Maximizing Returns Through Good Corporate Behavior?

Business leaders love shareholders - until the shareholders open their mouths.

Calpers (California Public Employees Retirement System), the largest pension fund in the US, is trying to balance its returns with the interests of its beneficiaries.

It is insisting on a 'sustainable' code of conduct which is less about the environment than about corporate survival, a not-unreasonable concern for any investor these days.

This implies that ethical behavior offers better long term returns than the alternative. That corporations find this outrageous is predictable. Many believe the long term is for pussies, let alone good behavior. That they may be forced to adhere to such a code if they want Calpers to invest, will be fascinating to watch. JL

Steven Solomon comments in DealBook:

Calpers is “looking at the balance between different considerations” and maximizing among those. It has the power to push companies, willingly or not, toward corporate sustainability, particularly if it starts nominating directors.

In the war to control corporations, the California Public Employees’ Retirement System, the $300 billion pension fund, has decided that it is willing to actively press companies to emphasize the environment, diversity and good corporate governance, perhaps even at the expense of profitability. It may save the planet by changing the way companies are run, but will it lead to the returns Calpers desperately needs?

The turn came this month at Calpers’s board of trustees meeting. The pension fund amended its investment policy for global governance to embrace what is called the corporate sustainability movement, the idea that companies should pay greater heed to the long-term future of themselves and society by adhering to social and environmental principles.

It represents a huge endorsement of the fledgling movement and at first blush seems like a great idea. What could be wrong with trying to improve the environment and society?

But like many things in the world of shareholders and corporations, it quickly becomes complicated.

Calpers’s global governance policy reflects how it votes its shares in the more than 67,000 votes it takes part in every year at thousands of companies. The most noticeable change this year was a deletion. Calpers deleted its first principle of corporate governance, which had stated that its investment “practices should focus the board’s attention on optimizing the company’s operating performance, profitability and returns to share owners.”

The deleted principle was replaced with a statement that companies that Calpers invests in are “expected to optimize operating performance, profitability and investment returns in a risk-aware manner while conducting themselves with propriety and with a view toward responsible conduct.” This type of vague statement often shows up in policy documents. It waters down the profitability part by adding responsible conduct and propriety, whatever that means.

Calpers then added three factors that it asserts create “long-term value”: corporate “governance,” “environment,” including climate change, and “social,” which includes fair labor practices and board diversity.

Calpers said it might seek to nominate director candidates if a company fails to perform up to these principles. Calpers managers are also expected to adhere to these principles in their investments.

Some of the changes were already reflected in policies adopted over the last few years. But by consolidating them all in one place and stating its position with full force, Calpers and a governance staff of about 20 people are not only fully embracing the corporate sustainability mantra, they are indicating that the pension fund will act to bring companies along with it as it changes the way it invests. Calpers is the largest and most influential of the pension funds, so even if it doesn’t assert this authority, other funds may follow its lead.

Corporate sustainability is undoubtedly becoming an increasing phenomenon in corporate America, and not just with shareholders. More and more companies have at least a vice president devoted to sustainable development if not a whole department. It’s a noble effort that can have real consequences for good if it succeeds.

But corporate sustainability is also controversial, and it may be doubly so for Calpers.

The first reason is the need for those all-important returns. Calpers was estimated to be underfunded by about 33 percent at the end of 2013 and needs to meet a high annual return goal of 7.5 percent.

A careful reading of the Calpers policy shows that it is asserting that long-term value can be created by adopting these practices. The argument is that returns for companies that adopt these practices will be higher because they help the world and help themselves. This justifies the focus because Calpers, as a pension fund, should be primarily focused on returns and indeed has a fiduciary duty to act in its pension holders’ best interests by earning the highest returns it can.

Yet, we just don’t know if Calpers’s assertion is true. It is uncertain that adopting corporate sustainability policies will in fact increase returns. They might rise, but even Calpers acknowledges the research on this is in its infancy, so they might not. Even more complicated, there is a big debate about what constitutes corporate sustainability. Does it mean disinvestment in fossil fuel companies to work against climate change or fast food chains to make Americans eat healthier? What are good practices toward the environment or employees?

To be fair to Calpers, it is in it for the long term — it has an investing horizon of forever. And if the world is increasingly a bad place, the companies in it will be, too. Consequently, in a world it hopes to be in forever, Calpers has an incentive to consider the broad picture. This might be fine if only Calpers were advocating its concept of these principles. But companies have thousands of shareholders. As each defines its own concept of sustainability, corporations may be buffeted by competing agendas.

The last, and perhaps thorniest, problem is that corporate sustainability, when it reduces profits over the long term, may in fact be illegal. Many United States public companies are incorporated in Delaware, whose courts have consistently ruled that companies have a responsibility to shareholders to maximize profits. Indeed, Chief Justice Leo E. Strine Jr. argued recently that corporate sustainability misunderstands Delaware law and that it “is not only hollow but also injurious to social welfare to declare that directors can and should do the right thing by promoting interests other than stockholder interests.”

That might appear coldhearted, but it underscores that corporations have the latitude to do good within their profit-maximizing context. Corporations give to charities and take social positions all the time. Consider the “Race Together” campaign at Starbucks, which pursued corporate sustainability. Although it was pursuing a noble goal, however misguided some thought it was for a corporation, Starbucks was trying to be more attractive to Americans so they would buy more coffee there. By focusing on profits, companies avoid the battle over whose social purpose they should adopt.

I spoke with Ann Simpson, senior portfolio manager and director of corporate governance at Calpers, who explained that the pension fund was not looking to “maximize corporate profits” but rather has its own fiduciary duties to its retirees to “optimize” its own returns over multiple generations. She further explained that “optimize” means “looking at the balance between different considerations” and maximizing among those.

It is this profit versus purpose conundrum that Calpers finds itself in. It has the power to push companies, willingly or not, toward corporate sustainability, particularly if it starts nominating directors.

Whether it will make the money Calpers needs, let alone change the world, is another story.