Principles for Responsible Investment: A Tough Road Ahead in the US
We welcome Capital Institute Board Member Peter Kinder to the Future of Finance Blog. As a founder and former President of KLD Risk Analytics, Peter is a highly respected pioneer in the socially responsible investment movement. His comments highlight the challenges on the road ahead for US institutional investors seeking to implement the Principles for Responsible Investment (PRI). In addition to the "we're all traders now" culture so prevalent among asset managers discussed in my recent The End of Investment? blog post, the legal challenges in the US are also suprising, as Peter explains. The following post first appeared at The Bell, Peter's blogsite.--John Fullerton
Peter Kinder writes:
The PRI represents the acceptance of incorporating environmental, social and governance (ESG) criteria in investment decision-making. The PRI has significantly advanced an effort that began in the US 40 years ago with socially responsible investors (SRI) and shareholder advocates.
The PRI’s signatories have driven this rapid climax. On September 27, they totaled 808: 210 asset owners (institutional investors); 437 asset managers and 161 professional service partners. For the most part, the signatories are well-known, usually very large, figures in financial services.
Much of the PRI’s success has come from strong support in Europe and Australia. Although Jane Ambachtsheer and Mercer Consulting’s Toronto office played an essential role in the PRI’s formation, Canada apart, North America has proven resistant.
I regret to say that I don’t believe that the US situation will change for at least two years. (Full disclosure: Over the past 11 years, my predictions about the UNEP FI (United Nations Environment Programme Finance Initiative) and the PRI have been invariably gloomy – and wrong.)
Besides the widely-appreciated culture gap PRI must bridge in the US, two very important, but greatly under-appreciated, regulatory barriers have existed since October 2008. And, the Department of Labor is putting muscle behind them.
I apologize for the length of this post. But, there’s a lot to cover. Here’s why I don’t forecast rapid ESG growth amongst American institutions.
US Institutional ESG Lag
Why will the US continue to lag Europe in ESG investing? The answer is partly cultural, partly geographical and mainly political.
The battle over incorporating social, moral and religious principles in investment decision-making began in earnest in the United States in the late 1960s, at least a decade before it started in Europe. Since the Depression, the US has had an equities-oriented investment profile and one that included a broad individual investor base – very different from Europe’s.
Social investing emerged from the efforts of small to very small investors and the managers who served them. Many of its early advocates had strong ties to churches, especially the Catholic and mainline Protestant one.
These origins – in morality and amongst small investors gave SRI considerable negative cachet in the US financial services industry which prizes the quantifiable and the large. Although much diminished, the industry retains something of that feeling about ESG.
The geography of business also inhibits US change. Something on the order of 47 percent of revenues of nominally US S&P 500 companies come from overseas, says Harper’s. This gives them a very different management and orientation than they had even a decade ago.
What US investors may want is just not as important as it was. And, the regions generating revenues for multi-nationals are not strong PRI supporters.
But more important than these inhibitors is American politics and federal regulation.
SRI Option in Fed Thrift Plan?
Pensions & Investments reported on September 23 that a Rhode Island Congressman had filed a bill that, if enacted, would require the Federal Thrift Savings Plan (TSP) offer an SRI option. This defined contribution plan for federal employees currently offers only unscreened funds.
P&I quoted a spokesman for the plan as saying,
The 4.4 million individuals with TSP accounts have invested their retirement savings with an explicit ‘no politics’ commitment from the Congress, The board opposes all efforts to alter this commitment and introduce political or social considerations into TSP investment policy.
One can still tar ESG and SRI as ‘political’. With highly visible ‘climate deniers’ in the US Senate and the reluctance through out that body to take on environmental regulation, the power of the ‘political’ taint is great.
ESG ERISA Safe Harbor?
Meanwhile, the September issue of Institutional Investor reports US Rep. Robert Andrews has floated a trial balloon suggesting legislation to provide a ‘safe harbor’ for federally regulated ESG investors. Says II:
This would eliminate their concern that they might be held liable for violating their fiduciary duty by placing clients’ money in “socially responsible” investments, which have a reputation for lagging the market.
Andrews is the Chair of a House budget sub-committee with jurisdiction over ERISA – the Employee Retirement Investment Security Act. ERISA covers corporate retirement plans – both defined benefit and defined contribution. The US Department of Labor administers the law, as well as the Taft-Hartley Act covering union plans.
Andrews indicated his staff would determine whether ERISA already provided a ‘safe harbor’ and, if it didn’t, propose legislation. His staff will have to draft legislation, or DoL will have to change its administrative interpretations and enforcement policies.
EBSA’s ‘Rigid Rule’ on ETIs
ERISA funds who wish to incorporate ESG factors may find themselves on stormy seas.
In the waning days of the Bush II Administration in October 2008, the Department of Labor’s Employee Benefits Security Administration (EBSA) issued an ERISA interpretive bulletin. It adopted a ‘rigid rule’: ERISA barred virtually any type of what it called ‘economically targeted investment’ (ETI) – which includes applying ESG-type criteria in investment decisions (29 C.F.R. §2509.08-1).
I described this reversal of prior policy in a post here 22 months ago. So far as I know, nothing has changed as to ETI bulletin.
But there has been a little-noticed but very important development at Labor affecting ESG and the prospects of the PRI in the US.
Proxy Voting under ERISA
On the same day that the ETI bulletin appeared, EBSA issued one on proxy voting by ERISA funds (29 C.F.R. §2509.08-2). This long paragraph contains its essence. It demands careful reading.
The fiduciary obligations of prudence and loyalty to plan participants and beneficiaries require the responsible fiduciary to vote proxies on issues that may affect the economic value of the plan’s investment. However, fiduciaries also need to take into account costs when deciding whether and how to exercise their shareholder rights, including the voting of shares. Such costs include, but are not limited to, expenditures related to developing proxy resolutions, proxy voting services and the analysis of the likely net effect of a particular issue on the economic value of the plan’s investment. Fiduciaries must take all of these factors into account in determining whether the exercise of such rights (e.g., the voting of a proxy), independently or in conjunction with other shareholders, is expected to have an effect on the economic value of the plan’s investment that will outweigh the cost of exercising such rights. With respect to proxies appurtenant to shares of foreign corporations, a fiduciary, in deciding whether to purchase shares of a foreign corporation, should consider whether any additional difficulty and expense in voting such shares is reflected in their market price…. [Emphasis added.]
Put simply, an ERISA fiduciary must establish the economic benefits of voting proxies. Lest anyone think ‘economic’ might be in the eye of the fiduciary, in the preceding paragraph EBSA says:
Votes shall only be cast in accordance with a plan’s economic interests. If the responsible fiduciary reasonably determines that the cost of voting (including the cost of research, if necessary, to determine how to vote) is likely to exceed the expected economic benefits of voting, or if the exercise of voting results in the imposition of unwarranted trading or other restrictions, the fiduciary has an obligation to refrain from voting.
There’s no wiggle room here. If the ERISA fiduciary can’t show a dollars and cents justification for a vote, it must refrain. And EBSA has backed that up by advising fiduciaries to keep records on voting, including the cost-benefit analyses.
Reversing 40 Years of Fiduciary Change
When I’ve pointed out EBSA’s change to non-ERISA trustees and lawyers, the result, usually, is spluttering. ‘They can’t do that!…’
Forty years ago, when I was in law school, the idea a fiduciary might have an obligation to vote proxies deluded only nutters such as the Gilbert Brothers. Fiduciaries routinely ignored proxies or voted with management.
Today, there is no question that fiduciaries must treat proxies as an essential element of share ownership, a valuable one. A prudent trustee must exercise care in considering what action to take on proxy votes.
In many quarters, the proxy has come to be understood as an essential tool in exercising the ownership interest in corporations shares represent. That is certainly what the PRI stands for. Principle 2 says, ‘We will be active owners and incorporate ESG issues into our ownership policies and practices.’
Among the actions suggested under Principle 2 are:
• File shareholder resolutions consistent with long-term ESG considerations
• Engage with companies on ESG issues
• Participate in collaborative engagement initiatives
• Ask investment managers to undertake and report on ESG-related engagement
I doubt EBSA’s explicit rejection of these items was either coincidental or accidental.
DoL ERISA Compliance Audits
‘Interpretive Bulletins’ are just what their title implies. They lack the force of regulations which an agency – the Department of Labor here – must adopt through the rule making procedure specified in the federal Administrative Procedures Act.
But the EBSA proxy voting bulletin is being enforced.
Sutherland Asbill & Brennan LLP , a US law firm, issued a ‘Legal Alert’ calling attention to selective audits of ERISA plans by Labor’s Office of the Inspector General (OIG) – not EBSA. According to Sutherland:
The [OIG audit] workplan states that “estimates indicate that some pension plans spend up to $1 million per plan per year on proxy activities. These activities encompass plan efforts to influence business, social, and political goals through proxy voting.” The workplan further states that in 2008, “DOL reiterated its view if proxy activities do not provide a clear benefit to plan participants, the expenditure of the funds is an Employee Retirement Income Security Act (ERISA) violation.” According to the workplan, the OIG audit will address the following question: “Is EBSA adequately enforcing ERISA requirements on plan proxy activities?”
ERISA covers only corporate retirement plans. But the Department of Labor also has jurisdiction over union pensions, and the Taft-Hartley Act has language in it almost identical to ERISA. It is reasonable to assume a similar standard would apply to those funds. It lacks jurisdiction over state and municipal funds, among others.
However, ERISA has proven highly influential with fund fiduciaries of every type – including ones outside of pensions. Although fiduciary rules vary – and vary considerably – depending on the nature of the trust, ERISA is sometimes cited as a ‘higher’ or better standard. For a quarter century, I have heard ‘the ERISA standard’ invoked to support rejections of SRI-influenced policies by foundations and endowments.
ESG, I fear, will fare no better.
PRI: A Hard US Road Ahead
For going on two generations, SRI advocates have argued the types of information they rely on belongs in the fiduciary’s decision-making. Its interpretations and weightings will vary. But its relevance to understanding a company – how its managers make decisions, what the effects of those calls has been – seems undeniable.
Over a somewhat longer period, corporate governance ‘gadflies’ – many of whom had ties to SRI – established that fiduciaries holding equities must act as owners of corporations at least to the extent of considering voting their proxies.
These positions remain contested in the US. Nothing on the horizon hints at a resolution, much less at one in accord with the PRI.
What a pity!
H/T: To give credit where hosannas are due, the PRI was conceived and nurtured by the United Nations Environment Programme Finance Initiative (UNEP FI).
H/T: Alan Petrillo who called my attention to the Pensions & Investments and Institutional Investor articles.
H/T: Tim Smith who flagged the Department of Labor investigations and the August 9, 2010 ‘Legal Alert’ from Sutherland.