Economy and Society: Lawsuit challenges SEC’s approval of NASDAQ diversity quotas

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG Developments This Week

In Washington, D.C.

Multinational regulatory agency crack down on overstated environmental credentials 

On November 23, the International Organization of Securities Commissions agreed to a framework that, in its view, ends what opponents refer to as greenwashing in ESG investments and brings transparency to ESG ratings providers. The effort to standardize the ESG ratings business follows the introduction, made earlier this month, of a global corporate ESG reporting standards organization, the International Sustainability Standards Board, which made its debut at the COP26 conference in Glasgow, Scotland, and will be based in Frankfurt, Germany. According to Reuters:

“Regulators are cracking down on many aspects of ESG investing with basic rules to make it easier to punish greenwashing, where the environmental credentials of an investment or activity are overstated, in a cross-border sector where investment is “exploding”.

The International Organization of Securities Commissions (IOSCO), which groups securities watchdogs from the United States, Europe, Asia and Latin America, published 10 recommendations for its members to apply in day-to-day work….

Asset managers use ratings from about 160 raters such as MSCI, S&P Global and Morningstar to pick stocks and bonds for “green” products now popular with ethical investors, but there are no regulatory checks on how those ratings were put together.

IOSCO said its recommendations will begin shining a light on how ratings are compiled and conflicts of interest handled in a largely unregulated business which is already worth around $1 billion and growing at 20% a year.

It recommends that ESG ratings and data providers consider implementing written procedures to underpin high quality ratings, and make public disclosure a priority.”

Lawsuit challenges SEC’s order approving diversity quotas for Nasdaq-listed companies

On November 22, in what experts believe is the first volley in a legal battle over various ESG-related investment rules, Boyden Gray & Associates filed its opening brief in a case brought by the firm’s client, the Alliance for Fair Board Recruitment, against the Securities and Exchange Commission (SEC). The case centers on the SEC’s approval of a diversity rule introduced by the Nasdaq Stock Exchange last year, which threatens corporations with de-listing from the exchange if they fail to meet certain board diversity demands. Citing its brief, the firm explains that the SEC has gone beyond its jurisdiction to promote a rule that, in its view, it has no legal or statutory right to promote:

“The SEC’s order violates the constitutional right to equal protection, as it encourages discrimination against potential board members and also by current board members and shareholders; and it stigmatizes board members who identify as one of the preferred demographics. The order also violates the First Amendment by demanding disclosure of “controversial” information, which the Supreme Court has prohibited absent compelling justifications and narrow tailoring. Finally, the SEC lacked statutory authority to issue the order, which seeks to regulate demographics through the guise of “financial disclosures.”

The firm continues, arguing that, in addition, the Nasdaq rule is discriminatory, thereby violating Supreme Court precedent:

“Nasdaq’s minority director rules, by requiring a quota of racial or sexual minorities to be board members—or else a public explanation—requires companies to discriminate based on race. The Supreme Court has always looked on such distinctions with extreme suspicion because, as the brief explains,

“Distinctions between citizens solely because of their ancestry are by their very nature odious to a free people.” Rice v. Cayetano (2000). There are no “benign” racial classifications; sorting people by race always “stimulates our society’s latent race consciousness,’ “delays the time when race will become … truly irrelevant,” and “perpetuates the very racial divisions the polity seeks to transcend.” Shaw v. Reno (1993).”

The firm’s namesakeC. Boyden Gray, the former White House Counsel to President George H.W. Bush and former U.S. Ambassador to the European Unionco-authored an op-ed for The Wall Street Journal this past April, in which he and one of the firm’s partners, Jonathan Berry, foreshadowed the case that they are currently making in court and argued that Nasdaq’s efforts are driven by social policy and not the best interests of companies, boards, and shareholders:

“Nasdaq has, in its own words, embraced “the social justice movement.” The actual job of a stock exchange, however, is to ensure that trading is orderly and its listed companies follow standard governance rules. But doing that doesn’t earn the applause of the political left.

Progressive approval apparently means a lot to Nasdaq, which has officially proposed to its regulator—the Securities and Exchange Commission, newly chaired by Gary Gensler —to increase boardroom diversity through a “regulatory approach.” This proposal would require that Nasdaq-listed companies not only disclose the diversity characteristics of their existing boards, but also retain “at least one director who self-identifies as female,” and “at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, two or more races or ethnicities, or as LGBTQ+.” Noncompliant firms must publicly “explain”—in writing—why they don’t meet Nasdaq’s quotas.

Nasdaq’s discriminate-or-explain rule is unlawful, unconstitutional, and unsupported by the evidence. Quota systems like this unjustifiably classify people by arbitrary categories of sex and race in violation of equal-protection principles, and the “alternative” of explaining why a firm won’t discriminate compels speech in violation of the First Amendment….

Under the Exchange Act, Nasdaq’s listing rules must be designed to achieve one of the lawful purposes of an exchange, such as preventing fraud or protecting investors. Aspirational statements of purpose are insufficient; Nasdaq needs to provide real evidence that its proposal is designed to further the purposes of an exchange. It doesn’t have the evidence….

Together with University of Pennsylvania professor Jonathan Klick, our own examination of Nasdaq’s sources—and those it omits—shows that the effect of boardroom gender diversity on firm performance is inconclusive. Instead, Nasdaq cherry-picks the studies it reports, and then cherry-picks even among the results of those studies. Take its citation of a 2019 study as finding “a positive association between women on the audit committee with financial accounting expertise and the voluntary disclosure of forward-looking information.” Nasdaq doesn’t cite that same study’s ultimate conclusion: It is the financial expertise of committee members—not their sex—that improves reporting outcomes. Counter to Nasdaq’s narrative, the study concludes that “intrinsic characteristics linked to women” are “insufficient . . . to enhance voluntary disclosures.”

As sparse as the evidence is for its female director quota, Nasdaq has even less support for its catchall minority director mandate. Indeed, none of the sources Nasdaq cites to prove that board diversity enhances corporate governance even examine racial diversity. And not one of Nasdaq’s sources examined firms with LGBTQ board members.”

On Wall Street and in the private sector

Schwab gets in the ESG game while some argue the game is too crowded as it is

Two weeks ago, Charles Schwab, one of the world’s best-known names in retail brokerage and one of the pioneers in commission-free stock and ETF trading, announced the launch of its first ESG ETF, which is also its first actively managed ETF. On November 12, Bloomberg Green reported that the deluge of new ESG funds was frustrating to many analysts and “risks [a] breaking point”:

“The flood of new ESG funds is threatening to test the limits of investor demand, with the world’s largest credit ETF the latest to get a socially responsible doppelganger even as it bleeds cash.

The iShares ESG Advanced Investment Grade Corporate Bond exchange-traded fund (ticker ELQD) — a copycat of the $38.4 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) — debuted this week touting higher environmental, social and governance standards. 

The BlackRock Inc. ESG launch comes despite a market backlash against credit strategies teeming with interest-rate risk….

The arrival of ESG versions of these currently unloved products is an acid test of demand for socially conscious investing options. U.S. issuers alone have launched 27 such ETFs in 2021 so far, one shy of last year’s record.

“Within the next year, I think we’ll start seeing a spike in ESG ETF closures,” said Nate Geraci, president of The ETF Store, an advisory firm. “A lot of product is being launched without proof that investor demand actually exists.”

Skeptics point to the modest $750 million invested on average in the 111 U.S.-listed ETFs that are designated as ESG — among the lowest asset-to-product ratios in the industry. By comparison, value-oriented funds have around $3.6 billion and growth-focused funds $5 billion, according to data compiled by Bloomberg. 

Eric Balchunas, senior ETF analyst with Bloomberg Intelligence, reckons issuers are “way overestimating the demand.” He doesn’t see such funds becoming a sizable chunk of the industry even as it grows over the medium term.”

In the spotlight

Professors argue supply chains potential ESG blind spot

With supply chain dominating business news the past few weeks, it should come as no surprise that the issue is now starting to appear in ESG news as well. Supply chains and their management are issues that some in the ESG field believe have been overlooked and should be given more attention, particularly now, when investors and others are more keenly attuned to their overall impact.

In a piece published on November 9, by the online magazine The Conversation, two management professorsTinglong Dai from Johns Hopkins and Christopher Tang from UCLAaddressed the issue as follows:

“[I]nvestors’ trust in ESG funds may be misplaced. As scholars in the field of supply chain management and sustainable operations, we see a major flaw in how rating agencies, such as Bloomberg, MSCI and Sustainalytics, are measuring companies’ ESG risk: the performance of their supply chains.

Nearly every company’s operations are backed by a global supply chain that consists of workers, information and resources. To accurately measure a company’s ESG risks, its end-to-end supply chain operations must be considered.

Our recent examination of ESG measures shows that most ESG rating agencies do not measure companies’ ESG performance from the lens of the global supply chains supporting their operations.

For example, Bloomberg’s ESG measure lists “supply chain” as an item under the “S” (social) pillar. By this measure, supply chains are treated separately from other items, such as carbon emissions, climate change effects, pollutants, and human rights. This means all those items, if not captured in the ambiguous “supply chain” metric, reflect each company’s own actions but not their supply chain partners’.

Even when companies collect their suppliers’ performance, “selective reporting” can arise because there is no unified reporting standard. One recent study found that companies tend to report environmentally responsible suppliers and conceal “bad” suppliers, effectively “greenwashing” their supply chain.

Carbon emissions are another example. Many companies, such as Timberland, have claimed great successes in reducing emissions from their own operations. Yet the emissions from their supply chain partners and customers, known as “Scope 3 emissions,” may remain high. ESG rating agencies have not been able to adequately include Scope 3 emissions because of a lack of data: Only 19% of companies in the manufacturing industry and 22% in the service industry disclose this data.

More broadly, without accounting for a company’s entire supply chain, ESG measures fail to reflect global supply chain networks that today’s big and small companies alike depend on for their day-to-day operations.”