An Earthquake in Texas

An Earthquake in Texas

The following commentary/analysis is one I wrote in my capacity as a senior fellow at “the nation’s oldest consumer protection agency,” Consumers Research, where, among other things, I compile a weekly letter for public pension-fund managers.  I am sharing it here today because I thought it might be useful to some of you.

 

The Beginning of the End for ESG?

Last Friday, Federal Judge Reed O’Connor (of the US District Court for the Northern District of Texas) issued a ruling that may prove to be the death knell for ESG.  Or it may not.  It’s hard to say at the moment.  The ruling – in a lawsuit brought by an American Airlines pilot against his employer and its retirement plan – will almost certainly be appealed.  Until it is, however, and unless it is reversed, it provides significant grist for the mill on ESG.  More to the point, even if it is reversed, or if parts of it are reversed, much of the argument made by Judge O’Connor in his ruling should stand as a stark warning to the nation’s corporate executives.  The story goes as follows:

American Airlines Inc. violated federal law by filling its 401(k) plan with funds from investment companies that pursue environmental, social, and corporate governance goals, a Texas federal judge ruled Friday in the biggest victory yet for opponents of the strategy.

The airline breached its fiduciary duty of loyalty—but not its fiduciary duty of prudence—in allowing its $26 billion retirement plan to be influenced by corporate goals unrelated to workers’ best financial interests, Judge Reed O’Connor of the US District Court for the Northern District of Texas said after a four-day, non-jury trial.

In his decision, O’Connor posited two key arguments, one of which is controversial, and the other of which really is not.  To date, most of the media attention and analysis of the ruling has focused on the controversial argument, largely because the potential ramifications are clearly and inarguably monumental.  This is a mistake.  The implications of the more conventional, non-controversial argument may not be as clear and inarguable, much less as monumental, but they are still significant and, indeed, pose a serious and imminent threat to the ESG movement.

In the more significant and more controversial of his arguments, Judge O’Connor essentially adopted the anti-ESG position in whole, declaring that ESG “considers or pursues a non-pecuniary interest as an end itself rather than as a means to some financial end.”  If this argument stands, then ESG is done.  Period.  Full stop.  The legal conclusion that ESG violates asset managers’ fiduciary duty by pursuing “non-pecuniary” interests “in and of themselves” would end it all right away.  ESG, RIP.

Of course, that’s the nub of the argument, isn’t it?  ESG opponents say it’s a non-pecuniary, political pursuit, while ESG advocates say exactly the opposite, that it’s the ultimate long-term risk-management research technique, designed to address and improve corporate performance over a longer event horizon.  Although Judge O’Connor supports his arguments with words from the horse’s (i.e. Larry Fink’s) mouth, his unilateral adoption of the anti-ESG position will, obviously, not go unchallenged and will almost certainly result in considerable additional legal wrangling.  In the end, one suspects that the courts will not want to take quite as bold and inflexible position on what ESG is and isn’t.

But Judge O’Connor went on…arguing that American Airlines’ use of BlackRock to manage its retirement plan constituted a conflict of interest.  This is, more or less, a statement of fact.  Such is the nature of the game with the massive passives.  Bloomberg’s Matt Levine – one of the few analysts to see this portion of O’Connor’s ruling for the potential earthquake that it is – described the conflict as follows:

BlackRock worked for American: American’s pension managers hired BlackRock to manage their 401(k) funds. But American also worked for BlackRock: BlackRock’s funds are American’s third-biggest shareholder, with more than 8% of the stock, and “also financed approximately $400 million of American’s corporate debt at a time when American was experiencing financing difficulties.” American’s managers, who selected BlackRock to manage the 401(k) and oversaw its work, were also well aware that they were working for BlackRock:

Defendants’ own personnel put it best when describing this “significant relationship [with] BlackRock” and “this whole ESG thing” as “circular.” It is no wonder Defendants repeatedly attempted to signal alignment with BlackRock.

You sometimes used to hear this theory, about investment managers and corporations, going the other way: “Big asset managers like BlackRock tend to support corporate management in proxy voting, because they want to win the business of managing those companies’ pension funds.” Here the theory is that, because BlackRock was one of American’s biggest shareholders, American had to defer to BlackRock and couldn’t be too critical of its 401(k) management performance.

Levine – who is usually skeptical of anti-ESG arguments – concludes that the argument makes sense and that it, therefore, should be worrisome for corporations, “particularly” those connected to BlackRock.

My colleagues at Consumers Research agree, and earlier this week, started sending letters to the directors of all Fortune 500 companies, warning them that the ruling means that they “risk violating their duties by continuing to entrust plan assets to BlackRock,” and concluding that “any corporation or company using BlackRock to manage their pension plans is now effectively aware that BlackRock has acted with a dual motive in the past and is still publicly committed to doing the same moving forward.”

This is all true – but it’s not even the half of it.

Levine mentions that BlackRock is American Airlines’ third-largest shareholder, which is where the conflict of interest originates.  You know who its largest shareholder is?  Vanguard.  Could American turn its pension management over to Vanguard?  Probably not, given Judge O’Connor’s ruling.  What about its fourth-largest shareholder, State Street?  Again, that would seem unwise.  The airline’s second-largest shareholder is Primecap Management, which is known primarily for its partnership with Vanguard.  Once more, this would seem to be problematic.

On and on it goes, down the list of American Airline’s largest shareholders: those that aren’t hedge funds are either larger fund companies with significant ESG exposure or are affiliated with larger fund companies with significant ESG exposure.  Although none of them (save, perhaps, Vanguard and State Street) are quite as overtly associated with the ESG movement as BlackRock, all would, at least in theory, meet O’Connor’s conflict of interest standard.  And all would, as a result, appear to be unfit choices to manage the pension funds of any large corporation.

Taken to its logical conclusion, then, the conflict-of-interest portion of Judge O’Connor’s ruling would seem to suggest that the entire pension management business is conflicted and possibly in trouble.  Currently, the largest 401(k) managers are asset management firms like Fidelity or Vanguard, subsidiaries of large banks, like Merrill Lynch (Bank of America), or dedicated recordkeeper companies that offer funds from the large asset managers (like Fidelity or Vanguard).  Can it stay that way for long?

I’m not saying that every corporation in the S&P 500 necessarily needs to switch management of its 401k/pension plans to Strive’s new 401k service (because Strive has been the post-ESG asset manager since its creation) but I’m not not saying that either.  I can’t say for certain what corporations will need to do or how much liability they have under O’Connor’s ruling, but I can say that this is likely to get messy.  And it goes far beyond BlackRock.

When the history books record the financial events of this era, the decision by Larry Fink and the rest of the folks at the Big Three to stick their noses into politics may well be recorded as a massive unforced error, the event that, in time, reversed their dominance.  They had it made, after all.  They were gobbling up bigger and bigger shares of the American investment market, with nothing standing in their way.  And then they got religion – or politics or whatever.

The other day, BlackRock announced that it has $11.7 trillion in assets under management, a new record.  One can only wonder how much more they might have under management if Fink hadn’t made his political preferences an issue.  More to the point, the ESG movement has spurred a backlash that now includes vocal opposition to passive management, calls to “break up” the massive passive firms, and legal rulings that hint at the means by which BlackRock, et al. might be challenged – something that seemed impossible just a few years ago.  That $11.7 may not represent the pinnacle of BlackRock’s AUM, but eventually, the time will come when BlackRock’s dominance ends.  And it is entirely possible that the impetus for that will be Larry Fink’s own conceit.

Stephen Soukup
Stephen Soukup
[email protected]

Steve Soukup is the Vice President and Publisher of The Political Forum, an “independent research provider” that delivers research and consulting services to the institutional investment community, with an emphasis on economic, social, political, and geopolitical events that are likely to have an impact on the financial markets in the United States and abroad.