This post responds to the paper Exit v. Voice by Eleonora Broccardo, Oliver Hart, and Luigi Zingales (BHZ). The paper discusses two possible mechanisms by which an ‘altruistic’ investor (ie, an investor who derives some utility from conferring a social benefit) can induce firms to change their behaviour in a socially responsible way, ‘exit’ (divestment) and ‘voice’ (shareholder voting). The paper follows prior work by Hart and Zingales that argues that investors can reasonably believe that firms can provide public goods at a lower cost than the government and can push firms to act accordingly. The investors modelled by BHZ are consequentialists, that is, their decisions are taken from the perspective of a benevolent social planner: the cost of externality abatement by the firm should be weighed against the social benefits conferred. These investors are also sensitive to their individual utility functions, considering the trade-off in returns, risks, and the depth of their altruism.

In the classic set-up [1], ‘exit’ and ‘voice’ are substitutes (and perhaps complements). Not here. When it comes to exit, investors on their own will engage either in excessive divestment, producing a signal that would lead firms to undertake excessive externality abatement (the BZH example is pollution) from a social point of view, or insufficient divestment. On likely measures of investors’ altruism, divestment is likely to produce insufficient abatement. BZH quote Bill Gates: ‘Divestment, to date, probably has produced about zero tons of emissions’. They see much more promise in ‘voice’, in which the votes cast by altruistic individual shareholders, if in the majority, will lead to a result that is consistent with the benevolent social planner, the right level of externality abatement.

From the perspective of an academic lawyer, one particularly interesting feature of BZH is its rejection of the classic ‘exit’ - ‘voice’ relationship. In the typical corporate governance account, investors’ exit (or the threat of exit) changes management’s behaviour for two reasons: First, reduced demand for the stock will lower the stock price, which managers dislike because of their stock-related compensation; second, exit conveys negative information to other investors, which can lead to lower estimates of expected earnings and additional stock sales, further lowering the stock price, and perhaps thus leading to the appearance of an avenging angel wielding voice, the shareholder activist threatening a proxy contest. In this telling, exit is powerful and exit and voice work together. That relationship does not pertain for BHZ. They agree that divestment will lower the stock price and thus provide an incentive for the ‘dirty’ firm (in their pollution example) to become ‘clean’. For BHZ, it is not the direction of action that matters, but getting the right amount of pollution abatement, on the social planner’s criterion. Although the intricacies of the model are complex, BHZ assess that the all-or-none-attributes of voice, in which a majority vote is decisive, will align the firm’s abatement behaviour with the social planner’s objective.

In a sense it is easy to see that divestment is an imperfect tool to change the firm’s behaviour. Because the decision makers are the managers trying to maximise the stock price, they are simply observing the flow of demand for stock from investors who have no collective way to express preferences. The privately maximising choice of the manager will not necessarily correspond to socially maximising course in this uncertain environment. Voice, expressed through shareholder voting, does not have this infirmity. A shareholder with an altruistic utility function will always act in accord with the socially desirable outcome, even if the private costs of pollution abatement are high (perhaps greater than the avoided private reputation costs). In BHZ this is fundamentally because the shareholder is diversified and thus the private welfare losses from the stock price decline resulting from privately inefficient abatement will be relatively minor. Or put otherwise, the non-pecuniary gains from achieving socially valuable externality abatement will satisfy the utility function of a diversified altruistic shareholder. It is not clear to me, however, why a vote of shareholders so-motivated will match the outcome of a social planner, if only because of the shareholders’ imperfect information. The shareholders may vote for too much externality abatement from a social planner’s perspective.

Another interesting feature of BHZ is its focus on the comparative decisiveness of the investors’ action. In the divestment case, the ultimate decision whether to abate the externality is left to management, which will be making a private cost-benefit calculation. In the voice case, assuming a sufficiently large shareholder coalition, the shareholder vote will be decisive. The decision is taken out of management’s hands. Because of the altruism in the shareholders’ utility function, this means the decision whether to abate the externality will be subject to a social cost-benefit calculation. Thus choosing ‘voice’ rather ‘divestment’ shareholders with altruism in their utility function can improve social welfare. Because of the shareholders’ diversification, the private cost to the shareholders will be less than the utility gain in their successful act of altruism. In this way the shareholders, because fully diversified, are different from managers or under-diversified blockholders.

What are the implications of this model for current investor-corporate social responsibility-sustainability practice? If the model goes through, then its implications are radical: the present agitation in favour of divestment should reverse itself. Divestment works through managerial incentives, which looks only private welfare calculation. Voice works through shareholder command-and-control, which is activated by social welfare calculation. Yes, ‘ethical’ investing is fine except perhaps in the most important cases, the ones in which abatement costs are greater than the share-value impact of divestment. Ethical investors should appreciate that consequentialism should supplement deontological thinking where there is chance to reduce socially harmful activity. The strong policy implications of the BHZ story call out for serious assessment.

In this assessment let’s bracket the corporate governance questions about the role of shareholder initiative in fashioning a firm’s business strategy. There are many good reasons why shareholders do not have direct say over, for example, whether and how much a firm should spend on pollution abatement or the abatement of other externalities. A particular concern about direct shareholder decision-making is the risk that shifting shareholder majorities on issues of business strategy and operations will produce destructive cycling. And the shareholder proposal rules of the US Federal Securities Laws limit the extent to which shareholders can directly raise questions about a company’s operational practices [2]. Nevertheless shareholders do have other vehicles. They can use the shareholder proposal process to call for ‘reports’ or offer other ‘precatory’ proposals that will call attention to a company’s externality-creating practices in a way that through reputational effects with the company’s customers or its recruitment and retention of the best employees can in fact change the managers’ private welfare calculations. More in the spirit of the BHZ model, shareholders can participate in proxy contests that may replace all or some of the management-nominated directors with directors who may look to the public welfare in the corporate actions they pursue. The recent success of climate change activist fund Engine No. 1 in placing three directors on the Exxon-Mobil after a heated proxy contest shows the potential. Let us similarly bracket the corporate law question whether such directors could unabashedly pursue externality-reducing policies that trade off public welfare for private shareholder value [3].

Putting those important issues to one side, these are the problems I see in transforming a perfectly fine model into a guide for policy. First, the critical assumption is that the private cost to the altruistically motivated shareholder is minimal because of diversification. But this will rarely be the case. The ‘voice’ model seems to contemplate an outlier firm in an industry segment that generally follows good practices, so that costs incurred to reform such outlier behaviour (and the resulting hit to the firm’s stock price) will be idiosyncratic. This easy case is surely rare. The issues that generally excite altruistically-minded shareholders reflect externality-creating practices across significant industry segments, for example, a pollutant that results from a widespread fabrication process, or exploitation of child labour in a supply chain, or firms whose very products (tobacco; plastics) create externalities. Put otherwise, on a firm-by-firm basis, diversification will lower shareholders’ pecuniary losses; but as applied across large portfolio segments, the pecuniary losses from such a ‘voice’ strategy will surely be substantial. The response might be: for each case of pecuniary loss there will also be non-pecuniary benefits.  Yet the aggregation of pecuniary losses and non-pecuniary benefits is unlikely to be a simple process of firm-by-firm addition for a representative shareholder.  And of course, for the current case of greatest interest, the massive reduction in carbon production and usage to mitigate climate change risk, diversification is not the answer to concerns about the impact on the wealth of altruistic shareholders.

The important cases then require a trade-off of substantial pecuniary value for the non-pecuniary returns of altruism. Shareholders will certainly vary in the extent of their taste for altruism. More generally, for problems that require adjustment across the portfolio (such as climate change) the purported benefits of diversification disappear.  We are left with simply a claim about investors’ valuation of socially responsible investing, how much expected return will they trade away to achieve an important social objective.

This leads to an empirical question about the extensiveness of what might be described as ‘deep’ altruism among shareholders. The evidence here is that such tastes are relatively rare. Yes, there is an increasing flow of flows into ESG-styled mutual funds and other vehicles, but compared to investments in funds and ETFs without such a mandate, ESG funds are a minority fraction. Moreover, it seems that ‘ESG’ funds are in fact geared to divestment strategies rather than voice. For example, some funds screen investments on explicit ESG exclusion criteria: no fossil fuels, no ‘vice’ products (alcohol, tobacco, gambling), no weapons, no violators of UN labour or anti-corruption principles. Other funds make portfolio selection on the basis of ESG scores. These funds (and thus their shareholders) cannot exercise voice in an altruistic way because, by design, they are unlikely to own shares in the relevant companies. It is also a common strategy for asset managers to claim that a portfolio screened in this way will either out-perform or will not exact an economic penalty, thus not putting altruism to the test. Until very recently ESG funds have been largely divestment-based, not focused on using ‘voice’ to change the behaviour of externality-creating companies. It is probably the case that most ‘voice’ driven ESG activism comes from public pension funds or sovereign wealth funds, which are likely to take political considerations into account. These are not test cases for the BHZ altruistic shareholder activism story.

Indeed, the fact that most ESG funds are divestment funds might warrant reconsideration of the BHZ argument against the effectiveness of divestment as a pro-social tool. Should the criterion for success of divestment be the social planner’s cost-benefit calculus? Perhaps we are so far away from the externality abatement ‘frontier’ that the concern about excess abatement that figures in BHZ is a second order concern. If divestment (or its threat) promotes a managerial response in the pro-social direction, should the altruistic shareholder forgo it? Does the very fact that divestment now occurs through collective vehicles overcome some of the BHZ objection?

The second general problem is that ‘ESG’ is not a unitary bundle, nicely packaged for the altruistic shareholder. Some shareholders may be highly motivated about climate change issues but not so much about supply chain issues. More problematically, much like the tension in the stakeholder debate, different elements of what might count as ESG are in tension with one another. Suppose retrofitting the plant to abate pollution will result in a technological change that will eliminate many jobs? Or, perhaps the problem is an obsolete plant that simply ought to be closed, resulting in a consolidation of facilities that results in layoffs and negative local community impact. Employee considerations are certainly a growing theme of ESG concerns. Closing down exploration and production for oil and gas resources surely will put many out of work, a significant externality. There is hardly a unanimity theorem to resolve the trade-offs among these ESG concerns for an altruistically minded shareholder. Instead of a unitary voice we have a polyphony.

Let us return to what I see as the major limitation in the BHZ approach: that for the most serious problems, such as addressing climate change risk, the necessary portfolio-wide adjustments undercut the benefits of diversification, and we are left with the socially responsible investing trade-off. It’s not just the flaring practices of a gas producer or the exploration activities of multinational oil company that must change, but the engineering and production strategies of so-called “scope three” parties.  GM’s decisions about migration away from the internal combustion engine matter more than Exxon-Mobil’s exploration decisions. Aggressive and risky growth by battery makers matters more than Exxon-Mobil’s decisions.

I have elsewhere offered an approach, ‘Systematic Stewardship’, that turns a weakness in the BHZ approach namely, the loss of idiosyncratic risk mitigation because of the portfolio-wide measures required to address the most serious problems, into a strength. ‘Systematic Stewardship’ observes that modern portfolio theory teaches that investors with diversified portfolios are trying to maximise risk-adjusted returns. This means that such shareholders would be attentive both to systematic risk as well as to expected return, and that their welfare, in a purely private wealth sense, could be enhanced by a strategy of firm-specific measures that in the aggregate mitigated systematic risk. The big payoff is that such systematic risk reduction would also enhance public welfare as well. In short, unlike in the BHZ approach, there is no trade-off of private welfare for public welfare. There is no need to speculate on the depth of investor altruism because the diversified investor acting from purely pecuniary motives wants measures taken that will reduce systematic risk. The approach also takes seriously the fact that individual investors hold diversified stock portfolios assembled by asset managers.  Indeed, the substantial ‘reconcentration’ of share ownership into institutional and asset manager hands may be an advantage.

The paper proposes three areas of systematic concern that diversified shareholders could pursue on this model: climate change, financial stability, and social stability.  Climate change is obviously of greatest urgency.

The paper puts it this way:

‘A salient form of systematic risk is climate change risk. The disruptions associated with various realizations of climate change risk will ramify across the entire economy and thus across a diversified stock portfolio; climate change risk is systematic. Failure to mitigate climate change risks will thus reduce risk-adjusted returns for an index fund investor. Here is the importance in bringing a portfolio theory perspective: Many arguments for a climate-sensitive engagement entail a trade-off between expected returns and the social value of avoiding the potential for severe climate change harms, “socially responsible investing.” Systematic stewardship grounds engagement to reduce climate change risk in the economics of investor welfare. The goal of such engagement is lower systematic risk and thus to improve risk-adjusted returns for portfolio investors. There is no trade-off investor welfare for social welfare’.

I would not over-claim for this approach. It does not reach many important areas of corporate behaviour that are of social concern and as to which some altruistic shareholders may have preferences other than private wealth maximising. Nevertheless it does reach some areas of central concern. Particularly at this moment, climate change risk dominates considerations of most other externalities. This is a risk of a uniquely existential character. ‘Systematic stewardship’ provides a strategy for asset managers who may as a matter of fiduciary duty or marketing feel obliged to prioritise shareholder welfare to engage positively on this central public question. It satisfies a unanimity rule.

It should be noted that large asset managers acting to address systematic issues via the exercise of shareholder governance rights does not raise the negative concerns associated with the ‘common ownership’ debate. The welfare effects of possible systematic risk mitigation are different from the anti-competitive harm that figures in the common ownership literature. The beneficiaries of such systematic risk reduction are not just the portfolio investors but the public generally. This is because any harm to portfolio values runs through the real economy. More specifically, climate change is a portfolio risk precisely because firms will be damaged, meaning employees will be laid off, wages will be cut, the economy will contract and the damage to stockholders may be the least of it. Thus actions by large owners to avoid such risks should not become a target of competition policy. Indeed, their broad diversification shows asset managers the need to reduce such systematic risks (since they cannot escape them) and their ownership heft may give them the power to achieve an important result.

Jeffrey N. Gordon is the Richard Paul Richman Professor of Law at Columbia Law School and a Visiting Professor at the University of Oxford.

This post is part of the series ‘Business Law and the Transition to a Net Zero Carbon Economy’. This series consists mainly of posts summarizing papers presented and presentations made at the 5th Annual Oxford Business Law Blog conference on ‘Business Law and the Transition to a Net Zero Carbon Economy’ which took place online on 25 to 27 May 2021. The recordings are available here. This post is forthcoming in Andreas Engert, Luca Enriques, Georg Ringe, Umakanth Varottil and Thom Wetzer (eds), Business Law and the Transition to a Net Zero Carbon Economy (CH Beck and Hart Publishing 2021) (forthcoming).


[1] Albert O. Hirschman, Exit, Voice, and Loyalty: Responses to decline in firms, organizations, and states (Harvard University Press 1970).

[2] Securities Exchange Act (1934) Rule 14a-8 (the Shareholder Proposal Rule). Section (7)(i)(7) permits the company to exclude a proposal from the company’s proxy statement if it ‘deals with a matter relating to the company’s ordinary business operations’. This provision has led to a robust course of time-varying administrative process and guidance.

[3] See, eg, eBay Holdings, Inc. v Newmark 16 A.3d 1 (Del Ch 2010) 9 (‘Directors of a for-profit Delaware corporation cannot deploy a [policy] to defend a business strategy that openly eschews stockholder wealth maximisation – at least not consistently with the directors’ fiduciary duties under Delaware law’).