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ESG and ERISA: Pity the Poor Tort Lawyers Their Lost Business as Biden Gives a Safe Harbor For Now
The pen taketh away, so the pen could giveth later.... (to the class action lawyers)
Well, looks like the Biden Admin is trying to give ESG funds a cover just as the supposedly ESG-i-est of ESG ops blew up.
WSJ editorial: Biden Puts Your 401(k) to ESG Work
The Biden regulatory machine doesn’t rest, even in Thanksgiving week. On Tuesday the Labor Department finalized a rule that empowers retirement plan sponsors to invest based on environmental, social and governance (ESG) factors and put your 401(k) to progressive political work.
The Labor Department casts its rule as a mere clarification of the 1974 Employee Retirement Income Security Act (Erisa), which requires that retirement plan sponsors act “solely in the interest” of participants and beneficiaries. A Trump Labor rule barred retirement managers from considering factors that weren’t material to financial performance and risk.
Let me break in here for a moment:
(editorials would be improved by the use of memes, don’t you agree?)
Asset managers and union pension plans claimed the Trump rule limited their discretion to consider such ESG factors as climate, workforce diversity and labor relations. The Biden DOL says it created a “chilling effect” on ESG investing. Its replacement rule gives plan sponsors nearly unlimited discretion and legal protection to invest based on these often political considerations.
“A fiduciary may reasonably conclude that climate-related factors” including “government regulations and policies to mitigate climate change, can be relevant to a risk/return analysis of an investment,” the rule says. Ditto workforce diversity, inclusion and labor relations since they may affect employee hiring, retention and productivity.
The main point of the Biden rule is to give legal protection to retirement plan fiduciaries that invest based on ESG. A secondary goal is to steer more retirement savings into ESG funds that often charge higher fees by allowing retirement sponsors to offer them as default options in 401(k) plans. Workers automatically enrolled in default funds can opt out, but they usually don’t.
Well, I guess the ESG forces have outbid the ERISA tort lawyers on this one.
FTX had stellar ESG ratings right before implosion
Oh, look who had the best ESG ratings, including the one I like, which is governance:
ESG ratings agencies such as S&P Global, MSCI, Sustainalytics, and Truvalue Labs calculate scores for individual companies and compile ESG indices based on a variety of factors such as the degree of diversity among board directors, exposure to greenhouse gas emissions, firearms, and human rights violations. According to an ESG score from Truvalue Labs, FTX scored higher on “leadership and governance” than ExxonMobil. However, FTX’s new CEO overseeing the bankruptcy stated, when talking about FTX, that he had never “seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information.”
Although still under investigation, FTX has been accused of several corporate governance failures. The company lacked a coherent board of directors. It also allegedly transferred customer funds to crypto hedge fund Alameda Research to conduct speculative transactions, failed to establish proper cash management procedures, and possessed unaudited financials.
When Sam Bankman-Fried (SBF) led FTX, the company prided itself on its social and environmental activism. The FTX Foundation, FTX’s charity arm, stated its dedication to climate change, animal welfare, and future pandemic prevention. The Foundation established projects such as the Future Fund, which was funded mainly by FTX’s top leaders, to “make grants to nonprofits and individuals, and investments in socially-impactful companies.”
While noble causes at face value, the board of directors’ fiduciary duty is to its shareholders and ensuring the maximization of financial returns. Too much focus on ancillary ESG factors distracts from a company’s fiduciary duty.
It sounds like the “leadership and governance” metric was leaning a little too heavily on bullshit, eh?
When I talk about “governance”, I’m talking about independent directors with relevant experience. I’m talking about having the chair of the board be a different person than the CEO. That sort of thing. Financials being issued on time. Good controls. No messing about where it’s obvious they’re doing “clever tricks” in the financials. That sort of thing.
It looks like they had zero governance.
No ESG Standard
WSJ editorial: Sam Bankman-Fried Becomes an ESG Truth-Teller
Mr. Bankman-Fried is also acknowledging that he genuflected to regulators and Democratic lawmakers to win political protection. ESG ratings company Truvalue Labs even gave FTX a higher score on “leadership and governance” than Exxon Mobil, though the crypto exchange had only three directors on its board. The directors were Mr. Bankman-Fried, another FTX executive and an outside attorney. Truvalue Labs says FTX was given an overall “laggard” score.
“ESG has been perverted beyond recognition,” Mr. Bankman-Fried confessed in an interview this week with Vox in which he also acknowledged that his advocacy for strong crypto regulations was “just PR.”
He said he feels “bad for those who get” harmed by “this dumb game we woke westerners play where we say all the right shiboleths [sic] and so everyone likes us.” Ah, yes, the poor saps who invest in companies because they claim to be sustainable.
And that’s one of the biggest problems with simply saying “it’s okay to privilege ESG in selecting funds”.
There is no real standard. Can you tell if the raters actually did something wrong with ESG scores?
At this time, there is no fully agreed-upon measure of what items should be evaluated in determining an ESG score, and there also is no agreement on how these items should be evaluated. That remains up to the individual entity itself, which obviously causes problems. There are organizations that try to publish their own guidelines about how to do this, but so far there is no “rating agency” using metrics generally agreed-upon in the same way as Moody’s and Standard & Poors work in the financial agency (although we saw in 2008 how susceptible they are to malfeasance).
Now comes FTX, which in one day literally wiped out billions of dollars of shareholder value, and is threatening the entire crypto-currency industry. As more information comes out about FTX, it becomes more likely that even the most basic levels of corporate governance and institutional transparency may not have been met. Indeed FTX’s new CEO, John J. Ray III, wrote in a bankruptcy court filing that “never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”
What makes this failure at FTX relevant to the corporate, governmental and airport world is that, just last week, it became public that one of the agencies trying to rate companies for ESG, Truvalue Labs, had given FTX a higher ESG score for governance than it had given to Exxon Mobil. Again, this score was given to FTX by an ESG rater despite the fact that it appears FTX had almost no level of corporate governance.
Behold! The Emperor’s new clothes!
Yeah, maybe we need to go back to basics here.
There is a big problem at the heart of ESG – there is no way you can measure how well the ESG scores measure anything.
At least with credit scores, one can check default and delinquency rates. ESG scores don’t really have an external result you can check against.
Tort lawyers and politicians aren’t always the bad guys — checks & balances
Points and Figures: The Newest Web: ESG Investing is a Fraud
But, if you are a mom-and-pop, you might put your money in a Fidelity-type fund. Due to the change in language, the manager of that fund can now invest into companies that will yield zero or negative return and suffer no consequences from doing it. Not only that, the government has shielded them from legal consequences as well.
The line about how the Trump administration verbiage “chilled” investment into these sorts of entities is telling. The language was put in to prevent fraud. That bad orange man Trump “limited their financial discretion”. Oh, the humanity. They might actually have to compete and earn the best return on investment for their customers.
The people in the game can’t play the game if they have to suffer legal consequences for playing it. They have to compete. They don’t want to compete because they might lose.
All this stuff that is being rammed down your throat invites fraud. It’s an engraved invitation with no RSVP on it. Come when you want as long as you toe the line. When you don’t have standards, you can’t have competency. If you can’t be held accountable, then you can do anything you want in the name of whatever cause du jour is the current thing.
The ESG funds already existed, for what it’s worth. They’ve existed for decades. But they were niche, having to sell via retail, attracting customers one-by-one. Some people are willing to pay the extra fees these funds charge, but it also costs more to acquire customers one-by-one.
The big money is attracting big buckets of money at a time — i.e., official retirement accounts through employment. But that’s why we have legislation like ERISA, because yes, we know that big piles of money attract all sorts of players.
One of the results of ERISA is that tort lawyers can seek big paydays via class action lawsuits against ERISA fiduciaries. It keeps the fiduciaries in line, usually the deep-pocket employers, who select the fund managers and funds for private pensions and 401(k)s. In general, for 401(k) funds, the lawsuits were around fee levels being too high. There had been a few lawsuits over default fund choices.
The point of all this is to help the inherent principal-agent problem at the heart of all this — the principal here is the employee who is having deferred compensation invested on their behalf, and multiple agents are acting for them: the employer and the fund managers in particular.
The employer may have something of an aligned interest, but they may care more about their reputation as an “enlightened” player in using ESG funds in their pension. So watch out, those with DB pensions!
As for fund managers, no, they don’t necessarily align their interests with those with 401(k)s. They get their fees as a percentage of the assets under management, usually, no matter the performance. They can lose assets if customers aren’t happy, but many people don’t change their allocations once their money is deposited.
ERISA imposes a fiduciary duty on these players, and in one particular, the employers in selecting appropriate funds for default choices in 401(k)s. Before this latest move by the Biden admin, the fiduciary duty meant the focus was the financial performance of the fund (and thus focused on the investment strategy and the fees charged), and so this kept a rein on how outlandish the funds could get.
The balancing powers were the tort lawyers who could break out class action lawsuits against these sponsoring employers. I have seen what I considered absurd lawsuits over a few basis point difference in fees (0.01 percentage point = 1 basis point — a standard unit for asset management fees).
Given that ESG funds definitely have higher fees, and by necessity will have lower returns than other funds, of course, prior ERISA interpretations of fiduciary duty requiring a focus on investment returns would have deterred sponsors from chasing the ESG dream.
Personal advice: check your own accounts and buy the politicians
My main advice for individuals is to actually check out the information on the funds on offer for your 401(k) accounts.
First, don’t feel guilty that you haven’t looked at it recently. In fact, don’t rush. There’s no hurry (unless you’re retiring tomorrow).
Pick a specific date within the next 6 months to look. What you’re going to look for: fees and strategy.
I’m not going to give any advice as to what allocation you should go for. Other people do that, for money.
But the main effect of this new rule with respect to 401(k)s, is that employers can set the default allocation to ESG funds. Those will tend to have higher fees than non-ESG funds. And a lot of people do not change their allocation away from the default.
So all I’m saying is to take a little look. My own research has been that when one is fairly far away from retirement, it’s okay to look at it only once a year.
My mom told me that as a rule of thumb when I was young, and then I checked that as a research project at TIAA, and yeah, you don’t need to look at it more often than that. You only need to get a bit more involved when you’re about within 5 years of retirement, and then it’s not that you should be actively investing, but that you could be considering your retirement income options.
I am unhappy with this Biden Admin pronouncement, and I feel so bad for the lost business for the tort lawyers. Such a lost opportunity.
But the tort lawyers know that what bureaucrats and executive orders take away can also be given by bureaucrats and executive orders. (note: I am not a lawyer of any kind).
Hang in there, guys! You were just outbid by the asset management folks for now… I bet you can outbid them next time!
Okay, maybe not, but keep the dream alive!
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