRD II is a directive and as such it is enacted by EU institutions and implemented into law by national institutions. (Dickson, 2011, p.194). Therefore, a risk is that the directive’s implementation differs. This appears to be the case regarding the potential enforcement mechanisms (article 14b SRD II). Some legislators have adopted no enforcement mechanism, whereas other legislators allow severe sanctions (Katelouzou & Sergakis, 2020, pp. 17-19). The implementation deadline recently expired, so it remains to be seen how market participants react to the different implementations of SRD II. Nonetheless, directives require an outcome to be attained (Dickson, 2011, p. 194) and courts are, in general, required to practice national law in compliance with EU law (Dickson, 2011, pp. 203-204). Also, the EC requires a “level of harmonization” (European Commission, 2014, p. 7). Therefore, a minimum degree of consistency might be expected. Thus, this analysis focuses on SRD II itself.

SRD II explicitly refers to the link between engagement and improving ESG (Recital 14) and states that disclosure obligations encourage engagements as it increases investor awareness (Recital 16). To that end, article 3g SRD II deals with disclosure of an asset manager’s engagement policy and disclosure of the implementation thereof. The scope of article 3g SRD II determines whether passive funds or managers are “asset managers”. SRD II recognizes several asset managers (article 1(2)(f)). The first relevant type is an investment firm as defined in Mifid II that provides portfolio management services. Mifid II defines investment firms in article 4(1), among others, as legal persons that provide investment services to third parties on

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a professional basis. Article 4(1)(8) Mifid II defines portfolio management as the management of portfolios in conformity with mandates given on a discretionary per client basis that includes financial instruments. Financial instruments are defined in Section C Mifid II and include instruments such as units in UCITS and transferable securities. It appears that passive managers qualify as such investment firms. The second type is an Alternative Investment Fund Manager (‘AIFM). AIFMs are presumably not passive managers for the purpose of this thesis. The next type relates to management companies as defined in article 2(1)(b) Directive 2009/65/EC (The European Parliament and the European Council, 2009) (‘UCITS Directive’). A management company’s business is the management of UCITS. It appears that passive managers that provide for UCITS qualify as management companies. The last type is an investment company without a management company as defined under type 3 (Hooghiemstra & van Hees, 2020, pp. 135-136). The UCITS relevant for this thesis presumably have an investment manager that manages the UCITS. Therefore, the fourth type is inapplicable.

Thus, passive managers fall within the scope of article 3g SRD II and the following applies. Subsection 1 introduces a comply or explain requirement. If compliant, subsection (1)(a) requires disclosure of engagement policies which includes among others:

• how passive managers monitor portfolio companies; • how they “conduct dialogues” with portfolio companies; • how they exercise voting rights;

• how they cooperate with other shareholders.

Subsection (1)(b) requires passive managers to disclose the implementation of the policy. This includes a general specification of voting with an explanation to significant votes, but votes that were “insignificant” can be excluded.

A weakness of EU engagement disclosure is found in the comply or explain basis. Strictly speaking, investment managers are not subject to a disclosure obligation. Investment managers can choose not to adopt and disclose an engagement policy if they provide a “clear and reasoned explanation”. However, there are reasons to assume a stronger ‘comply’ nature. Some authors argue that SRD II introduced a “duty to demonstrate engagement” (Chiu & Katelouzou, 2016, p. 142) (Katelouzou and Sergakis, 2020, p. 16) They argue that it is atypical to include soft law in legislation. Therefore, there is a “normative expectation” that engagement is included in investment manager practices. Second, institutions need to have engaged for disclosure to take

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place. This breaks with the notion of “voluntary” engagement. Third, engagement is of public interest, because investment managers’ AuM consists mostly of “household and pension savings.” These savings benefit from a long-term perspective in the corporate sector. (Chiu & Katelouzou, 2016, p. 143,145). Therefore, engagement disclosure in SRD II might be of a more obligatory nature.

This view is supported by legislation not yet into force. Regulation 2019/2088/EU (The European Parliament and the European Council, 2019) introduces disclosure obligations for information related to sustainability (Article 1). Subsequently, due diligence procedures considering the impact of activities on sustainability have to be made available online (Article 4(1)) which consists at least of disclosure of engagement policies as required by article 3g SRD II, “if applicable” (Article 4(2)(c)). Therefore, the legislator appears to consider engagement disclosure as important for sustainability disclosures. This adds to the interpretation of article 3g SRD II as possibly containing a “duty to demonstrate engagement” as previously discussed. SRD II only defines “the subject matter” of engagements, whereas engagements can span “across a spectrum” (Ahern, 2018, p. 105). This might lead to uncertainty. Therefore, it is important to determine the dimensions of engagement disclosure and to differentiate between public and private engagements. The proposal of the EC advanced three dimensions of engagement disclosure, namely disclosure of policies, the implementation thereof and disclosure of results (European Commission, 2014, p. 19-20). These dimensions appear to be consecutive, i.e. passive managers have to publish an engagement policy, the implementation of which can be disclosed after which the results thereof can be disclosed. Assume that these three dimensions result in disclosure in its entirety. Article 3g SRD II specifically refers to a voting policy, the implementation thereof and how votes have been cast. Thus, EU law requires public engagements to be entirely disclosed.

Next, the question arises if private engagements are in scope of article 3g SRD II. In that respect, the ESMA lists three engagement types: “(i) engaging in private conversations with management and the board; (ii) exercising voting rights at companies’ shareholder meetings and (iii) proposing resolutions at companies’ shareholder meetings. […] ESMA focuses on the three categories above, which is consistent with the scope of SRD II” [emphasis MTS] (European Securities and Market Authority, 2019, p. 55). This shows that the ESMA considers private engagements as in scope of SRD II. Furthermore, Ahern (Ahern, 2018, p. 105-106) and Strand (Strand, 2015, p. 38) discuss possible adverse effects of private engagement disclosure (see Section 7.2) which arguably presupposes such disclosure. Also, the US Committee on

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Capital Markets Regulation writes that “non-voting engagement is governed by SRD II” (Committee on Capital Markets Regulation, 2020, p. 13). Therefore, despite uncertainty surrounding SRD II (see e.g. HSBC, 2019) the disclosed engagement policy appears to include private engagements. Moreover, it appears that the implementation thereof has to be disclosed, because the implementation of the policy that includes private engagements has to be disclosed (article 3g SRD II).

However, it is ambiguous if results of private engagements have to be disclosed. The EC’s proposal encompassed disclosure of an engagement policy which included disclosure of the results of such policy (European Commission, 2014, p.19-20). This suggests that the EC’s proposal included disclosure of private engagement results. However, in the 2017 adopted text, the wording on disclosure of results is absent. This might indicate that results of private engagements do not have to be disclosed. Nonetheless, there are suggestions that indicate that SRD II does require disclosure of private engagement results.

Recital 18 of SRD II deals with implementation disclosure of institutional investor engagement policies “and in particular how they have exercised their voting rights” [emphasis MTS]. This might entail that results are part of the implementation of the engagement policy, because voting results appear to be only one aspect of the disclosure of implementation. This depends on the interpretation of “implementation”. Moreover, Chiu writes that “certain engagement conduct needs to be carried out in order for there to be sufficient matters to report”. Therefore, it might be concluded that: “[…]there is a duty to publicly disclose the implementation and achievement of any engagement […]” [emphasis MTS] (Chiu, 2016, p.35)3. It is important to reiterate the caveat in the current Section that SRD II has to be implemented in national law which has occurred only recently. Thus, it remains ambiguous whether disclosure of results is required. E.g., Lyxor lists private engagement statistics under the heading “implementation of the engagement policy” (Lyxor, 2019, pp. 8-9), whereas DWS does not (DWS, 2019, p. 6). So far there are three dimensions to private engagement disclosure. There may be another aspect distinct from the previously mentioned dimensions which relates to different types of private engagements. Voting is perhaps of a ‘binary’ nature. In principle, passive managers either vote or they do not, subject to e.g. the use of proxy advisers or how informed the votes were cast. However, private engagements can range from Blackrock’s letter to all portfolio companies (Blackrock, 2020b) to private dialogues with management. Thus, it is important to differentiate

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between the types of private engagements. To my knowledge, it is unclear what is required by SRD II in this respect.

At the minimum, this suggests that the EU places emphasis on private engagements through disclosure of policy and implementation, which is an interesting difference. At maximum, EU law might even require disclosure of the outcomes of the private engagements and which means were employed. This can be called the ‘minimum interpretation’ and ‘maximum interpretation’ of article 3g SRD II.

6.4 Conclusion: differences

The first difference is the nature of the disclosure requirements. US disclosure requirements are legal obligations. In the EU, there is a comply or explain basis. However, there are reasons to regard EU disclosure requirements as a legal duty.4 Second, US disclosure of voting statistics applies at the fund level. EU disclosure requirements apply at the fund level or the manager level if applicable. Third, the US requires granular voting disclosure. Information on individual votes has to be disclosed (Committee on Capital Markets Regulation, 2020, p. 19). The EU requires a general explanation of voting that includes significant votes. This suggests that the US attaches more weight to the importance of voting than the EU.

Furthermore, the US does not oblige passive managers to disclose dimensions of private engagements (Committee on Capital Markets Regulation, 2020, p. 12). Conversely, the EU requires private engagement disclosure of policy and implementation. It is ambiguous whether the EU requires passive managers to disclose results, although there are suggestions to that end. Also, it is unclear what types of private engagements have to be disclosed. Table 2 summarizes the differences.

Table 2

SRD II is subject to several qualifications (Section 6.3) which makes it difficult to accurately predict the extent of EU private engagement disclosure. Nevertheless, a possible conclusion is

4_{In that respect, the US Committee on Capital Markets Regulation also writes of “binding regulations” for the} disclosure of voting in the EU (Committee on Capital Markets Regulation, p. 19).

Disclosure of Policy Implementation Result Means

EU Public engagements Yes Yes Yes Inapplicable

Private engagements Yes Yes Ambiguous Unclear

US Public engagements Yes Yes Yes Inapplicable

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that the extent to which EU and US disclosure differ is a function of the extent to which EU law requires private engagement disclosure. This depends on the minimum or maximum interpretation of article 3g SRD II. This is exemplified by figure 4.

Figure 4

Chapter 7: How might these differences affect the engagement

activities of EU and US passive managers?

7.1 Introduction

In Section 5.4 it was established that the EU and US both lack a framework that unequivocally incorporates ESG in fiduciary duties, although the EU is in the process of developing such a framework. Given the uncertainty surrounding ESG incorporation in fiduciary duties in both jurisdictions, it is unlikely that the differences in engagements result from different fiduciary obligations. On the contrary, Section 6.4 established that there are interesting differences regarding disclosure obligations of engagement activities. The degree to which these differences influence relative incentives to engage depend on whether one accepts the minimum or the maximum interpretation of engagement disclosure required by the EU as exemplified by figure 4. This thesis suggests the following. The minimum interpretation may lead to a slight

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degree of different incentives for EU passive managers compared to their US counterparts. The maximum interpretation may result in large differences in incentives.

This chapter analyses how these differences might influence the economic reality of passive managers subject to several caveats (Section 6.3 and Section 7.2). It provides for several suggestions as to the disincentives or incentives created by the differences in disclosure obligation to a degree that depends on the minimum or maximum interpretation.

7.2 Difficulties and disincentives to engage

First, a difficulty arises with private engagement disclosure. It has been recognized that the very essence of private engagements is that they are unobservable. Thus, there is a lack of knowledge on private engagements (Becht, Franks, & Wagner, 2019, p. 1) (McCaherty, Sautner, & Starks, 2015, p. 1). Consequently, there exists a conundrum that disclosure of private engagements seeks to disclose something that is in principle unnoticable.

Additionally, a relevant question is whether there are drawbacks to disclosure of private engagements. There are multiple obstacles to consider, because there is not “one single, very important reason for not engaging” (McCaherty, Sautner, & Starks, 2015, p.19). Ahern recognizes that disclosure may result in more “adversarial-type interactions” undermining the “deftness, fluidity, and focus […] on a ‘win-win’ outcome” (Ahern, 2018, p.106). Bebchuck recognizes that portfolio companies might become reluctant to communicate with their shareholders if this were disclosed. However, it is improbable that companies refuse discussions with large shareholders (Bebchuk & Hirst, 2018, pp. 99-100). Also, McCahery e.a. recognize that free rider problems and legal concerns may impede engagement (McCaherty, Sautner, & Starks, 2015 p. 2).

Acting in concert legislation may impede engagements (McCaherty, Sautner, & Starks, 2015, p. 19). Section 7.7 shows a solution, because ESMA has published a white list of activities that do not qualify as acting in concert (Strampelli & Balp, 2019, pp. 57-64). Furthermore, Strampelli recognizes that problems relating to insider trading rules should not be magnified, because institutional investors mostly engage through communicating their own views. This minimizes the risk of obtaining inside information from the engaged company (Strampelli, 2018, p. 14). However, the expectation of being caught by insider trading rules is probably already enough to disincentivize engagements if they have to be disclosed. Therefore, a possible solution can be clarifications of the legislator, the SEC or ESMA equal to the abovementioned white list (Strampelli, 2018, p. 32). Last, it may be expected that disclosure worsens free rider

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problems, e.g. because research on effective types of private engagements is a cost for one party whereas other parties benefit from this information. Section 7.7 establishes that third party coordinating entities may solve free rider problems (Strampelli & Balp, 2019, p. 49). That being said, there are several advantages to disclosure.

7.3 Private engagements are more often used than public engagements

Section 2.3 showed that private engagements are more employed than public engagements. Regulation should reflect this practice. A suggestion can be made as to why US legislation relies on voting, whereas EU legislation might minimally or maximally incorporate private engagements. Ownership in US financial markets was traditionally dispersed and only recently has there been a concentration of ownership (Fichtner, Heemskerk, & Garcia-Bernardo, 2017, p. 4). It may be argued that dispersed owners do not have the means and opportunities to engage privately. Conversely, ownership in EU financial markets has traditionally been concentrated, (European Savings and Retail Banking Group, 2016, p. 4). Concentrated owners probably have the means for private engagements. Therefore, EU financial markets historically already reflect the current institutional ownership patterns. Thus, regulation might concentrate more on disclosure of private engagements which possibly incentivizes passive managers to engage accordingly.

7.4 Passive funds can only rely on ‘voice’

Section 3.4 established that passive funds can be expected to rely more on voice mechanisms compared to active managers. Within voice mechanisms, private engagements appear to be more important than voting (Section 2.3). Active managers have the ability to screen companies in advance or to exit companies by selling their investments. Conversely, in principle passive managers cannot apply such mechanisms because they replicate an index. There are also passive funds that exclude companies that do not meet ESG criteria. Such funds can use exit and selection. However, the traditional index fund that replicates an index has to buy and sell shares in companies of which an index is composed. Therefore, passive funds generally cannot rely on exit and selection. What they can do, is publicly or privately engage their portfolio companies.

This argument says nothing about whether passive managers are incentivized to engage to the level that is optimal for their investors (Bebchuk & Hirst, 2018, p. 20). It only explains the limitations of the engagement mechanisms available to such investment managers and therefore it touches upon the relative importance of disclosure of private engagements. Hence, depending

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on the degree of EU private engagement disclosure this may result in EU passive managers relying more on private engagements than their US counterparts.

7.5 Voting disclosure may result in ‘box-ticking’

A risk of any type of regulation is that it results in mechanical box-ticking (Çelik & Isaksson, 2014, p. 94). Passive managers adopt voting guidelines that in principle apply throughout all portfolio companies. Furthermore, passive investment managers often make use of “proxy advisory firms which adopt standardized in-house voting policies” (Strampelli & Balp, 2019, p. 22). Therefore, it may be expected that passive funds vote according to a predefined policy and not according to the merits at hand. This is supported by empirical research that shows that “the internal agreement in proxy voting among the Big Three’s funds is remarkably high.” E.g. in only 18 out of 100,000 proposals did Blackrock funds not vote in conformity with other funds. (Fichtner, Heemskerk, & Garcia-Bernardo, 2017, p. 18).

In that respect, voting as a means of engagement appears to lend itself well for an automatic application compared to private engagements. This is exemplified by the approach taken by investment advisers after the adoption of voting disclosure rules by the SEC in 2003. The rules do not oblige funds to vote on every proposal. Mutual funds were generally not engaged with corporate governance before the voting disclosure rules. However, “mutual funds have responded […] by voting virtually all of their shares” (Fisch, Hamdani, & Davidoff Solomon, 2020, p. 44) (Strampelli & Balp, 2019, pp. 23-24). This suggests that it is easier and more cost efficient for mutual funds to apply policies where all shares are voted, than to analyze what proposals were voted on and disclose only these votes. Consequently, all shares are voted, but voting has occurred according to predefined guidelines. Moreover, it may be cost efficient for passive managers to vote with management if votes are cast at all (Enriques & Romano, 2018, p. 12).

It can be argued that some private engagements, such as standard letters (Blackrock, 2020b), equally lend themselves for an automatic application. However, the range of private engagement possibilities spans from a standard letter to meetings with the board of a portfolio company. Therefore, private engagements can be tailored to a specific situation. Hence, depending on the degree of EU private engagement disclosure this may result in EU passive managers engaging less mechanically than their US counterparts and voting more often against management.

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7.6 Disclosure of private engagements may result in more meaningful engagements

Private engagements are used the most by institutional investors (Section 2.3). Private engagement disclosure provides information to investors in passive funds. Assuming that the maximum interpretation applies (Section 6.3), the means and topics of private engagements are disclosed. Disclosure enables investors to analyze such engagements. This should incentivize passive managers to adopt the most effective engagemenent policies (Bebchuk & Hirst, 2018, p. 99). Hence, it might become clear that sending an email is less effective than meeting in person with management of the portfolio company. Thus, depending on the extent of EU private engagement disclosure this may result in EU passive managers engaging more meaningfully.

7.7 Disclosure of collaboration is beneficial

EU investment managers may have to disclose their cooperation with other shareholders (Section 6.3). Cooperation with other shareholders is a means of private engagements. Disclosure incentivizes investment managers to collaborate with other shareholders (Strampelli & Balp, 2019, p. 55). There are several benefits of shareholder collaboration. First, evidence shows that collaborative engagements are often more succesfull than individual engagements. Second, collaborative engagements allow investment managers to engage on subjects “that would not be profitable if pursued individually” (Strampelli & Balp, 2019, pp. 45-47). For such collaborative engagements to work, a “third-party coordinating entity” is necessary which reduces free-rider problems and “can facilitate the circulation of information and agreement” (Strampelli & Balp, 2019, pp. 47-49). The free rider problem is one of the main causes of the alledged lack of incentives for passive funds (Section 4.2). Therefore, disclosed shareholder collaboration might have the potential to address this problem. Third, a third party entity may reduce the risk of being caught by acting in concert provisions (Strampelli & Balp, 2019, p. 49). Fourth, collaborative engagements through a third party entity allow investment managers that possess specific expertise to lead private engagements. Fifth, collaborative engagements may increase reputational concerns for investment managers that do not participate (Strampelli & Balp, 2019, pp. 51,54). Acting in concert regulation might influence shareholder collaboration. As opposed to the SEC, the ESMA provided a list of activities exempted from acting in concert legislation (Strampelli & Balp, 2019, pp. 57-64). Hence, depending on the degree of EU private engagement disclosure this may result in EU passive managers to collaborate more than their US counterparts.