In getting a good deal on a loan, numbers matter: Lenders look at companies’ financial statements and payback on past loans. Strong financial statements could mean a lower interest rate or better terms for the borrower.
But in the competitive landscape of loan acquisition, it’s not just about crunching numbers. Loan officers and borrowing managers are people, after all, and those who do repeat business build relationships and trust over time. The soft information accumulated in these relationships can reduce the costs of screening and monitoring, and thus reduce the cost of debt, according to new Berkeley Haas research.
“While two companies with the same credit score may appear similar on paper, our research shows that individual lending relationships can reveal important differences between them,” said Omri Even-Tov, assistant professor of accounting at the Haas School of Business. “These relationships foster trust and reduce information gaps, allowing lenders to gain valuable soft information about a borrower’s sense of responsibility and overall creditworthiness.”
Even-Tov’s forthcoming paper in the Review of Accounting Studies—coauthored by Xinlei Li of the Hong Kong University of Science and Technology, Hui Wang of the Renmin University of China, and Christopher Williams of the University of Michigan—shows that established relationships between a loan officer and a borrowing manager not only increase the likelihood of a loan, but tend to make the conditions of that loan better for the borrower without increasing risk for the lender.
These results, the researchers suggest, are increasingly important as technological innovation means fewer personal relationships in banking—and beyond.
Even-Tov and his colleagues examined a sample of loans from between 1996 and 2016. They manually collected the signatures on these loans to determine the names of two key actors who are typically engaged in contracting negotiations and interact extensively. This laborious process allowed them to create a dataset comprising nearly 4,000 loans with 2,800 unique borrowing managers and 2,100 unique loan offices. The vast majority of these loans were one-off interactions, but some of them were conducted by the same loan officer and borrowing manager two or more times.
Comparing these groups, the researchers found that established relationships between lenders and borrowers proved favorable for both parties. For the borrowers, they led to better interest rates. For the lenders, they allowed for better screening and monitoring as evidenced by fewer rating downgrades.
The cost of turnover
They also found that when a borrowing manager and loan officer left their jobs, the two firms were roughly 70% less likely to engage in business together. These results were especially pronounced among smaller institutions, and with loan officers who manage fewer transactions, as these two groups rely more heavily on soft information accumulated in their relationships.
“This really quantifies a lot of anecdotal evidence about the importance of relationships, and it also sheds light on an underappreciated cost of turnover,” Even-Tov said. When an employee leaves a company, it’s a loss not only of their knowledge and skills, but their relationships, too. If a company loses its CFO, it has not only lost that distinct set of talents, but possibly the chance of getter better deals on loans. “Companies need to factor in these less-tangible assets of their employees.”
Decline in professional relationships
Even-Tov highlighted two related implications raised by this paper: New technological tools are driving a decline in professional relationships, and this is happening in industries beyond banking. He gave the auditing industry as an example. Auditors in previous years would be embedded in clients’ offices. They got to know the companies they were auditing, and the people who worked there. Today, a great deal of auditing is done remotely, or even automatically. The same is true for consulting, real estate, venture capital, and private equity.
“We need to think about what we lose when technologies allow us to bypass the need for interaction between individuals,” Even-Tov said. “There are advantages to doing this work more quickly or from a distance, of course. But these changes also introduce costs, and this work makes some of those costs clear.”
New research published in the Journal of Monetary Economics
BERKELEY, Calif.—Inflation is back with a vengeance. Prices of goods and services have risen at rates not seen since the 1980s, slamming households, small businesses, corporations, and governments at all levels.
But new research by Berkeley Haas Associate Professor Yaniv Konchitchki finds that most corporations that face significant risk from inflation have failed to disclose it. Inflation has caused trillions of dollars in shareholder stock price loss damages thus far and is threatening major additional losses for shareholders.
In a paper published in the Journal of Monetary Economics and coauthored with Jin Xie of Peking University’s HSBC Business School, the authors show that when it comes to inflation, companies widely ignore U.S. Securities and Exchange Commission (SEC) legal rules requiring them to disclose important risks to their business. The authors developed a novel approach to extracting the attitudes and beliefs of corporate managers toward inflation risk from SEC reports, by examining over 65,000 10-K annual reports filed by major corporations with the SEC from January 2005 to April 2021. They discovered that, despite SEC legal requirements to disclose risk factors, more than 61% of the companies at high risk when prices rise never mentioned inflation or used inflation-related words in the risk disclosure section of those reports.
The failure of exposed companies to disclose inflation risk is not a trivial matter. Securities laws require public companies to disclose risks to their business in order to protect investors. “Corporate executives do not follow the legal requirement to warn shareholders about inflation risk,” said Konchitchki, an expert on the interface between capital markets, corporate financial reporting, and macroeconomics. “Several trillions of dollars in shareholders’ wealth have been damaged, and more are at stake.”
Consider the losses on stocks over the past one-to-two years of rising inflation. Any individual or institutional investor who holds shares in companies, directly or indirectly—such as through retirement accounts—has suffered losses, Konchitchki said.
“Our textual analysis of corporate reports filed with the SEC reveal that executives in many of these companies never mentioned—even once over the past several years of our sample period—the word inflation, inflation-related phrases, or that the companies are highly exposed to inflation risk,” he added. “Diligent investors, plaintiff attorneys, and regulators should ask, and will probably be asking, ‘Why didn’t you tell us?’”
The paper’s findings and framework enable the identification and evaluation of shareholder damages—especially for firms with inadequate risk disclosures—and could transform corporate disclosure practices, inflation expectations, and monetary policy, Konchitchki said.
The risks of inflation
Inflation can hurt companies in a variety of ways. For example, companies currently hold in total hundreds of billions of dollars in cash on their balance sheets. “Inflation erodes the purchasing power of these cash amounts, generating massive losses that are not shown in their financial statements because the U.S. financial reporting regime is nominal—i.e., it ignores inflation effects,” Konchitchki said.
Furthermore, the authors show that inflation risk exposure is common across almost all industries. Restaurant chains that can’t raise menu prices as fast as the soaring costs of food see their profit margins squeezed—imagine a burrito and the avocados that go into it. Utility companies that need a regulator’s approval to raise prices when costs rise are also highly exposed to inflation shocks. Silicon Valley Bank collapsed recently because it was holding billions of dollars in long-term government bonds that plunged in value as the Federal Reserve raised interest rates to combat inflation.
Given inflation’s increasing prevalence, there are emerging examples across many industries that Konchitchki said he is monitoring to study the macroeconomic effects of inflation.
Damages to shareholders
Konchitchki and Xie identified companies highly vulnerable to inflation by looking for those that had seen their share prices drop following inflation shocks, that is, when inflation data was released showing prices had risen more than had been forecasted. “We developed a measure to determine the extent to which shareholder value was damaged by unexpected inflation,” Konchitchki explained. The authors found that 14-18% of the companies in their sample, calculated across all industries, are exposed to rising prices.
The failure to be warned about inflation risk could be devastating for shareholders. Konchitchki and Xie created a model to simulate stock price losses if inflation shocks occurred in a 2-6% range over three years. The model projected total shareholder damages of $0.9 trillion to $2.8 trillion for shareholders of inflation-exposed companies.
One thing did seem to change the practices of corporate executives: getting sued. Companies exposed to inflation that had been targets of shareholders’ securities class action lawsuits were more likely to begin disclosing inflation risk, the authors discovered. In contrast, companies that were not exposed to inflation risk did not change their reporting practices following such class action lawsuits.
Why would companies not discuss inflation dangers in their annual reports? Konchitchki doesn’t believe that executives are trying to pull the wool over investors’ eyes. After all, a failure to provide adequate disclosure puts executives and their companies in jeopardy of legal action and regulatory sanctions.
The most probable explanation, Konchitchki said, is “rational inattention”—the economic theory that decisionmakers can’t process all available information but can rationally choose which pieces of information to pay attention to. The potential damage from rising prices just isn’t on the corporate radar screen—perhaps especially among Gen X and Millennial managers who have never experienced periods of runaway prices. “Because inflation has been relatively low over the past decades and/or identifying the damages from inflation might have been too costly, executives haven’t been attuned to it,” he suggests. He predicts that in coming years executives will be more liable, and thus will pay more attention to inflation if they wish to reduce their legal liability and excel in their jobs.
This lack of attention is also a problem for Federal Reserve policymakers who have been loudly warning about inflation and its risks in a bid to manage expectations of corporations and other players in the economy. Konchitchki’s and Xie’s research shows that many executives aren’t getting the message.
As a founder of a new research area that he termed macro-accounting, Konchitchki pioneered the examination of linkages between accounting data, capital markets, and the macroeconomy. He believes there’s a larger lesson in the failure to recognize the threat of rising prices in financial reports.
“There is a disconnect between executives and an understanding of the macroeconomy,” he said. “We’ve seen shortcomings in appreciation of how inflation can be disruptive. It’s important that corporate managers become more familiar with macroeconomic and accounting research and take a more holistic approach, considering how economic turbulence will affect the financial performance of their businesses.”
Going forward, given the increase in the level and fluctuations of inflation, the effects analyzed in the paper will be even more critical for executives, shareholders, attorneys, and the macroeconomy, he said. And the methodology developed in the paper can be generalized to other macroeconomic risks. “Executives can improve their companies’ performance and risk management by adopting a macro-accounting, research-based approach, which focuses on assessing the effects of current and forecasted macroeconomic fluctuations—such as inflation, recessions, wars, and other economic uncertainties—on their accounting performance metrics.”
When local governments were required to disclose their long-term pension liabilities, they responded by diverting funds away from public welfare, salaries, and hiring, a new study has shown.
The study, in press at the Journal of Accounting and Economics, examined the economic impacts of a 2015 rule known as GASB 68 issued by the Governmental Accounting Standards Board (GASB). While the rule did not directly affect pension plans themselves, it aimed to make governments more accountable by requiring them to disclose their full defined-benefit pension obligations, which are among the most significant liabilities for local governments.
“The disclosure requirements increased awareness and clarity about future funding requirements of pension obligations,” said co-author Omri Even-Tov, an assistant professor of accounting at the Haas School of Business, UC Berkeley. “In other words, the new requirement changed the information set of county managers who did not previously understand the future cash flow requirements of their pension plan.”
Even-Tov collaborated on the paper with Michael Dambra, an associate professor of accounting at the University at Buffalo School of Management and James Naughton, an assistant professor of accounting at the University of Virginia Darden School of Business.
Chronic pension underfunding
About 83% of full-time public sector employees—or more than 25 million people—participated in a defined benefit pension plan as of 2018, with annual payments costing governments more than $300 billion. However, long-term unfunded obligations far exceed these yearly payments: According to a recent study, the national public pension funding shortfall reached $6.5 trillion as of 2021.
Despite those obligations, municipalities tend to rely more heavily on their cash budgets in managing their annual financial cycle, the researchers wrote.
Even-Tov, an authority on the impact of accounting rule changes who has also studied how conflict minerals disclosure requirements reduced violence in Central Africa and how relaxed disclosures enacted to stimulate the IPO market harmed investors, wanted to know whether governments would change their budgeting when required to make their full pension liabilities public.
Public welfare reductions
The researchers analyzed data from census bureau reports and hand-collected GASB financial statements for 432 counties across 45 states from 2013 to 2016. About half of the counties in the sample had already been reporting their pension liabilities, but the other half had been exempt from disclosure rules because their pension liabilities were only reported as part of their states’ pension plans. GASB 68 removed this exemption, requiring them to report their share.
The analysis found that when counties disclosed underfunded pension costs for the first time, they reduced public welfare expenses by 6%, payroll by 2.5%, and employee headcounts by 2%. They generally accomplished this by freezing their budgets relative to the counties that had already been disclosing their pension obligations, rather than by raising taxes or finding other ways to increase revenues.
The findings are important because they demonstrate the real impact of financial regulation on governments.
“Despite the economic importance of the government sector, we know relatively little about how GASB financial statements influence the provision of resources,” Dambra said in a press release from the University at Buffalo. “Our study shows that mandatory disclosure in the public sector can influence local-level managerial decisions.”
As repercussions from the stunning collapse of Silicon Valley Bank (SVB) continue to ripple through the banking industry, we asked Haas experts for their views on where the system broke down and whether there may be broader trouble viewing.
Professors Ross Levine, Panos Patatoukas, and Nancy Wallace said SVB’s problems were “banking 101” and that its management and board failed in their fiduciary duties. Levine, a banking industry expert, said the situation “suggests stunningly incompetent bank supervision and regulation,” and cited research that Silicon Valley Bank may be “the tip of a gigantic iceberg.” Patatoukas agreed, asking “If (regulators) cannot spot something as straightforward as SVB’s issues, then what else are they missing?”
Professor Ross Levine, Willis H. Booth Chair in Banking and Finance, Haas Economic Analysis & Policy Group
“Silicon Valley Bank (SVB) failed in the simplest and most vanilla way. It had long-term assets, including Treasury securities and other U.S. government backed-securities, and short-term liabilities, namely deposits. This exposed the SVB to interest rate risk because long-term securities are much more sensitive to interest rate changes than deposits. As interest rates went up over the last year, the price of long-term securities went down, challenging SVB’s solvency.
Regulators at the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) did not need sophisticated supervisory and regulatory skills or elaborate training to recognize such interest rate risk. It is banking 101.
While new information might emerge, current knowledge suggests stunningly incompetent bank supervision and regulation. The Federal Reserve and FDIC regulators need to explain why they did not require SVB to hedge interest rate risk three years ago, two years ago, etc.
The apparent failure of Federal Reserve and FDIC regulators in the case of SVB raises questions about the effectiveness of U.S. regulatory authorities in general. First, if regulators failed to address the most basic of risks—interest rate risk—in SVB, did they miss this interest rate risk in other banks? Second, have regulators effectively addressed the more complex risks that some banks take? Third, did regulators allow systemic risks to grow in the U.S. banking system?
Recent research provides an alarming answer to whether the Federal Reserve and FDIC blew it on interest rate risk beyond SVB, suggesting that SVB is the tip of a gigantic iceberg. A study conducted over the weekend indicates that the market value of U.S. banking assets is about $2 trillion dollars less than the reported book value due to increases in interest rates during the last year. It is impossible to determine the degree to which banks used derivatives to hedge interest rate risk. Thus, one cannot conclude definitively that the U.S. banking system experienced a loss of $2 trillion. However, these statistics, in conjunction with the details on SVB, scare me.
While Secretary of the Treasury Janet Yellen and Jay Powell, Chair of the Federal Reserve Board, might claim that the U.S. banking system is very well capitalized and very well supervised and regulated, they have some explaining to do.
Recent events also raise concerns about the competency of U.S. monetary policy, which, like much of bank regulation, is conducted by the Federal Reserve. The Federal Reserve started raising interest rates a year ago to combat inflation. (As a side point, the Federal Reserve created the inflation it is now combating.) It should have been evident to the Federal Reserve that banks with long-term assets and short-term liabilities that had not hedged interest rate risk would experience significant losses as interest rates rose. Moreover, the Fed has or can obtain information on banks’ assets and liabilities and the degree to which they were hedging interest rate risk. Thus, they knew—or should have known—which banks were most exposed to interest rate risk as they started raising interest rates. As a result, even if bank regulators failed to force banks to address interest rate risk before the Federal Reserve began to raise rates, the Fed should have been aware of this vulnerability as it started tightening monetary policy to fight inflation.”
“The SVB management and board failed in their fiduciary duties. The Fed also failed in its supervisory role since it failed to spot a basic duration mismatch and a massive run-prone deposit base, together with a lack of interest rate risk management on the part of SVB. It would have been straightforward to see from SVB’s financial statements that its (tier 1) liquidity ratio was much lower after accounting for the accumulated but unrecognized losses from the revaluation of their long-term bond portfolio, which basically indicates that SVB had elevated risk well before the run on the bank.
The SVB failure raises concerns about structural problems impacting regional banks, their depositors, and capital providers. It also raises concerns about the ability of regulators to spot risks ahead of time. If they cannot spot something as straightforward as SVB’s issues, then what else are they missing?”
Professor Nancy Wallace, Lisle and Roslyn Payne Chair in Real Estate and Capital Markets
“This is a monumental failure of risk management on the part of both the bank and the regulators. Interest rate risk is basic banking 101. Added to that is the very large depositor concentration from one industry. I also suspect that the loans on (Silicon Valley Bank’s) balance sheet are likely to be poorly underwritten given the overly cosy relationship between the bank and the king makers in Silicon Valley. They frequently provided loans to startups as a bridge between funding rounds. They did this to protect startup founders from the dilution effects of additional equity rounds—the more normal way to fund startups.”
Fall 2022|By Laura Counts| ILLUSTRATION: DAVID POHL
Moving ESG investing forward
As investors pay increasing attention to companies’ track records on environmental, social, and governance issues, trillions of dollars have flowed into the ESG investing industry.
Assets in so-called ESG funds have risen 38% globally in the past year alone, to $2.7 trillion by the end of March, according to Morningstar Direct. While Europe still dominates with 82% of the market, a burgeoning class of U.S. financial products promises investors an ROI aligned with their values.
At the same time, a backlash is growing against the sustainable investing industry, disparaged by some political and business leaders as “woke capitalism.”
In June, Associate Professor Panos Patatoukas, the faculty director of the Center for Financial Reporting and Management, brought together high-level ESG investing thinkers with wide-ranging perspectives on the direction of the industry. Berkeley Haas asked Patatoukas to synthesize some of the major discussion points.
Some argue that ESG issues cover so many variables as to be meaningless. What do you think?
I think everybody understands that environmental activities are significant, corporate governance matters, and social issues are becoming increasingly important. Where people disagree is: How do we define and verify the different types of carbon emissions? What are the corporate activities that fall under the “S” of ESG? What constitutes good or bad governance? Because there’s a disagreement of what constitutes ESG, there’s disagreement on the measurement of those dimensions.
Pooling environmental, social, and governance together into one single measure is problematic since it’s missing the granularity of the underlying data. You could think of a company with “bad” governance, with an entrenched CEO who has all the power and shareholders who lack voting power, but that same CEO might prioritize reducing the organization’s carbon footprint.
If we can agree on the definitions and measurement and we have external auditor assurance, that will completely change the field. The accounting firms can play a significant role in the transformation that’s happening and accelerate the convergence of policy, regulation, and technology that’s rewriting the ESG investing playbook.
Does removing a “brown” company from a portfolio drive change?
The goal of ESG investing is not just to make money for ESG-motivated investors but also to change companies’ behavior through engagement and divestment. One example is divesting from fossil fuel companies that have negative environmental impacts and buying “green” companies in other sectors.
But will divesting from fossil fuel companies accelerate the path to decarbonization? Where will the technology that will change our lives come from—an entirely different sector or from leading companies in this sector?
Outright divesting should be contrasted with selective divesting. Within the fossil fuel sector, there are leading companies that are innovating, investing in new technologies, and there are lagging companies that are continuing their dirty practices. An alternative would be to divest only from the laggards and reallocate this capital to the leaders. In other words, blending divestment with engagement.
What are you most optimistic about?
I think over time, we will have more transparency and more tools that will allow everyday investors to invest with their values and be more aware of what they’re investing in. And we’re going to have better data to overcome the measurement challenges, monitor corporate impact, align management incentives with long-term sustainability goals, and facilitate the allocation of capital in ideas and technologies that will drive change for good.
Summer 2022|By Laura Counts| Photo: peshkova/stock.adobe.com
The unintended consequences of the JOBS Act
In the decade since the 2012 Jumpstart Our Business Startups (JOBS) Act relaxed initial public offering requirements for companies with revenues under $1 billion, a growing number of them have taken advantage of the option to disclose less financial information in their IPOs.
This reduced-disclosure provision may have helped stimulate the market, but it came at a cost: lower IPO quality and more risk exposure for individual investors, concluded a new study by accounting professors Omri Even-Tov and Panos Patatoukas, with PhD candidate Young Yoon.
“The evidence shows that nearly two-thirds of the reduced-disclosure issuers underperform the market in the three years after they go public,” says Even-Tov. “While we find evidence that institutional investors have the ability to use publicly available information to avoid the worst-performing IPO stocks, individual investors tend to ignore fundamentals when investing in IPO stocks and are more exposed to the risks.”
Based on their findings, the researchers argue that the SEC should require all IPO issuers to disclose at least three years of audited financial information—up from the two years allowed under the JOBS Act.
“We recommend that regulators balance the benefits of increasing the number of IPO registrants against the costs of enabling speculative issuers to go public with reduced financial disclosures,” says Patatoukas, the L.H. Penney Chair in Accounting. “The quality of IPOs is as important, if not more so, than the quantity.”
In Part 2 of this two-part interview, Assoc. Professor Panos Patatoukas shares insights on the SEC’s new rules around the marketing of investment products marketed as socially responsible, as well as disclosure rules around companies’ ESG (environmental, social, and governance) activities. The interview also covers ESG valuation and investing, as well as divestment versus engagement—two different investor approaches to pressuring
The interview follows the Center for Financial Reporting and Management’s (CFRM)annual conference, which brought together high-level ESG investing thinkers with a wide range of perspectives on the direction of the industry. Among them were SEC Commissioner Hester M. Peirce, a Republican appointed by former President Trump; Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), which has developed the leading framework for ESG data; Andrew Behar, CEO of shareholder advocacy nonprofitAs You Sow, AJ Lindeman, who leads index and ESG quant research at Bloomberg; Karen Wong, who leads ESG & Sustainable Investing for State Street Global Advisors; and Wall Street Journal Senior Columnist James Mackintosh, an ESG investing skeptic.
Haas News: The Securities and Exchange Commission (SEC) is considering a host of new ESG disclosure rules. What will they do?
Panos Patatoukas: There are two new policy proposals (both released in May 2022) that would require additional disclosure regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures. The SEC also proposed amendments to what’s called the fund names rule. Under the proposal, a fund that considers ESG factors alongside non-ESG factors may not be permitted to use ESG or similar terminology in its name, if doing so is materially deceptive or misleading. The idea behind these amendments is to prevent potential greenwashing or ESG lip-servicing, so that Main Street investors will not be deceived or misled.
At the conference, we heard from SEC Commissioner Hester Peirce argued that existing rules already allow the SEC to go after companies for any misrepresentations or omissions of “material” information? Do you agree?
I think it was important to have her perspective. Our conversation with Commissioner Peirce indicated that she is opposed to the rules not because she doesn’t think that greenwashing isn’t happening, but because she thinks we already have the regulatory tools to address it.
One good example of what she is talking about: The SEC recently fined Bank of New York Mellon Capital $1.5 million for misleading investors on false ESG quality reviews of some of the firm’s mutual funds. Of course, the $1.5 million fine is just a slap on the wrist, but it’s a signal that says the SEC can go after fund managers who make ESG claims but aren’t true to their promises. Consistent with the idea that the Bank of New York Mellon Capital case may provide a roadmap for future enforcement cases, the SEC has now taken on a much bigger player, looking into whether some of Goldman Sachs’ mutual funds don’t meet the ESG metrics proclaimed in their marketing materials.
If you scratch the surface of Commissioner Peirce’s argument, we get to the old question of: What’s the point of having rules and more rules if we don’t have sufficient enforcement? Should we allocate more resources creating new rules, or should we allocate those resources on enforcing existing rules—to the extent that the old rules are still relevant and effective?
My view is that the recent SEC proposals on funds and advisers that market themselves as having an ESG focus respond to the need for more transparency. More regulation in this regard might actually facilitate more enforcement. The bottom line is that unless we have both meaningful regulation and enforcement, we’re not going to achieve real progress.
But will these new disclosure rules actually make it easier for investors to, as you say, invest with their values?
In the absence of standardized and informative disclosures, in my opinion, it’s not entirely surprising that an ESG fund could exaggerate its actual consideration of ESG factors. If adopted, the proposed rules would require ESG-focused funds to provide more detailed information in a standardized tabular format. By providing information prominently, in the same location in each fund’s prospectus, the idea is that more disclosure would help improve investors’ understanding of ESG investment strategies and would assist them in comparing ESG-focused funds at a glance. The SEC also proposed amendments to existing rules to address materially deceptive or misleading ESG fund names. This new regulation basically says that fund managers who make ESG claims better be true to their promises. Because if not, that’s the definition of greenwashing.
I believe that a common, standardized disclosure framework tailored to ESG investing makes sense. So overall, I am in favor of providing more standardized disclosures about fund performance, investment strategies,and portfolio characteristics.
But we need to be careful. More disclosure will not automatically level the playing field for individual investors allowing them to make more informed decisions while investing in alignment with their values. If investors don’t have the financial acumen to process the disclosed information, then disclosure on its own may not be as impactful. Remember, while we are all investors, not everyone can access financial education. One of the things that preoccupies me is finding ways to make financial education and the power of financial data more accessible to everyone.
Critics of ESG investing say that it limits the universe of available stocks, which will negatively impact performance. You asked some of the panelists: “Can investors have their ESG cake and eat it too?” Can they do well by doing good?
I asked that question to the representatives from State Street and Bloomberg. State Street has been a leader in the ESG investment sector. They have all kinds of financial products, including scoring models, indices, and fund offerings using ESG data. For example, a key premise of State Street’s “Responsibility-Factor”—or “R-Factor”—scoring model is that it allows investors to identify companies that score higher on material ESG metrics. State Street’s R-Factor is also the ESG scoring model powering the Bloomberg/SASB ESG indices, which are used as ESG investing benchmarks.
My question was whether outperformance, relative to passive benchmarks, is a good measure of the effectiveness of State Street’s ESG scoring model. The response was ideally yes, but in practice, it doesn’t usually work that way and that a better measure of effectiveness might be “do no harm.” In other words, just make sure you don’t underperform the market benchmark, but without necessarily outperforming the benchmark.
This response in my opinion deviates from the way ESG scoring models have been marketed to everyday investors. ESG scoring models have often been promoted on the premise that the resulting ESG scores can help investors select stocks that will generate higher future returns.
In fact, the premise that you can “have the ESG cake and eat it too” has proven to be a highly effective narrative for the marketing of ESG funds and indices. Reflecting on these dynamics, I believe that there is a need for caution and more transparency on the part of ESG index providers and fund managers when marketing ESG scoring models and indices to everyday investors.
One of the most interesting discussions of the day centered on ESG strategies of engagement versus divestment. Let’s say we have good data to identify “brown” companies. Does removing them from a portfolio drive change?
The issue of engagement versus divestment is one of the most important, because I think that’s the one that can have immediate, real implications. The goal of ESG investing is not just to make money for ESG-motivated investors but also to change companies’ behavior through engagement and divestment. For example, divestment involves selling fossil fuel companies that have negative environmental impacts and buying “green” companies in other sectors. The idea behind divestment is that it raises the cost of capital for fossil fuel companies, thereby impeding their growth, while helping green companies grow. Based on this, several ESG-motivated investors have called for complete divestment from the fossil fuel sector.
For example, the University of California made the decision to remove all companies that own fossil fuel reserves from the UC Retirement Savings Program (RSP) fund. As of today (June 30, 2022), they sold existing holdings from RSP core funds and will no longer invest in fossil fuel companies.
The UC retirement fund is a relatively small fraction of the total market, and when UC RSP sold stocks of fossil fuel companies, somebody else bought that stock. Nevertheless, it does raise the question: Will divesting from fossil fuel companies accelerate the path to decarbonization of the economy? Where will the technology that will change our lives come from? Will it come from an entirely different sector, or could it also come from leading companies in this sector?
Outright divesting should be contrasted to an alternative approach, let’s call it selective divesting. Consider the fossil fuel sector as a whole. Within the sector, there are leading companies that are innovating, investing in new technologies, and there are lagging companies that are falling behind and continuing their dirty practices. Divesting from all of them is one possibility. An alternative would be to divest only from the laggards and reallocate this capital to the leaders. This approach of selective divesting and tilting may be desirable for an ESG-motivated investor because (a) it would reward companies that invest in transformative technologies and (b) it would penalize companies that do not adopt. This approach effectively blends divestment with engagement. The bottom line: Is indiscriminate divestment from fossil fuel the best way to accelerate progress or is the alternative approach of selective divesting and rewarding change a more effective approach to realizing our sustainability goals?
Wall Street Journal columnist James Mackintosh argued an investor’s role is to make a return within an acceptable level of risk, not push for change. He said it’s more effective to push change at companies through consumer actions, through buying power, or through government. What do you think?
Consumers and investors can be a force for change. ESG-motivated investors are asking for more transparency and verifiable data that they can use to make more informed investment decisions. Consumers are also asking for more transparency, and more reliable, verifiable and standardized data to inform their consumption choices. I believe that change could come from anywhere.
With respect to lawmakers, I agree that they have the power to drive change. For example, as many economists have been arguing for years, introducing a carbon tax in the corporate tax code would effectively change the incentives and behavior of companies by internalizing the negative externalities of carbon emissions. But still, measurement issues may hamper the effectiveness. Suppose we introduce a carbon tax, we still need to measure carbon emissions. Should the measure of carbon emissions include only direct emissions and emissions resulting from the company’s energy use—known as Scope 1 and 2 emissions? Or, should the measure also include Scope 3 emissions, those resulting from activities that the organization indirectly impacts in its value chain? While Scope 3 emissions often account for the biggest part of a company’s emissions, they are also the hardest to measure.
What are you most optimistic about right now in terms of ESG investing?
I think over time, we will have more transparency and more tools that will allow everyday investors to invest with their values and to be more aware of what they’re investing in. And we’re going to have more and better data that will allow us to overcome the measurement challenges, monitor corporate impact, align management incentives with long-term sustainability goals, and facilitate the allocation of capital in ideas and technologies that will drive change for good.
I also think we’ll have the technology required for individual investors to be more active participants in corporate decision-making. For example, I think it’s a matter of time before pass-through voting becomes available to every individual investor. A bit of context: Many of us individual investors participate in the stock market through index funds offered by large asset managers. Stock indexing has enabled us to get access to diversified portfolios at a low cost. The Big 3 asset managers—Vanguard, BlackRock, and State Street—dominate the field, with a collective >80% share of index fund assets. The Big 3 alone manage $20 trillion in assets.
One key implication of the growth in stock indexing among the largest asset managers is the voting power they have amassed over time, since they typically vote on behalf of individual investors. Giving every individual investor the option to participate in the proxy voting process can help them amplify their impact collectively on the issues that matter to them the most. This is an exciting prospect compared to today’s reality where a small set of individuals representing the top asset managers gets to decide on our behalf.
It’s about time to ensure that the voices of everyday investors are being heard.
As investors pay increasing attention to companies’ track records on environmental, social, and governance issues such as executive compensation, trillions of dollars have flowed into the ESG investing industry.
Assets in so-called ESG funds have risen 38% globally in the past year alone, to $2.7 trillion by the end of March, according to Morningstar Direct. While Europe still dominates with 82% of the market, a burgeoning class of U.S. financial products promises investors an ROI aligned with their values.
Yet as the SEC considers new regulations, a backlash is growing against the sustainable investing industry, disparaged by some political and business leaders as “woke capitalism” and even a “scam.”
This month, the Center for Financial Reporting and Management’s (CFRM)annual conference brought together high-level ESG investing thinkers with a wide range of perspectives on the direction of the industry. Among them were SEC Commissioner Hester M. Peirce, a Republican appointed by former President Trump; Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), which has developed the leading framework for ESG data; Andrew Behar, CEO of shareholder advocacy nonprofitAs You Sow, AJ Lindeman, who leads index and ESG quant research at Bloomberg; Karen Wong, who leads ESG & Sustainable Investing for State Street Global Advisors; and Wall Street Journal Senior Columnist James Mackintosh, an ESG investing skeptic.
“I wanted to bring all these perspectives together and have a structured discussion around ESG disclosures in order to gain new understanding and figure out how to move forward,” said Associate Professor Panos Patatoukas, L.H. Penney Chair in Accounting and faculty director of CFRM, who organized the ESG accounting conference.
In Part 1 of this two-part interview, we asked Patatoukas to synthesize some of the major discussion points around ESG measurement and disclosure, as well as reporting standards and assurance by external auditors.
Part 2 of the interview, publishing July 1, will address the SEC’s proposed ESG rules, valuation and investing, as well as divestment versus engagement—two different investor approaches to pressuring companies to change their ways.
Haas News: There’s a growing backlash against ESG investing. Recently, some politicians and business and financial leaders are dismissing ESG as “woke capitalism” and even “a scam” (Elon Musk). They argue these issues aren’t relevant to investors, whose job is to maximize returns. Is this an existential threat to the industry?
Panos Patatoukas: Will political rhetoric get in the way of progress and meaningful change? I just don’t believe that. ESG becomes de facto relevant when you have so many investors who want to invest with their values and don’t want to be misled. The reality is that this growth has been driven by demand from investors. With respect to ESG disclosures, improved access to higher quality data will allow investors, especially individual investors, to invest with their values and will mitigate the risk of greenwashing.
What is greenwashing, in terms of financial products?
Greenwashing is the result of the lack of clarity in the ESG setting. Let’s say you have a preference for “green” companies and you are willing to pay a premium to get access to a green fund. Let’s now consider the possibility that the index fund manager is actually deviating from the presumed investment objective and they are actually investing in green and not-so-green stocks. Labeling the fund as a green fund could be misleading, especially for individual investors that are not fully attuned to fund characteristics and may not be fully aware of what they actually own when they invest in this particular fund. This goes to the core of greenwashing issues. And the problem is that many of these ESG products are marketed to individual investors as a way for fund managers and advisers to charge management fees in excess of what they would make in a plain vanilla, non-ESG product. But because of bad data or limited access to good data, investors effectively may be getting the same old thing packaged in a different way. Transparent financial products that allow you to invest in alignment with your values at low management fees should be accessible to everyone, but we are not there. Not just yet.
Why is it so hard to get there?
Let’s first talk about E+S+G measurement. I think everybody understands that environmental activities are very important, corporate governance matters, and social issues are becoming increasingly important. Where people really disagree is: How do we define, measure, and verify the different types of carbon emissions? What are the corporate activities that fall under the “S” of ESG and how should we measure those? What is important to measure on governance and what constitutes good or bad governance?
Because there’s a disagreement in terms of what adds up to ESG, there is disagreement on the measurement of those dimensions. That shows up in the weak correlation on ESG ratings across rating agencies. If it was 100% clear as to what it is we’re trying to measure, the correlation across agencies would be much higher.
Some people argue that E, S, and G issues cover so many different things as to be meaningless. What do you think?
Pooling environmental, social, and governance together into one single measure is problematic. These are different things that might be interacting with each other and that may even trade-off against each other. For example, you could think of a company with “bad” governance, with an entrenched CEO who has all the power and the shareholders who don’t have much voting power, but on the other hand, that same CEO might prioritize reducing the carbon footprint of the organization. So those things would be in opposition. And within each one of these dimensions—environment, social issues, and governance—there are going to be strengths and weaknesses. It’s not always the case that you can offset a negative in one area by doing something good in another. The practice of pooling different activities together to generate a single ESG score is a bad practice, in my opinion, since it’s missing the granularity of the underlying data.
So all this uncertainty about measurement must also make it difficult to define what companies should be required to disclose.
There are different views not only on how much companies should be required to disclose, but who should be responsible, and to what extent, for the assurance of the reliability of these disclosures. What I mean by assurance is external auditors attesting to the validity of the data, which is already happening when it comes to financial activities. Disclosures without assurance may not be reliable. What’s going to change the game is assurance of ESG data, because when auditors attest to the validity of the data, they can be held liable and take on the risk that what they’re signing off on is actually true and verifiable.
What became clear in our discussion is that there is real demand for more consistent, comparable and decision-useful information. We call that “material’ information, which means any information that may impact a reasonable investor’s decision making. Material ESG data need to be verifiable and audited. If we can agree on the definitions, and we agree on the measurement, and we have external auditor assurance, that will completely change the field. That will be a real revolution, or an evolution, depending on how you want to see it. We can end up in a market setting where everyday investors will have access to more accurate data based on which they can make informed decisions and invest with their values. The accounting firms can play a significant role in the transformation that’s happening and accelerate the convergence of policy, regulation, and technology that’s rewriting the ESG investing playbook.
At the conference, Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), explained that they’ve merged with others to create a global baseline of ESG standards through the International Sustainability Standards Board (ISSB). These standards have already been adopted by 65% of S&P 500 companies. Is this getting us closer to standardization?
The SASB started a decade ago as a private, nonprofit organization with the mission to develop and disseminate industry-specific sustainability accounting standards that help businesses “disclose material, decision-useful information to investors.. This is the framework that seems to be the frontrunner, and stewardship of the SASB Standards is now passing to the International Sustainability Standards Board.
However, the SASB framework is, in essence, a disclosure template that has helped companies and investors develop a common language around ESG issues. So adopting the SASB standards doesn’t necessarily mean that the data that companies disclose is meaningful. The point here is that a higher adoption rate of a sustainability reporting framework, like the one developed by SASB, is not necessarily a measure of success of the sustainability accounting standard-setting process.
So how do we define success in sustainability standard-setting? Well, it would be interesting to systematically evaluate whether the adoption of sustainability standards will ultimately have a real impact on emissions, new technologies, productivity, and social welfare. Higher adoption rates among corporations and fund managers and more licensing fees to private standard-setting organizations for using their sustainability reporting framework does not necessarily translate into a more sustainable and equitable future for everyone.
Nine new assistant professors have joined the Haas School of Business faculty this year, with cutting-edge research interests that range from illicit supply chains to unequal social hierarchies; from financial crises to the incentives that shape innovation; and from health care management to decentralized finance to marketing and the demand for firearms.
The nine tenure-track hires are the result of a concerted effort by Dean Ann E. Harrison and other Haas leaders to expand and diversify the faculty.
“We are thrilled to welcome this wonderful, diverse new group of academic superstars to Berkeley Haas,” says Dean Ann E. Harrison. “We clearly are bringing the best to Haas, increasing the depth and breadth of our world-renowned faculty, and reinforcing our place among the world’s best business schools.”
The new faculty members have hometowns throughout the U.S. and around the world, including Texas, New York, Massachusetts, and Illinois; Iran, the Dominican Republic, China, and the Netherlands. Seven of them are women; one is Black, and one is Latinx.
“This is our most diverse cohort of new faculty ever, each one a rock star in their own right,” says Jennifer Chatman, Associate Dean for Academic Affairs and the Paul J. Cortese Distinguished Professor of Management. “We are very proud that we were able to lure them to Berkeley Haas.”
The new faculty members start on July 1, with most beginning to teach in spring 2023. They bring the total size of the ladder faculty to 88, up from 78 in 2020-2021.
Meet the faculty
Assistant Professor Matthew Backus, Economic Analysis & Policy
Hometown: Chicago, Ill.
PhD, Economics, University of Michigan, Ann Arbor
MA, Economics, University of Toronto
BA, Economics and Philosophy, American University
Research focus: Industrial organization
Introduction: I’m an economist with broad interests. Most recently, I’m interested in how we can use the tools developed by the industrial organization community to understand inequality and the distributional effects of policy.
Teaching: Microeconomics and Antitrust Economics (MBA)
Most excited about: After spending a year visiting, I’m most excited about the economics community at Berkeley.
Fun fact: I have a border collie, who is in training as a herding dog.
Assistant Professor Sa-kiera (Kiera) Tiarra Jolynn Hudson, Management of Organizations
Hometown: Albany, NY
PhD/MA, Social Psychology, Harvard University
BA, Psychology and Biology, Williams College
Research focus: I study the psychological processes involved in the formation, maintenance, and intersections of unequal social hierarchies, with a focus on empathic/spiteful emotions, stereotypes, and legitimizing myths.
Introduction: I am a social psychologist by training, focusing on the nature of intergroup relations as dominance and power hierarchies. I have studied several psychological processes, including the role of legitimizing myths in justifying unequal societal conditions, the role of group stereotypes in the experience and perception of prejudice, and the role of empathic and spiteful emotions in supporting intergroup harm. My work is multidisciplinary, incorporating quantitative as well as qualitative methods from various disciplines such as political science, sociology, and public policy.
I am a fierce advocate for building community, providing mentorship, and supporting authentic inclusion for everyone. I believe it is a moral imperative to be present as a vocal, queer-identified Black women in academe, given the lack of representation, and I’m excited to see how I can contribute to diversity, equity, and inclusion efforts at Haas.
Teaching: Core Diversity, Equity, and Inclusion (MBA)
Most excited about: I identify UC Berkeley as my intellectual birthplace. It was during a summer internship program through the psychology department in 2010 where I first became interested in studying power structures and intergroup relations simultaneously. My overall research interests haven’t changed since that fateful summer. Being a faculty member here is truly a dream come true!
Fun fact: I love organizing and planning, so much so I taught myself how to use Adobe InDesign to create my own planner. I am also an avid foodie and cannot wait to check out the Bay’s food and wine scenes.
Assistant Professor Ali Kakhbod, Finance
Hometown: Isfahan, Iran
PhD, Economics, MIT
PhD, Electrical Engineering & Computer Science (EECS), University of Michigan
Research focus: Information frictions; liquidity; market microstructure; big data; and contracts
Introduction: I am a financial economist with research interests in financial intermediation, liquidity, contracts, big (alternative) data, banking and financial crises. A common theme of my research agenda is to study various informational settings and their financial and economic implications. For example: When does securitization lead to a financial crisis? Why is there heterogeneity in the means of providing advice in corporate governance? How does information disclosure in OTC (over-the-count) markets affect market efficiency? My research has both theory and empirical components with policy implications.
Teaching: Deep Learning in Finance (MFE)
Most excited about: Berkeley Haas is the heart of what’s next with world-class faculty working on exciting and innovative research. Given that my interdisciplinary research interests span finance, economics and big data issues, I could not ask for a better fit.
Fun fact: In my free time, I like to ski, sail, hike, and enjoy the outdoors.
Assistant Professor Ambar La Forgia, Management of Organizations
Hometown: I was born in Santo Domingo, Dominican Republic, but I grew up in Washington, DC and São Paulo, Brazil.
PhD, Applied Economics and Managerial Science, The Wharton School, University of Pennsylvania
BA, Economics and Mathematics, Swarthmore College
Research focus: Health care management; mergers and acquisitions; firm performance
Introduction: My research studies the relationship between organizational and managerial strategies and performance outcomes in the health care sector. In particular, I use quantitative methods to study how the strategic decisions of corporations to merge, acquire, or partner with other organizations can change managerial processes in ways that impact both financial and clinical performance. A secondary research strand studies how health care organizations adapt their service delivery and prices following changes in state and federal legislation.
Before joining UC Berkeley, I was an assistant professor of health policy and management at Columbia University’s Mailman School of Public Health. I am excited to continue to explore issues of healthcare quality, equity, and cost, while digging deeper into the management practices and organizational structures that could influence these outcomes.
Teaching: Leading People (EWMBA)
Most excited about: It is an honor to join the world-class faculty at Haas, and I am so excited to learn from and collaborate with my MORs colleagues on both the macro and micro side. Since my research is interdisciplinary, I also look forward to connecting with scholars in the School of Public Health.
As a self-proclaimed “city girl,” I am excited to get out of my comfort zone and explore the natural beauty of Northern California.
Fun fact: My hobbies include yoga, urban gardening, adopting animals and stand-up comedy.
Assistant Professor Sarah Moshary, Marketing
Hometown: New York City, NY
Phd, Economics, MIT
AB, Economics, Harvard College
Research focus: Marketing and industrial organization
Introduction: My research interests span quantitative marketing, industrial organization, and political economy. I am currently working on projects related to paid search advertising, the pink tax (price gap in products targeted to women), and the demand for firearms. Before joining Haas, I worked at the University of Chicago Booth School of Business and at the University of Pennsylvania.
Teaching: Pricing (MBA)
Most excited about: I am excited to get to know my future colleagues!
Fun fact: My two hobbies are running and pottery—though I am more enthusiastic than talented at either :).
Assistant Professor Tanya Paul, Accounting
Hometown: Murphy, Texas
PhD, Accounting, The Wharton School, University of Pennsylvania
BS, Economics, Statistics and Finance, The Wharton School, University of Pennsylvania
Research focus: Standard-setting and financial reporting; the determinants and consequences of voluntary disclosures
Introduction: After getting my PhD, I spent a year at the Financial Accounting Standards Board learning about contemporary accounting issues and understanding the types of questions that standard setters are grappling with. I hope to continue working on research that is helpful to standard setters in coming up with standards that ultimately improve financial reporting.
Teaching: Corporate Financial Reporting (MBA)
Most excited about: I love how interconnected the area groups are within Haas. There are so many potential learning opportunities, especially for a newly minted researcher like me.
Fun fact: In my free time, I love to read and play the piano—I had learned it as a child and am trying to relearn it now as an adult.
Assistant Professor Carolyn Stein, Economic Analysis & Policy
Hometown: Lexington, Mass.
PhD, Economics, MIT
AB, Applied Mathematics and Economics, Harvard College
Research focus: Economics of science, innovation, and applied microeconomics
Introduction: I study the economics of science and innovation. My research combines data and economic theory to understand the incentives that scientists face and decisions that they make, and how this in turn shapes the production of new knowledge.
One thing I love about economics is that it’s less of a narrow subject area, and more a set of tools and principles that apply to a stunningly wide array of topics. I’m excited to work with Haas students to help them understand how economic principles can improve their decision-making, both in their careers and in other areas of their lives—maybe even in ways that surprise them!
Teaching: Microeconomics (EWMBA)
Most excited about: I’m excited to be part of a large and superb applied microeconomics community—at Haas, and more broadly at Berkeley as a whole.
Fun fact: I am an avid cyclist and skier, and I was on the cycling team at MIT. Since moving to the Bay Area, I’ve loved the hills and mountains in the area. I’m working on taking my riding off road (gravel and mountain biking) and skiing off-piste (backcountry).
Assistant Professor Sytkse Wijnsma, Operations and IT Management
Hometown: Amsterdam, the Netherlands
PhD, Management Science and Operations, Judge Business School, University of Cambridge
MPhil, Management Science and Operations, Judge Business School, University of Cambridge
BSc & MSc, Economics and Finance, VU University, Amsterdam
Research focus: My primary research interest is designing supply chain and policy interventions that help solve real-world challenges with social and environmental impact.
Introduction: I am very excited about my projects on illicit supply chains and how they undermine social and environmental goals. The context of these projects spans a wide range of areas, from illicit waste management to illegal deforestation. I am also excited to deepen and expand ongoing research collaborations with governments and industry to investigate these issues.
Teaching: Sustainability in Business (Undergraduate)
Most excited about: Many things! Berkeley Haas, being at the forefront of sustainability, has a unique position that combines the same ideals that drive my research with opportunities for collaborative research with serious impact. The amazing colleagues and close connections to industry make it even more exciting to join this community!
Fun fact: My first and last name originate from Fryslân, a northern province in the Netherlands, where it is still tradition to name your children after family members. So although my name is quite rare in the rest of the world, in our family it crops up in every generation!
Assistant Professor Valerie Zhang, Accounting
Hometown: Shanghai, China
PhD, Northwestern Kellogg School of Management
MA, Economics, University of Toronto
BCom, Finance and Economics, University of Toronto
Research focus: Information dissemination; information cascades on social media; retail investor behavior; decentralized finance
Introduction: I am passionate about doing research or working on personal projects that can express my creativity. I enjoy merging disjointed ideas and working on interdisciplinary research. My dissertation combines two literatures: one in computer science on information cascades on social media, and another in finance and accounting on the effects of disseminating financial news. I am also very curious about emerging technologies that are reshaping the financial industry. Since I work on areas that are new to the research community, I sometimes feel like a lone traveler exploring completely new territories. It is terrifying but also extremely rewarding!
Teaching: Financial Accounting (Undergraduate)
Most excited about: I look forward to inspiring my students to be entrepreneurial and to come up with creative business ideas or projects.
Fun fact/hobby: I write short stories. The one I am working on has an alien and a squirrel in it.
As regulators wrestle with disclosure standards for the burgeoning $35 trillion ESG investing industry—named for its focus on corporations’ environmental, social, and governance activities—a group of influential thought leaders is gathering at Berkeley Haas to share their expertise.
“The timing and the content of the conference are unique,” says Panos Patatoukas, associate professor of accounting at Berkeley Haas and faculty director of the Center for Financial Reporting and Management (CFRM), which organized the event. “Our set of panelists and moderators are at the cutting edge of the ESG investing world and represent a wide range of perspectives, including ESG strategies, scoring and indexing, investing, regulation, and sustainability reporting standards.”
The importance of measurement, standardization, and verification is becoming more urgent as ESG investing grows, and the amount of capital allocated in ESG indices and financial products has exploded. For example, the SEC recently fined Bank of New York Mellon over misleading claims about funds that use environmental and social criteria to pick stocks. A transparent standard setting process can play a crucial role in advancing the clarity that investors and businesses are asking for in the area of ESG disclosures, Patatoukas says.
ESG from four angles
The conference will approach ESG accounting from four main angles, Patatoukas says: disclosure, assurance, standardization, and valuation and investing. After an introduction from Dean Ann Harrison, the first panel will focus on measurement and disclosure, and will be moderated by James Webb, executive director of the CFRM.
Next, Andrew Behar, CEO of As You Sow, a nonprofit that uses shareholder advocacy to “create lasting change by protecting human rights, reducing toxic waste, and aligning investments with values,” will lead a discussion on ESG advisory and auditing, with partners from PwC, KPMG, Deloitte, and Moss Adams.
Berkeley Law Professor Stavros Gadinis will moderate two keynote addresses: SEC Commissioner Hester M. Peirce will speak on ESG reporting regulations, and Janine Guillot, CEO of the Value Reporting Foundation, will speak on reporting standards.
The afternoon discussion of ESG valuation and investing will feature AJ Lindeman, Bloomberg’s head of Index and ESG Research; Wall Street Journal Senior Columnist James Mackintosh, and Karen Wong, head of ESG & Sustainable Investing for State Street Global Advisors. Patatoukas will moderate.
The event, which is the 26th annual Conference on Financial Reporting, will run from 9 a.m. to 4 p.m. in Chou Hall’s Spieker Forum on the Haas campus.Registration is open to all. Attendees can receive CPA Continuing Education credits.
It’s been a decade since the Jumpstart Our Business Startups (JOBS) Act relaxed initial public offering requirements for companies with revenues under $1 billion, and a growing number of them have taken advantage of the option to disclose less financial information in their IPOs.
But while this reduced-disclosure provision may have helped stimulate the market, it came at the cost of lower IPO quality and more risk exposure for individual investors, suggests a new study by Berkeley Haas professors Omri Even-Tov and Panos Patatoukas, along with PhD candidate Young Yoon.
“The evidence shows that nearly two-thirds of the reduced-disclosure issuers underperform the market in the three years after they go public,” said Even-Tov, an assistant professor of accounting. “While we find evidence that institutional investors use publicly available information to avoid the worst-performing IPO stocks, individual investors tend to ignore fundamentals when investing in IPO stocks and are more exposed to the risks.”
Even as Senate Republicans have unveiled a new set of relaxed rules dubbed JOBS Act 4.0 to spur business and ensure retail investors have access to young ventures, “the evidence questions that the SEC’s objective to increase the quantity of IPOs came at the expense of quality,” said Patatoukas, associate professor and L.H. Penney Chair in Accounting. Based on their findings, the researchers argue that the SEC should ratchet back and require all IPO issuers to disclose at least three years of audited financial information—up from the two years allowed under the JOBS Act.
“We recommend that regulators balance the benefits of increasing the number of IPO registrants against the costs of enabling speculative issuers to go public with reduced financial disclosures,” Patatoukas said. “With respect to investor protection in the IPO aftermarket, the quality of IPOs is as important, if not more so, than the quantity.”
Stimulating the IPO market
When the JOBS Act was signed into law on April 5, 2012, the goal was to invigorate the IPO market by making the process less risky and burdensome for smaller companies. The Act created a new category called emerging growth companies (EGCs), defined as issuers with pre-IPO revenues of less than $1 billion.
The new rules gave companies the option of presenting just two years of audited financial statements and selected financial data in their IPO filing, rather than the three years of audited financials and five years of selected financial data required previously.
By the end of 2015, almost half of emerging growth companies with an operating history of more than two years opted for reduced disclosures. By 2018, it was over 80%.
Quantity vs. quality
While prior studies have found that the JOBS Act did lead to an increase in the number IPOs—which had dropped off following the dot-com bust—the Berkeley Haas researchers questioned their quality.
They looked closely at EGCs that went public before and after the JOBS Act took effect, and also compared them to companies with revenues over $1 billion that went public during the same time period and did not have the option of reduced disclosures.
The EGCs that had been operating more than two years, yet opted to release only two years of financials, had more speculative valuation profiles and lower institutional ownership, they found. These companies’ stocks tended to become overpriced in the aftermarket, and after three years, 66% of them underperformed a broad market index—compared with 49% of emerging growth companies that chose to disclose three years of financials.
They also found that individual investors were more attracted than institutions to the speculative, “lottery-type” companies that went public under the new rules, implying that individual investors were more exposed to the downsides.
Their findings contradict prior research suggesting that the Act led smaller companies to underprice their IPOs. Rather, the analysis found that the bigger average jumps in share prices relative to offering prices after the Act was passed were due to overall market conditions, and weren’t limited to EGCs.
Enhancing companies’ access to the public capital market, and their ability to conduct successful IPOs, gives investors more opportunities to invest in public companies, the researchers agreed. Yet the increased risk that the reduced accounting rule brings to individual investors led them to recommend that the SEC remove the provision and require issuers to disclose at least three years of audited financial statements.
“Having three years of data rather than two will enable investors to gauge the trend in company growth leading to the IPO,” Even-Tov said. “This has the potential to help level the playing field for Main Street investors, and the incremental cost to companies of providing another year of historical information should be small.”
Patatoukas added that the findings have direct relevance for both the SEC and for retail investors.
“Our evidence that individual investors may have been disproportionately exposed to shareholder value destruction post-JOBS Act could inform the SEC’s efforts to facilitate capital formation while protecting the interests of Main Street investors,” he said. “On the part of Main Street investors, our evidence calls attention to the risks of actively targeting IPO stocks with speculative valuation profiles.”
Spring 2022|By Katie Gilbert| Photo: GUY OLIVER/ALAMY STOCK PHOTO
The impact of sourcing responsible minerals
An ambitious change in U.S. accounting rules appears to be helping reduce violent conflicts in Africa, according to a new study.
The conflict minerals disclosure rule, or Dodd-Frank’s Section 1502, has required companies as of 2014 to publish detailed reports on their sourcing of tantalum, tin, tungsten, and gold. These so-called 3TG, or “conflict minerals,” used in smartphones, laptops, electric vehicles, and other devices, have fueled a humanitarian crisis by serving as a major source of revenue for armed groups in Central Africa.
“With Dodd-Frank, the SEC made an unprecedented move by requiring disclosures intended to tackle issues outside of the shareholder-protection realm,” says Assistant Professor Omri Even-Tov, co-author of the study.
The U.S. government’s response focused on transparency rather than sanctions. The hope was that if consumers, investors, employees, and other stakeholders knew more about the conflicts linked to the mining of minerals in the devices they use every day, they would push companies to change their supply chains and, more importantly, that the changes in companies’ mineral-sourcing decisions would help alleviate the conflicts.
It seems to be working, Even-Tov found.
Analyzing data from the first four years after the disclosure requirement was enacted, Even-Tov, along with Seoul National University Professor Bok Baik and others, found that companies became substantially more responsible in sourcing minerals. What’s more, their analysis found that the number of conflicts decreased.
The researchers collected data from over 4,000 minerals disclosure reports published by more than 1,000 companies between 2014 and 2018. Over the four-year period, responsible sourcing nearly doubled, increasing from 45% to almost 82%.
Even though companies were not penalized for continuing to buy conflict minerals, the researchers found that public attention made companies more committed to responsible sourcing. For every 100 downloads of a company’s disclosure report, they noted a 1.2% increase in the percentage of conflict-free smelters and refiners and a 4.5% increase in the likelihood that a company would put in place a policy for avoiding conflict minerals.
Market reaction also appeared to play a role. In the five days surrounding the publication of a disclosure report, Even-Tov found that a one standard-deviation increase in the number of conflict-free smelters and refiners that companies sourced from (which amounted to a 24% overall increase) was associated with a bump of about 0.6% in market value, which equates to $66 million for the average company in the sample.
To determine the humanitarian impact, the researchers drew from the Armed Conflict Location & Event Database to obtain the dates, locations, and types of conflict events between 2010 and 2019.
They found that the number of conflicts decreased by 15% in the mining regions of the Democratic Republic of Congo and the nine neighboring countries covered by the disclosure rule, relative to countries not covered. They also found that conflicts had not spilled over into non-mining areas.
“I don’t want anyone to think that the conflict minerals disclosure rule is a panacea; it’s not,” says Even-Tov. “But our results show that increased transparency is effective at nudging companies toward responsible actions that are having a real impact.”
He even thinks that the policy should be applied more broadly. For example, the Democratic Republic of Congo supplies most of the world’s cobalt, a mineral not currently mentioned in the rule. He believes it should be added.
Still, Even-Tov acknowledges the need for policymakers to strike a delicate balance with laws requiring more disclosure. “It’s easy to ask companies to disclose more,” he adds, “but what’s crucial is to measure the impact the disclosures have. That’s what we, as accountants, are endeavoring to do.”