SEC must say no to ESG regulation

Some institutional investors and public officials are calling on the Securities and Exchange Commission to develop mandatory rules for companies to disclose high-quality, comparable, decision-useful environmental, social and governance information — especially on corporate political spending.

Most of those pushing this proposal oversee public employee pension funds, college endowments or charitable foundations. If the proposal is accepted, the next step might be to seek to impose ESG standards on companies.

Is more SEC regulation really needed? We could be approaching regulation strangulation. The number of publicly listed companies has declined by 46% in the past two decades. Surely the cost and hassle of dealing with the SEC and its regulations is a deterrent to going public, or remaining public, especially as other sources of capital are readily available.

Ironically, executives at some of those funds seeking more regulation are providing the capital that allows companies to stay or go private.

Before the SEC issues a new disclosure regulation, it should require that the proponents of it present a cost-benefit analysis showing how the regulation would improve long-term corporate earnings and stock prices. That analysis should be peer-reviewed and double-checked by disinterested parties.

This is especially important as only 28% of institutional investors support disclosure of political spending by companies. This suggests the vast majority of institutional investors do not believe such spending has any negative effect on company earnings, or at least not enough to offset the cost and distraction of collecting and reporting such information.

Further, only 29% of institutional shareholders support social and environmental proposals, suggesting a large majority feels these issues have no material effects on earnings and stock prices for most companies. The support was even lower among retail investors at 16%.

The SEC should not bend to the wishes of a minority of shareholders without clear evidence that any new regulation will have a strong beneficial effect on company financial well-being and stock prices.

Proponents of ESG investing will likely point to studies suggesting that companies that follow ESG principles perform better than those that don't. But new reviews of such studies might reveal flaws, or even question such evidence, much as a recent paper threw into question the conventional wisdom that private companies invest more than public companies.

The belief is that managers of public companies focus on short-term profits under pressure from shareholders who want quick returns on their investments. One way to increase earnings in the short term is to cut investment in research and development. That in turn might produce an increase in the companies' share prices, but at the expense of long-term profitability.

The authors of a working paper published by the Federal Reserve Board in Washington wrote: "In recent years, the concern that shareholders' focus on short-term performance induces public firms to forego profitable investment opportunities has become more prevalent."

Even CEOs believe it. Michael Dell and Richard Branson claimed they took their companies private so they could focus on investing for the long term, which they supposedly could not do while their companies answered to shareholders.

Also, surveys have shown that CEOs claim to prefer short-term investments because shareholders undervalue long-term projects.

But the new working paper suggests the conventional wisdom is wrong and that public companies actually invest more than private companies.

The authors examined reported research and development expenditures from public company and private company tax returns filed between 2004 and 2015. The tax return data allowed the researchers to distinguish short- and long-term physical capital investment from R&D investment.

Among the findings, the analysis showed that after an initial public offering, total investment increased by 80.7 percentage points over the pre-IPO level. The authors reported that "we find robust evidence that public firms invest significantly more than private firms, and that this overall investment advantage stems largely from commitments to R&D investment."

The results are inconsistent with the notion that earnings pressure renders public firms so shortsighted that they forego long-term investment, the authors said.

This suggests those urging policy changes by regulators to curb "short-termism" should move slowly so as not to invite unintended consequences. Imposing more regulations on public companies to curb the possibly imaginary short-term decision-making might simply drive more public companies to go private. This would likely reduce the overall level of corporate investment in the U.S. economy, which is not a result any would desire.

The implication is that those institutional and other investors seeking regulations to induce more long-term investment by public companies had best be careful what they wish for — the law of unintended consequences could strike and harm investment returns.

Likewise, those seeking to impose more ESG disclosure on public firms through SEC regulation should move carefully, and the SEC should take no action without careful consideration and strong evidence.