The Fire and Police Pension Association of Colorado recently asked San Francisco Partner Joseph J. Tabacco, Jr., to discuss the challenges of squaring fiduciary obligations with calls for socially responsible investing and divestment. The following article was adapted from his August presentation.
In the emotionally charged debate over socially responsible investing, middle ground is hard to find – especially when it comes to laws requiring public pension funds to sell assets tied to genocide or terrorism.
To advocates, divesting from companies that do business with Sudan, Iran or Syria is nothing less than a “moral imperative.” To opponents, forced divestment undermines their highest duty as a fiduciary: to make prudent financial decisions based solely on the interests of pension plan participants.
Both sides make valid points. But from a practical standpoint there is no contest. As divestment sweeps the country, public pension funds are scrambling to protect their investment returns and salvage their autonomy.
The idea of socially responsible investing in financial markets goes back at least as far as the early 1900s, when the Methodist Church spurned stocks related to alcohol and gambling. It came of age in the 1980s, with the international campaign to turn South Africa’s apartheid regime into a financial pariah.
Individuals today can buy mutual funds that screen out cigarette makers, polluters and other companies deemed undesirable. Socially responsible investing can also funnel investments into companies that may offer a social benefit – dedicating a portion of a fund’s portfolio to companies that create local jobs, for example.
The most successful recent divestment campaign has targeted war-torn Sudan, where the United Nations estimates as many as 450,000 people have been killed and up to 2.5 million have been displaced. As of early August, 19 states had adopted policies to divest from Sudan, while another 19 had initiated divestment campaigns, according to the Sudan Divestment Task Force.
Though they often hail from different parts of the political spectrum, the activists behind divestment from Sudan and Iran – the next country targeted for action – offer the same simple logic when arguing on behalf of their causes.
“It is immoral to own shares in companies that now willingly engage in commerce with a regime that is guilty of ongoing genocide,” says Sudan activist Eric Reeves.
Missouri State Treasurer Sarah Steelman, who advocates so-called “anti-terror” investment screens, says that “public tax dollars should not be used to finance terrorism anywhere in the world.”
The effect of Sudan divestment on public pension funds pales compared with the anti-terror initiatives now gathering momentum around the country. Because Sudan’s economy is small, fewer than 25 companies are on activists’ hit list.
Critics of divestment must resort to more nuanced arguments and risk running a gantlet of bad press if they oppose popular initiatives outright. Testifying about a socially responsible investing bill in Texas, Keith Brainard of the National Association of State Retirement Administrators focused on several key issues. (The Texas legislation illustrates the challenges faced by public funds; it passed unanimously.)
Pension funds are held in trust.
Socially responsible investing may conflict with trustees’ “duty of loyalty,” which requires them to act as a prudent expert in the exclusive interests of plan participants. That, in turn, means weighing potential risks and potential returns and choosing the investment mix most likely to fulfill the trust’s obligations.
Investors lose leverage when they sell. Divestment is a one-time act. Funds such as the California Public Employees’ Retirement System believe a policy of constructive engagement gives them a better chance to effect change.
Divestment costs beneficiaries money. It costs money to establish a mechanism to weed out offending securities. It costs money to sell targeted stocks and replace them with others. Finally, it may cost money, year in and year out, in lost returns if the replacement stocks do not perform as well as the divested shares.
Divestment may not be effective. Other investors will almost certainly purchase divested shares.
So what should pension funds do? There are some steps that make sense.
In the early stages of a divestment campaign, for example, funds can work to add language to any pending legislation to expressly state that trustees’ actions must be consistent with their fiduciary duties. Funds can also work to keep control of the list of impacted investments, said fiduciary counsel Ian Lanoff in a recent teleconference on divestment sponsored by the Council of Institutional Investors.
According to Lanoff, funds should ask two key questions once a law is enacted:
- Is it prudent to hold the investments on the list?
- Is it imprudent to sell the investments on the list?
When conducting their analysis, fiduciaries should evaluate the economic characteristics of each scrutinized investment – chiefly its performance potential and volatility – and the availability of substitute investments with similar characteristics. They should carefully document their analysis.
Though fiduciaries must restrict themselves to an economic analysis, they may have some wiggle room when asking these questions. That is because some funds have decided to expand their risk analysis to include factors such as risks from litigation, regulatory or legislative actions and policy actions taken by the institutional investor community. In other words, the movement to divest from companies tied to a certain country could actually add to the risk of holding onto those stocks.
Fiduciaries may consider so-called collateral benefits, such as social good, if another investment with similar risk-return characteristics is available, according to a 1994 Department of Labor Interpretive Bulletin. Of course, that does not factor in transaction costs associated with divestment.
Trustees may have an obligation to oppose divestment if they cannot keep control of the list and guarantee consistency with their fiduciary duty. But in the end, they also must consider the costs of undertaking a legal battle with the government, which could end up costing considerably more than divestment itself.
Funds also should be wary about supporting any divestment law, no matter how politically popular, because it sets a bad precedent. Though Sudan divestment may carry a small price tag, the impact of divestment from Iran is potentially huge. And Iran may be just the beginning.
In a report released just this August, the Center for Retirement Research at Boston College cautions against investing for social or environmental reasons, calling a broad-based divestiture movement a “slippery slope” that “will definitely hurt returns.”
“The issue remains whether pension funds are an appropriate vehicle for implementing [foreign] policy. The answer seems unquestionably ‘no,'” the study concludes. “Encouraging public pension fund trustees to take ‘their eyes off the prize’ of the maximum return for any given level of risk is asking for trouble.”