ARTICLE A HARD LOOK AT PORTFOLIO-FOCUSED STEWARDSHIP Amanda M. Rose* Financially motivated diversified investors want to maxim- ize the overall value of their portfolio and are not inde- pendently concerned with the performance of any given portfo- lio firm. A growing number of scholars have concluded that index fund managers should therefore engage in stewardship designed to force portfolio firms to internalize the costs their activities impose on other portfolio firms (“portfolio-focused stewardship”). This seemingly provides a financial justifica- tion for SEC-mandated disclosure on ESG topics—ESG dis- closures concerning how a firm’s activities affect the broader economy might help index fund managers identify and, through stewardship, force the internalization of intraportfolio externalities, leading to increases in risk-adjusted portfolio value. This Article critically examines whether, and under what circumstances, financially motivated diversified inves- tors would want their index fund managers to engage in port- folio-focused stewardship, paying careful attention to the real- world frictions that cast doubt on the likelihood that portfolio- focused stewardship would lead to net gains in risk-adjusted *Cornelius Vanderbilt Chair in Law, Vanderbilt University. I am grateful to Taylor Robbins for excellent research assistance. For insightful comments, I am grateful to individuals in the asset management industry who took time to speak with me as well to numerous participants at: the 2023 Tulane Corporate and Securities Law Roundtable; Vanderbilt Law School’s faculty workshop; Vanderbilt Law School’s 25th Annual Law & Business Confer- ence; the Comparative Takeovers and Securities Law Conference at Trinity College Dublin; the Fordham Law & Columbia Law School Conference: Cel- ebrating the Enduring Influence of Zohar Goshen and Gideon Parchomov- sky’s seminal article The Essential Role of Securities Regulation; and the Business Law & Economics Workshop at the University of Texas at Austin Law School. 314 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 portfolio value as well as the alternative tools available to di- versified investors for addressing intraportfolio externalities. The analysis has important implications for contemporary de- bates over SEC-mandated ESG disclosure as well as index fund managers’ fiduciary responsibilities. I. Introduction ...................................................................... 314 II. Portfolio-Focused Stewardship Gains Academic Adherents ................................................................... 326 III. Is Portfolio-Focused Stewardship Likely to Increase Portfolio Value? .......................................................... 331 A. Real World Friction #1: Managerial Agency Costs 333 B. Real World Friction #2: Intermediary Agency Costs 340 C. Real World Friction #3: Imperfect Information .. 355 1. Command-and-Control Regulation ................ 363 2. Disclosure Regulation .................................... 368 D. Real World Friction #4: Market Dynamism ....... 371 IV. Evaluating the Big Three’s Efforts ............................ 373 A. Statements of Corporate Purpose ....................... 374 B. Gender Quotas for Corporate Boards .................. 376 C. Emissions Reductions .......................................... 376 D. Disclosure Initiatives .......................................... 381 V. Available Alternatives ............................................... 383 VI. Conclusion: Implications for Modern Debates .......... 387 I. INTRODUCTION The United States Securities & Exchange Commission (“SEC”) recently finalized a controversial set of new disclosure mandates related to climate change,1 and pressure is on for 1 See The Enhancement and Standardization of Climate-Related Dis- closures for Investors, 89 Fed. Reg. 21668 (Mar. 28, 2024) (to be codified at 17 CFR §§ 210, 229, 230, 232, 239, 249); The Enhancement and Standardi- zation of Climate-Related Disclosures for Investors, 87 Fed. Reg. 21334 (Apr. 11, 2022). The SEC’s climate disclosure proposal garnered thousands No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 315 the SEC to adopt additional “ESG”2 disclosure mandates.3 The SEC’s climate disclosure mandates have already prompted numerous challenges, in both courts of law and pub- lic opinion, and the same can be expected if the SEC imposes additional “ESG” disclosure requirements.4 This makes the of comment letters expressing a broad array of divergent views. See, e.g., Lawrence A. Cunningham, What the Volume and Diversity of Comment Let- ters to the SEC Say About its Climate Proposal, HARV. L. SCH. F. ON CORP. GOVERNANCE (July 3, 2022), https://corpgov.law.har- vard.edu/2022/07/03/__trashed-4/ [https://perma.cc/VE6B-UP9N] (observ- ing that “only a handful of the thousands of SEC rule proposals have gar- nered anywhere near the level of comment letters as this one, and few with the diversity of views”); Cynthia A. Williams & Robert G. Eccles, Review of Comments on SEC Climate Rulemaking, HARV. L. SCH. F. ON CORP. GOVERN- ANCE (Nov. 23, 2022), https://corpgov.law.harvard.edu/2022/11/23/review-of- comments-on-sec-climate-rulemaking/ [https://perma.cc/Q28W-SDZX] (providing an overview of the positions taken in the comment letters sub- mitted). 2 The acronym “ESG” is used as shorthand for a broad array of “envi- ronmental,” “social,” and “governance” topics affecting businesses, including climate change, human capital management, supply chain management, human rights, cybersecurity, diversity and inclusion, corporate tax policy, corporate political spending, executive compensation practices, and more. Amanda M. Rose, A Response to Calls for SEC-Mandated ESG Disclosure, 98 WASH. U. L. REV. 1821, 1822 (2021). Sometimes the equally broad terms “sustainability” and “non-financial disclosure” are used synonymously to re- fer to this collection of topics. For a discussion of the origin of the term ESG, see Elizabeth Pollman, The Making and Meaning of ESG (Univ. of Pa. Carey L. Sch. Inst. for L. & Econ., Research Paper No. 22-23, 2022), https://ssrn.com/abstract=4219857 [https://perma.cc/47JP-X7EM]. 3 See, e.g., Marcel Kahan & Edward Rock, The Emergence of Welfarist Corporate Governance 15 J. LEGAL ANALYSIS 122 (2023) (describing numer- ous recent requests for disclosure rulemaking on social topics). 4 See Zoya Mirza & Lamar Johnson, SEC Battles Climate Disclosure Rule Legal Challenges, ESG DIVE (Mar. 27, 2024), https://www.esgdive.com/news/SEC-climate-disclosure-rule-legal- challenges-tracker-roundup-analysis/711313/ [https://perma.cc/X6AP- PTHH] (summarizing ongoing litigation challenging the SEC’s final climate disclosure rule); Andrew Ramonas, SEC Freezes Climate Rules After Chal- lengers Pushed for Pause, Bloomberg L. (Apr. 4, 2024), https://news.bloom- berglaw.com/esg/sec-freezes-climate-rules-after-challengers-pushed-for- pause [on file with the Columbia Business Law Review] (noting that the SEC temporarily stayed implementation of the final rule in response to legal pressure). 316 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 rationale for their adoption of vital importance. While socially motivated investment has skyrocketed in popularity in recent years,5 ESG disclosure advocates—which include many of the largest traditional asset managers—are often careful to cast their demands as in the interests of purely financially moti- vated investors,6 and the SEC has explicitly justified its cli- mate-related disclosure mandates in terms of their financial rather than social significance to investors.7 Some allege that 5 See Tamara Kostova, Beyond Returns: The Rise Of Values-Aligned In- vesting, FORBES (May 26, 2023), https://www.forbes.com/sites/forbesbusi- nesscouncil/2023/05/26/beyond-returns-the-rise-of-values-aligned-investing [https://perma.cc/83KK-S74S] (discussing this trend); INV. CO. INST., INVEST- MENT COMPANY FACT BOOK: A REVIEW OF TRENDS AND ACTIVITIES IN THE IN- VESTMENT COMPANY INDUSTRY 31–33 (2023), https://www.ici.org/sys- tem/files/2023-05/2023-factbook.pdf [https://perma.cc/VQ5T-BJVU] (providing data on the rise of funds that engage in sustainable investing strategies). 6 See Paul G. Mahoney & Julia D. Mahoney, The New Separation of Ownership and Control: Institutional Investors and ESG, 2021 COLUM. BUS. L. REV. 840, 843 (“Institutional investors who have joined environmental and social activists in supporting mandatory ESG disclosures argue that the disclosures will help them generate superior returns—that ESG investing is about ‘value, not values.’”) (quoting Letter from Cyrus Taraporevala, President & CEO, State St. Glob. Advisors, to Bd. Members (Jan. 28, 2020)). For useful attempts to clarify the distinction between financially motivated ESG investing and ESG investing driven by broader concerns, see Max M. Schanzenbach & Robert H. Sitkoff, Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee, 72 STAN. L. REV. 381, 397 (2020) (referring “to ESG investing motivated by providing a benefit to a third party or otherwise for moral or ethical reasons as collat- eral benefits ESG, and ESG investing to improve risk adjusted returns as risk-return ESG”); Paul Brest, Ronald J. Gilson & Mark A. Wolfson, How Investors Can (and Can’t) Create Social Value, 44 J. CORP. L. 205, 211–13 (2018) (drawing a distinction between “concessionary” ESG investing, which tolerates sacrificing some financial return to achieve ESG goals, and “non- concessionary” ESG investing, which carries an expectation of a full risk- adjusted market-rate financial return). 7 See, e.g., The Enhancement and Standardization of Climate-Related Disclosures for Investors, 87 Fed. Reg. 21334, 21335–36 (April 11, 2022) (stating that “[i]nvestors need information about climate-related risks—and it is squarely within the Commission’s authority to require such disclosure . . . —because climate-related risks have present financial consequences that investors in public companies consider in making investment and No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 317 this is subterfuge, that in fact those calling for SEC-mandated ESG disclosures are motivated by a desire to promote other policy objectives, or perhaps to advance their own personal fi- nancial interests rather than those of investors.8 This Article does not take a position on this heated, and increasingly par- tisan, question.9 Instead, it attempts something more voting decisions” and disclaiming any objective “to address climate-related issues more generally” (emphasis added)). 8 See Mahoney & Mahoney, supra note 6, at 843–44 (calling the finan- cial value argument in favor of ESG disclosure mandates “cheap talk” and noting that there are “good reasons to believe that [asset managers’] pur- pose [in supporting such mandates] is in part to pursue public policy goals outside the normal political process”); see also Elon Musk (@elonmusk), X (formerly Twitter) (May 18, 2022, 11:09 AM), https://twit- ter.com/elonmusk/status/1526958110023245829 (“ESG is a scam. It has been weaponized by phony social justice warriors.”); Press Release, James Comer, Chairman, House Committee on Oversight and Accountability, Comer: ESG is Just Window Dressing for Liberal Activism and Far-left Ide- ology (May 10, 2023), https://oversight.house.gov/release/comer-esg-is-just- window-dressing-for-liberal-activism-and-far-left-ideology%EF%BF%BC/ [https://perma.cc/6PJG-FABY] (stating that Representative James Comer (R-Ky.) asserted at a Congressional hearing on ESG that “[t]he ESG agenda prioritizes leftist ideology over the growth of retirees’ investments”); Writ- ten Testimony of Steven T. Marshall Alabama Attorney General Before the United States House of Representatives Committee on Oversight and Ac- countability, ESG Part I: An Examination of Environmental, Social and Governance Practices with Attorneys General (May 10, 2023), https://over- sight.house.gov/wp-content/uploads/2023/05/Marshall-written-testi- mony.pdf [https://perma.cc/P34P-FVEV] (“An unelected cabal of global elites are using ESG, a woke economic strategy, to hijack our capitalist sys- tem, coerce corporations, and threaten the hard-earned dollars of working Americans. ESG must be stopped.”); see also Rose, supra note 2, at 1823 (“ESG proponents . . . include members of an emerging corps of people and institutions who profit from the movement, including corporate sustainabil- ity officers, providers of ESG ratings and indices, accounting firms that offer ESG-related services, and managers of specialized ESG-investment vehi- cles.”). 9 Clara Hudson, BlackRock’s Shifts in Governance Leave ESG Foes Hungry for More, BLOOMBERG L. (July 21, 2023), https://news.bloomber- glaw.com/esg/blackrock-changes-set-up-anti-esg-forces-to-seek-next-tar- gets [on file with the Columbia Business Law Review] (“Republicans say ESG pushes progressive policies that don’t prioritize financial metrics for shareholders. Democrats, meanwhile, have countered that investors want 318 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 constructive by subjecting the financial case for SEC-imposed ESG disclosure mandates to much-needed analytical rigor. Financial arguments in favor of SEC-imposed ESG disclo- sure mandates come in at least three different permutations, only the last of which is examined in this Article. The first is traditional—that ESG information would be important to a fi- nancially-motivated investor or prospective investor in the disclosing firm because the information is likely to signifi- cantly impact the disclosing firm’s future expected cash flows.10 To call this argument traditional does not, of course, answer whether it is convincing in application. Its strength as a justification for mandatory ESG disclosure will depend on, inter alia, the specific piece of ESG information at issue and the plausibility of the contention that such information is likely to be valuation relevant.11 The second argument is more novel. ESG information might be thought of in terms of its relation not only to firms’ future expected cash flows but also in relation to firms’ contri- bution to, or sensitivity to, systematic risk in the economy, in which case disclosure might improve the market’s under- standing of the level of, and specific firms’ sensitivity to, ESG information because it’s good for the performance of their invest- ments.”). 10 See e.g., George S. Georgiev, The Market-Essential Role of Corporate Climate Disclosure, 56 U.C. DAVIS L. REV. 2105, 2124–29 (2023) (defending certain aspects of the SEC’s climate disclosure proposal on this basis). 11 As I have explained elsewhere, not even the most ardent ESG disclo- sure advocate would contend that all ESG information is financially im- portant to companies—certain ESG topics may impact corporations’ cash flows in a material way, whereas other ESG topics may not, and variations will exist amongst industries and amongst corporations within industries. See Rose, supra note 2, at 1833–34. Moreover, even if information on a spe- cific ESG topic is plausibly valuation-relevant, mandatory disclosure is not necessarily justified. See id. at 1834 (explaining that the SEC does not man- date disclosure of information simply because it is material to firms’ finan- cial performance: “[t]he decision to create a duty to disclose requires a weighing of, inter alia, the cost to companies of producing the information and the magnitude of the benefit to investors of the information’s produc- tion”). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 319 systematic risk.12 If such disclosures revealed that systematic risk was higher or lower than previously understood, inves- tors could better optimize their portfolios across asset classes; and if investor understanding of particular firms’ sensitivity to systematic risk became more accurate by virtue of the dis- closure, investors could construct portfolios that better match their risk preferences.13 Whether the SEC should be in the business of mandating disclosures designed to promote more accurate pricing of systematic risk is an interesting question that warrants further thought. While the benefits of this sort of disclosure are easy to articulate, so too are the costs, partic- ularly as it concerns placing meaningful boundaries on the SEC’s authority.14 The third argument, which is the focus of this Article, builds on a theory that has become popularized recently in 12 See, e.g., Madison Condon, Market Myopia’s Climate Bubble, 2022 UTAH L. REV. 63 (arguing that climate risk is systematic in nature, in the sense that it cannot be diversified away, and that it is underpriced by the market); The Enhancement and Standardization of Climate-Related Disclo- sures for Investors, 87 Fed. Reg. 21334, 21446 (Apr. 11, 2022) (discussing how climate change is a form of systematic risk and how disclosure can help investors appreciate this and adjust their portfolios to decrease vulnerabil- ity to sudden losses). 13 See ZVI BODIE, ALEX KANE & ALAN J. MARCUS, INVESTMENTS, Part II (13th ed. 2024) (providing an introduction to portfolio theory). 14 Establishing that the market is underpricing a systematic risk to the economy, and that mandatory disclosure of related information is likely to correct the distortion, would be incredibly difficult to do with any degree of certainty. Indeed, establishing that something even is a systematic risk is fraught with uncertainty. See, e.g., John C. Coffee, Jr., The Future of Dis- closure: ESG, Common Ownership, and Systematic Risk, 2021 COLUM. BUS. L. REV. 602, 620–21 (observing that “[s]keptics may doubt that [ESG] dis- closures [focused on racial diversity and inclusiveness] relate at all to sys- tematic risk disclosure,” but positing that “over the long run, these disclo- sures arguably relate to the potential viability of our corporate system” because if that system “cannot offer inclusiveness and promote diversity, it may subject itself to a political risk that capitalism . . . will be politically challenged . . .”). If the SEC were given broad deference by the courts when invoking this rationale for disclosure, it could have the practical effect of broadly expanding the scope of the SEC’s authority. 320 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 both academic literature and in asset manager discourse.15 The theory, which has been referred to as “portfolio primacy theory,” proceeds from a clearly correct premise: financially motivated diversified investors want to maximize the risk-ad- justed value of their portfolio as a whole and are not inde- pendently concerned with the performance of any given port- folio firm. In familiar economic terms, this means that such investors would, all else equal, want their portfolio firms to internalize the costs their activities impose on other portfolio firms, leading those firms to conduct business in a way that leads to Kaldor-Hicks efficient outcomes at the portfolio level. From this solid premise about the desired end of financially motivated diversified investors, portfolio primacy theory makes a contestable claim about the means by which such in- vestors would wish to pursue it—namely, that they would want to use their influence as investors over portfolio firm managers to cause those managers to pursue portfolio value maximization, even at the expense of firm value maximiza- tion. Because the vast majority of diversified investors are passive investors in index funds, this translates into a claim that financially motivated diversified investors would want their index fund managers to wield their funds’ influence in this way. I refer to this as “portfolio-focused stewardship.”16 15 See, e.g., Roberto Tallarita, The Limits of Portfolio Primacy, 76 VAND. L. REV. 511, 514 (2023) (explaining the theory and noting that “[it] has re- ceived increasing support among public institutions, market players, and environmental activists”); Coffee, Jr., supra note 14, at 646 (noting that the theory “has excited scholars”). 16 The dramatic growth of indexed mutual and exchange traded funds in recent years is what makes the notion that public companies could suc- cessfully be pushed to subordinate firm-value maximization to portfolio- value maximization plausible. See generally Lucian A. Bebchuk & Scott Hirst, The Specter of the Giant Three, 99 B.U. L. Rev. 721 (2019) (providing empirical evidence of this growth). Management of the index fund sector is dominated by BlackRock, Inc. (Blackrock), State Street Global Advisors (State Street), and the Vanguard Group (Vanguard), collectively known as the “Big Three.” See Lucian Bebchuk & Scott Hirst, Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy, 119 COLUM. L. REV. 2029, 2033 n.2 (2019) (describing the origins of the term). The Big Three collectively direct the votes of roughly 25% of the shares in all S&P500 companies, and it has been estimated that the average proportion No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 321 The idea that financially motivated diversified investors would want their index fund managers to engage in portfolio- focused stewardship might justify a more expansive set of SEC disclosure mandates than would be called for if such in- vestors preferred their fund managers to focus more narrowly on issues affecting individual firm value. For example, ESG disclosures about how a firm’s activities affect the broader economy might help index fund managers identify and, through stewardship, force the internalization of intraportfo- lio externalities. Such externalities would include, but are po- tentially much broader than, a portfolio firm’s contributions to unpriced systematic risk, distinguishing this argument from the second. There is another, more fundamental, distinc- tion between this and the second argument: whereas the sec- ond assumes that investors will use the enhanced disclosures to inform their investment decisions, the third posits that in- dex fund managers may use the enhanced disclosures to in- form their stewardship decisions.17 It is the effect of portfolio- focused stewardship on the behavior of firms that may cause the risk-adjusted value of the portfolio as a whole to increase, not just the impact of the information on trading decisions that improve share price accuracy. Indeed, portfolio primacy theory presumes diversified investors whose portfolios are fixed and thus for whom “exit” is not an option. This Article interrogates the logic of portfolio-focused stew- ardship, with direct implications for the debate over ESG dis- closure mandates. It considers the issue from the perspective of a rational, financially motivated diversified investor—not of shares in S&P500 companies voted by the Big Three could reach as much as 40% within two decades. See Bebchuk & Hirst, The Specter of the Giant Three, supra, at 737–40. Big Three voting power raises important questions beyond the capacity of the Big Three to use that power to achieve portfolio- level financial gains—questions related to democratic legitimacy as well as the potential anti-competitive effects of common ownership. While incredi- bly important, those concerns are beyond the scope of this Article. See infra notes 61 & 158–160 and accompanying text (discussing these concerns). 17 The term “stewardship” refers to the influence that fund managers can exert over their portfolio firms through monitoring, engagement, and voting. See Bebchuk & Hirst, Index Funds and the Future of Corporate Gov- ernance, supra note 16, at 2044–46 (discussing these forms of stewardship). 322 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 because real investors are always rational and care single- mindedly about financial returns, but because this is the type of investor whose interests portfolio-focused stewardship (and SEC disclosure mandates in support thereof) is purported to advance.18 The Article posits that such an investor would log- ically prefer the path of portfolio-focused stewardship as a way to limit intraportfolio externalities and thus enhance risk-ad- justed portfolio value only if two conditions are satisfied. First, the benefits of that path must be expected to exceed the costs—that is, net of fees and other costs, it must be expected that such stewardship will in fact lead to an increase in risk- adjusted portfolio value. Second, the expected net benefits of such stewardship must exceed the expected net benefits of pursuing alternative methods available to diversified inves- tors for causing portfolio firms to internalize intraportfolio ex- ternalities (unless the alternative(s) and the stewardship to- gether would be expected to produce more net benefits than the alternative(s) alone). As explored herein, four frictions render dubious an as- sumption that portfolio-focused stewardship would lead to an increase in risk-adjusted portfolio value. They are: (1) 18 No human investor is single-mindedly focused on financial returns; individuals have broader concerns based on their social, political, and reli- gious commitments. But whereas one can assume that all (or almost all) investors have an interest in increasing their risk-adjusted financial re- turns, one cannot assume homogeneity with respect to investors’ non-finan- cial concerns. See Sean J. Griffith, Opt-In Stewardship: Toward an Optimal Delegation of Mutual Fund Voting Authority, 98 TEX. L. REV. 983, 1009 (2020) (similarly explaining that the norm of shareholder wealth maximiza- tion “is often posited or assumed not because it is the highest and best thing for real-life shareholders but because it is the most that can be assumed about shareholders as a class,” operating as “a kind of lowest common de- nominator solution to their inability to coalesce around other objectives”). Hence, federal securities regulation has traditionally focused on the disclo- sure needs of a fictionalized financially driven “reasonable investor,” and managers of traditional index funds are understood to owe their fiduciary duties to such an investor. See Amanda M. Rose, The “Reasonable Investor” of Federal Securities Law: Insights from Tort Law’s “Reasonable Person” & Suggested Reforms, 43 J. CORP. L. 77, 88–92 (2017) (discussing other attrib- utes of the “reasonable investor”); Schanzenbach & Sitkoff, supra note 6 at 399–422 (discussing the fiduciary duties of asset managers). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 323 managerial agency costs; (2) intermediary agency costs; (3) imperfect information; and (4) market dynamism. Several re- cent scholarly works address one or more of these frictions.19 One contribution of this Article is to bring the insights of these works together within a comprehensive analytical framework focused on the ultimate question: under what circumstances, if any, would financially motivated diversified investors wish their asset managers to engage in portfolio-focused steward- ship? Another contribution is to surface insights developed in the law and economics and public choice literature relevant to government lawmaking designed to curb negative externali- ties. This rich body of scholarship sheds considerable light on the relative capacity of index fund managers to step into a comparable private lawmaking role and prove effective, but it has gone largely ignored in discussions of portfolio primacy theory.20 A further contribution is to lay out, in consideration of the second condition, the alternative means available to di- versified investors for reducing intraportfolio externalities— such as direct advocacy for legal change and interventions to 19 See, e.g., Tallarita, supra note 15; Dorothy S. Lund, Asset Managers as Regulators, 171 U. PA. L. REV. 77 (2023); Bernard S. Sharfman, Oppor- tunism in the Shareholder Voting and Engagement of the “Big Three” Invest- ment Advisers to Index Funds, 48 J. CORP. L. 463 (2023); Jill Fisch & Jeff Schwartz, Corporate Democracy and the Intermediary Voting Dilemma, 102 TEX. L. REV. 1, 31 (2023); Jeffrey Schwartz, Stewardship Theater, 100 WASH. U. L. REV. 393 (2022); Marcel Kahan & Edward B. Rock, Systemic Steward- ship with Tradeoffs, 48 J. CORP. L. 497 (2021); David H. Webber, Michal Barzuza & Quinn Curtis, Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance, 93 S. CAL. L. REV. 1243 (2020); Griffith, supra note 18; John D. Morley, Too Big to Be Activist, 92 S. CAL. L. REV. 1407 (2019). 20 One notable exception is Professor Dorothy Lund’s recent article As- set Managers as Regulators, which among other things analyzes the relative vulnerability of asset managers and public lawmakers to regulatory cap- ture. Lund, supra note 19, at 101–05. Asset Managers as Regulators also discusses other advantages and limitations of asset manager regulation as compared to public lawmaking (see id. at 133–44), but unlike this Article does not explore the relative capacity of asset managers to employ various legal instruments for forcing the internalization of externalities. See infra Section III.C. 324 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 reduce corporate influence in politics—and assess their rela- tive attractiveness. The analysis produces a set of criteria for evaluating spe- cific stewardship interventions, and it leads to some general conclusions about the types of portfolio-focused stewardship interventions that rational, financially motivated diversified investors would—and would not—be likely to support. The analysis suggests that these investors would not generally support portfolio-focused stewardship interventions by index fund managers designed to directly regulate portfolio compa- nies’ externalizing activities (“command and control regula- tion”), but that under certain conditions they might support stewardship interventions that force portfolio companies to disclose information about intraportfolio externalities (“dis- closure regulation”). Importantly, the analysis suggests that disclosure regulation would not be supported because it would assist index fund managers in crafting future command-and- control style portfolio-focused stewardship interventions, but rather because it might prod other actors (including, e.g., non- index investors, consumers, labor and environmental organi- zations, regulators, and legislators) to take actions that would lead portfolio firms to internalize their intraportfolio external- ities. The narrow band of portfolio-focused stewardship inter- ventions that this Article suggests financially motivated di- versified investors might rationally support has important im- plications. For example, it should assist index fund managers seeking to understand their fiduciary duties to fund investors, a topic that is currently under Congressional scrutiny.21 In short: index fund managers should not view themselves as possessing broad license to wield their influence over portfolio firms in a manner that purports to prioritize portfolio over firm value. 21 See Press Release, Bill Huizenga, Chairman, House Financial Ser- vices Subcommittee on Oversight and Investigations, Huizenga Opens In- quiry into How Asset Managers Fulfill Their Fiduciary Responsibility, (July 18, 2023), https://huizenga.house.gov/news/documentsingle.aspx?Docu- mentID=402668 [https://perma.cc/43VW-XEH5]. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 325 The Article’s analysis also has significant implications for the contemporary debate over SEC-imposed ESG disclosure mandates. The idea that disclosure of ESG information—if made more consistent and credible through SEC mandates— would assist index fund managers in future portfolio-focused stewardship efforts seems consistent with the materiality standard set forth by the Supreme Court in TSC Industries, Inc. v. Northway Inc.22 That case provides that information is material if there is “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”23 But, as just noted, the analysis herein suggests that financially motivated diversified investors would not ration- ally want their index fund managers to use the information in this way. Instead, they would view the information as poten- tially valuable only insofar as it might catalyze other actors to take actions that would result in portfolio firms’ internaliza- tion of intraportoflio externalities. To the extent such man- dates were expected to catalyze more informed trading by fi- nancially-motivated non-index investors, portfolio primacy theory would add nothing to the first two financial arguments for SEC-imposed ESG disclosure mandates discussed above. The upshot is that portfolio primacy theory potentially pro- vides an independent financial justification for SEC-imposed ESG disclosure mandates only if the SEC may mandate dis- closures designed for consumption by audiences other than fi- nancially motivated investors (assuming those audiences are expected to respond in ways that may lead to an increase in the risk-adjusted value of a diversified portfolio). This is a novel and expansive understanding of the SEC’s regulatory authority, one many—including the Court of Appeals for the D.C. Circuit—are likely to reject. The remainder of this Article proceeds as follows. Part II discusses the recent embrace of portfolio-focused stewardship by legal academics and lays out the idea’s premises. Part III interrogates whether, and under what circumstances, finan- cially motivated diversified investors might rationally expect 22 TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976). 23 Id. at 449. 326 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 portfolio-focused stewardship to lead to net gains in risk-ad- justed portfolio value. It develops criteria for evaluating whether specific stewardship interventions are of the sort that rational, financially motivated diversified investors might en- dorse, criteria that are then applied in Part IV to evaluate the recent stewardship efforts of the “Big Three” asset manag- ers.24 Part V turns to discuss alternative approaches available to such investors for forcing the internalization of intraportfo- lio externalities, commenting on their relative attractiveness. The Article concludes by remarking on the implications of the analysis for current debates over SEC-mandated ESG disclo- sures and the scope of index fund managers’ fiduciary duties. The conclusion also highlights implications of the analysis for recent proposals that index fund managers pass their funds’ voting rights through to fund investors. II. PORTFOLIO-FOCUSED STEWARDSHIP GAINS ACADEMIC ADHERENTS For decades before “ESG” was a household term, commen- tators hotly debated the purpose of a corporation. Should boards and managers run corporations to maximize firm value for the benefit of shareholders, or in service of broader social interests?25 Proponents of “corporate social responsibility” or “CSR” advocated for the latter, but their position has tradi- tionally been considered an outside view: the firm-value-max- imization perspective is firmly embedded both in Delaware law and management culture, and market-oriented corporate law scholars tend to find it normatively appealing.26 The rise 24 Bebchuk & Hirst, supra note 16. 25 For one of the early, foundational manifestations of this debate, see Adolf A. Berle, Jr., Corporate Powers as Powers in Trust, 44 HARV. L. REV. 1049 (1931); E. Merrick Dodd, Jr., For Whom Are Corporate Managers Trus- tees?, 45 HARV. L. REV. 1145 (1932); and Adolf A. Berle, Jr., For Whom Cor- porate Managers Are Trustees: A Note, 45 Harv. L. Rev. 1365 (1932). See also A. A. Sommer, Jr., Whom Should the Corporation Serve? The Berle- Dodd Debate Revisited Sixty Years Later, 16 DEL. J. CORP L. 33, 36–39 (1991) (tracing the history of this debate). 26 See Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439, 441 (2001) (observing that “as a No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 327 of “ESG” has rekindled this old debate, but in a muddied way. Some view “ESG” as simply a repackaging of “CSR,” a carry- ing forward of the same position under a new acronym.27 Oth- ers view “ESG” as not only different from “CSR,” but as fully consistent with a firm-value-maximization view of corporate purpose—corporations do well by paying heed to “ESG” is- sues.28 A third perspective has also emerged, one that touts “ESG” not as a substitute for CSR nor as a means for achieving firm value maximization, but rather as a means for diversified in- vestors to maximize portfolio value. Diversified investors can actualize on this potential, the argument goes, through the portfolio-focused stewardship efforts of their increasingly powerful asset managers, who can use their clout to force port- folio firms to internalize the costs their activities impose on one another, leading to more portfolio-level efficient behavior and increased risk-adjusted portfolio-level returns. Because it is based on the financial incentives of diversified investors, ra- ther than on more amorphous notions of the “social good,” this perspective seems less radical than the CSR perspective, and, consequence of both logic and experience, there is convergence on a consen- sus that the best means to [pursue] aggregate social welfare[] is to make corporate managers strongly accountable to shareholder interests and, at least in direct terms, only to those interests”); William W. Bratton & Mi- chael L. Wachter, Shareholder Primacy’s Corporatist Origins: Adolf Berle and The Modern Corporation, 34 J. CORP. L. 99, 100 (2008) (observing that “shareholder primacy prevails today as the dominant view,” and describing “advocates of corporate social responsibility (CSR) as a rearguard”). 27 See Pollman, supra note 2, at 24–25 (discussing this perspective). 28 This view, sometimes called “enlightened shareholder value,” has be- come more difficult to defend as the war in Ukraine, consumer backlash to corporate social initiatives, and rising interest rates have made the poten- tial cost to firms of “ESG” initiatives more readily apparent than they were just a few short years ago. See Lucian A. Bebchuk & Roberto Tallarita, The Illusory Promise of Stakeholder Governance, 106 CORNELL L. REV. 91, 97 (2020) (using the term “enlightened shareholder value” to describe the view that “corporate leaders should take into account stakeholder interests as a means to maximize shareholder value”). 328 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 as discussed below, it has recently captured the imagination of a growing cohort of corporate and securities law scholars.29 Madison Condon’s article Externalities and the Common Owner, published in 2020, sparked recent interest by legal ac- ademics in portfolio-focused stewardship.30 In that article, Professor Condon made a positive claim to explain institu- tional investor interest in climate-related stewardship—viz., that “institutional investors’ climate activism is motivated by their desire to mitigate climate change risks and damages to their economy-mirroring portfolios.”31 She argued that portfo- lio value maximization, not share value maximization, best explains institutional investor interventions with portfolio companies to achieve emission reductions, and detailed what those interventions have looked like.32 While subsequent works have cited her article to support normative arguments in favor of institutional investors engaging in this sort of stew- ardship activity, Professor Condon was careful not to reach normative conclusions herself, identifying several reasons why “common ownership internalization of negative external- ities” might not be socially desirable.33 29 Enthusiasm for portfolio-focused stewardship extends beyond the ivory tower. Organizations like the Shareholder Commons provide tools to asset managers to help them ensure that portfolio firms “prioritize their systemic impacts over individual company profit in order to protect portfolio values.” See System Stewardship Theory, S’HOLDER COMMONS, https://theshareholdercommons.com/resources-page/#tsc-and-system-stew- ardship [https://perma.cc/R79N-GVF7]. 30 Madison Condon, Externalities and the Common Owner, 95 WASH. L. REV. 1 (2020). For some earlier contributions by scholars in other disci- plines, see the articles discussed infra at note 42, as well as James Hawley & Andrew Williams, The Emergence of Universal Owners: Some Implica- tions of Institutional Equity Ownership, 43 CHALLENGE 43 (2000). 31 Condon, Externalities and the Common Owner, supra note 30, at 6. 32 Id. at 12, 19–26. 33 Id. at 65. But see Condon, Market Myopia’s Climate Bubble, supra note 12, at 125 (explaining that “large institutional shareholders should have a particular interest in how climate constitutes a systematic risk to their portfolios, as these unhedgeable risks cannot be diversified away,” and stating that they therefore “should” integrate climate risks into their stew- ardship efforts, including potentially by “taking a portfolio perspective and No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 329 John Coffee embraced the idea of portfolio-focused stew- ardship without the same level of hesitancy in his 2021 article The Future of Disclosure: ESG, Common Ownership, and Sys- tematic Risk.34 In that article, Professor Coffee observed that we may be “moving from a system of corporate governance that is premised on a ‘shareholder primacy model’ to a system that is premised on a ‘portfolio primacy model,’” where “our largest institutions [] knowingly accept, and even cause, losses at some firms in their portfolio if they expect that those losses will be outweighed by correlative gains at other portfolio firms.”35 “[A] possibility has arisen,” he writes, “that institu- tional activism may curb externalities and lead to a better (and not just more profitable) society” and that SEC disclosure mandates in service of portfolio-focused stewardship efforts could help “bring about significant social change.”36 In a sub- sequent article titled The Coming Shift in Shareholder Activ- ism: From ‘Firm-Specific’ To ‘Systematic Risk’ Proxy Cam- paigns (and How to Enable Them), he similarly asserts that “[i]f some companies are imposing negative externalities on the market [as a whole], it would be both rational and feasible for large index investors to seek to curb such conduct (at least when the gains from such efforts are expected to exceed the losses to the companies imposing such externalities).”37 He proceeds to discuss how such behavior can be encouraged, by identifying ways to stimulate proxy campaigns with such aims. Jeffrey Gordon has similarly argued that because a “diver- sified investment vehicle internalizes many of the externali- ties that firms may create,” “the portfolio managers have seeking direct mitigation of climate risk itself through pressuring compa- nies to reduce their emissions”). 34 Coffee, Jr., supra note 14. Coffee does note in passing that this phe- nomenon may work to the detriment of undiversified retail investors, prompt political backlash, and lead to anticompetitive effects. 35 Id. at 604–05. 36 Id. at 650. 37 John C. Coffee, Jr., The Coming Shift in Shareholder Activism: From “Firm-Specific” to “Systematic Risk” Proxy Campaigns (and How to Enable Them), 16 BROOK. J. CORP. FIN. & COM. L. 45, 50 (2021). 330 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 incentives to exercise corporate governance rights to mitigate them.”38 His 2022 article Systematic Stewardship advocates for a portfolio-focused stewardship approach, albeit one that “focuses not on increasing expected returns across the portfo- lio but on reducing systematic risk and, in this way, improving risk-adjusted portfolio returns.”39 Professor Gordon views such interventions as compatible with asset manager incen- tives because, if successful, they “will reduce the likelihood of events that could abruptly shrink portfolio values and thus reduce manager profits.”40 Such interventions, he believes, are best targeted at a subset of systematic risk, namely sys- temic risks like climate change risk, financial stability risk, and what he calls “social stability risk,” as the avoidance or mitigation of such risks would have a bigger impact on risk- adjusted portfolio returns than the avoidance or mitigation of non-systemic systematic risks. He identifies several forms these interventions might take, including the endorsement of shareholder proposals that call for “a modification in business conduct.”41 38 Jeffrey N. Gordon, Systematic Stewardship, 47 J. CORP. L. 627, 633 (2022). 39 Id. at 646–47. 40 Id. at 647–48. In earlier work with John Armour, Professor Gordon dismissed the potential for index fund managers to effectively address sys- temic risks through firm-level (as opposed to political) channels, due to their poor incentives. John Armour & Jeffrey N. Gordon, Systemic Harms and Shareholder Value, 6 J. LEGAL ANALYSIS 35, 60–61 (2014). 41 Gordon, Systematic Stewardship, supra note 38, at 660. Professors Luca Enriques & Alessandro Romano also endorse portfolio-focused stew- ardship, but only vis-à-vis certain “central” firms that play a large role in generating system-wide externalities; they believe firm-value maximizing shareholders should have greater influence than portfolio-value maximizing shareholders in other firms. See generally Luca Enriques & Alessandro Ro- mano, Rewiring Corporate Law for an Interconnected World, 64 ARIZ. L. REV. 51 (2022); see also Armour & Gordon, supra note 40 (generally endorsing the share value maximization norm but arguing that it should be relaxed in systemically important financial firms). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 331 III. IS PORTFOLIO-FOCUSED STEWARDSHIP LIKELY TO INCREASE PORTFOLIO VALUE? To assert that rational, financially motivated diversified investors want to maximize the value of their portfolios and are not independently concerned with the performance of any individual portfolio firm is tautological. The hard question is whether such investors would view portfolio-focused steward- ship as a desirable way to pursue portfolio value maximiza- tion. Under certain strict assumptions, they clearly would— namely, if portfolio firm managers did exactly what diversified investors’ asset managers asked them to do, those asset man- agers only asked portfolio firm managers to do what is portfo- lio value maximizing, and the whole endeavor were costless and the market static. Early economic proofs that diversified investors would prefer firm managers to manage with the aim of maximizing portfolio rather than firm value, cited by both Coffee and Condon in the articles discussed above, are explic- itly qualified by assumptions this strict.42 42 Professor Coffee asserts that the “idea that common ownership will lead rational investors in a common portfolio to seek to minimize externali- ties” probably originates in a 1996 article by economists Robert Hansen and John Lott. Coffee, Jr., supra note 14, at 646 n.122 (citing Robert Hansen & John Lott, Externalities and Corporate Objectives in a World with Diversi- fied/Shareholders/Consumers, 31 J. FIN. & QUANTITATIVE ANALYSIS 43 (1996)). He also cites to a paper by economist Roger H. Gordon, first pub- lished by the National Bureau of Economic Research in 1990. Id. (citing Roger H. Gordon, Do Publicly Traded Corporations Act in the Public Inter- est? (Nat’l Bureau of Econ. Research, Working Paper No. 3303, 1990)). Mad- ison Condon also cites to these two articles as support for the proposition that “[i]f a subset of firms in a portfolio impose costs on the broader portfolio through the generation of negative externalities, a portfolio-wide owner should be motivated to curtail those externalities at the source.” Condon, supra note 30, at 6 n.19. Both of the referenced papers offer mathematical models to prove, inter alia, that common owners would prefer firm manag- ers to pursue portfolio value maximization over share value maximization. Both of the models are highly stylized. One key assumption is that firm managers always act in the interests of common owners (assuming the lat- ter have voting control)—viz., that there are no managerial agency costs. See, e.g., Hansen & Lott, supra, at 45 (“[W]e will assume that firms are, in all cases, run by managers who act entirely in the interest of owners—that is, we ignore any agency problem between managers and owners.”); Gordon, 332 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 In the real world, of course, these assumptions are all false. Asset managers are not perfect agents to diversified investors, nor are portfolio firm managers. Asset managers cannot supra, at 5 (“I assume that the firm follows the preferences of the median shareholder, and ignore any possible agency problems.”). The authors also concede that, even under this assumption, their models work only if the market for corporate control is hindered, and diversified shareholders are prohibited from undiversifying. See, e.g., Gordon, supra, at 5 (“I assume that there are sufficiently many shareholders with the same preferences as that of the median shareholder that no single shareholder is in a position to change the firm’s behavior through changing his portfolio choices.”); cf. id. at 11 (relaxing this assumption). This is because “if shareholders are suc- cessful in maximizing portfolio value rather than firm value, corporate prof- its will decline,” creating “an incentive to become undiversified and acquire a controlling interest in the company, change its policies, and reap the gains of increased profits.” Hansen & Lott, supra, at 54. Hansen and Lott offer some potential solutions to this problematic aspect of their model, including if “citizens of a country have delegated investment decisions to large invest- ment institutions such as pension funds” that hold most of an economy’s firms, coupled with “restrictions that keep any one fund from being undi- versified,” or, alternatively, outright government ownership of the economy. Id. at 55–56. In suggesting these fixes, Hansen and Lott assume that the envisioned institutions or government overseers would act in the best inter- ests of common owners—that is, that intermediary agency costs are non- existent. Of course, if all investors were permanently diversified, stock price signals would no longer exist. Hansen and Lott do not address this, perhaps because if one assumes that firm managers and portfolio managers are per- fect agents of common owners (both perfectly loyal and perfectly competent), it does not matter. Roger Gordon, too, ignores the potential for agency costs at the intermediary level. Finally, both articles acknowledge that their mod- els prove not only that firm managers, faithful to common owners and under the other stated assumptions, would have efficiency-increasing incentives to take account of negative intraportfolio externalities, but also that they would have efficiency-reducing incentives to behave anticompetitively. See, e.g., Gordon, supra, at 22 (explaining that if firms were to take spillovers into account, “then collusion among existing firms would become much eas- ier since firms would not focus on how market shares are divided among the firms in the industry”). For an early economic model showing that firms, acting in the interest of their shareholders, tend to act collusively when their shareholders have diversified portfolios, see Julio Rotemberg, Finan- cial Transaction Costs and Industrial Performance (Mass. Inst. of Tech. Al- fred P. Sloan Sch. of Mgmt., 1984) https://dspace.mit.edu/bitstream/han- dle/1721.1/47993/financialtransac00rote.pdf [https://perma.cc/XWQ9- KEGD]. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 333 costlessly adopt and enforce internalization policies, and im- perfect information may lead them to make mistakes. Finally, the market is dynamic and may react in ways that undermine any potential portfolio-value enhancing effects of portfolio-fo- cused stewardship. Given these frictions, a rational, finan- cially-motivated diversified investor would doubt whether portfolio-focused stewardship interventions would lead to net gains in risk-adjusted portfolio value, and even worry that they could lead to portfolio losses. This, combined with the al- ternative paths available to diversified investors for dealing with intraportfolio externalities, discussed in Part V, may lead them to conclude that the best way to maximize portfolio value is to place extensive limits on portfolio-focused steward- ship, or perhaps to eschew it altogether. This Part elaborates on these frictions, which it groups un- der the headings (1) managerial agency costs; (2) intermedi- ary agency costs; (3) imperfect information; and (4) market dy- namism. First, it explains how the need to constrain managerial agency costs places important limitations on the types of portfolio-focused stewardship interventions that in- dex fund investors would want their fund managers to pursue. Second, it discusses intermediary agency costs, explaining how the conflicts of interest that exist between index fund managers and index fund investors place additional limita- tions on the types of portfolio-focused stewardship interven- tions that index fund investors would view as desirable. Third, it discusses informational barriers to the crafting of effective internalization policies, drawing on a rich body of public law scholarship focused on regulatory techniques for dealing with negative externalities. The discussion highlights the problems asset managers will face if they seek to serve as private regu- lators of their portfolio firms, including problems of legiti- macy. Finally, this Part comments on the transient nature of any gains that might be achieved through portfolio-focused stewardship given the existence of a competitive marketplace. A. Real World Friction #1: Managerial Agency Costs Left to their own devices, managers of public companies may place their own interests above those of investors. They 334 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 may divert firm value to themselves, act less prudently in their management of the enterprise than they would in the conduct of their own affairs, and avoid risks that investors would want them to take.43 These “agency costs” reduce firm value,44 and when multiplied across a broad portfolio can sub- stantially reduce its overall value. It is therefore rational for diversified investors to take steps to prevent these losses, if the steps cost less than the expected savings. Direct monitor- ing of firm managers is one option, but information deficits and collective action problems make it uneconomical for diver- sified investors to directly police firm managers’ behavior on a systematic basis.45 While the largest index funds own enough shares in their portfolio companies to make some in- vestment in direct monitoring rational, lingering information deficits and collective action problems, as well as the interme- diary agency costs discussed in the next part, mean that index fund managers cannot be relied upon to systematically moni- tor the behavior of portfolio firm managers either. Luckily, a variety of other, more cost effective, techniques exist for constraining managerial agency costs. One of the most powerful is incentive-alignment through compensation structures tied to firm value.46 Such structures push manag- ers to focus on the task of increasing firm value without the need for continual investor oversight of management deci- sions.47 Other important techniques, such as fiduciary duties 43 Amanda M. Rose, Cutting Class Action Agency Costs: Lessons from the Public Company, 54 U.C. DAVIS L. REV. 337, 350–52 (2020). 44 Michael C. Jensen & William H. Meckling, Theory of the Firm: Man- agerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976). 45 Rose, supra note 43, at 350. 46 See, e.g., Michael C. Jensen & Kevin J. Murphy, CEO Incentives–It’s Not How Much You Pay, But How, HARV. BUS. REV. May–June 1990 (dis- cussing this technique). 47 Stock-option based compensation can also help to align firm manag- ers’ risk preferences with those of diversified shareholders. See David M. Schizer, Executives and Hedging: The Fragile Legal Foundation of Incentive Compatibility, 100 COLUM. L. REV. 440, 453 (2000) (explaining that stock options “increase an executive’s appetite for risk, an effect that diversified No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 335 owed to the firm’s residual claimants (coupled with a judicial assumption that such claimants want to maximize firm value), the market for corporate control, and hedge fund activ- ism, serve a similar function.48 To be sure, these techniques also create incentives for managers to externalize costs onto other firms, and onto society more broadly, so as to increase firm value at others’ expense.49 Social and ethical norms will constrain such behavior, but only to an extent. Corporate law scholars have traditionally treated this as a problem best managed by substantive laws external to corporate law, which should—within their relevant subject matter area—force firms to internalize the externalities they produce.50 But ex- ternal laws, along with social and ethical norms, may fail to force the internalization of all firm externalities—hence the problem that portfolio-focused stewardship is designed to solve (albeit on behalf of diversified investors, not society at large51). Excitement over the fact that diversified investors self-in- ternalize many public company externalities sometimes leads to a forgetfulness about managerial agency costs. But if it were not for managerial agency costs and the techniques that have been adopted to mitigate them, laws designed to prevent firms from imposing uncompensated costs on other portfolio shareholders value because they are otherwise more risk-tolerant than un- diversified managers”). 48 For an overview of the techniques used to constrain agency costs in U.S. public companies, see Rose, supra note 43, at 363–80. 49 Armour & Gordon, supra note 40, at 37. 50 This, at least, has been the dominant view since shareholderism overtook managerialism as the dominant corporate governance ideology. See Kahan & Rock, supra note 3 (charting this history). 51 It is important not to conflate the idea of portfolio primacy with stakeholder primacy. As Professor Coffee has explained, the latter “has been supported by many commentators who want boards and managers to bal- ance the interests of other stakeholders in the corporation with those of shareholders,” but a “focus on maximizing the value of the portfolio is quite different from a focus on sustainability or wealth transfers to stakeholders (even though the two perspectives may overlap).” Coffee, Jr., supra note 14, at 604 n.2. Cf. Ann M. Lipton, Not Everything Is About Investors: The Case for Mandatory Stakeholder Disclosure, 37 YALE J. ON REGUL. 499 (2020) (cri- tiquing the tendency to treat investors as a proxy for broader society). 336 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 firms would be unnecessary, as would portfolio-focused stew- ardship efforts to supplement those laws. Managers would simply do what diversified investors want—i.e., act to maxim- ize portfolio value—without the need for prodding by lawyers, regulators, or asset managers.52 Investors obviously cannot trust firm managers to behave so virtuously. Nothing about the trend of investor diversification has changed the nature of firm managers; if left to their own devices, they are as likely to act selfishly or carelessly as they ever were.53 And not even the strongest proponents of portfolio primacy theory suggest that assets managers for diversified investors can now be counted on to directly monitor managerial performance in any systematic way. There therefore remains a need to tie mana- gerial fortunes to firm-specific performance.54 Two important points follow from this as it concerns portfolio-focused stew- ardship. First, rational, financially motivated diversified investors would not favor portfolio-focused stewardship interventions that generally reduce firm managers’ sensitivity to firm value in the hope that managers will use the breathing room to 52 When portfolio companies sue one another, they create intraportfolio externalities; if managerial agency costs did not exist, financially motivated diversified investors would want to prohibit such lawsuits. See Hansen & Lott, supra note 42, at 47 (explaining that because damage awards would be mere pocket-shifting, “diversified owners would [only be] concerned about the ‘leakage’ going to lawyers (who are not part of publicly owned firms)”). In work that pre-dates the recent academic interest in portfolio pri- macy theory, Professor Richard Squire and I explained that in a world with managerial agency costs, intraportfolio litigation is (under certain circum- stances at least) consistent with the pursuit of portfolio value maximization, because it attributes portfolio-level costs to the firms of responsible corpo- rate managers, making it easier for diversified shareholders to evaluate and motivate their agents. See generally Amanda M. Rose & Richard Squire, Intraportfolio Litigation, 105 NW. L. REV. 1679 (2011). 53 This is true even if the insider-shareholder dynamic has become more collaborative than competitive in recent years. See Jill E. Fisch & Simone M. Sepe, Shareholder Collaboration, 98 TEXAS L. REV. 863 (2020). 54 Tying executive compensation to portfolio performance is not a viable alternative way to motivate portfolio firm managers to work hard and self- lessly, given that they have little capacity to influence overall portfolio value. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 337 prioritize portfolio over firm value. This includes interven- tions that would insulate firm managers from the market for corporate control or hedge fund activism, as well as those that would weaken the link between executive compensation and firm performance.55 While interventions that generally reduce firm managers’ sensitivity to firm value would mitigate incen- tives managers have to exploit gaps in the law to externalize costs onto other portfolio firms, they would also erode manag- ers’ incentives to work hard and honestly to increase firm value, thus risking more profound losses to portfolio value.56 Second, and following from that, to be effective portfolio- focused stewardship interventions need to be crafted with the firm-focused incentives corporate managers face in mind. Given these incentives, vague portfolio-focused stewardship policies that leave discretion in the hands of firm managers 55 Financially motivated diversified investors would always prefer more targeted interventions, meeting the criteria discussed infra, to address intraportfolio externalities over a general relaxation of firm-focused incen- tives coupled with a hope that firm managers will respond in ways that align with their preferences (as opposed to the managers’ own). Such tar- geted interventions could involve changes to compensation structure—for example, bonus payments for meeting verifiable emissions-reduction tar- gets, or tilting executive pay at systemically important financial firms to- ward restricted stock rather than options as a way to calibrate incentives toward risk taking—although targeted interventions may be undesirable for other reasons discussed infra. 56 This is not to suggest that financially motivated diversified investors cannot disagree about the best way to calibrate firm managers’ sensitivity to firm value. For example, commentators have debated the optimal holding periods for stock-based compensation. See, e.g., Lucian Bebchuk & Jesse Fried, Paying for Long-Term Performance, 158 U. PA. L. REV. 1915 (2010); Sanjai Bhagat & Roberta Romano, Reforming Financial Executives’ Com- pensation for the Long Term, in RESEARCH HANDBOOK ON EXECUTIVE PAY (Randall Thomas & Jennifer Hill eds., 2014). But even if financially moti- vated diversified investors might favor adjustments to incentive compensa- tion or other governance structures to mitigate perceived managerial “short termism” or other deficiencies in particular structures’ design, this is fully consistent with a commitment to tethering managerial incentives to indi- vidual firm value. See Mark J. Roe, Social Costs from Stock-Market-Driven Corporate Short-Termism?, in MISSING THE TARGET (2022) 52, 56 (explain- ing the distinction between corporate short-termism and corporate exter- nalities). 338 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 are unlikely to be effective, as are interventions that call on managers to take actions that cannot effectively be monitored. To be successful, portfolio-focused stewardship policies need to be specific regarding the actions or outcomes demanded of firm managers, and asset managers need to be capable of ob- serving and judging compliance.57 This requirement of specificity and enforceability intro- duces distinct complications, however. In their article Sys- temic Stewardship with Tradeoffs, Professors Marcel Kahan and Edward Rock describe the “deep architecture” of corpo- rate law that operates to focus firm managers on firm value, including legally enforceable fiduciary duties.58 They warn that firm managers who acquiesce to asset manager demands to take specific actions that involve a sacrifice of firm value for the benefit of a broader portfolio expose themselves to poten- tial liability. How big a risk this presents can be debated,59 but there is at least some universe of potential portfolio-fo- cused stewardship interventions that firm managers might reject due to litigation risk, and the more specific—and hence potentially effective—the policy being pushed, the more push- back due to litigation risk can be expected. Moreover, to the extent that managerial acquiescence to a portfolio-focused stewardship intervention does produce litigation risk, it is a cost that diversified investors will ultimately bear, at least partially, reducing any portfolio level gains the intervention is expected to produce. Again, the more specific and hence po- tentially effective the intervention, the higher these offsetting costs. (Notably, corporate law cuts through this Gordian Knot vis-à-vis legal obligations imposed on the corporation by inter- preting fiduciary duties to require legal obedience.60) 57 See Lucian A. Bebchuk & Roberto Tallarita, The Perils and Question- able Promise of ESG-Based Compensation, 48 J. CORP. L. 37, 66–68 (2022) (making a similar point regarding ESG performance metrics). 58 Kahan & Rock, supra note 19, at 508–09. 59 See Coffee, Jr., supra note 37, at 65–67; Jeffrey N. Gordon, System- atic Stewardship: It’s Up to the Shareholders—A Response to Profs. Kahan and Rock, 48 J. CORP. L. 26 (2023). 60 See, e.g., Elizabeth Pollman, Corporate Oversight and Disobedience, 72 VAND. L. REV. 2013, 2018 (2019) (explaining that state corporate law No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 339 The requirement of specificity and enforceability also in- teracts in problematic ways with the other frictions discussed infra. For example, the more specific and enforceable the port- folio-focused stewardship intervention, the more personally costly asset managers will view the intervention because it will make it harder for them to deflect rising antitrust con- cerns about their common ownership positions.61 To the ex- tent that they manage other funds with different portfolios, heightened specificity also increases risks to their business model and, if they vote as a fund family, their fiduciary liabil- ity risk.62 For these reasons, intermediary agency costs may discourage asset managers from designing effective interven- tions. The dynamic nature of the market might also hobble effective interventions because firms that acquiesce to specific firm value-reducing initiatives may find themselves more imposes fiduciary duties on directors “that prohibit them from acting with the intention of violating the law”). 61 The “common ownership hypothesis, which suggests that when large investors own shares in many firms within the same industry, those firms have an incentive to soften competition by producing fewer units, raising prices, reducing investment, innovating less, or limiting entry into new mar- kets,” MATTHEW BACKUS, CHRISTOPHER CONLON & MICHAEL SINKINSON, THE COMMON OWNERSHIP HYPOTHESIS: THEORY AND EVIDENCE 1 (2019), https://www.brookings.edu/wp-content/up- loads/2019/02/ES_20190205_Common-Ownership.pdf [https://perma.cc/543A-KRKR], has in recent years captured the attention of not only antitrust scholars, see generally id. (surveying the growing em- pirical literature on this topic), but also of media and politicians. Rose, supra note 2, at 1824 n.12. Prominent legal scholars and economists have sug- gested policy responses in light of these concerns—reforms that would sig- nificantly and detrimentally impact the fortunes of the Big Three. See, e.g., Einer Elhauge, Horizontal Shareholding, 129 HARV. L. REV. 1267 (2016); Fiona Scott Morton & Herbert Hovenkamp, Horizontal Shareholding and Antitrust Policy, 127 YALE L.J. 2026 (2018); Eric A. Posner, Fiona Scott Mor- ton & E. Glen Weyl, A Proposal to Limit the Anti-Competitive Power of In- stitutional Investors, 81 ANTITRUST L.J. 669 (2017). For broader concerns regarding the concentration of power in the hands of the leaders of index fund managers, see John C. Coates, The Future of Corporate Governance Part I: The Problem of Twelve (Harvard Pub. L. Working Paper No. 19-07, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247337 [https://perma.cc/35UC-CWD5]. 62 See infra note 99 and accompanying text. 340 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 exposed to a takeover or activist hedge fund campaign.63 The cost of deflecting such campaigns would be borne by diversi- fied investors and thus would erode the benefits of the inter- vention, and if such campaigns were successful those benefits would prove short-lived. Firm managers might also take preemptory actions in response to these threats—such as by going private or selling assets—that could erase the benefits (and even result in losses) to risk-adjusted portfolio value. B. Real World Friction #2: Intermediary Agency Costs Like portfolio firm managers vis-à-vis their firm and its shareholders, an index fund manager is an agent who may prioritize its own interests over those of the fund it manages and the fund’s investors. But index fund managers are im- mune from many of the techniques used to mitigate manage- rial agency costs at portfolio companies64: index fund manag- ers’ pay is not strongly linked to performance,65 nor are index fund managers subject to the pressures of the market for 63 See infra Section III.D. 64 John C. Coffee, Jr., Liquidity Versus Control: The Institutional In- vestor as Corporate Monitor, 91 COLUM. L. REV. 1277, 1283 (1991) (explain- ing that traditional mechanisms of corporate accountability are not gener- ally available to constrain institutional intermediaries). 65 Index fund managers earn fees calculated as a percentage of assets under management (“AUM”). They can therefore increase their fee income by increasing AUM, either by selling more shares in the fund or by taking steps that cause portfolio companies to increase their value. The first tech- nique does not inure to the benefit of fund investors (unless it allows the fund to realize economies of scale that lower per share costs); the second does, but because fees are extremely low the incentive for index fund man- agers to engage in such efforts is very weak. See Coates, supra note 61, at 15 (“[I]t would take large increases in shareholder value at a given portfolio company for an action by an index provider to result in significant gains to that provider’s fee income.”). The Investment Advisers Act prohibits stronger forms of incentive compensation, with narrow exceptions that are not utilized by index fund managers. See 15 U.S.C. § 80b-5; 17 C.F.R. §§ 275.205-1 to -3. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 341 corporate control or hedge fund activism.66 They stand little chance of being fired or successfully sued.67 The way fund managers’ incentives deviate from the funds they manage has been well chronicled.68 To oversimplify69: in- dex fund managers bear the full cost of their stewardship 66 Mutual fund shares are priced based on the net asset value (“NAV”) of the fund’s holdings and are thus are not sensitive to fund manager per- formance. See, e.g., John Morley & Quinn Curtis, Taking Exit Rights Seri- ously: Why Governance and Fee Litigation Don’t Work in Mutual Funds, 120 YALE L.J. 84, 89 (2010). Fund outflows can, however, discipline managers by shrinking AUM and hence management fees. 67 See generally id. (arguing that fund investors’ exit right almost com- pletely eliminates any incentive to use voting or litigation to discipline fund managers); see also Fisch & Schwartz, supra note 19, at 30 (observing that mutual fund managers’ fiduciary duty to fund investors “at this point is toothless”: “To our knowledge, there has not been a successful claim that institutional investors have [breached their duty] when voting shares in their portfolio companies”). 68 I provide only a brief summary here. For more detailed examina- tions, see Lucian A. Bebchuk et al., The Agency Problems of Institutional Investors, 31 J. ECON. PERSP. 89 (2017); Dorothy S. Lund, The Case Against Passive Shareholder Voting, 43 J. CORP. L. 493 (2018); Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16. 69 Not all index fund managers are identical, and differences in their clientele and ownership structure (among other things) will influence the nature and severity of the conflicts of interest they face. See generally Dor- othy Lund & Adriana Robertson, Giant Asset Managers, the Big Three, and Index Investing (USC Gould Sch. of L. Ctr. for L. & Soc. Sci., Research Paper Series No. 23-13, 2023), https://ssrn.com/abstract=4406204 [https://perma.cc/WAK5-RWER]. Among the “Big Three,” for example, Van- guard is uniquely owned by its funds, rather than by a separate set of in- vestors (by contrast, Blackrock is publicly traded, as is State Street’s parent company). Id. at 12. Therefore, the interests of Vanguard’s owners and its funds are better aligned. While nothing causal can be established, it is in- teresting to note that among the Big Three, Vanguard has reportedly been the least supportive of ESG initiatives. See Hannah Zhang, Stop Lumping the ‘Big Three’ Asset Managers Together, Academics Say, INSTITUTIONAL INV. (June 26, 2023), https://www.institutionalinvestor.com/arti- cle/2btxellkcqh4xzqlt8c1s/corner-office/stop-lumping-the-big-three-asset- managers-together-academics-say [https://perma.cc/RU28-8NEY] (“Accord- ing to Lindsey Stewart, director of investment stewardship research on Morningstar’s global manager research team, in the trailing 24 months end- ing March 31, BlackRock and State Street Global Advisors supported twice as many key ESG resolutions as Vanguard did.”). 342 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 efforts but typically stand to capture only a small fraction of the benefit;70 competitive pressures push index fund manag- ers to keep costs low and create few incentives to engage in stewardship; 71 fund managers may privately benefit from friendly relations with portfolio firm managers (who can di- rect corporate 401(k) business their way)72 and may face con- flicts of interests due to their management of other funds with different portfolios.73 As just alluded to, they also risk incur- ring private costs if they attempt to wield significant influence over portfolio companies—not just antitrust scrutiny,74 but also special burdens that corporate and securities laws impose on those who exercise control.75 In addition, index fund man- agers are themselves firms, giving rise to the possibility that their personnel may act in ways that do not align with the interests of the fund manager or the managed fund and its investors. If index fund managers were only tasked with maintaining an index-mirroring portfolio, the risk of residual agency costs would be very low: a fund manager’s job would be easy and there would be almost no discretion to abuse. But index fund managers are expected to vote their funds’ shares.76 When in- dexing began growing in popularity, a hope emerged that this 70 Bebchuk & Hirst, Index Funds and the Future of Corporate Govern- ance, supra note 16, at 2052–56. 71 See Schwartz, supra note 19, at 417–18 (“For index funds, there is no hope for competitive advantage through stewardship” because they “own the same firms in the same proportion as other index funds [and thus] can- not outcompete other index funds by improving the performance of their portfolio firms.”). 72 Bebchuk & Hirst, Index Funds and the Future of Corporate Govern- ance, supra note 16, at 2062–65. 73 See, e.g., Morley, supra note 19 (exploring such conflicts); Sean J. Griffith & Dorothy S. Lund, Conflicted Mutual Fund Voting in Corporate Law, 99 B.U. L. REV. 1151 (2019) (same). 74 See supra note 61. 75 See, e.g., Kahan & Rock, supra note 19, at 517–19; Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16, at 2065–66. 76 See Griffith, supra note 18, at 992 (discussing the delegation of mu- tual fund voting authority to fund managers). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 343 reconcentration of share ownership and voting power might lead to greater monitoring of public company managers and a reduction in managerial agency costs. When patterns of pas- sivity and deference to management emerged instead, many blamed the misaligned incentives of fund managers discussed above.77 This led the SEC in 2003 to adopt rules requiring as- set managers to “adopt and implement policies and proce- dures for voting proxies in the best interest of clients.”78 The SEC also emphasized that asset managers have a fiduciary duty to vote shares in the best interest of fund shareholders and implemented annual fund voting disclosure require- ments.79 Asset managers initially attempted to satisfy these obligations by soliciting voting advice from proxy advisory firms, and when proxy advisory firms began drawing regula- tory scrutiny they augmented their in-house stewardship teams.80 But the incentive and capacity of index funds to vote intelligently on the thousands of matters put up for a vote at their portfolio companies each year remains doubtful.81 Some view the SEC’s efforts to induce voting by index fund managers as fundamentally misguided. Professor Dorothy Lund, for example, has taken the view that index fund man- agers’ incentives to engage in informed voting are so poor that index funds should be stripped of their voting rights alto- gether, or alternatively that index fund votes on non-routine matters should pass through to fund shareholders rather than be exercised by fund managers.82 She warns that index fund managers are “likely to adhere to low-cost voting strategies, 77 See generally Rose, supra note 43, at 355–58. 78 Proxy Voting by Investment Advisors, 68 Fed. Reg. 6585, 6586 (Feb. 7, 2003). 79 Schwartz, supra note 19, at 422. The Department of Labor had ear- lier “made clear that advisers to private pension plans owe a fiduciary duty to vote shares in portfolio firms in the best interests of pension fund partic- ipants.” Fisch & Schwartz, supra note 19, at 14 & n.57. 80 Schwartz, supra note 19, at 422–23. 81 See Sharfman, supra note 19 at 472–73 (explaining that BlackRock casts tens of thousands of votes each year at almost all of the approximately 4,000 U.S. public companies despite having a global stewardship team of 45 people, only 21 of whom are based in the United States). 82 Lund, supra note 68, at 528–31. 344 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 such as following a proxy advisor’s recommendation or voting ‘yes’ to any shareholder proposal that meets pre-defined qual- ifications,” leading to the “proliferation of an unthinking, one- size-fits-all approach to governance [that] will make many companies worse off.”83 She further warns that uninformed voting by index fund managers may determine the outcome, or contours, of hedge fund activism, undermining its effective- ness as a constraint on managerial agency costs.84 Other scholars recognize index fund managers’ problem- atic incentives, but nevertheless see some limited potential for those managers to help monitor portfolio firms and hence con- strain managerial agency costs. For example, Professor Ber- nard Black has observed that because “many process and structural issues arise in similar form at many companies,” becoming informed with respect to how to vote on such issues may therefore be rational for fund managers because econo- mies of scale can be achieved by supporting implementation of preferred policies across the portfolio.85 In the wake of the 83 Id. at 495. 84 Id. at 520–23. 85 Bernard S. Black, Agents Watching Agents: The Promise of Institu- tional Investor Voice, 39 UCLA L. REV. 811, 822 (1992); see also Marcel Ka- han & Edward Rock, Index Funds and Corporate Governance: Let Share- holders Be Shareholders, 100 B.U. L. REV. 1771, 1776 (2020) (agreeing that index fund advisers are not well positioned to identify company-specific per- formance problems, but arguing that their incentives to vote intelligently on the small number of votes per year that are potentially consequential, to develop proper guidelines for voting on market-wide governance standards, and to engage on company-specific governance deficiencies are superior to most other institutional investors); Luca Enriques & Alessandro Romano, Institutional Investor Voting Behavior: A Network Theory Perspective, 2019 U. ILL. L. REV. 223 (using network theory to argue that asset managers have better motivations to become informed about portfolio companies than standard accounts predict); Jill Fisch. Asaf Hamdani & Steven Davidoff Sol- omon, The New Titans of Wall Street: A Theoretical Framework for Passive Investors, 168 U. PA. L. REV. 17, 32 (2019) (arguing that index fund manag- ers, especially the largest, have incentives to engage in stewardship in order to compete with managers of active funds, while conceding that they may face suboptimal incentives to do so); cf. Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16, at 2058–59 (critiquing Fisch et al.’s argument); J.B. Heaton, Where the Fisch, Hamdani, and Da- vidoff Solomon Theory of Passive Investors Goes Awry, CLS BLUE SKY BLOG No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 345 SEC’s 2003 reforms, institutional investors did begin voting systematically in favor of corporate governance reforms thought to reduce managerial agency costs, such as the des- taggering of boards and the elimination of plurality voting rules for director elections.86 Whether these represent thoughtful interventions or examples of the unthinking, one- size-fits all approach that Professor Lund warns of is a matter of debate.87 Empirical evidence on their value to investors is inconclusive.88 Professors Ronald Gilson and Jeffrey Gordon also point to a symbiotic relationship that may exist between mutual fund managers and activists hedge funds. Whereas the former do not have sufficient incentives to identify firm specific perfor- mance issues and advocate for change, the latter do given, in- ter alia, the more concentrated positions they take in portfolio firms and the compensation structure which motivates their managers. Mutual fund managers, their argument proceeds, may have sufficient incentives to vote intelligently on the (July 25, 2018), https://clsbluesky.law.columbia.edu/2018/07/25/where-the- fisch-hamdani-and-davidoff-solomon-theory-of-passive-investors-goes- awry/ [https://perma.cc/643G-DL6A]. Professors Lucian Bebchuk and Scott Hirst critique index fund managers for being too passive in corporate gov- ernance and propose a variety of reforms meant to improve fund managers’ efforts at policing managerial agency costs, such as mandated investments in stewardship and enhanced disclosure about engagement efforts with portfolio firms. See generally Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16. 86 See Bebchuk & Hirst, Index Funds and the Future of Corporate Gov- ernance, supra note 16, at 2102 (discussing Big Three support for share- holder proposals calling for governance changes). 87 See, e.g., Paul Rose, The Corporate Governance Industry, 32 J. CORP. L. 887, 892 (2007) (warning of the ill effects of pressuring public companies “to adopt a homogenized set of governance rules which may be ill-suited to the companies’ respective situations”); K.J. Martijn Cremers, Lubomir P. Litov & Simone M. Sepe, Staggered Boards and Long-Term Firm Value, Re- visited, 126 J. FIN. ECON. 422, 424 (2017) (observing that the “heterogeneous relation of board structure with performance . . . indicates that a one-size- fits-all view of board structure is not supported by the data”). 88 See Fisch & Schwartz, supra note 19, at 21 & n.105 (discussing this evidence). 346 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 matters teed up by activists, even if they lack adequate incen- tives to develop and pursue the interventions on their own.89 What does all of this mean for portfolio-focused steward- ship? At the outset, it challenges advocates to explain why in- dex fund managers would incur costs to achieve intraportfolio internalization of externalities, given their perverse incen- tives for passivity and managerial deference. Notably, judging whether certain corporate governance features are likely (at least on average) to increase firm value, or whether an activist hedge fund’s plan for a particular company is better than the plan of the firm’s managers, will typically be far easier than crafting or judging internalization policies that will govern an index fund’s entire portfolio, the complexities of which are dis- cussed in Section III.C. Moreover, the stakes to portfolio value of getting those answers wrong would seem to be far less than with respect to portfolio-focused stewardship interventions that induce portfolio-wide changes in operational business practice. Yet even with respect to these traditional efforts, in- dex funds have staunch critics. Why then should we expect them to take up the mantle of portfolio-focused stewardship and, more importantly, do it well? Professors Gordon and Coffee partially address this ques- tion. Professor Gordon, for example, acknowledges that index fund managers’ incentives generally bias them toward passiv- ity but argues that some portfolio-focused stewardship inter- ventions could be “incentive compatible” because of their ex- pected impact on risk-adjusted portfolio value.90 In other words, some interventions may be expected to increase the in- dex fund manager’s compensation by increasing the value of assets under management enough to make the costs of pursu- ing the intervention rational.91 He also points out that just as the work of activist hedge funds lowers the cost to index fund managers of firm-focused stewardship interventions, so too can the work of ESG activists when it comes to portfolio- 89 Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 COLUM. L. REV. 863, 896–902 (2013). 90 Gordon, supra note 38, at 647–48. 91 See supra note 65. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 347 focused stewardship interventions.92 Professor Coffee also points to investor coalitions as a way for index fund managers to overcome collective action problems.93 The foregoing logic is sound, but how often in practice will the increase in compensation expected by virtue of a steward- ship intervention’s impact on portfolio value outweigh the pri- vate costs fund managers would incur to pursue it? There are reasons to doubt that ESG activists will be as helpful in pro- ducing useful information for index fund managers confronted with a decision on a portfolio-focused stewardship matter as activist hedge funds are with respect to decisions on firm spe- cific performance issues. Socially motivated ESG activists can be expected to advocate for stewardship policies that advance their vision of what is in the social interest, but what (in the activist’s view) is in the social interest may conflict with what is portfolio-value maximizing.94 ESG activists seeking to court index fund support will portray their preferred interventions as portfolio-value maximizing, but index fund managers faith- ful to the notion of portfolio-value maximization would place little stock in their representations. Activist hedge funds, by contrast, take actions that they hope will increase a targeted firm’s value, something that is naturally aligned with the in- terests of financially motivated diversified investors. To be sure, activist hedge funds have been accused of advocating for changes that destroy long-term firm value in pursuit of short- term price effects,95 but it should be far easier for index fund managers to assess whether a hedge fund’s strategy is likely to produce lasting positive effects on firm value than it is to determine the effects of a portfolio-focused stewardship 92 Gordon, supra note 38, at 660. 93 Coffee, Jr., supra note 37, at 62–63; see also Gordon, supra note 38, at 665. 94 See, e.g., Tallarita, supra note 15, at 537 (cataloguing how index funds—which are heavily weighted toward American public companies— internalize only a small fraction of climate externalities and are likely to prefer climate mitigation strategies that are privately efficient for large companies over those that are socially efficient). 95 See, e.g., Leo E. Strine, Jr., Who Bleeds When the Wolves Bite?: A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Cor- porate Governance System, 126 YALE L.J. 1870, 1873 (2017). 348 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 intervention on portfolio value.96 Moreover, index fund man- agers’ willingness to turn to investor coalitions for help may be inhibited by concerns about antitrust scrutiny. Indeed, in the wake of such scrutiny, Vanguard recently withdrew from the Net Zero Asset Managers initiative.97 It is also the case that index fund managers simultane- ously manage other portfolios, often voting as a fund family.98 As Professors Kahan and Rock have observed, “a business model that prioritized the interests of index fund investors over other funds would likely doom those other funds, as com- petitors would offer competing products that pledged loyalty to fund investors.”99 This represents an additional private cost to index fund managers of pursuing portfolio-focused steward- ship, further biasing them toward passivity. Finally, interventions that would have the sort of signifi- cant impact on portfolio value that Gordon and Coffee envi- sion, if crafted poorly, could also significantly damage portfo- lio value, and even introduce new systematic risks. Consider, for example, what more aggressive interventions regarding fossil fuels might have meant for global stability in the wake 96 See infra Section III.C (discussing the information needed to evalu- ate such effects). 97 Mark Segal, Republican AGs Warn Asset Managers that ESG Invest- ing Risks Fiduciary, Antitrust Violations, ESG TODAY (Apr. 3, 2023), https://www.esgtoday.com/republican-ags-warn-asset-managers-that-esg- investing-risks-fiduciary-antitrust-violations [https://perma.cc/9JSH- ZPJU] (reporting on these developments); see also Amelia Miazad, From Zero-Sum to Net-Zero Antitrust, 56 U.C. DAVIS L. REV. 2067 (2023) (describ- ing the recent antitrust scrutiny and arguing that antitrust law should ac- commodate investor alliances focused on reducing systematic risks to the economy). 98 See Ann Lipton, Family Loyalty: Mutual Fund Voting and Fiduciary Obligation, 19 TENN. J. BUS. L. 175 (2017). 99 Kahan & Rock, supra note 19, at 521; see also Tallarita, supra note 15, at 565 (explaining that if “the Big Three overtly pressured energy com- panies to engage in value-decreasing strategies for the benefit of other com- panies, it is very likely that investors in their energy-focused funds would flee (and perhaps even take legal action),” and observing that mutual funds shareholders’ strong exit rights and the desire of investment managers to attract new investors force fund managers to pay careful attention to con- flict-of-interest issues). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 349 of Russia’s invasion of the Ukraine. Professors Gordon and Coffee seem to assume that asset managers will always get their portfolio-focused stewardship interventions right, but asset managers would rationally recognize that they might not and discount the potential benefits accordingly. But even if Professors Gordon and Coffee are correct that some set of portfolio-value enhancing stewardship interven- tions exist in the real world that are compatible with fund managers’ incentives, it is also the case that portfolio-value decreasing stewardship interventions may exist that are like- wise compatible with fund managers’ incentives—because they produce more private benefits than they decrease man- agement fees. This is a point that is too often missed in dis- cussions of portfolio-focused stewardship.100 The attenuated relationship between index fund manager compensation and portfolio value means not only that expected portfolio gains must be sufficiently significant to motivate index fund man- agers to incur private costs to achieve them, it also means that expected portfolio losses must be sufficiently significant to mo- tivate index fund managers to forego using their funds’ gov- ernance powers when doing so would allow them to reap pri- vate benefits. A variety of selfish incentives have been identified that might lead index fund managers to engage in stewardship related to ESG matters under a false banner of increasing risk-adjusted portfolio value. For example, embracing the ESG movement may help in- dex fund managers curry political favor, enabling them to fend off greater regulation of the industry at a time when the Big 100 But see Jesse M. Fried, Will Nasdaq’s Diversity Rules Harm Inves- tors?, 12 HARV. BUS. L. REV. ONLINE art. 1, 2021, at 8 (2021) (observing that “an index fund operator will benefit from engaging in activism that sacri- fices 1% of aggregate portfolio company value but attracts 2% more in man- aged assets”); Sharfman, supra note 19, at 488 (explaining that “an expected small positive movement in market share will, in terms of AUM, overwhelm any expected loss in the value of an index fund or family of funds,” and providing a numeric example); cf. C. Scott Hemphill & Marcel Kahan, The Strategies of Anticompetitive Common Ownership, 129 YALE L.J. 1392, 1429–34 (2020) (explaining how index fund managers may benefit from a decline in aggregate portfolio value due to differential fees charged to dif- ferent funds). 350 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 Three face intense political scrutiny over their perceived out- sized influence on capital and product markets.101 Professor Jeff Schwartz posits that this is the most likely motivation for index fund voting.102 He argues that if index fund managers found stewardship profitable, they would have participated in it since the industry’s inception rather than avoiding it until the SEC intervened through rulemaking.103 He also points out that if index fund managers viewed stewardship as a way to improve portfolio returns, they would involve fund-level fi- nance professionals in the process, whereas in reality they del- egate the task to centralized (and woefully understaffed) com- pliance-oriented teams.104 In Professor Schwartz’s view, it is no coincidence that “[a]fter consistently voting down ES pro- posals, the large asset managers pivoted to supporting such measures in the same year the U.S. presidency switched 101 See supra note 61; see also David McLaughlin & Annie Massa, The Hidden Dangers of the Great Index Fund Takeover, BLOOMBERG (Jan. 9, 2020), https://www.bloomberg.com/news/features/2020-01-09/the-hidden- dangers-of-the-great-index-fund-takeover [on file with the Columbia Busi- ness Law Review] (observing that the Big Three are “potentially the most powerful force over a huge swath of America Inc.” and that “[a]larm bells have begun to go off with some regulators, as well as with an ideologically diverse array of academics and activists”); Matt Egan, BlackRock and the $15 Trillion Fund Industry Should Be Broken up, Antimonopoly Group Says, CNN BUS. (Nov. 24, 2020), https://www.cnn.com/2020/11/24/busi- ness/blackrock-vanguard-state-street-biden/index.html [https://perma.cc/24AH-X9FF] (reporting that “[c]ritics say [the Big Three] have become too powerful and that the Biden administration and Congress need to rein them in”). 102 Schwartz, supra note 19, at 398. 103 Id. at 424. 104 Id. at 425. For how mutual fund advisors approach their voting re- sponsibilities across fund families, as well as the conflicts of interest fund advisers face in casting votes, see generally Griffith & Lund, supra note 73; Lipton, supra note 98. For empirical evidence “that the Big Three devote an economically negligible fraction of their fee income to stewardship and that their stewardship staffing levels enable only limited and cursory steward- ship for the vast majority of their portfolio companies,” see Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16, at 2033, 2075–84. Cf. Fisch et al., supra note 85, at 50 (responding to those who have criticized the limited size of index fund managers’ governance staffs). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 351 parties from the Trump to the Biden administration.”105 “The abrupt shift in large assets managers’ voting parallels the ab- rupt shift in government policy” on topics such as climate change; politics, he asserts, “is the only plausible explana- tion.”106 If Professor Schwartz is correct, voting by index fund managers may injure the very diversified investors it is meant to help by forestalling new regulations designed to protect them, and may also negatively affect the functioning of the economy more broadly by introducing an indirect form of state capitalism (albeit one unconstrained by democratic electoral accountability or constitutional limits).107 Another self-serving motive that could explain index fund managers’ positions on ESG matters is a desire to court mil- lennial investors to their funds, not only to their index funds but also to a milieu of higher-fee ESG-themed funds that they offer. Professors Michal Barzuza, Quinn Curtis, and David Webber have advanced this argument, pointing out that mil- lennials, who will soon accumulate significant assets, place a premium on social issues in their economic lives.108 Professor Lund offers an alternative marketing-based the- ory for index fund managers’ interventions on ESG topics. She theorizes that, subject to a constraint of avoiding government 105 Schwartz, supra note 19, at 442. 106 Id. at 443. Schwartz’s hypothesis that the Big Three’s embrace of ESG has been driven by political expediency is consistent with the Big Three’s apparent backpedaling on those commitments in the wake of recent threats by Republican lawmakers. See infra note 194 and accompanying text. 107 See infra notes 158–160 and accompanying text. Professor Schwartz recommends requiring asset managers to vote in line with their fund inves- tors’ polled preferences as an antidote to this concern. “For instance,” he explains, “investors could be asked about whether they support diversity efforts and climate transparency efforts at portfolio firms. The asset man- ager would then be required to proportionally reflect investor preferences at each company where activism or shareholder proposals that implicate these issues arise.” Schwartz, supra note 19 at 451. Professor Schwartz re- jects a pure form of pass-through voting, where fund investors would in- struct the asset managers on how to vote their percentage share ownership with respect to each matter at each portfolio company, due to rational apa- thy concerns. Id. For more on pass-through voting, see notes 16 & 160. 108 Barzuza, et al., supra note 19, at 1304–06. 352 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 backlash, the Big Three take ESG positions that will satisfy the bulk of their clients and potential clients, because doing so is likely to increase fund inflows and in turn assets under management and their compensation.109 Because “client tastes will dictate policies, rather than the principled consid- eration of systematic risk or externalities,” she posits that the Big Three’s efforts will reflect the views of the corporate man- agers who control 401(k) plans as well as the officials who con- trol government and union pension funds, given that such funds constitute the bulk of the Big Three’s assets. She acknowledges that this will tend to privilege elitist views and explains why those who control public pension funds are likely to have an outsized voice.110 It is also possible that the positions taken by the Big Three are driven by the personal preferences of those who run them. Blackrock’s positions could have more to do with Larry Fink’s sociopolitical commitments, or those of Blackrock’s steward- ship team, than an assessment of portfolio value. In the liter- ature on managerial agency costs at public companies, the psychological benefits of empire building are well under- stood.111 Serving, along with leaders at Vanguard and State Street, as controllers of funds constituting the largest voting bloc in nearly 90% of S&P 500 companies represents an em- pire beyond the wildest dreams of any public company CEO.112 Using the power that comes along with that position offers commensurate private benefits.113 109 Lund, supra note 19. 110 Id. at 110 n.170. 111 See Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833, 903–07 (2005) (discussing firm managers’ in- centives to engage in empire building and observing that some scholars view it as the most significant agency problem that large public companies face). 112 Schwartz, Stewardship Theater, supra note 15, at 406 (explaining that the ownership stakes of Vanguard, BlackRock, and State Street “is enough to make them, collectively, the largest shareholders in 88% of S&P 500 companies”). 113 See Coates, supra note 61, at 18–19 (discussing the non-wealth power and other private benefits the leaders of large index providers may obtain through use of their funds’ voting power). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 353 I cannot answer which of the foregoing motives, if any, drives index fund managers to engage in stewardship on ESG topics. Multiple motivations could be at play, and their influ- ence could be subconscious. Indeed, when the outcome of a de- cision is ambiguous, the self-serving bias is likely to cause fund management personnel to view decisions that are pri- vately beneficial, to themselves or the fund manager, as hav- ing a beneficial impact on the portfolio they manage. And in some cases, of course, what is privately beneficial to a fund manager or its personnel may also be beneficial to the portfo- lio.114 My point is simply that given the selfish motives that could drive index fund managers to engage in stewardship that is destructive of portfolio value, financially motivated di- versified investors would rationally discount the touted bene- fits of portfolio-focused stewardship interventions. As dis- cussed below, some generalities can be stated about the sorts of characteristics that would trigger heightened skepticism— and hence a steeper discount. First, as explained in the last part, interventions which im- pose vague, discretionary policies on portfolio firms, or policies that are difficult to monitor compliance with, are unlikely to work given the firm-focused incentives portfolio firm manag- ers face. If index fund managers push such policies, there is strong reason to suspect that they are driven not by a desire to increase portfolio value but rather by improper motives— such as a selfish desire to benefit in the eyes of various con- stituencies (e.g., politicians, millennials, other clients) from the false appearance that they are taking meaningful action to address ESG issues, when in fact they are accomplishing little. Or perhaps the virtue signaling is psychologically re- warding to those who run the fund manager, or those same constituencies. Notably, portfolio firm managers are unlikely to resist such toothless policies and may in fact benefit from them; such policies are therefore also consistent with index fund managers’ pro-manager bias, presenting another reason for skepticism. With respect to firm-focused stewardship, 114 See Kahan & Rock, supra note 85, at 1800 (observing that reputa- tional incentives of index fund managers may sometimes be aligned with the interests of fundholders, and sometimes not). 354 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 Professors Bebchuk and Hirst view managerial deference as a reason to expect Big Three passivity—pushing effective gov- ernance reforms or policing for performance could lead corpo- rate managers to instigate a backlash leading to regulatory break-up of the Big Three or other draconian interventions that affect their profitability.115 Interventions touted as port- folio-focused stewardship, by contrast, can be advantageous to portfolio firm managers, if the interventions allow them to cast themselves in a better public light without actually changing their behavior, or better yet if they operate to give firm managers breathing room from market discipline.116 Second, interventions which operate by generally eroding managerial sensitivity to firm value are suspect for similar reasons and would therefore also be viewed disapprovingly by financially motivated diversified investors. As discussed in the last part, such interventions are likely to decrease portfo- lio value by increasing managerial agency costs more than they decrease intraportfolio externalities, and because they benefit portfolio firm managers are likely motivated by fund managers’ pro-manager bias.117 Third, financially motivated diversified investors would also discount interventions that align with the self-interest of fund managers or their personnel (beyond their self-interest in increased management fees resulting from effective portfo- lio-focused stewardship policies) when the benefits of those in- terventions are difficult to verify. This would be the case, for example, if the relationship between the portfolio firm behav- ior sought to be modified and risk-adjusted portfolio value is 115 See Bebchuk & Hirst, Index Funds and the Future of Corporate Gov- ernance, supra note 16, at 2069–70. 116 See id. at 2070 (noting “that Martin Lipton, who has long been as- sociated with support for takeover defenses and other pro-management po- sitions, has favorably described the increasing influence of index funds”); Mark J. Roe & Roy Shapira, The Power of the Narrative in Corporate Law- making, 11 HARV. BUS. L. REV. 233, 263 (2021) (discussing how narratives can “condition[] lawmakers to accord executives more autonomy from stock markets,” while flattering “executives’ self-image by allowing them to view themselves not as pursuing their self-interest but as heroically overcoming the shortsightedness of financial markets for the good of all”). 117 See supra note 115. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 355 opaque. It would also be the case if the relationship between the behavior sought to be modified and risk-adjusted portfolio value is clear, but the effect of the specific intervention on portfolio value is not. Fourth is a related but distinct observation. As discussed in the next part, identifying the right policy intervention to address an externality-producing behavior can be a complex endeavor, and sometimes the cure can be worse than the pro- verbial disease. The more complicated it is to determine whether an intervention will do more good than harm to the portfolio, the more costly an informed determination is to reach. Given index fund managers’ strong incentives to keep costs low, portfolio-focused stewardship interventions that purport to solve very difficult externality problems should be looked at skeptically. C. Real World Friction #3: Imperfect Information Proponents of portfolio primacy theory suggest that asset managers have not only the incentive (at least under certain circumstances) to adopt and enforce portfolio-wide policies de- signed to increase risk-adjusted portfolio value, but also the capacity to do so effectively. As Professor Lund has observed, adopting portfolio-wide policies in an effort to cause firms to internalize intraportfolio externalities is a lawmaking-like ac- tivity.118 It involves declaring and enforcing policies that gov- ern within the jurisdictional boundaries of the portfolio. In- deed, portfolio-focused stewardship is potentially warranted only in situations where law, as augmented by social and eth- ical norms, does not already cause firms to internalize the ex- ternalities they impose on other firms in the economy.119 This is notable because much has been written in the law and economics tradition about negative externalities and how 118 See Lund, supra note 19 at 80 (observing that “the Big Three are providing a form of privatized regulation—a body of standards and man- dates that is more stringent than existing law, enforced with penalties, and applied across the market”). 119 Professors Fisch and Schwartz analogize fund managers to legisla- tors in a representative democracy. See Fisch & Schwartz, supra note 19, at 9, 61. 356 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 the law can best intervene to address them; indeed, forcing the internalization of negative externalities is one of the most well-accepted grounds for government intervention in the market.120 This literature teaches that the proper approach lawmakers should take to an externality-producing behavior turns in part on whether the behavior should be sanctioned— i.e., deterred unconditionally—or instead regulated or priced. Behavior warranting sanction should be outlawed altogether, backed up by punishments that make it economically irra- tional to engage in; lawmakers should approach other types of behaviors with the goal of encouraging firms to engage in them only in socially efficient ways and amounts.121 This can be attempted by using a well-recognized array of instruments, each with its own unique advantages and pitfalls.122 120 See Bryan Caplan, Externalities, CONCISE ENCYCLOPEDIA OF ECO- NOMICS (2023) https://www.econlib.org/library/Enc/Externalities.html [https://perma.cc/NC7H-9GMR] (“Externalities are probably the argument for government intervention that economists most respect.”); Maureen L. Cropper & Wallace E. Oates, Environmental Economics: A Survey, 30 J. ECON. LIT. 675, 678 (observing that the “literature on [the theory of exter- nalities] is enormous”). I will focus here on negative externalities, as that is the focus of the portfolio primacy theory literature. But if an index fund manager would want to suppress the overproduction of negative externali- ties in order to increase portfolio value, it should also want to address the underproduction of positive externalities for the same reason. It has been theorized that asset managers may be incentivized to support good govern- ance in part because it produces positive externalities that are captured at the portfolio level. See Viral V. Acharya & Paolo F. Volpin, Corporate Gov- ernance Externalities, 14 REV. OF FIN. 1 (2010); He Jie, Huang Jiekun & Zhao Shan, Internalizing Governance Externalities: The Role of Institutional Cross-Ownership, 134 J. FIN ECON. 400 (2019). 121 The law and economics literature would treat behavior that should be deterred unconditionally as criminal. For an overview of the economic rationale for the civil-criminal divide, see Amanda M. Rose, Public Enforce- ment: Civil versus Criminal, in THE OXFORD HANDBOOK OF CORPORATE LAW AND GOVERNANCE 946 (2018). 122 The law and economics literature on instrument choice is vast. For field-level overviews, see STEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW (2004); RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW (8th Ed. 2011). For an environmentally focused overview, including an anal- ysis of private governance analogues, see Sarah E. Light & Eric W. Orts, No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 357 One dimension along which these legal instruments vary is temporal. Some operate by imposing liability ex post, after harms occur, whereas others operate ex ante, before harms oc- cur. Which is more desirable will depend on several factors, including how knowledgeable the lawmaker is about the harmfulness of the particular activity relative to the parties that engage in it, the effectiveness and feasibility of imposing ex post sanctions under the circumstances, and relative ad- ministrative costs.123 Designing an ex post liability regime in- volves numerous sub-choices that will affect its efficacy in forcing the internalization of externalities—for example, whether to impose strict or standards-based liability,124 how to calculate damages,125 and the contours of enforcement pro- cedure.126 With respect to ex ante instruments, lawmakers have an array to choose from. One type is command-and-control style regulation. As the term is used here, command-and-control style regulation attempts to prescriptively dictate how (or at what levels) an externality-generating activity will be con- ducted.127 It is best contrasted with the so-called Pigouvian Parallels in Public and Private Environmental Governance, 5 MICH. J. ENV’T & ADMIN. L. 1 (2015). 123 Shavell, supra note 122, at 575–78; see also Richard A. Posner, Reg- ulation (Agencies) Versus Litigation (Courts): An Analytical Framework, in REGULATION VERSUS LITIGATION: PERSPECTIVES FROM ECONOMICS AND LAW 11 (Daniel P. Kessler ed., 2011); Posner, supra note 122, at 852–56. 124 For the classic treatment of this choice, see Steven Shavell, Strict Liability Versus Negligence, 9 J. LEGAL STUD. 1 (1980). For a succinct over- view of the tradeoffs, see Kyle D. Logue, Coordinating Sanctions in Torts, 6 CARDOZO L. REV. 2313, 2321–23 (2010). 125 For discussions of optimal damages, see, e.g., Logue, supra note 124 at 2324; A. Mitchell Polinsky & Steven Shavell, The Optimal Tradeoff Be- tween the Probability and Magnitude of Fines, 69 AM. ECON. REV. 880 (1979). 126 See Amanda M. Rose, The Multi-Enforcer Approach to Securities Fraud Deterrence: A Critical Analysis, 158 U. PA. L. REV. 2173, 2192–97 (2010) (discussing how procedural choices, as well as the choice of enforcer, can affect the efficiency of a deterrence regime). 127 The prescription could be enforced either through punishment for noncompliance or reward for compliance; any difference between the effect of these two approaches is not relevant for purposes of the discussion here. 358 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 tax, another ex ante instrument.128 Whereas command-and- control style regulation requires the lawmaker to decide what specific steps a firm must take to align its externality-gener- ating activity with social welfare—something that requires an analysis of both costs and benefits—Pigouvian taxes require only that the lawmaker estimate the cost of the harm the ex- ternality produces and charge it back to externality-producing firms based on their output levels, thus causing firms to incor- porate social cost into their internal profit function. Because Pigouvian taxes generally require less knowledge on the part of lawmakers to craft, they are thought to be less error prone than command-and-control style regulations and are gener- ally preferred by economists.129 Pigouvian taxes may be 128 The name derives from economist Arthur Pigou and his classic work ECONOMICS OF WELFARE (1932). 129 In an article advocating for greater use of Pigouvian taxes, Profes- sors Masur and Posner provide an example to illustrate this point: Other forms of regulation are inferior to the Pigouvian tax. Consider com- mand-and-control regulation, in which a regulator forces a firm to take a particular action, such as installing a pollution-reducing scrubber. Under this form of regulation, the regulator may conduct a cost-benefit analysis to determine whether the benefit of alleviating the pollution for the firm’s neighbors is greater or less than the cost to the firm of having to install the scrubbers or take other precautions. If scrubbers pass a cost-benefit analy- sis, then the regulator orders the firm to install them. If they do not pass, the regulator allows the firm to continue its activity unabated. A perfectly conducted cost-benefit analysis should produce results as efficient as a Pigouvian tax, but in a world of administrative costs, command-and-control regulation will be inferior. The reason is that in order to determine the cor- rect command-and-control rule, the regulator must know both the cost and benefit of the activities. In contrast, the regulator only needs to know the cost of the activity to determine the correct Pigouvian tax. It is not necessary to know the benefit. Thus, as long as regulators make errors (as they una- voidably do), a Pigouvian tax is superior to command-and-control regula- tion. Jonathan S. Masur & Eric A. Posner, Toward A Pigouvian State, 164 U. PA. L. REV. 93, 95 (2015) (internal footnotes omitted). See also id. at 96 (observ- ing that it “would be an understatement to say that economists endorse Pigouvian taxes over command-and-control regulation” and noting that “Pigouvian taxes are constantly advocated by economists who seek to influ- ence public policy”); Victor Fleischer, Curb Your Enthusiasm for Pigovian Taxes, 68 VAND. L. REV. 1673, 1676 (2015) (noting the “academic No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 359 inferior to command-and-control style regulation when harms are non-linear, however,130 and may prove ineffective when the marginal social cost of an externality-generating activity is non-uniform across firms.131 Other ex ante instruments that can help solve externality problems include the assignment of property rights132 as well as disclosure regulation designed to promote Coasean bargaining solutions.133 What does this mean for portfolio-focused stewardship? First, it is plausible that index fund managers could effec- tively enforce a prohibition on a discrete portfolio firm activity that should be deterred unconditionally—imagine the produc- tion of an irredeemably noxious chemical. While a shareholder proposal could not be used for this purpose, given that share- holders lack authority under Delaware corporate law to dic- tate substantive managerial decisions,134 index fund manag- ers could make known their intention to vote against directors who fail to cause their firm to cease producing the chemical.135 Compliance would be relatively easy for index fund managers exuberance” for Pigouvian taxes); Louis Kaplow & Steven Shavell, On the Superiority of Corrective Taxes to Quantity Regulation, 4 AM. L. & ECON. REV. 1, 14 (2002) (“Economists traditionally have favored the use of correc- tive taxes to reduce harmful externalities because taxes leave control deci- sions in the hands of individual firms, which have better knowledge of their own control costs than does the state.”). 130 Fleischer, supra note 129, at 1686 n. 63–69 and accompanying text; cf. Kaplow & Shavell, supra note 129 (arguing against this view). 131 See generally Fleischer, supra note 129. 132 See, e.g., Harold Demsetz, Towards a Theory of Property Rights, 57 AM. ECON. REV. 347 (1967); Robert J. Smith, Resolving the Tragedy of the Commons by Creating Private Property Rights in Wildlife, 1 CATO J. 439 (1981). 133 See, e.g., David W. Case, Corporate Environmental Reporting as In- formational Regulation: A Law and Economics Perspective, 76 U. COLO. L. REV. 379, 423 (2005). Hybrid use of various instruments is also possible. Cap-and-trade systems in environmental law, for example, combine com- mand-and-control style regulation (the cap) with the assignment of property rights (the allocation of rights to trade emissions permits). 134 CA, Inc. v. AFSCME Emples. Pension Plan, 953 A.2d 227, 232 (Del. 2008). 135 For the ways that fund managers can influence portfolio firm man- agers, see Fisch & Schwartz, supra note 19, at 10–12. 360 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 to monitor. The rub is that dictating production choices across their broad portfolios would place index fund managers on an antitrust collision course, making these sorts of stewardship interventions highly unlikely. More fundamentally, it is hard to think of activities that warrant sanctions that are not al- ready illegal. The reality is that most legal externality-gener- ating activities by firms today are of the type that should be regulated or priced, rather than sanctioned. The production of greenhouse gases clearly falls in this category, given our pre- sent need for fossil fuels to meet society’s energy demands. Thus, the theoretical capacity of index fund managers to ef- fectively sanction portfolio firm conduct is of little practical importance. Second, with respect to externality-producing behaviors that do not warrant sanctions, an index fund manager’s toolkit is much more limited than a public lawmaker’s toolkit. An ex-post liability regime is not a viable option for index fund managers: they are ill-equipped to stand in the shoes of courts to determine whether a portfolio company should be held lia- ble for imposing costs on another, and they lack any practical ability to force liable firms to pay monetary fines tethered to the cost of the intraportfolio externalities a firm’s activity has produced. However, as Professor Squire and I have previously argued, a desire to deter intraportfolio harms may justify in- dex fund managers’ support for traditional litigation between portfolio firms using the extant judicial system.136 Moreover, if the traditional litigation system is failing in some material 136 See generally supra note 52; see also Rose & Squire, supra note 52, at 1697 (explaining that “diversified shareholders effectively delegate to the court system the responsibility for authorizing compensatory payments among portfolio firms, thereby correcting the distortions in those firms’ fi- nancial data caused by intraportfolio injuries,” and that while they ulti- mately bear the costs of this system, those costs “may be outweighed by the informational benefits of the lawsuit, which could cause financial data about each portfolio firm to better reflect the contribution of that firm’s managers to overall portfolio wealth,” making it more likely that managers will “make decisions that maximize portfolio value, including by investing in measures to prevent subordinates from engaging in conduct that is not cost-justified from the perspective of diversified shareholders”). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 361 way, it might justify their advocacy in support of litigation re- form efforts.137 Index fund managers’ ex ante instrument options are also much more restricted than those of public lawmakers. Unlike Congress, index fund managers cannot impose a Pigouvian tax on portfolio firms. They could attempt something analo- gous by requiring that the pay of portfolio firm executives be tethered to an adjusted measure of firm financial perfor- mance—one that charged back to the firm the cost of the in- traportfolio externalities the firm generated. The best candi- date would be a charge based on the costs the firm’s carbon emissions impose on other portfolio firms.138 But calibrating the appropriate charge would be immensely challenging,139 as would determining how to select and adjust the baseline of firm financial performance.140 Additionally, a “significant challenge” in the design of a carbon tax “is the design of a sys- tem for ensuring that the rate changes over time as new infor- mation becomes available about the costs and benefits of re- ducing emissions.”141 It seems unreasonable to expect that cost-conscious index fund managers would invest in this 137 See infra Part V (discussing alternatives to portfolio-focused stew- ardship for addressing intraportfolio externalities). 138 See Fleischer, supra note 129 (arguing that Pigouvian taxes are likely to be the optimal regulatory instrument only when the harm to be internalized is properly analogized to global pollution and does not vary sig- nificantly based on the source, or the variation in marginal social cost is easily observed and categorized). 139 Calibrating this tax would be much more difficult than calibrating a true carbon tax tied to the cost firms’ carbon emissions impose on society generally, itself no walk in the park. See Gilbert E. Metcalf & David Weisbach, The Design of a Carbon Tax, 33 HARV. ENV’T L. REV. 499, 511 (2009) (discussing the challenges in calibrating a carbon tax). This is be- cause it would require calculating the tenuous impact of portfolio firms’ emissions on risk-adjusted portfolio value. See Tallarita, supra note 15, at 517 (questioning the ability of the Big Three’s climate stewardship to actu- ally impact climate change given that “[p]ublicly traded companies, the tar- get of index fund stewardship, represent only a subset of the global econ- omy”). 140 This would not be required if public lawmakers imposed a carbon tax on firms directly and introduces additional room for error. 141 Metcalf & Weisbach, supra note 139, at 501. 362 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 endeavor, particularly given that dictating executive pay so specifically would raise their risk of facing antitrust liability and being considered “controllers” for purposes of the corpo- rate and securities laws.142 Index fund managers also lack the capacity to assign for- mal property rights as a way to deal with intraportfolio exter- nalities. As with any attempt to mimic Pigouvian taxes through executive pay, devising a way to mimic a property rights regime within the portfolio would be immensely com- plicated, and overseeing such a scheme would require index fund managers to assert a level of control that would leave them legally vulnerable. Thus, even if theoretically possible, it is not plausible that they would pursue this approach.143 That leaves just two instruments that index fund manag- ers might plausibly utilize in an effort to cause portfolio firms to internalize their intraportfolio externalities: (1) command- and-control style regulation (i.e., demands that portfolio firms adjust their business practices in specified ways144) and (2) disclosure regulation. Each is briefly discussed below. 142 See supra note 75. It is telling that companies incorporating ESG metrics into executive pay packages have taken a very different approach; rather than mimicking a Pigouvian approach, they set a (typically vague) ESG-linked command-and-control style performance target and then adjust the executive’s annual cash bonus based on the board’s assessment of whether it has been met. See Bebchuk & Tallarita, supra note 57 (providing an empirical analysis of ESG metrics in executive pay and warning that the ESG compensation trend “poses the danger of creating vague, opaque, and easy-to-manipulate compensation components, which self-interested CEOs can exploit to inflate their payoffs, with little or no accountability for actual performance”). 143 A portfolio firm could, however, assign property rights within the firm as a means of achieving compliance with command-and-control style edicts handed down by index fund managers. Cf. Light & Orts, supra note 122, at 30–32 (explaining a private governance form of the property ap- proach to environmental regulation that involves allocating internal prop- erty rights to business units within a single firm). They could likewise im- pose Pigouvian taxes on units within the firm with the same aim. See id. at 34–35 (discussing how Disney and Microsoft have adopted internal carbon fees to support efforts to achieve their goal of carbon neutrality). 144 Some scholars treat regulations that tell firms what they must ac- complish but leave them to decide how best to do so as a distinct instrument No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 363 1. Command-and-Control Regulation In the instrument choice literature, command-and control style regulation has been heavily criticized, particularly in comparison to Pigouvian taxes.145 The most fundamental cri- tique concerns the tremendous amount of information law- makers must acquire and process in order to craft command- and-control style regulations that are even nominally effi- cient.146 Expert agencies are generally relied upon to conduct (sometimes called “performance-based standards”). See Jon D. Hanson & Kyle D. Logue, The Costs of Cigarettes: The Economic Case for Ex Post In- centive-Based Regulation, 107 YALE L.J. 1163, 1273–74 (1998) (taking this approach and limiting use of the term “command-and-control” to rules that impose specific requirements on regulated firms, such as a rule requiring a polluter to adopt a particular type of pollution-reducing technology). This article treats such performance-based standards as a species of command- and-control style regulation. See id. at 1267 (noting that the informational needs of regulators in both contexts are the same). 145 See, e.g., Rena I. Steinzor, Reinventing Environmental Regulation: The Dangerous Journey from Command to Self-Control, 22 HARV. ENV’T L. REV. 103, 103 & n.1 (1998) (citing academic and popular works critiquing command-and-control regulation as economically inefficient and observing that these critiques “have gained widespread acceptance among partici- pants in the policymaking process”); Howard Latin, Ideal Versus Real Reg- ulatory Efficiency: Implementation of Uniform Standards and “Fine-Tun- ing” Regulatory Reform, 37 STAN. L. REV. 1267, 1268 (1985) (“[P]rominent legal scholars such as Bruce Ackerman, Steven Breyer, and Richard Stew- art have concluded that command-and-control regulation is inefficient and should be replaced by more flexible strategies.”); Bruce A. Ackerman & Richard B. Stewart, Comment: Reforming Environmental Law, 37 STAN. L. REV. 1333, 1341–51 (1985) (critiquing command-and-control regulation and advocating for greater use of market mechanisms). 146 See, e.g., supra note 129; Kyle D. Logue, In Praise of (Some) Ex Post Regulation: A Response to Professor Galle, 69 VAND. L. REV. EN BANC 97, 103, 105 (2016) (discussing the “enormous informational burden” crafting command-and-control style regulations imposes on the regulator, while rec- ognizing that even though “command-and-control regulation is difficult to implement effectively and requires a great deal of information on the part of the regulator,” “there are plenty of situations in which specific regulatory mandates, despite the difficulty of getting them right, may be optimal”); Hanson & Logue, supra note 144, at 1264–1265 (discussing the massive amount of information regulators would need to craft command-and-control style regulations designed to address smoking externalities). There is sig- nificant literature debating the relative merits of command-and-control 364 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 the intensive information gathering and analysis needed to draw the lines correctly. But, as the public choice literature has emphasized,147 the process of crafting command-and-con- trol style regulations is subject to predictable pathologies which can lead to inefficient rules that stifle innovation148 and suppress competition.149 Various safeguards exist that help to style regulations versus Pigouvian taxes as instruments for dealing with environmental externalities; as noted above, most economists view Pigou- vian taxes as superior. In an article defending command-and-control style regulations, Professors Cole and Grossman observe that this literature tends to conflate nominal and relative efficiency. They explain that the nom- inal efficiency of a regulatory regime is determined by comparing its so- cial costs and benefits; the regime is nominally efficient if it produces bene- fits in excess of its costs. And it remains nominally efficient even if it turns out to be less efficient than (or relatively inefficient compared to) some real or imagined alternative regulatory regime. Daniel H. Cole & Peter Z. Gross- man, When Is Command-And-Control Efficient? Institutions, Technology, and the Comparative Efficiency of Alternative Regulatory Regimes for Envi- ronmental Protection, 1999 WIS. L. REV. 887, 893 (1999). See also Latin, su- pra note 145, at 1272 (warning that “intemperate academic criticisms of command-and-control standards combined with support of unrealistic ‘fine- tuning’ strategies may lend an aura of intellectual credibility to political initiatives designed to achieve less regulation, not better regulation”). While the efficiency of command-and-control style portfolio focused stewardship interventions relative to (realistically attainable) political alternatives is relevant to whether financially motivated diversified investors would sup- port them (see infra Part V), the present discussion is focused on nominal efficiency. 147 For a general introduction to the public choice literature, see DAN- IEL A. FARBER & PHILIP P. FRICKEY, LAW AND PUBLIC CHOICE: A CRITICAL IN- TRODUCTION (1991). 148 See generally Richard B. Stewart, Regulation, Innovation, and Ad- ministrative Law: A Conceptual Framework, 69 CALIF. L. REV. 1256, 1264 (1981). This critique has less force when the regulation sets a performance standard. See David M. Driesen, Does Emissions Trading Encourage Inno- vation?, 33 ENV’T L. REP. 10094 (2003) (drawing this distinction). 149 For arguments along this line directed at environmental regulation, see Nathaniel O. Keohane, Richard L. Revesz & Robert N. Stavins, The Choice of Regulatory Instruments in Environmental Policy, 22 HARV. ENV’T L. REV. 313, 348–50 (1998) (explaining “why private firms (and their trade associations) may have a strong preference for command-and-control stand- ards, which may create rents, and especially for considerably more strin- gent command-and-control standards for new pollution sources, which cre- ate barriers to entry”); Todd J. Zywicki, Environmental Externalities and No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 365 protect against this, and to promote efficient lawmaking more generally. These include oversight of administrative agencies by democratically accountable bodies, requirements that agencies engage in notice-and-comment rulemaking, and the specter of judicial review. But, the efficacy of these safeguards is hotly contested. Regardless of one’s views on the capacity of the adminis- trative state to craft efficient command-and-control style reg- ulations, there are good reasons for one to take concerns about the informational burden this sort of regulation places on law- makers more seriously in the context of portfolio-focused stew- ardship. Index fund managers have nothing akin the exper- tise of the administrative state at their disposal to assist them in gathering and analyzing the information needed to judge whether a command-and-control style stewardship interven- tion is likely to increase risk-adjusted portfolio value.150 This means they would have to develop or hire the requisite exper- tise if they wanted to make intelligent decisions—something that cuts against their financial incentives to keep costs low.151 As already discussed, the assistance that ESG activists Political Externalities: The Political Economy of Environmental Regulation and Reform, 73 TUL. L. REV. 845, 911 (1999) (arguing that “[l]arge, politi- cally connected corporations and industries” use command-and-control style environmental regulation “as a method to impose costs on and create barri- ers to entry for new, smaller businesses”). 150 See, e.g., Lund, supra note 19, at 141 (observing that “the people at the Big Three who make the rules are salaried employees with backgrounds in investing and corporate governance,” and thus “lack expertise in regula- tory policy that seasoned public officials bring to the table”); see also En- riques & Romano, supra note 41, at 18 (“estimating interfirm spillovers can be a very complex endeavor, especially for institutional investors that hold stakes in thousands of corporations”). 151 See supra note 71 and accompanying text; see also Lund, supra note 19, at 141–42 & n. 318 (“[T]he Big Three devote far fewer staff and resources to stewardship than the typical administrative agency.”). The Big Three rarely even provide comments on SEC proposed rules that will impact port- folio value, or chime in as amicus curiae in significant litigation. Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16, at 2095–2112; but see Fisch, et al., supra note 85, at 54–55 (presenting data that the authors contend demonstrate index fund managers’ active 366 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 and investor coalitions might offer is limited in important ways.152 Moreover, index fund managers who cut corners or allow self-interest to infect their decisions face far less accountabil- ity than government actors.153 Index fund shareholders lack meaningful voting rights.154 The policies index fund managers adopt are not subject to anything resembling notice-and-com- ment rulemaking. Judicial review is weak—while index fund managers technically owe fiduciary duties to the funds they manage, they face essentially no liability risk for their stew- ardship decisions.155 Index fund investors do have the capac- ity to discipline a fund manager who engages in value-destroy- ing stewardship activities by switching to a fund with a different advisor, thereby reducing the fund manager’s com- pensation by lowering the value of its assets under manage- ment. But index fund investors are rationally apathetic and cannot be expected to pay attention to stewardship.156 Moreo- ver, command-and-control style portfolio stewardship engagement in policy discussions related to investor voice as well as issues beyond corporate governance). 152 See supra notes 94–97 and accompanying text. 153 See, e.g., Lund, supra note 19, at 129 (“[T]he Big Three’s regulatory power exceeds that of the typical government agency, despite a near total lack of oversight.”). 154 See Morley & Curtis, supra note 66, at 92–93, 106–08. 155 See supra note 67. 156 See, e.g., Bebchuk & Hirst, Index Funds and the Future of Corporate Governance, supra note 16, at 2073 (“[M]ost investors are unlikely to have sufficient expertise or resources to evaluate the many stewardship decisions made by index fund managers.”). Even if index fund investors did pay at- tention to stewardship, switching can be costly. Company 401(k) plans usu- ally do not offer employees multiple competing funds of the same type to choose from. Moreover, if the Big Three take the same position on steward- ship interventions, fund investors may have no funds they can flee to with- out sacrificing the lower fees that the Big Three can offer due to their econ- omies of scale. See id. at 2130 (“There is . . . no market mechanism that rewards index fund managers for good judgement about stewardship for their portfolio companies.”); Fisch & Schwartz, supra note 19, at 26, 41 (not- ing “many fund managers appear to be herding on ESG issues” and observ- ing that, “[a]lthough a handful of anti-ESG funds are now available, they are new, small, and higher cost than broad-based index funds”). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 367 interventions may take place entirely outside of public view, or may be intentionally obfuscated by index fund managers, making monitoring by even interested parties difficult.157 Theoretically, command-and-control style regulation can be more easily corrected when implemented by index fund man- agers than it can be when implemented by government: in the unlikely event fund managers are willing to acknowledge they have made a mistake, it is simpler to change course. But even then, if the initial intervention required that portfolio compa- nies make substantial investments or alter their business op- erations, the ease of ex post revision may be of little value. Unlike public lawmakers, asset managers also do not face constitutional limitations on their authority. They can there- fore impose regulations on large sectors of the economy that government could not, such as gender or racial quotas that would violate the Equal Protection Clause if adopted by gov- ernment, and restrictions on corporate speech that if adopted by government would violate the First Amendment. The is- sues raised by this, like the issues raised by the potential for asset managers to promote anticompetitive behavior,158 are not strictly relevant to the preferences of our hypothesized di- versified investor concerned purely with financial returns.159 But they are certainly relevant to a broader public policy dis- cussion regarding the power of the Big Three. Even if portfo- lio-focused stewardship were good for financially motivated diversified investors, it may still be something society would not want to permit or encourage.160 157 See Bebchuk & Hirst, Index Funds and the Future of Corporate Gov- ernance, supra note 16, at 2123–26 (advocating for reforms that would in- crease transparency surrounding engagement by the Big Three with portfo- lio companies); Kahan & Rock, supra note 19, at 534 (explaining index fund managers’ incentives to cloak portfolio-focused stewardship interventions in the language of firm value maximization). 158 See supra note 61. 159 See supra note 18 and accompanying text. 160 Professor Sean Griffith has observed that when a determination as to whether a portfolio-focused stewardship intervention will create more benefit than cost must be made based on incomplete information about the proposed intervention’s ultimate effects on portfolio value, the decision can be viewed as coming down to tradeoffs between competing values. Griffith, 368 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 2. Disclosure Regulation While its use by index fund managers is beset by the same accountability problems as command-and-control style regu- lation, disclosure regulation may be a relatively more attrac- tive instrument from the perspective of financially motivated diversified investors because it is less expensive to comply with, is more flexible, and presents less risk of distortion than prescriptive regulatory commands.161 But just because supra note 18, at 1019. He argues that individual fund investors are better suited to make these tradeoffs relative to fund managers and argues more generally that index fund managers should be stripped of discretionary vot- ing power with respect to environmental and social proposals. In the event fund investors failed to provide instructions on how to vote, he would re- quire fund managers to vote the non-instructed shares in line with the rec- ommendations of portfolio firm managers. Professors Fisch and Schwartz express similar concern over fund managers making values-based voting decisions that may not reflect the ideological preferences of fund investors. Fisch & Schwartz, supra note 19, at 26 (“How one views the impact of envi- ronmental and social proposals on firm performance is largely a function of values and political leanings, not finance. Because support for such measures is based on contested values, not just financial analysis, fund managers cannot, at the same time, ignore beneficiary views and claim to faithfully represent them.”); id. at 27 (“It is undemocratic to rely on une- lected, largely unaccountable, financial institutions to set public policy with- out any input from the public.”). Their proposed solution is to not to strip fund managers of voting power, but rather to require fund managers to so- licit input from fund investors on their voting preferences and to incorporate the feedback received into the fund managers’ stewardship decisions. 161 See, e.g., Cass R. Sunstein, Informational Regulation and Informa- tional Standing: Akins and Beyond, 147 U. PA. L. REV. 613, 626 (1999) (ob- serving that it “is increasingly recognized that information is often a far less expensive and more efficient strategy than command-and-control, which consists of rigid mandates about regulatory ends (a certain percentage re- duction in sulfur dioxide, for example), regulatory means (a technological mandate for cars, for example), or both,” and noting its comparative flexi- bility); Michael Vandenbergh, From Smokestack to SUV: The Individual as Regulated Entity in the New Era of Environmental Law, 57 VAND. L. REV. 515, 530–31 (2004) (explaining that information disclosure may be less ex- pensive for regulators and regulated entities, and more flexible and effi- cient, than command and control requirements); George Loewenstein, Cass R. Sunstein & Russell Golman, Disclosure: Psychology Changes Everything, 6 ANN. REV. ECON. 391, 392 (2014) (explaining that “[an] important ad- vantage of disclosure requirements, as opposed to harder forms of No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 369 disclosure regulation may be less costly than command-and- control style regulation does not mean that it is costless, or effective. As for costs, information disclosure can in fact be quite ex- pensive—particularly given the liability risk that U.S. public companies face for disclosure missteps.162 To evaluate the likely effectiveness of disclosure regulation as a portfolio-fo- cused stewardship technique requires clarity as to the mech- anism through which the mandated disclosure is supposed to lead portfolio firms to internalize their intraportfolio external- ities. After all, disclosure regulation alone does not magically internalize externalities; its success as a regulatory technique requires that the disclosures produced by it catalyze (or that portfolio firms anticipate that they will catalyze) action by oth- ers that, in turn, cause portfolio firms to take account of the external effects of their behavior.163 This requires that the dis- closure mandates target relevant information, that firms credibly comply with those mandates, and—importantly— that the disclosures trigger the desired response by those who are meant to consume them.164 The last requirement is regulation, is their flexibility and respect for the operation of markets” and observing that “[r]egulatory mandates are blunt swords; they tend to ne- glect heterogeneity and may have serious unintended adverse effects”). 162 Actual costs will vary significantly depending on the nature of the disclosure mandates. C.f. Rose, supra note 2, at 1834 (discussing factors that affect the cost of SEC disclosure mandates). 163 See, e.g., Paula J. Dalley, The Use and Misuse of Disclosure as a Regulatory System, 34 FLA. ST. U. L. REV. 1089, 1108-1113 (2007) (discuss- ing how disclosure regulation works and its benefits). Disclosers may some- times adjust their behavior more than disclosee’s reactions to the infor- mation would rationally warrant, in an example of what has been referred to in the behavioral economics literature as the “Telltale Heart Effect.” See, e.g., Loewenstein, et al., supra note 161, at 403-404 (describing this phe- nomenon); see also Stephanie Bornstein, The Enforcement Value of Disclo- sure, 72 DUKE L.J. 1771 (2023) (discussing how disclosure regulation can operate as a “nudge” on the discloser). 164 Dalley, supra note 163, at 1113-19 (discussing limitations of disclo- sure regulation, including “the ability of individuals to process information” as well as “the way information affects individuals’ behavior”); David Weil, Elena Fagotto, Archon Fung & Mary Graham, The Effectiveness of Regula- tory Disclosure Policies, 25 J. POL’Y ANALYSIS AND MGMT. 155, 157 (2006) 370 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 perhaps the biggest wildcard, given that cognitive biases make predicting human behavior fraught, and even if a dis- closure audience responds rationally to information it may not have the power to change firm behavior.165 Scholars who have studied disclosure regulation have concluded that the “condi- tions for effectiveness are quite demanding and therefore not easily met.”166 With respect to disclosure-style portfolio-focused steward- ship interventions, one could imagine three potential groups whose behavior the disclosures could be meant to influence. In the first category are market actors who might adjust their market behavior by virtue of the disclosures in a way that forces companies to take account of the external costs of their actions. This could include consumers, suppliers, as well as non-index investors and their fund managers. These actors could modify their market behavior based on their own diges- tion of the disclosures or based on their reaction to others’ re- sponses to those disclosures, such as campaigns organized by various advocacy groups, media coverage, etc.167 In the second category are government actors who may be catalyzed to (explaining that “[w]hether and how new information is used to further pub- lic objectives depends upon its incorporation into complex chains of compre- hension, action, and response”); Sunstein, supra note 161, at 627 (noting that even when disclosure mandates “are not prohibitively expensive, they may be ineffectual and thus have low benefits; they may even be counter- productive”). 165 Dalley, supra note 164, at 1130; see generally Loewenstein, et al., supra note 161, at 398-404 (cataloguing the biases that can render disclo- sure regulation ineffective and even counterproductive). 166 Weil et al., supra note 164, at 175; see also Loewenstein et al., supra note 161, at 413 (explaining that “[p]sychological factors severely complicate the standard arguments for the efficacy of disclosure requirements” and concluding that “disclosure requirements appear to have been less effective in changing recipient behavior than their proponents seem to assume”). 167 Cf. Michael P. Vanderburgh, Private Environmental Governance, 99 CORNELL L. REV. 129, 137–38 (2013) (explaining how environmental goals can be advanced through private preferences “expressed in purchasing, lending, investing, and supply chain contracting decisions, not just at the ballot box or through lobbying public officials”). For an extensive discussion of the ways that non-investor audiences may use corporate disclosures to affect corporate behavior, see Lipton, supra note 51, at 511–19. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 371 adopt new regulations (or better enforce existing ones) in light of the disclosures.168 Third are the index fund managers themselves, who might use the information to help them craft new command-and-control style policies (or better enforce ex- isting ones). Note that the interests of the actors in each of these cate- gories clearly deviate from the interests of financially moti- vated diversified investors. There is no guarantee that their reactions (or anticipated reactions)—even if entirely ra- tional—will result in an increase in risk-adjusted portfolio value net of compliance costs, and it is possible that the net result could be a reduction in risk-adjusted portfolio value.169 D. Real World Friction #4: Market Dynamism In addition to assuming away managerial agency costs, in- termediary agency costs, and information deficits, early eco- nomic proofs that firms owned by diversified investors would seek to maximize portfolio rather than firm value made one additional key assumption: a static marketplace.170 This as- sumption is critical, because if diversified investors “are suc- cessful in maximizing portfolio value rather than firm value, corporate profits will decline.”171 In a dynamic market, this would create an incentive for an investor “to become undiver- sified and acquire a controlling interest in the company, change its policies, and reap the gains of increased profits.”172 Declining profits would also create incentives for activist hedge funds to team up with non-indexed (or differently- 168 But see OMRI BEN-SHAHAR & CARL E. SCHNEIDER, MORE THAN YOU WANTED TO KNOW: THE FAILURE OF MANDATED DISCLOSURE (2014) (warning that disclosure regulation is often politically expedient to adopt as a com- promise against more effective alternatives). 169 Cf. Hans B. Christensen, Luzi Hail & Christian Leuz, Mandatory CSR and Sustainability Reporting: Economic Analysis and Literature Re- view, 26 REV. ACCT. STUD. 1176 (2021) (warning that mandatory disclosure regimes can have negative unintended consequences and outlining the po- tential effects on firm behavior of mandatory ESG disclosure mandates). 170 See supra note 42 and accompanying text. 171 Hansen & Lott, supra note 42, at 54. 172 Id. 372 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 indexed) institutional investors to force such changes.173 This reality means that any positive effects of portfolio-focused stewardship on portfolio value may prove fleeting. As previ- ously discussed, a financially motivated diversified investor would not favor insulating firm managers from market disci- pline as a solution to this problem, because doing so would ex- acerbate managerial agency costs.174 Moreover, even if firm managers were insulated from the market for corporate control and hedge fund activism, if they prioritize portfolio over firm value they may cede market share to firm-value maximizing firms outside the portfolio. Non-portfolio firms might increase their production of an ex- ternality in response, leading to offsetting harms to portfolio value. After all, there is no magic bubble that limits the expo- sure of portfolio firms to only the externalities produced by other firms in the same portfolio. The portfolio primacy liter- ature sometimes glosses over this by assuming that diversi- fied investors own the entire global economy, but they do not: most are invested in only a subset of U.S. public companies— there are no true “universal owners.”175 In Systemic Stewardship with Tradeoffs, Professors Kahan and Rock detail how competitive responses in the marketplace can detract from the potential for portfolio-focused steward- ship interventions to increase risk-adjusted portfolio value.176 173 See generally Gilson & Gordon, supra note 89. 174 See supra Section III.A. 175 Kahan & Rock, supra note 19, at 504. It is also the case that some portfolio firms will be immune from index fund managers’ portfolio-focused stewardship efforts because they have controlling shareholders or signifi- cant blockholders; these firms’ competitive responses might also offset an- ticipated portfolio gains. See Tallarita, supra note 15, at 517 (observing that even among publicly traded companies, the target of index fund steward- ship, “most companies have a controlling shareholder or an influential blockholder who can frustrate stewardship initiatives”); Dhammika Dhar- mapala & Vikramaditya S. Khanna, Controlling Externalities: Ownership Structure and Cross-Firm Externalities 1, (Eur. Corp. Governance Inst., Working paper No. 603/2021, 2021) (“[T]he widespread prevalence of con- trolled firms with undiversified controlling shareholders constitutes a sig- nificant obstacle to the internalization of cross-firm externalities.”). 176 Kahan & Rock, supra note 19, at 505-08. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 373 They provide examples to illustrate how such responses “can, depending on the circumstances, eliminate or greatly reduce any benefits” from such interventions, leaving diversified in- vestors “with a portfolio loss rather than the gain they had hoped to reap.”177 Professors Fisch and Schwartz similarly warn that because the impact of fund managers’ efforts to ad- dress environmental externalities “is limited to the companies in which their funds invest,” “pollution producing activities can migrate offshore or to private companies rather than dis- appear,” with the result that “public investors continue to bear the costs of the pollution but do not share in the benefits.”178 Market dynamism thus further complicates the task of pre- dicting the effects a portfolio-focused stewardship interven- tion will have on risk-adjusted portfolio value, whether that intervention takes the form of a command-and-control style regulation or disclosure regulation. IV. EVALUATING THE BIG THREE’S EFFORTS There are several points to take away from Part III’s dis- cussion of the real-world frictions that affect portfolio-focused stewardship. To wit: • Interventions which operate by generally eroding man- agerial sensitivity to firm value will likely do more harm to portfolio value (by increasing managerial agency costs) than good (by reducing intraportfolio ex- ternalities). • Interventions which impose vague, discretionary poli- cies on portfolio firms, or policies that are otherwise difficult to monitor compliance with, are unlikely to work given the firm-focused incentives portfolio firm managers face. • Index fund managers may find stewardship interven- tions that decrease risk-adjusted portfolio value com- patible with their private incentives. If a motive other than increasing risk-adjusted portfolio value (and in turn management fees) could explain a purported 177 Id. at 8. 178 Fisch & Schwartz, supra note 19, at 28. 374 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 portfolio-focused stewardship intervention, and the impact of the intervention on risk-adjusted portfolio value is difficult to verify, financially motivated diver- sified investors would question its worth. Verification of the intervention’s value might be difficult because (a) the relationship between the portfolio firm behavior sought to be modified and risk-adjusted portfolio value is opaque, or (b) the effect of the specific intervention on portfolio value is hard to predict. • Relative to public lawmakers, index fund managers have far fewer instruments they can use to force the internalization of externalities—being practically lim- ited to command-and control style regulation and dis- closure regulation—and they face far less accountabil- ity for their policies. • Crafting efficient command-and-control style regulation is very information intensive, and the efficiency of dis- closure regulation will depend on how others (with dif- ferent incentives than financially motivated diversi- fied investors) react to it, which can be difficult to predict. • Judging the likely effect of any type of stewardship in- tervention on portfolio value is complicated by the dy- namic nature of the marketplace, as portfolio gains can be erased through changes in ownership or competitive responses by other firms. With these points in mind, let us turn to evaluate some of the Big Three’s recent stewardship interventions that might be characterized as “portfolio focused.” Would rational, finan- cially motivated diversified investors expect these interven- tions to lead to a net increase in risk-adjusted portfolio value through the forced internalization of intraportfolio externali- ties? A. Statements of Corporate Purpose Starting in 2018, Blackrock began asking the CEOs of its funds’ portfolio firms to express their firm’s “corporate pur- pose,” while emphasizing that a corporation’s purpose should be to “benefit all of [its] stakeholders, including shareholders, No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 375 employees, customers, and the communities in which [it] op- erate[s].”179 In 2019, 181 CEOs of America’s largest public companies signed a letter put out by the Business Roundtable stating that the purpose of a corporation is to serve all stake- holders, not merely to maximize shareholders’ firm-specific re- turns.180 The statement contained vague commitments by the signatories, such as to: “meet[] or exceed[] customer expecta- tions”; compensate employees “fairly” and provide them with “important benefits”; foster “diversity and inclusion”; and “embrac[e] sustainable practices.”181 Many public companies have followed up with firm-specific statements of corporate purpose, which tend to be equally vague. For example, Coca- Cola’s corporate purpose is “[t]o refresh the world and make a difference,”182 and Nike’s is “to unite the world through sport to create a healthy planet, active communities, and an equal playing field for all.”183 Because such vague commitments do not meaningfully limit managerial discretion, they cannot be expected to cause portfolio firm managers to ignore their strong firm-focused in- centives and act to prioritize portfolio over firm value.184 Thus, financially motivated diversified investors would not 179 Larry Fink, Larry Fink’s 2018 Letter to CEOs: A Sense of Purpose, BLACKROCK (2018), https://www.blackrock.com/corporate/investor-rela- tions/2018-larry-fink-ceo-letter [https://perma.cc/4X6T-3UYU]; see also Larry Fink, Larry Fink’s 2019 Letter to CEOs: Purpose and Profits, BLACKROCK (2019), https://www.blackrock.com/corporate/investor-rela- tions/2019-larry-fink-ceo-letter [https://perma.cc/XU66-TEPD]. 180 BUSINESS ROUNDTABLE, STATEMENT ON THE PURPOSE OF A CORPORA- TION (Aug. 19, 2019), https://system.businessroundtable.org/app/up- loads/sites/5/2023/02/WSJ_BRT_POC_Ad.pdf [https://perma.cc/YLM3- KF6A]. 181 Id. 182 Does The Coca-Cola Company Strive to Operate Its Business Respon- sibly?, THE COCA-COLA CO., https://www.coca-cola.com/us/en/about- us/faq/does-the-coca-cola-company-strive-to-operate-its-business-respon [https://perma.cc/5EBN-E5UG]. 183 Nike, THE ALUMNI SOC’Y, https://thealumnisociety.com/part- ners/nike [https://perma.cc/J46C-XKWX]. 184 See supra Section III.A. 376 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 view Blackrock’s intervention on corporate purpose as effec- tive portfolio-focused stewardship. B. Gender Quotas for Corporate Boards The Big Three have each threatened to vote against direc- tors of portfolio companies that fail to increase female repre- sentation on the board.185 Unlike requests for statements of corporate purpose, this type of intervention imposes specific and easily enforceable obligations on portfolio companies. Moreover, the intervention does not generally undermine firm-focused managerial incentives. But financially motivated diversified investors would nevertheless doubt that it would lead to a net increase in risk-adjusted portfolio value, because there are obvious self-serving marketing reasons why the Big Three might want to champion the policy,186 and the link be- tween gender representation on corporate boards and portfo- lio value is not well established.187 C. Emissions Reductions What about the Big Three’s demands that portfolio compa- nies cut greenhouse gas emissions? First off, it is not clear that the Big Three are committed to making such demands. They have recently taken pains to say that they do not require 185 Barzuza et al., supra note 19, at 1265–69 (detailing the Big Three’s efforts at increasing female representation on the boards of portfolio firms). 186 Id. (arguing that marketing incentives best explain the Big Three’s efforts to promote diversity). 187 See Order Approving Proposed Rule Changes Related to Board Di- versity and To Offer Certain Listed Companies Access to a Complimentary Board Recruiting Service, 86 Fed. Reg. 44424, 44432 (Aug. 6, 2021) (noting that studies on the “effects of board diversity are generally inconclusive”); see Fried, supra note 100, at 1 (reviewing empirical evidence and finding that increasing board diversity may reduce investor returns, but positing that doing so could nevertheless be in asset managers’ selfish interest by helping them attract socially minded millennial investors and pensions funds, leading to increased AUM and hence management fees); Sharfman, supra note 19, at 480-87 (arguing that a business case cannot be made for gender diversity mandates and attributing the Big Three’s support there- fore to a millennial marketing strategy). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 377 portfolio companies to meet specific climate targets or other- wise tell them what to do to address climate change; in other words, they have expressly disavowed that they are engaged in command-and-control style regulation.188 Earlier state- ments suggested that they expected commitments from port- folio firms related to emissions and were willing to punish firms that did not make adequate progress toward reduc- tions189—a threat some believe they followed through on in 2021, when they supported Engine No. 1’s proxy campaign to replace three directors at ExxonMobil.190 Some have critiqued this seeming change in position, demanding the Big Three “re- commit” to command-and-control style climate interven- tions.191 What might explain this apparent retrenchment? One pos- sibility is that the Big Three now recognize that prescriptive stewardship interventions are dangerous because their 188 See Larry Fink, Larry Fink’s 2023 Annual Chairman’s Letter to In- vestors, BLACKROCK (2023), https://www.blackrock.com/corporate/investor- relations/larry-fink-annual-chairmans-letter [https://perma.cc/9L6D- E9PW] (“It is not the role of an asset manager like BlackRock to engineer a particular outcome in the economy, and we don’t know the ultimate path and timing of the transition. . . . As minority shareholders, it’s not our place to be telling companies what to do . . . it is for governments to make policy and enact legislation, and not for companies, including asset managers, to be the environmental police. . . . Transition toward lower carbon emissions will reflect the regulatory and legislative choices governments make to bal- ance the need for secure, reliable and affordable energy with orderly decar- bonization.”). 189 See, e.g., Larry Fink, Larry Fink’s 2020 Letter to CEOs: A Funda- mental Reshaping of Finance, BLACKROCK (2020), https://www.blackrock.com/americas-offshore/en/larry-fink-ceo-letter [https://perma.cc/3VTD-2V69]. 190 It is possible, of course, that Big Three support for Engine No. 1’s proxy campaign was driven not by climate concerns but rather by more tra- ditional concerns about firm performance. 191 See, e.g., Angel Au-Yeung, BlackRock Takes Heat From New York City Over Climate Stance, WALL ST. J. (Sept. 22, 2022), https://www.wsj.com/articles/blackrock-takes-heat-from-new-york-city- over-climate-stance-11663864059 [on file with the Columbia Business Law Review] (quoting the New York City Comptroller as writing that “BlackRock now abdicates responsibility for driving net zero alignment on its own port- folio by saying that it does not ask companies to set specific targets”). 378 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 stewardship teams do not possess the necessary information or expertise to determine whether they will have a positive effect on risk-adjusted portfolio value. This realization may have been helped along by Russia’s invasion of the Ukraine, which increased the salience of dangers associated with too quickly abandoning domestic fossil fuel production,192 or by cogent academic arguments as to the uncertain likelihood that the Big Three’s efforts could actually affect the trajectory of climate change.193 Another possibility is that the Big Three’s private cost-benefit calculation has shifted in ways that make such interventions no longer attractive. Whereas environmen- tal activism may have previously paid political dividends by muting common ownership criticism from the Left, recent pushback by Republicans in Congress and by officials in con- servative states has now made it a political and financial lia- bility for the Big Three.194 It is also the case that the potential to profit from such activism by attracting millennial 192 Cf. Alon Brav & J.B. Heaton, Brown Assets for the Prudent Investor, 12 HARV. BUS. L. REV. ONLINE, art. 2, 2021, at 7 (noting the “national secu- rity and economic security implications of ceding fossil fuel production to foreign adversaries”). 193 See generally Tallarita, supra note 15. 194 See, e.g., Fisch & Schwartz, supra note 19, at 29 (describing the re- cent “political backlash” and divestment threats by red states and suggest- ing that this pressure may have caused Blackrock “to reevaluate its ESG stance”); Saijel Kishan & Jeff Green, Onetime Trump Appointee Helps Spark Sweeping ESG Backlash, BLOOMBERG (Nov. 20, 2022), https://www.bloomberg.com/news/articles/2022-11-20/onetime-trump-ap- pointee-helps-spark-sweeping-esg-backlash [on file with the Columbia Business Law Review] (describing the “ESG backlash” against BlackRock and other asset managers). In addition to disclaiming placing environmen- tal demands of portfolio firms, Blackrock has reportedly lessened its support for environmental and social proposals recently. See Brook Masters, BlackRock Pulls Back Support for Climate and Social Resolutions, FIN. TIMES (July 26, 2022), https://www.ft.com/content/48084b34-888a-48ff-8ff3- 226f4e87af30 [https://perma.cc/RAY2-3JBY]. As noted supra, Vanguard also recently quit the Net Zero Asset Managers initiative. See supra note 97 and accompanying text; Ross Kerber & Noor Zainab Hussain, Vanguard Quits Net Zero Climate Effort, Citing Need for Independence, REUTERS (Dec. 7, 2022), https://www.reuters.com/business/sustainable-business/vanguard- quits-net-zero-climate-alliance-2022-12-07/ [on file with the Columbia Busi- ness Law Review]. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 379 investment has decreased, as the popularity of ESG products has waned.195 Whatever the cause, financially motivated diversified in- vestors would likely support the Big Three’s recent turn against prescriptive climate interventions. While such inves- tors would recognize that portfolio firms contribute to climate change, and that climate change poses risks to a diversified portfolio, the impact particular climate interventions would have on risk-adjusted portfolio value is very difficult to deter- mine. As Professor Tallarita has explained, such interven- tions could impose costs on portfolio firms without actually achieving any reduction in portfolio risk, given that some of the largest contributors to climate change are firms outside the portfolio.196 Moreover, the market could react in ways that mute the impact of the intervention—for example, portfolio firms could go private or sell dirty assets to firms outside the portfolio, or non-portfolio firms could gain greater market share, leading to potentially worse climate outcomes and greater portfolio risk.197 It is also hard to anticipate the possi- ble unintended consequences of such interventions on techno- logical innovation, domestic energy security and geopolitical stability—consequences that could negatively impact risk-ad- justed portfolio value. In addition, such interventions could al- ter political dynamics in ways that reduce the likelihood of government action that would more effectively address cli- mate change.198 Given fund managers’ incentives to keep 195 Lauren Foster, U.S. ESG Funds Suffer Worst Quarterly Outflows in More Than 5 Years, BARRON’S (Jan. 27, 2022) https://www.barrons.com/ar- ticles/us-esg-sustainable-funds-outflows-51674767507 [on file with the Co- lumbia Business Law Review]. 196 Tallarita, supra note 15, at 517-18. 197 See infra Section III.D. 198 See, e.g., Tariq Fancy, Blackrock Hired Me to Make Sustainable In- vesting Mainstream. Now I Realize It’s a Deadly Distraction From the Cli- mate-change Threat, GLOBE & MAIL (Mar. 30, 2021), https://www.theglobe- andmail.com/business/commentary/article-sustainable-investing-is-a- deadly-distraction-from-actually-averting [https://perma.cc/G9BR-D97H ] (asserting that government action required to effectively address climate change “is still being held up by the illusion promoted by many global busi- ness leaders that the free market will somehow correct itself and the climate 380 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 costs low and their lack of both expertise and accountability, financially motivated diversified investors are unlikely to trust them with such a difficult calculus. Similar points could be made about most command-and- control style interventions. Importantly, when the expected impact of a command-and-control style intervention on port- folio value is easy to determine, its adoption via government channels should be both feasible and, for reasons discussed in the next section, preferable. Thus, financially motivated di- versified investors—whose rational apathy precludes case-by- case monitoring of stewardship interventions—would likely categorically prefer index fund managers to avoid command- and-control style portfolio-focused stewardship interventions. Notably, Blackrock appears to share this view. Larry Fink’s recent statement that it is not the role of an asset manager “to engineer a particular outcome in the economy” or to “tell[] companies what to do” has implications beyond climate—it ex- presses disapproval of command-and-control style steward- ship interventions on any topic.199 crisis without government action”); Tallarita, supra note 15, at 567 (warn- ing that “portfolio primacy’s flawed promise of an internalization mecha- nism might become a political argument to justify weaker support for pain- ful but necessary regulation” to address climate change); cf. Kahan & Rock, supra note 19, at 539 (suggesting that imposing regulatory costs on portfolio firms through stewardship might serve as a catalyst for political change); Vandenbergh, supra note 167, at 186–87 (warning against assuming that private governance efforts will detract from, rather than promote, the like- lihood of additional regulation); Aneil Kovvali, Stark Choices for Corporate Reform, 123 COLUM. L. REV. 693 (2023) (presenting theoretical arguments in opposition to the claim that corporate governance measure to promote stakeholder interests will impede stakeholder-oriented governmental re- forms). There is a growing empirical literature testing this contention. See Kovvali, supra, at 734 n.180 (collecting studies); Hajin Kim, Joshua Macey & Kristen Underhill, Does ESG Crowd Out Support for Government Regu- lation? (Univ. of Chi. Coase-Sandor Inst. for Law & Econ. Rsch. Paper No. 983, 2023), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4521781 [https://perma.cc/J64W-NLD4]. 199 See supra note 188. No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 381 D. Disclosure Initiatives What about disclosure regulation? Index fund managers have been active in pursuing this sort of intervention in recent years on a range of topics. For example, Blackrock, State Street and Vanguard have all demanded that portfolio firms publish disclosures in line with both the industry-specific guidelines promulgated by the Sustainability Accounting Standards Board (“SASB”) and the recommendations of the Task Force on Climate-Related Financial Disclosures (“TCFD”).200 They have also demanded information related to companies’ diversity, equity and inclusion (“DEI”) efforts, as well a variety of other topics spanning from human capital management to human rights.201 Portfolio-focused stewardship interventions that take the form of disclosure regulation are specific and enforceable, and they do not directly undermine firm managers’ sensitivity to firm value. Such interventions are also less likely to land in- dex fund managers in the crosshairs of regulators or ruffle the feathers of investors in the fund’s other portfolios, so they have fewer disincentives to pursue this type of intervention relative to command-and-control style interventions. This 200 Rose, supra note 2, at 1854–55. 201 See, e.g., Eric Knox, Sehrish Siddiqui & David Venturella, The Big Three Remain Big on ESG, DEI – 2021 Proxy Season in Review, CORPORATE COMPLIANCE INSIGHTS (Sep. 14, 2021), https://www.corporatecompliancein- sights.com/year-in-review-big-three-voting-trends/ [https://perma.cc/9ZU9- 42CB] (reporting on State Street’s “expectations” that portfolio companies will provide “enhanced disclosure regarding the role of diversity in human capital management practices, diversity-related goals, measures of diver- sity (including EEO-1 report data), board-level diversity and board over- sight over diversity and inclusion”); STATE STREET GLOBAL ADVISORS, STEW- ARDSHIP ACTIVITY REPORT Q42022 (2022) reporting that State Street voted against certain directors at Moderna, Inc. after the company failed to acqui- esce to requests to publish its EEO-1 report and SASB-aligned disclosures, and that it has communicated with Walt Disney Company regarding “op- portunities for Disney to enhance its human rights-related disclosures”); STATE STREET GLOBAL ADVISORS, ASSET STEWARDSHIP: GUIDANCE ON DISCLO- SURE EXPECTATIONS FOR EFFECTIVE CLIMATE TRANSITION PLANS (2023) (providing “portfolio companies with clarity on our expectations for effective climate transition plan disclosure”). 382 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 does not mean that disclosure regulation will only be pursued when index fund managers perceive that it will increase risk- adjusted portfolio value, however, given that index fund man- agers may have selfish motives for pushing disclosure regula- tion. For example, doing so may allow index fund managers to create an appearance that they are doing something, which may produce benefits for them regardless of whether it im- proves (or even harms) portfolio value. The disclosures may also subsidize their management of ESG-themed financial products. Financially motivated diversified investors would there- fore likely expect such interventions to increase portfolio value only if there was a clear link between the topic of the disclosure regulation and portfolio value.202 If such a link ex- its, they would also consider how likely it is that that the dis- closures would lead to improvements in risk-adjusted portfolio value. As already discussed, the impact of disclosure regula- tion on portfolio value can be difficult to predict. In the port- folio-focused stewardship context, the hope of disclosure regu- lation is that it will cause certain actors to react in ways that will force portfolio companies to internalize their intraportfo- lio externalities, leading to net increases in risk-adjusted port- folio value. But it can fail to do that and may even have the opposite effect by triggering reactions that reduce risk-ad- justed portfolio value. Recall that potentially affected actors fall into three groups: (1) market actors, such as consumers, suppliers, and non-index investors and their fund managers, who may adjust their market behavior by virtue of the disclosures in a way that forces companies to take account of the external costs of their actions; (2) government actors who may be catalyzed to adopt new regulations (or better enforce existing ones) in light of the disclosures; and (3) index fund managers, who may use the information to help them craft new command-and-control style portfolio-focused stewardship policies (or better enforce 202 See supra note 187. This test is far more likely to be met with re- spect to the Big Three’s demands for climate-change related disclosures than with respect to their demands on various disclosure topics that fall under the “S” in “ESG.” No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 383 existing ones). It seems unlikely that financially motivated di- versified investors would want their index fund managers to promulgate command-and-control style interventions even with the help of additional disclosures, and as just explained the Big Three have seemingly disavowed any intention to do so.203 Thus, we can eliminate the third group from our analy- sis and conclude that financially motivated diversified inves- tors might support portfolio-focused stewardship interven- tions that take the form of disclosure regulation, but only if the disclosure topic bears a clear relationship to portfolio value and it seems likely that the disclosures will prod either (1) market or (2) government actors to take steps that have the effect of causing portfolio firms to internalize their intra- portfolio externalities, leading to increases in risk-adjusted portfolio value net of compliance costs. A full analysis of whether the myriad disclosure demands the Big Three have placed on their portfolio companies in re- cent years pass this test would take us far beyond the scope of this Article. Suffice it to say that many probably would not. With respect to some, reasonable minds might disagree. V. AVAILABLE ALTERNATIVES The foregoing suggests that rational, financially motivated diversified investors would discount the benefits of a portfolio- focused stewardship intervention touted by asset managers, to varying degrees depending on the intervention’s character- istics. They would also consider the alternatives available to them for achieving the internalization of intraportfolio exter- nalities. If those alternatives were expected to lead to a greater net increase in risk-adjusted portfolio value if pursued alone, financially motivated diversified investors would ra- tionally prefer them. Alternatives include direct advocacy by diversified inves- tors for government actors to address intraportfolio external- ities through legal change, as well as delegated advocacy for 203 See infra Section IV.C. 384 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 the same by asset managers.204 Just as financially motivated diversified investors would likely not support command-and- control style portfolio-focused stewardship interventions, they would likely not want index fund managers to advocate for specific regulatory solutions. But they might support advocacy by index fund managers designed to raise awareness of prob- lems that negatively impact portfolio value and to encourage legislative or administrative attention be paid to those prob- lems. Indeed, this approach could complement disclosure reg- ulation imposed by asset managers with the goal of prodding government action. Advocating for legal change may be preferable to portfolio focused stewardship because, as explained above, government lawmakers have a broader array of instruments available to them, often have expertise that index fund managers lack, and are subject to a much greater degree of accountability that serves as a constraint on opportunism. Moreover, laws avoid the Gordian Knot that portfolio focused stewardship interven- tions face because complying with laws is consistent with firm managers’ fiduciary duties. To be sure, laws should be de- signed to maximize social welfare, not risk-adjusted portfolio value, and the two are not the same. But given the foregoing advantages, legal interventions may nevertheless result in greater increases in risk-adjusted portfolio value than portfo- lio-focused stewardship interventions. What if pathologies were expected to preclude effective government action? If that were the case, then obviously ad- vocating for government action would not be an attractive al- ternative to portfolio-focused stewardship as a way to deal with intraportfolio externalities. But the absence of a viable government alternative would not make portfolio focused stewardship interventions that are unlikely to increase risk- adjusted portfolio value suddenly attractive to financially mo- tivated diversified investors. As discussed above, most com- mand-and-control style portfolio-focused stewardship inter- ventions would not be trusted to have a positive effect on 204 Cf. Armour and Gordon, supra note 40, at 61 (remarking that “there may be grounds for institutional investors to influence governance in sys- temic firms through political, rather than firm-level, channels”). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 385 portfolio value. Those that would are the sort that would pro- duce clear portfolio payoffs with little risk, and thus would likely garner broad bipartisan support if a government alter- native was pursued.205 Moreover, disclosure regulation by in- dex fund managers will often fail to effectively address intra- portfolio externalities. Therefore, a more promising approach to the issue of government failure might be to try to correct the underlying pathologies that interfere with effective gov- ernment action. Index fund managers could be viewed as having a role to play in this endeavor, although it is debatable whether finan- cially motivated diversified investors would want them to. Specifically, index fund managers could use fund influence over portfolio firm managers to disable the latter from using corporate resources to fight legal changes that might operate to force the internalization of intraportfolio harms. While this might be thought of as an example of a command-and-control style portfolio-focused stewardship intervention, it is distin- guishable in one critical respect: it leaves the crafting of the internalization solution to the public lawmaking process. They could, more softly, demand disclosure about corporate political spending and lobbying efforts. This could be viewed as disclosure regulation of the sort discussed above, but again it is slightly different. When disclosure regulation was ex- plained supra, the assumption was that the disclosed infor- mation would directly prod actions that would in turn force the internalization of intraportfolio externalities. Here, the chain is more attenuated: the information would be designed to prod—through market actors’ response (or anticipated re- sponse) to the disclosures—a reduction in corporate political spending and lobbying efforts, which in turn could make gov- ernment intervention to address the externality more likely. Whether financially motivated diversified investors would 205 Moreover, it must be remembered that index fund managers are un- likely to push command-and-control style regulations of any sort, given the numerous incentives they face to remain passive, and the Big Three have recently declared that they view doing so as inconsistent with the proper role of an asset manager. 386 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 rationally support these sorts of interventions is contestable for at least two reasons. First, there may be uncertainty regarding the premise that corporate political spending or corporate lobbying have led to a government failure that in turn has negatively impacted risk-adjusted portfolio value. Arguments of government fail- ure must be analyzed rigorously because what one views as government dysfunction another may view as government working by design. Whenever political roadblocks are hit that stall a government response to an externality-generating be- havior, it may be the result of rent-seeking behavior by special interests, or it may reflect genuine disagreements about the correct intervention operating against a government design meant to stall lawmaking in such a situation. Second, and relatedly, corporate lobbying as well as corpo- rate political spending can be both good and bad from the per- spective of financially motivated diversified investors. Such activities would be viewed negatively if they stymied the craft- ing of laws that would cause portfolio firms to internalize in- traportfolio externalities. But such activities would be viewed positively if the efforts prevented the passage of laws that are bad for the portfolio. Corporate lobbying, for example, can help reduce regulatory misunderstandings about what companies are actually doing and the effect regulatory interventions would have on their operations and the economy more broadly; it can also counteract the influence of other special interest groups. Whether reducing corporate influence in pol- itics is desirable from the perspective of a financially moti- vated diversified investor thus turns on a complicated balanc- ing of likely effects, including whether other groups with knowledge about corporate realities could be relied upon to educate policymakers when other special interest groups over- reach. Notably, the Big Three have not been strong supporters of efforts to constrain corporate political spending or corporate lobbying.206 This could reflect their view that limiting 206 Lund, supra note 19, at 86 (“[T]he Big Three generally vote against shareholder proposals aimed at limiting corporate influence in the political process.”); Leo E. Strine, Jr., Fiduciary Blind Spot: The Failure of No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 387 corporate voice in politics would not in fact increase risk-ad- justed portfolio value, perhaps because it would do more harm to the lawmaking process than good, or perhaps because it is not the source of the government gridlock. Alternatively, it could be explained by intermediary agency costs: the impact of such efforts on portfolio value may not be significant enough to index fund managers’ compensation to warrant the under- taking. Figuring out whether the effort would actually benefit the portfolio would be difficult and hence costly. Moreover, supporting efforts to reduce corporate influence in politics could alienate portfolio firm managers, jeopardizing 401(k) business, and risks triggering political backlash. The Big Three may also wish to preserve their own ability to engage in lobbying and political spending. Professor Lund offers an- other possibility. She writes that “the Big Three appear to en- joy exercising regulatory heft as a result of government dys- function,” noting that “[r]ather than using their power to alleviate rent-seeking by industry (which they also engage in), they choose to maintain the status quo, which positions them well to attract new clients and satisfy existing ones.”207 VI. CONCLUSION: IMPLICATIONS FOR MODERN DEBATES This Article’s critical examination of portfolio-focused stewardship sheds light on several contemporary debates. Most directly, it offers guidance on how index fund managers’ fiduciary duties should be understood in relation to steward- ship—a timely contribution, given that Congress is currently investigating whether the Big Three’s ESG-related steward- ship efforts conform with their fiduciary responsibilities.208 The analysis suggests that the financially motivated diversi- fied investors to whom index fund managers owe their duties Institutional Investors to Prevent the Illegitimate Use of Working Americans’ Savings for Corporate Political Spending, 97 WASH. U. L. REV. 1007, 1019 (2020) (asserting that the Big Three “have opted for a policy of total defer- ence to management” on political spending issues). 207 Lund, supra note 19, at 125. 208 See supra note 21. 388 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 would likely support only a narrow band of portfolio-focused stewardship interventions. Index fund managers should therefore not be viewed as possessing broad license to wield their influence over portfolio firms in a manner that purports to prioritize portfolio over firm value. In particular, the anal- ysis suggests that index fund managers should generally avoid command-and-control style portfolio-focused steward- ship interventions and should carefully consider the likely ef- fect of disclosure-based interventions on portfolio value. The Article’s analysis also has significant implications for the contemporary debate over SEC-mandated ESG disclosure. It demonstrates that financially motivated diversified inves- tors would likely limit their support of portfolio-focused stew- ardship to interventions that take the form of disclosure reg- ulation (if they support portfolio-focused stewardship interventions at all). One threshold question this raises for SEC-imposed ESG disclosure mandates is why/whether finan- cially motivated diversified investors would support those mandates, given the ability of their index fund managers to directly impose disclosure regulation on portfolio firms through portfolio-focused stewardship efforts. The answer that ESG disclosure advocates would likely offer is that SEC disclosure mandates provide a comparability and credibility that cannot be achieved through the private efforts of index fund managers. Reasonable minds might differ on how con- vincing such a response is. The SASB and TCFD disclosure frameworks that the Big Three have pushed on portfolio com- panies are specifically meant to foster comparability, and in- dex fund managers could insist that portfolio firms include SASB and TCFD disclosures in SEC filings. Moreover, codify- ing disclosure in SEC regulations undermines one of the main benefits of a privatized regulatory approach—flexibility to change and adjust over time at low cost.209 But a more fundamental question is lurking. The benefits of comparability and credibility, while often cited as a reason favoring mandatory as opposed to voluntary disclosure, are 209 For an argument that the SEC should make its climate-related dis- closure mandates optional, see Scott Hirst, Saving Climate Disclosure, 28 STAN. J.L. BUS. & FIN. 91 (2023). No. 1] A HARD LOOK AT PORTFOLIO FOCUSED STEWARDSHIP 389 not a sufficient basis for SEC disclosure mandates. The disclo- sures that SEC mandates would standardize, and whose cred- ibility they would enhance, must be of the sort that the SEC has the authority to compel. The foregoing analysis suggests that if financially motivated diversified investors were to sup- port portfolio-focused disclosure regulation, the goal would not be to provide index fund managers with the information they need to craft more prescriptive portfolio-focused stewardship interventions in the future. In other words, they would not consider the information, to use the materiality test set forth in TSC Industries, Inc. v. Northway Inc., “important in decid- ing how to vote.”210 Rather, the goal of the disclosure regula- tion would be to prod other market actors or, alternatively, government actors (e.g., Congress or the EPA), to take steps that have the effect of forcing portfolio companies to internal- ize the costs their actions impose on other portfolio firms. Should the SEC view disclosure designed for this purpose as within its mandate? Should the courts condone such a view? While ultimately serving the interests of diversified investors, such disclosures would be directly aimed at different audi- ences, including non-financially motivated investors and var- ious non-investor groups like consumers, labor unions, regu- lators and legislators. This represents a significant departure from the traditional use of SEC disclosure mandates to assist investors in making investment and voting decisions.211 Ac- cepting it could lead to a broad expansion of the scope of the agency’s authority. Finally, this Article’s analysis helps to contextualize calls for index funds to adopt pass-through voting regimes. Many recent proposals recommend that index funds’ beneficial 210 TSC Indus. v. Northway, 426 U.S. 438, 440 (1976). 211 Cf. Kahan & Rock, supra note 3, at 122 (stating that the SEC’s man- date “does not include supplying product information to consumer [sic] or work-related information to employees”). As noted in the introduction, if the disclosures were aimed at influencing the behavior of financially motivated non-index investors, portfolio primacy theory would add nothing to the other two financial arguments that have been advanced in favor of SEC- mandated ESG disclosure—namely, that mandated ESG disclosure may be warranted to the extent that it helps investors better estimate firms’ future expected cash flows or their systematic risk exposure. 390 COLUMBIA BUSINESS LAW REVIEW [Vol. 2024 owners, rather than their fund managers, be given the right to vote fund shares in proportion to their beneficial ownership; legislation has been proposed that would require this212; and the Big Three have begun some experimentation with the idea.213 The clout of the Big Three—their ability to impose pol- icies that could potentially have portfolio-wide effects—stems from their ability to collectively direct the votes of the shares owned by the index funds they manage. If voting rights in- stead passed through to the funds’ beneficial owners, it could eliminate the potential for portfolio-focused stewardship. The analysis herein suggests that hamstringing portfolio-focused stewardship would likely be perceived by financially moti- vated diversified investors as a benefit, rather than a cost, of pass-through voting. But, depending on how it is designed, pass-through voting could also diminish the ability of index fund managers to police portfolio firms for managerial agency costs. Whether, or under what circumstances, financially mo- tivated diversified investors would support pass-through vot- ing given this tradeoff is an important topic for future re- search. 212 See supra notes 107 & 160; see also Investor Democracy Act, S.4241, 117th Cong. 2d Sess. (2022). 213 See, e.g., Larry Fink, Letter to Blackrock Clients and Corporate CEOs: The Transformative Power of Choice in Proxy Voting, BLACKROCK (Nov. 3, 2022), https://www.blackrock.com/corporate/about-us/investment- stewardship/blackrock-voting-choice/proxy-voting-power-of-choice [https://perma.cc/99HR-HLLL]; Ross Kerber, State Street to Offer Proxy Vot- ing Choices to Retail Investors, REUTERS (May 22, 2023), https://www.reu- ters.com/business/finance/state-street-offer-proxy-voting-choices-retail-in- vestors-2023-05-22/ [on file with the Columbia Business Law Review]; Empowering Everyday Investors Through Proxy Voting Choice, VANGUARD (Feb. 1, 2023), https://investor.vanguard.com/investor-resources-educa- tion/article/empowering-everyday-investors-through-proxy-voting-choice [https://perma.cc/PT88-R48Y].