A new approach to ESG rules should not overlook the role of proxy advisory firms.
In an age characterized by the politicization of virtually everything, it is unsurprising to see political pressures exerted upon the managers of investment funds established for the financial benefit of current and future retirees. These funds are large repositories of financial resources, and for many the temptation is strong to find ways to divert those dollars toward a furtherance of their preferred political goals. “Environmental, social, and governance” (ESG) objectives are prominent among them: efforts to substitute political investment criteria in place of the narrow fiduciary interests of the current and future retirees.
Examples are divestment and/or avoidance of fossil-fuel investments as part of a political “climate” agenda, investments in producers of firearms, military goods and services, tobacco and alcohol products, firms failing some numerical test of “diversity” or a specified ratio of executive to workforce compensation, or a subjective test of management/union relations, and on and on.
There exists no limit — other than that imposed by the human imagination — on such uses of other people’s money, a completely accurate description of pressures for an ESG investment orientation for pension and retirement funds. Such diversions of fund assets often are advocated in proxy proposals for consideration by the managers of the funds. Because ESG investing by definition imposes artificial constraints on the range of potential investments and on diversification opportunities, it must over time yield a reduction in the expected rate of return. That inevitable outcome is likely to be observed as a decline in the value of the fund at the outset of such ESG investing, and also a continuing depression of that value as an endless and shifting series of ESG proposals and pressures are exerted upon the managers of the given fund.
Why has this process come to pass? In 2003, the Securities and Exchange Commission promulgated a regulation that has engendered an outcome unintended and perverse: a duopoly of two firms enjoying a position as the most powerful arbiters of corporate governance in America. Those firms, Institutional Shareholder Services (ISS) and Glass Lewis (GL), provide proxy-advisory recommendations to investors and asset managers on how they should vote their shares in the many companies that they own. The two account for 97 percent of the market for proxy-advisory services. They have become de facto regulators of America’s public companies. Because of subsequent staff interventions and interpretations, the 2003 regulation evolved from a simple requirement that investment funds provide transparency involving potential conflicts into an SEC policy that was interpreted to mean in effect that funds must vote on all proxy issues, that the funds could avoid liability by retaining proxy advisers, and that the proxy advisers would bear liability only in extreme cases.
The “extreme cases” limitation on the potential liability of proxy advisers means that in practice they are unconstrained by considerations of fiduciary responsibility. So the policy or political preferences of the proxy advisers (or their staffs) carry substantial weight in terms of decisions on proxy proposals concerning executive compensation and corporate policies on a range of social and environmental questions.
The fiduciary interests of current and future retirees are defined narrowly and clearly in the 1974 Employee Retirement Income Security Act (ERISA). In a nutshell, the law makes it clear that the proponents of ESG objectives and other such political and policy goals must do so with their own dollars; playing political games with retirees’ financial wellbeing is inconsistent with the law.
Because of the inconsistency between growing ESG investment pressures and the fiduciary interest of current and future retirees protected by ERISA, the Department of Labor last June proposed a “Financial Factors in Selecting Plan Investments” rule “to confirm that ERISA requires plan fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.” This proposed rule is timely and needed, and ought to be adopted as a final rule.
But two related problems are not addressed in that proposed rule. Because of the staff interpretations of the 2003 rule noted above, fund managers are forced to vote on every proxy proposal; and the liability shield means that they have powerful incentives to vote automatically in accordance with the recommendations of the proxy advisers.
A new “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights” rule now has been proposed by the Department of Labor. It makes it clear that funds are not required to vote on every proxy proposal that they confront. Instead, “A fiduciary’s duty is only to vote those proxies that are prudently determined to have an economic impact on the plan after the costs of research and voting are taken into account.” And fiduciaries are required to “act solely in accordance with the economic interest of the plan considering only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan.”
These newly proposed requirements represent a crucial constraint on the ability of the proponents of proxy proposals and proxy-advisory firms to substitute their own preferences, whether political or otherwise, inconsistent with the fiduciary interests of plan participants, upon the decisions of fund managers.
But the proposed rule barely mentions automatic voting, despite the reality that automatic voting is deeply perverse in the context of the fiduciary interests of plan participants. Accordingly, the proposed rule should be strengthened as follows:
- The definition of automatic voting should be made explicit, and the Department of Labor should make it clear that automatic voting is presumed to be inconsistent with the fiduciary responsibilities of the fund managers precisely because the proxy firms have no obvious incentives or responsibilities to shape their recommendations so as to further those fiduciary interests.
- Accordingly, automatic voting should be proscribed by preserving the requirement for explicit analytic justification for specific votes on proxy proposals.
- When a given recommendation from a proxy-advisory firm is contested, in particular by the company to which the vote pertains, the managers of the fund should be required to publish a detailed analysis of the proxy recommendation and the response, and an explanation of the fund’s voting decision if the fund chooses to vote.
- If automatic voting is not proscribed, the Department of Labor should emphasize the due-diligence requirements attendant upon acceptance of proxy advisers’ recommendations. Fund managers should be required to publish issuer responses to proxy recommendations and all other relevant information before casting a vote on a proxy proposal.
Adoption of this proposed rule, with these suggested modifications on automatic voting, would change the nature of proxy proposals and the recommendations of the advisory services. There would be substantially fewer such proposals, as many or most clearly would not be consistent with the fiduciary interests of the plan participants, or would not be considered for a vote by the plan managers given the analytic costs of addressing them. The proxy advisers would face more formidable constraints with respect to imposing their own political and policy preferences upon the funds. As there are no obvious scale economies in the provision of advisory services — the duopoly noted above is a wholly artificial result of the regulatory environment — we can predict an expansion in the number of firms offering them, perhaps with some specialization in terms of the specific topics addressed by the advisers. Most important: The fiduciary interests of plan participants would be served by a reorientation of proxy proposals away from ESG objectives, and by a decline in the cost of the proxy-advisory services themselves.