Saturday, June 27, 2020

Private Equity In, ESG Out

The Department of Labor has been a busy bee.

First, it approved the use of private equity investments in 401(k) plans.  The idea would be that workers would be able to invest in funds that invest in private equity funds; apparently, some funds are already on offer, and they also hold a small amount of publicly traded stock to satisfy liquidity concerns. Jay Clayton at the SEC endorsed the move, saying it would “provide our long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds as well as the benefit of selection and monitoring by ERISA fiduciaries.”

Second, the DOL proposed new rules to discourage the use of ESG investing with respect to ERISA-regulated retirement plans (and because many state pension funds are not covered by ERISA but follow its lead, the rules could extend much further).  The proposed rules are not exactly a surprise; they follow guidance that the Trump Administration put out in 2018, and which I blogged about at the time.  And – as I also blogged– in 2019, the Administration warned the DOL was continuing to examine the issue with a view to more action on this front.

So what are the implications?

First, though the private equity rules are championed by those who argue they will allow retail investors access to higher profits, it’s ironic that they come just when a new study shows that private equity investments are no more profitable than public markets, and almost concurrently with a new SEC warning of pervasive conflicts in the private equity industry that lead to hidden fees and unequal allocation of investment opportunities.  Institutional investors in private equity funds have long complained to the SEC of the lack disclosure of these matters, and rather than respond to that, we’re apparently … going to open the 401(k) spigot.  That, I think, will make private equity managers less accountable to investors and the public (why bargain with a union pension fund when you’re getting billions from a bunch of different funds layered through so many intermediaries that no one’s able to monitor things?) and more opaque. 

Second, as I’ve talked about before, ESG can have a bunch of different meanings.  Some use it as a stockpicking technique like any other, on the theory that socially responsible companies are valuable companies.  Others use it for moral/impact reasons; they are willing to sacrifice at least some returns in order to adhere to their ethical commitments.  When it comes to ERISA plans, the past several presidential administrations have all agreed that fiduciaries must only use ESG to advance the economic interests of plan beneficiaries; they are not permitted to use beneficiaries’ money to advance unrelated social goals.  What’s been different over the years, however, is the standard of proof that fiduciaries must meet in order to incorporate ESG factors into their decisionmaking.  The new rule imposes a very high standard, by explicitly directing that fiduciaries using ESG analysis “examine the level of diversification, degree of liquidity, and the potential risk-return in comparison with other available alternative investments that would play a similar role in their plans’ portfolios.”   That requirement, unique to ESG, betrays a deep distrust of ESG investing, and will very likely dissuade at least some fiduciaries from engaging in ESG activity at all for fear of being unable to adequately justify their decisionmaking.  And, critically, the rule does not merely apply to buying and selling securities; it also applies to other types of plan administration, including voting and engagement decisions.  Which means, among other things, it targets union involvement with shareholder proposals.

It’s worth pointing out that the US’s approach here is precisely the opposite of the European approach, where the default assumption is that ESG factors should be considered as a part of prudent asset management.  Recently, the SEC Investor as Owner Subcommittee recommended that the SEC “begin in earnest an effort to update the reporting requirements of Issuers to include material, decision-useful, ESG factors,” and part of the rationale was that the US risks letting other jurisdictions set the pace on these issues.  The DOL’s proposed rule, I believe, will only accelerate the process of ceding leadership to the European Union.

Notably, in recent years, several commenters have pushed institutional investors to look beyond simple financial returns and consider to the overall welfare of their human beneficiaries when making investment decisions.  David Webber has argued that pension funds should be able to allocate dollars in a way that benefits labor and unionization, Nathan Atkinson has argued that institutional investors should be mindful of the overall interests of their clients (as consumers, employees, etc), and former Chief Justice Strine has argued that institutional investors should concern themselves with the health and welfare of their human beneficiaries when casting proxy votes (the latter piece with Antonio Weiss).  The proposed DOL rule would put the kibosh on that, at least for ERISA plans, explicitly mandating that plan fiduciaries evaluate “investments and investment courses of action based solely on pecuniary factors that have a material effect on the return and risk of an investment based on appropriate investment horizons and the plan’s articulated funding and investment objectives…”

The new rule also discourages including ESG funds in 401(k) plan menus.  If the rule takes effect, ERISA fiduciaries would only be permitted to include such funds if they are chosen for their financial returns, with a special requirement that they document their reasoning.  Those special recordkeeping requirements, of course, will make it difficult to include ESG funds in 401(k) plans at all. According to the DOL release, there aren’t many 401(k) plans that offer ESG investments now – maybe 9% of them do – but ESG funds are a growing segment of the market and there has been a lot of advocacy to expand 401(k) ESG offerings.  This rule, if enacted, will likely dampen that effort.  More broadly, it could discourage the development of any ESG funds, because these funds would be functionally unavailable both to 401(k) plans and to ERISA-covered pension plans.  Notably, the rule has a capacious definition of ESG – it encompasses any fund that includes “one or more environmental, social, and corporate governance-oriented assessments or judgments in their investment mandates … or that include these parameters in the fund name” – so the rule’s knock-on effect may be to dissuade mutual funds from considering these factors at all (or at least mentioning them in their prospectuses).  Which is significant, given that Larry Fink has said that he plans to “mak[e] sustainability integral to portfolio construction” in BlackRock funds.

The DOL rules, then, are of a piece with new SEC proposals to limit shareholder use of 14a-8 and expand retail access to private offerings. The rules, collectively, favor minimizing corporate accountability to investors and the general public in favor of opacity and unfettered management discretion.  And the Administration seems to be encouraging short-term business models – private equity – over the long-term risk mitigation strategy of ESG, which is odd, because as I previously blogged, the Administration, like a lot of Delaware caselaw, has explicitly stated that the purpose of the corporation is to maximize long-term shareholder welfare. 

(That said, it appears the Chamber of Commerce objects to the ESG proposal, on the ground that the recordkeeping requirements may prove a tempting target for plaintiffs raising fiduciary duty claims, and with that kind of opposition, we may see some changes before a formal enactment.)

Stepping back, it should be obvious none of this has anything to do with investor choice. The true tell is the rule regarding ESG fund inclusion in 401(k) plans.  As I said the first time I blogged about this issue:

It’s all well and good to require that ERISA fiduciaries act solely in the economic interests of beneficiaries, on the assumption that this is what beneficiaries would likely want, and on the assumption that wealth maximization functions as “least common denominator” for beneficiaries’ otherwise conflicting interests.

But this reductionistic approach to defining beneficiary interests, adopted for the purpose of making them more manageable, should not stifle opportunities to accommodate the actual preferences of beneficiaries, especially when it is feasible to allow beneficiaries to sort themselves – like, say, when ESG-focused funds can be made available to those beneficiaries who are willing to sacrifice some degree of financial return to advance social goals.  Providing these opportunities to beneficiaries who choose them inflicts no damage on the interests of beneficiaries solely interested in financial return, and, in fact, the principle that investors should be able to control their own retirement planning is (supposedly) the reason these types of ERISA platforms are offered in the first place.

The new guidance, then, seems less about protecting beneficiaries from politically-motivated fiduciaries than it is about forcing beneficiaries to participate in the political goals of the Trump administration, namely, minimizing shareholder participation in corporate governance, particularly when those shareholders advance (what are usually) liberal policy priorities.

To be sure, we don’t have a whole lot of funds that openly advertise their plan to sacrifice returns in favor of social goals; it’s a real issue that funds billing themselves as “ESG-focused” are not clear about their strategies, and that’s something the SEC is legit investigating. But assuming we can get full disclosure, and there is a demand for such funds, the DOL is dictating the choices of millions of investors, many of whom will have no other exposure to the market.

Which brings me to my main point, which is, all of these proposed changes simply highlight that it is inaccurate to the point of absurdity to describe the American corporate governance system as “private law.”  State choices dictate the build of the business form, its accessibility to the public, the structure of investors themselves, and their preferences when allocating capital.  That’s the thesis of my latest Essay, Beyond Internal and External, which argues that corporate governance is subject to pervasive regulation in a manner that directly effectuates public policy.  If we’re going to have the state make these kinds of choices, we should at least own them, rather than cloak them in the language of “private ordering.”

Ann Lipton | Permalink


The DOL's proposed rule simply reinforces what ERISA requires. The Rule is not inconsistent with the statute or judicial interpretation of the statue by the federal courts, including the Supreme Court. For example, in “‘providing benefits’” under ERISA, the Supreme Court has held that the relevant purpose to which ERISA’s "sole interest rule" applies is “financial benefits” for the plan beneficiaries. See Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459, 2468 (2014). In sum, if you want ESG funds to play a major role under ERISA, you will need to change the law.

For an excellent explanation of what the law is, please see Max M. Schanzenbach & Robert H. Sitkoff, "Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee," Stanford Law Review, . I also have a related article, Now is the Time to Designate Proxy Advisors as Fiduciaries Under ERISA, Stanford Journal of Law, Business & Finance,, which relies heavily on the thinking found in Schanzenbach and Sitkoff.

Posted by: Bernard S. Sharfman | Jun 27, 2020 8:23:28 AM

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