“The Liability Trap” authors’ critique of pension fiduciary model misses the mark

Environmental, social, and governance (ESG) policies continue to be a subject of contention among taxpayers, lawmakers, and administrators tasked with managing public funds. With growing pressures from both political sides to leverage public funding to achieve social or political ends, policymakers are wrestling with the limits of what is and is not an appropriate use of public money.

Three ESG advocates recently teamed up to use the Harvard Law School Forum on Corporate Governance to promote their paper “The Liability Trap: Why the ALEC Anti-ESG Bills Create a Legal Quagmire for Fiduciaries Connected with Public Pensions.” However, the report’s authors base their conclusions on an overly broad understanding of the anti-ESG proposals being considered and consequently mischaracterize some of the impacts these policies would have.

The study’s authors, David H. Webber (Boston University), David Berger (Wilson Sonsini Goodrich & Rosati), and Beth Young (Corporate Governance & Sustainable Strategies), critique two American Legislative Exchange Council (ALEC) policy proposals. 

The first is the “State Government Employee Retirement Protection Act,” which, as approved as ALEC model legislation in 2022, would direct government pension plan fiduciaries to consider only pecuniary factors in their investment decisions. These factors must have a material effect on the risk and return of an investment based on appropriate investment time horizons consistent with the pension plan’s investment objectives and funding policy. 

This piece of model legislation excludes non-pecuniary, environmental, social, political, or ideological goals or objectives. It directs fiduciaries that they cannot consider risks or return factors that primarily relate to events that involve a high degree of uncertainty in the distant future and events that are systemic, general, or not investment specific. It also prohibits the voting of shares held by these pension plans to promote non-pecuniary or non-financial goals. 

The second proposal is the “Energy Discrimination Elimination Act,” which was rejected by ALEC as model legislation in Jan. 2023. This proposal would have generally prohibited state and local government agencies and funds from investing in identified financial service companies that boycott either fossil fuel-based energy companies or companies that do not commit or pledge to meet environmental standards beyond applicable federal and state law. Despite its rejection as an ALEC model in January, other organizations are promoting similar policies. 

If Webber, Berger, and Young focused on this “Energy Discrimination Elimination Act” proposed model only, their critique would have more merit. But they often combine and conflate the two bills in arguing the two ALEC draft bills should both be rejected: 

“The boycott bill and the fiduciary duty bill dramatically increase liability risk for plan fiduciaries and service providers without providing any corresponding or even off-setting benefits to fiduciaries or their members. They will reduce the number of service providers willing to work with such pensions, increase liability, insurance, and investment costs for taxpayers, and fund participants and beneficiaries. They should be rejected.”

The principal arguments in support of their position include the following:

• The distinction in the ESG bill between “pecuniary” and “non-pecuniary” is blurry and self-contradictory. 
• Using the concept of “materiality” for determining pecuniary factors conflicts with other securities and U.S. Supreme Court decisions. 
• The boycott bill suffers from similar and self-contradictory requirements.
• The bills effectively transfer proxy voting rights to politicians, ensuring the politicization of such voting rather than restricting it.

According to “The Liability Trap” authors, ESG considerations are good for investing, and the two model policies offered in the draft bills limit investment opportunities and put fiduciaries in jeopardy of breaching their legal obligations. However, instead of providing a separate systematic and objective review of the two very different policy proposals, the authors constantly conflate the two draft bills while ultimately arguing for greater access and use of public pension dollars by private fund managers. Due to their failure to recognize the fundamental differences between the two model bills, many of the points made are relevant to one but not the other, yet they reject both as if they are the same.

The heart of the argument against anti-ESG legislation is that the policies in question “proceed from the erroneous assumption that investors’ consideration of systemic risks … is improper.” By claiming that ESG skeptics ignore basic systemic risks facing investors, some ESG supporters attempt to offer a counter-narrative made to imitate an objective, technical critique without sounding political. 

What policymakers should recognize is that clarifying a public fiduciary’s responsibilities is an attempt to improve fiduciary investment risk management. It reflects the risks associated with the lack of transparency around much of today’s subjective environmental, social, and governance (ESG) goal-setting and reporting, the inaccuracy of many long-term models, the premiums placed on ESG investments by money managers, and a host of other issues that surround many ESG investment products, services, and strategies that are considered by public pension fiduciaries with little to no public oversight. 

Systemic risk is an established concept in investing that the ALEC bills’ proponents would generally recognize as a prudent consideration, but not all ESG factors are universally defined, much less understood universally as systemic risk factors. “The Liability Trap” authors prove this by acknowledging that “the line between governance and ‘environmental, social, or political,’ as well as the definition of governance itself, can shift over time.” Although the authors attempted to highlight a contradiction in the ESG model policy text, they inadvertently stated the obvious. Of course, things change as new information comes in to validate or invalidate criteria for investment risk management.  

The ESG fiduciary policy in the “State Government Employee Retirement Protection Act” does not change that dynamic one bit, but it does make public fiduciaries “show their work” when it comes to investment decisions.

“The Liability Trap” authors argue that the definition of a “pecuniary factor” is too vague to administer because the list of non-pecuniary factors is too long, and the definitions of pecuniary and non-pecuniary do not mirror each other. But there are plenty of legal terms that are asymmetrical. The fact is that the term “pecuniary” is well understood in the public pension and investment world, and the test for fiduciaries is to make sure it is present when acting. If it is not there, they should pause and conduct the necessary due diligence to find it if it exists.

The argument that the securities law definition of materiality is in conflict with that of the “State Government Employee Retirement Protection Act” is simply misleading. Different bodies of law can have different meanings for terms of art. The fiduciary body of law can use materiality in a different way than securities law. They need not and probably should not be identical. It is not problematic that a fiduciary actor requires a different level of materiality than what a company must use when disclosing financial information to shareholders.

Requiring a fiduciary responsible for public dollars to adhere to objective criteria set within a specified time frame and to remain oriented towards achieving the pecuniary goals of the pension trust is the most basic policy plan sponsors can set. That does not mean factors like rising sea levels or prolonged droughts are barred from consideration by public fiduciaries when weighing investment opportunities. If climate change and fossil fuel investments can be demonstrated to have pecuniary effects in the investment time frames specified, then the fiduciary should feel comfortable acting in accordance with those factors. If not, then greater due diligence is needed before acting. 

The argument against the need to show objective due diligence is predicated on the logic that, first, an investment can and should be used to make the world a better place. Second, if the world is a better place, it must have a vaguely measured positive impact on pension risk and return. For these important public funds, more evidence is needed than mere speculation. The use of mere speculation is already prohibited under general fiduciary standards. The model ESG policy is trying to shine a light on something that already should be part of every public pension fiduciary’s playbook.

Being a fiduciary of public funds is not a position to be taken lightly. Being elected or appointed as a trustee puts you at the helm of hundreds of millions, if not tens of billions, worth of taxpayer and pensioner dollars. Any decision to allocate those funds in any way should be held to higher standards than the decisions of those who manage their own funds or the funds of a client with an appetite for risk. 

The ALEC model, “State Government Employee Retirement Protection Act,” ESG fiduciary policy understands the unique and inherent gravity of public pension funds and aligns public policy to ensure decisions are objective and pecuniary as required by the fiduciary “sole interest” standards. However, the authors claim that clarifying public fiduciary policy like this will make it more difficult to make important investment decisions. In “The Liability Trap,” th authors jump from one scenario to another, emphasizing contradictions where there are none and offering hypotheticals to test the logic of the pecuniary standard, but ultimately offer little in the way of evidence for their hindrance claim.

For example, the authors cite Russia’s invasion of Ukraine as a governance risk that would be prohibited from consideration under the proposed fiduciary policy. However, as part of their argument, the authors make the error of describing the internal governance of investment firms instead of the governance structure of a public pension trust. 

So, what would Russian divestment mean for a pension investment fiduciary? The model ESG fiduciary policy only requires that public pension trustees understand what the companies they are investing in are doing. If trustees find out that the company or fund is being managed in a way that doesn’t align with the pecuniary risk and return objectives of the pension trust, then they must divest and look for alternative investments. The investment company or fund, on the other hand, can keep doing what they are doing, but if it cannot justify the quality of its investment offering as supporting the pecuniary interest of the retirement plan, then they run the risk of losing the business. That is as it should be.

According to the “State Government Employee Retirement Protection Act,” mode fiduciary policy, it doesn’t matter what the fiduciary’s subjective intentions are as long as the decision is justified under the pecuniary standard. Public fiduciaries don’t have to ignore a company’s statements, nor are they prohibited from considering any specific type of reporting from a company. The model fiduciary policy frees trustees to continue to do so, and prudence demands that they listen to those sources. But a public fiduciary should not stop there. They must make an objective assessment about whether those non-pecuniary, ESG-based business decisions are valid enough to warrant an investment based on the pecuniary standard. 

With the report’s authors conflating the prohibitions included in the model boycott bill with the limits placed on public trustees and investment managers in the model ESG fiduciary bill, “State Government Employee Retirement Protection Act,” they incorrectly conclude that the fiduciary bill would limit investment opportunities. 

However, the lack of clarity around objective ESG factors leads the report’s authors to argue that constraints on using ESG factors will hinder a fiduciary’s ability to manage long-term risk and return strategies while simultaneously arguing that it also slows them down and prevents them from being nimble for short-term investment management decisions. One could easily interpret the authors’ argument to be that pension fiduciaries must have unfettered discretion to manage the investments of a trust. Without universal standards based on pecuniary factors, how can public pension plan sponsors have confidence that the plan’s very real pecuniary objectives aren’t just strived for but actually met?

A public pension plan sponsor that creates the pension trust has every right to set the rules governing how fiduciaries go about their business. That’s the nature of being a plan sponsor—they get to set the rules under which plan fiduciaries must do their job. It is untenable to argue that once you start a pension plan, you lose complete control and can never ask whether it is being managed properly. 

Having said that, this is one of many red herrings offered by “The Liability Trap’s” authors. The fiduciary policy in question does not require freezing investment approaches in place. It simply requires justification for the discretionary management decisions being made and proof that they stay within the set of fiduciary boundaries.  

In the end, the report’s authors mistakenly see the two ALEC drafts, the boycott bill, and the fiduciary bill, as one entity with identical implementation and impact. Their belief is that value isn’t always pecuniary, but this perspective leaves far too much opportunity to insert controversial political or social considerations into investment decisions. They use qualitative examples to argue against adding a pecuniary limit and, in doing so, imply that those examples couldn’t exist in the free market under the fiduciary bill. By extending the timeframes for potential returns or finding ways to expand the scope and magnitude of an issue, anything can be considered an ESG investment. The authors insinuate that public pension trustees, for example, should be free to do whatever they feel is right when it comes to managing public funds, despite the potential negative outcomes of those actions being fully borne by retirees, active members, and taxpayers. In doing so, they exhibit a fundamental misunderstanding of the relationship between governments and their public pension trust.

As the investment world continues to see new products, services, and philosophies directed at influencing policy, public pension system trustees and their government sponsors would do well to seek out ways to increase the prospect of investment returns to fund promised pension benefits, not try to solve society’s problems. The State Government Employee Retirement Protection Act would be a great first step in that direction for any state and shouldn’t be lumped together with other proposals.