Heads are spinning over the changing rules governing ESG investing. Investments that take into account environmental, social and governance (ESG) factors have become a political hot potato for public plans governed by state laws, and ERISA fiduciaries who make or advise about investments in private employer 401(k) and ERISA-governed 403(b) plans have been put in what can only be called a “no win” situation by competing pressures.
Investment professionals can point to situations where factors, such as required environmental cleanup or poor governance, can diminish investment returns and to other situations where good governance and positive practices may increase returns. Younger participants, in particular, want ESG investment options and some are demanding that their employers add ESG options to plans. However, the legal exposure of ERISA fiduciaries who make ESG funds available to participants is unclear, and the case discussed here may be the first of many similar lawsuits.
The Department of Labor and the U.S. Supreme Court in its Hughes v. Northwestern University decision (142 S. Ct. 737) recognize that prudence is a facts and circumstances determination not to be reviewed with 20-20 hindsight. You might think that means that specific ESG investments that perform at least as well as competing investments with superior track records would be acceptable on plan investment menus, and under the Biden administration’s ESG regulations, they would be.
However, politically-motivated lawsuits were filed earlier this year to invalidate the Biden administration’s ESG regulations. The plaintiffs in these lawsuits don’t even claim specific losses from having made ESG investments. After that, it seemed that it was only a matter of time before the first lawsuit against a corporate plan sponsor was filed. Now we have one. A new lawsuit targets American Airlines and aggressively challenges its 401(k) “ESG” investment offerings.
American Airlines was probably selected as a defendant for two reasons: 1. It sponsors very large plans; and 2. its headquarters are in Texas, allowing the suit to be filed in a jurisdiction with a track record of invalidating regulations issued during Democratic administrations. It is hard to see plaintiffs prevailing in any of these cases based on the statements in their complaints, though the district and appeals courts in Texas tend to go their own way on many issues. Here are some of the reasons plaintiff in the American Airlines case may have an uphill battle:
Standing.
Plaintiffs in private lawsuits have to allege specific harm. They can’t sue just because they don’t like something, and vague statements about purely speculative losses are also insufficient. Standing rules are necessary to prevent the courts from being flooded with lawsuits by plaintiffs who don’t have an actual stake in the decision. This lawsuit doesn’t even allege that the plaintiff actually invested in any of the funds said to use ESG factors. It also fails to propose any benchmark that could be used to establish plaintiff’s hypothetical losses. The proposed class would include all plan participants regardless of whether they invested in the challenged funds, so class certification would seem to raise the same issues.
ERISA Doesn’t Establish a List of Prudent Investments.
When ERISA was enacted, it was determined not to include lists of permissible and impermissible investments. Investments wouldn’t be categorized by class. The Supreme Court recognized in the Hughes decision that different fiduciaries could make different determinations about investments and still satisfy ERISA’s prudence standard. Because prudence is determined based on the facts and circumstances, courts have avoided classifying any class of investments as “per se” imprudent, but that is exactly what the plaintiff in this action wants.
Questionable Facts in the Complaint.
There is no settled definition of ESG investing. There are many different approaches to ESG investing, and different standards are used by investment fiduciaries to take ESG factors into account. Plaintiff has used the broadest possible exaggerated definition in the complaint without regard to whether it reflects the standards actually in use in the challenged funds. The complaint also contains a long list of 25 funds alleged to be ESG investments. This is likely to be wrong. There is probably no plan in the country that has 25 ESG funds on its regular investment menu. The complaint cites Morningstar and one study alleging underperformance of ESG funds as a group. It also vaguely references other studies purported to show that ESG funds underperform compared to non-ESG funds without providing citations to the actual sources, so those statements are impossible to check.. The complaint even cites a Wall Street Journal editorial opinion as if it were fact.
Questionable Statements about the Law.
Plaintiff challenges the inclusion of ESG funds in the plan self-directed brokerage window, claiming that options under a brokerage window must satisfy the same requirements as options on the plan’s regular investment menu. This is contrary to DOL guidance on brokerage windows and the understanding of just about all practitioners. Plaintiff also claims breaches of the duty of loyalty, but it will be difficult to prevail on that claim if the investments are not imprudent.
No Information about the Challenged Funds.
There is no information at all in the complaint about the actual performance of any of the funds alleged to be imprudent investments. That alone may be sufficient to sink the case. Plaintiff’s lawyers seek to get around the usual pleading requirements that apply in these cases with a kitchen sink allegation that all of these funds are per se imprudent, so everyone must have losses, but under traditional pleading standards, that shouldn’t work.
Plaintiff is not suing only the American Airlines fiduciaries. He has also sued Fidelity and Financial Engines, alleging that Fidelity and Financial Engines were investment fiduciaries.
A number of fee and investment cases have been dismissed recently because the complaints had similar conclusory and non-specific allegations. Defendants will probably move to dismiss this complaint based at least in part on the deficiencies discussed above. However, if the case proceeds, we will find out more about the fiduciary process used by American Airlines and the other fiduciaries to select these investments, which should be central to any prudence determination. We will also see how closely the courts in the Fifth Circuit will be following Supreme Court precedent on ERISA’s prudence requirement.
Fiduciaries of plans offering ESG-related investments can put themselves in the best position to defend any similar lawsuits by following sound fiduciary processes and documenting the reasons for their decisions.