Cherry Reynard examines how environmental, social and governance (ESG) principles are being incorporated into securities lending programmes.
The concept of investing sustainably has moved from the side lines to the mainstream over the past 10 years. A perfect storm of regulatory intervention, pressure from investors and increasingly onerous consequences for poor corporate behaviour have seen the investment industry wake up and take note, examining their investments through a sustainability lens.
The Global Sustainable Investment Alliance’s Global Sustainable Investment Review 2018, published this April, found that at the start of 2018, global sustainable, responsible and impact (SRI) investment assets reached $30.7 trillion, up 34% since 2016. This varies markedly across the world: responsible investment commands 18% of professionally managed assets in Japan, rising to 63% in Australia and New Zealand. Europe and the US are the two biggest markets, with €12.3 trillion ($14.1 trillion) in assets under management, and $12.0 trillion respectively.
A recent report from BNP Paribas Securities Services, The ESG Global Survey 2019, showed that ESG factors are increasingly embedded within asset owners and managers’ activities, with the aim of both increasing returns and managing risk. In 2019, BlackRock CEO Larry Fink said in his annual letter to CEOs: “Companies that fulfil their purpose and responsibilities to stakeholders reap rewards over the long term. Companies that ignore them stumble and fail. This dynamic is becoming increasingly apparent as the public holds companies to more exacting standards. And it will continue to accelerate as millennials – who today represent 35% of the workforce – express new expectations of the companies they work for, buy from, and invest in.” It is not unrealistic to suggest that those asset managers that do not embrace sustainability in their security selection may not have a business in future.
Voting rights and borrower purpose
How does this interact with securities lending? This is a huge business for many asset managers and allows them to offer cheaper fees to clients. It is clear that there is the potential for conflict in several areas. The first is voting rights. Xavier Bouthors, senior portfolio manager at NN Investment Partners (NN IP), says: “Our Responsible Investing team cannot engage with companies if the voting rights have been passed on to someone else. So, every security needs to be available for voting, which may sound simple and obvious, but it requires a solid process of monitoring record dates and issuing recalls when necessary.”
Ryan Smith, head of ESG research at Kames Capital, says where voting rights are passed over it can spell trouble: “The trouble with stock lending is that you don’t always know who you are lending it to and whether that person could be using it to advocate for something bad, or short termist.”
This is ‘empty voting’ - where activist investors borrow from long-term shareholders to use their voting rights. The practice is generally condemned, but still goes on. The Bank of England’s money market code is clear - “Securities should not be borrowed solely for the purpose of exercising voting rights.” – but it is not legally binding. The most notorious case was in 2002 when activist investor Laxey Partners borrowed 42 million shares in British Land, including from governance champion Hermes Investment Management, and then used it to put pressure on the board. More recently, the Oasis hedge fund borrowed stock on Premier Foods, which it used to vote against the chief executive.
Guillaume Prache, managing director at Better Finance, says: “ESG investment managers must examine carefully what is the identity and business purpose of the securities borrowers. ESG managers should beware short sellers who try to influence the price of an issuer’s securities for short or very short-term purposes. Helping those by lending them securities is not compatible in our view with at least the G part of ESG: governance.” The same is true where borrowers are trying to use stock lending to improve their tax position. There can be short-term transactions around a dividend date, for example.
Knowing and understanding the nature of the borrower is also important in reducing the risk of a rogue or unethical counterparty, another challenge for securities lending programmes. Whereas previously a counterparty may only have been assessed on their creditworthiness, now they may need to fit certain ethical criteria as well. Lenders such as NN IP have dealt with this by creating internal ratings on counterparties. This will incorporate a review of counterparties’ code of conduct and tax principles. It also stops any new loans being issued on securities within one week prior to the record date, to prevent stock lending being used for tax manipulation.
Lenders are adjusting their practices to meet these new requirements. Bouthors says: “We monitor the record dates and AGMs so that we can ensure our securities are back well in time to vote. Lenders should seek to automate this as much as possible. We are fortunate to be able to rely on our lending agent to take most of the burden of this, but we are aware that not all agents offer this.
“A key step in incorporating ESG factors is the protection of voting rights. So we maintain the right to recall and restrict our securities at any time to engage in shareholder meetings…We then recall the securities and restrict them from lending until voting is concluded.” This approach is aligned with the UN’s PRI Guidance on Securities Lending as well as EFAMA’s Stewardship Code and Principles.
Collateral can also be a problem. Does the collateral received meet the investment guidelines of the fund? It is no use if the collateral for lending on a responsible sustainable company is government bonds from a country with a poor human rights record, for example. In practice, collateral is increasingly posted in cash, so the problem does not necessarily arise, but investors need to bear it in mind.
Bouthors says this is becoming easier: “‘Exclusion lists’ were once tricky to incorporate but are now adopted by tri party collateral agents as part of a push from beneficial owners.” Citi Agency Securities Lending, for example, says it allows clients to tailor cash collateral investment in accordance with the ESG factors that are most important to them. KAS Bank says its collateral programme can take full account of an investor’s ESG policy, labelling it ‘ESG proof’.
The compatibility question
There is a broader question on whether facilitating shorting - as securities lending does - is unethical in itself. Shorting can be seen as going against the principles of long-term investment in good, ethical companies. However, Prache argues that the two are compatible: “Securities lending can be compatible with ESG investment. ESG investment funds should be in a position to lend part of their portfolios of securities as ESG means long-term investments and therefore should also mean a lower turnover of their portfolio, thus allowing to lend part of the securities they hold for a short period. It is also the duty of any asset manager to try to maximise the returns for their clients, and securities lending, if done in a controlled way, is an opportunity to add value for fund investors.”
There is also an argument that short selling facilitates price discovery and can help expose poor behaviour by companies. Short selling should play an important role in creating efficient markets.
In May 2019, the Alternative Investment Management Association (AIMA) published a Responsible Investment Primer which states that short selling is neither irresponsible nor unethical, and that it can form a critical tool in responsible investment: “For instance, a manager could short a company with poor environmental practices that were hidden from the public and which the market had failed to price in.” The primer goes on to note, however, that “some of the most stringent responsible investors may prohibit short selling for a variety of reasons”.
The move to incorporate ESG principles is a sea-change for asset managers and securities lending programmes must move with them. There is a growing realisation that securities lending programmes must be able to integrate these preferences. They are now moving with the times.