Texas district court refuses to dismiss ESG prudence and loyalty challenge
On February 21, 2024, the United States District Court Northern District of Texas found in favor plaintiff in Spence v. American Airlines, denying defendants’ motion to dismiss, allowing plaintiff to proceed with his claim that fiduciaries of the American Airlines 401(k) plan violated ERISA’s fiduciary prudence and loyalty rules by “by knowingly including funds ‘that are managed by investment managers that pursue non-financial and nonpecuniary ESG [environmental, social, and governance] policy goals through proxy voting and shareholder activism.’” In this article we review the decision and consider its implications for 401(k) plan ESG policies.
Background
Plaintiff Bryan P. Spence, a participant in the American Airlines, Inc. 401(k) Plan and the American Airlines, Inc. 401(k) Plan for Pilots (collectively, the “Plan”), individually and as a class representative, sued American Airlines Inc. and the Plan’s Employee Benefits Committee as Plan fiduciaries.
While plaintiff’s lawsuit originally challenged the fiduciaries selection of (allegedly) “imprudent ESG funds,” he subsequently dropped that claim “to streamline this case and focus on the primary issue” – the retention of managers who, in effect, exercise shareholder rights (e.g., vote proxies) to further ESG goals. Quoting the court:
Specifically, Spence contends that Defendants’ Plan primarily contains funds administered by investment management firms like BlackRock, Inc. (“BlackRock”). According to Spence, certain managers like BlackRock pursue pervasive ESG agendas. That is, BlackRock’s “engagement strategy . . . covertly converts the Plan’s core index portfolios to ESG funds.” As a result, BlackRock’s investments harm the Plan participants’ financial interests because BlackRock focuses on socio-political outcomes instead of exclusively on financial returns. BlackRock is just one of the many investment managers Spence references by name. Due to such actions by Plan investment managers, Spence argues that Defendants violated their fiduciary duties to act in the Plan participants’ financial interests by investing in funds managed by BlackRock and others who engage in conduct, such as proxy voting, to support ESG policies rather than purely pursuing financial gain.
Noting the obvious, BlackRock (which had been vocal about its commitment to ESG principles) gets special attention in this case.
A different, more subtle litigation strategy
In real life, it may turn out that explicit “ESG funds” – e.g., a fund that targets investing in solar technology – are a sideshow. Most of the flows into 401(k) plans go into target date funds. And many of those funds are invested in passive funds, e.g., S&P 500 index funds. A plaintiff can’t argue that an S&P 500 index fund is an ESG fund. But that plaintiff may be able to, as in this case, argue that the managers of those funds are using shareholder rights (critically, proxies) to push S&P 500 companies to adopt ESG policies, for (as this plaintiff puts it) “nonpecuniary” reasons.
In 2023, the Republican House of Representatives working group on ESG produced a report making a similar claim, targeting the market influence of the “Big Three” – BlackRock, Vanguard, and SSGA – arguing that:
The Big Three’s dominance in the index fund market grants them unparalleled influence. They have a combined voting share of approximately one-quarter at shareholder meetings of most S&P 500 companies. [Citing research from 2017] Despite being labeled as passive investors, they actively utilize voting power to advance liberal social goals such as ESG and DEI (diversity, equity, and inclusion), which may not align with maximizing investor returns.
We emphasize this point not to raise a political issue but to note a possible shift in litigation strategy – away from a claim that “fiduciaries put an underperforming fund in the fund lineup” to a claim that “fiduciaries selected fund managers that use proxies to influence companies to make decisions that negatively affect shareholder value.”
With that framework, the question becomes, for that sort of claim, what does a plaintiff have to allege to get past a motion to dismiss?
The court’s decision – duty of prudence
Plaintiff claimed that this conduct – plan fiduciaries retaining managers who exercised shareholder rights to “push” ESG initiatives in their portfolio companies – violated both ERISA’s fiduciary prudence and loyalty rules.
In support of its prudence claim, plaintiff argued that “funds managed by ESG-focused investment managers have continually underperformed compared to other similarly situated funds due, for example, to investment managers casting proxy votes for ESG measures.” Defendants countered that plaintiff “provide[d] no benchmark by which to compare performance” and did not otherwise allege facts showing underperformance.
The court rejected defendants’ assertion that plaintiff must provide a “meaningful benchmark” to establish underperformance. In this regard, we would note that plaintiff’s claim – unlike a challenge to the selection of a specific fund, where an alternative, similar/identical fund could be used as a benchmark – is a challenge to the management (via proxy initiatives) of a portfolio company’s ESG policies, where (it could be argued) the only “meaningful benchmark” would be the performance of that portfolio company with different (or no) ESG policies.
The court found that plaintiff had alleged sufficient facts to support its prudence claim, citing plaintiff’s allegation of:
“[T]he known poor performance [of ESG funds] relative to . . . similar investments . . . available in the marketplace,” along with the particular “proxy voting and shareholder activism of the investment managers that [Defendants] selected, included, and retain in the Plan.”
The court noted that “[a]s Plaintiff points out, various sources have reported on the underperformance of ESG funds, including those managed by BlackRock.” In his amended complaint, plaintiff included references to (for instance): a journal article purporting to show that (generally) mutual funds with high ESG ratings underperform funds with low ESG ratings; a claim that “[o]ver the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year;” and the statement by Vanguard’s CEO that “We don’t believe that we should dictate company strategy. It would be hubris to presume we know the right strategy for the thousands of companies that Vanguard invests in.”
Based on the foregoing (and, at the motion-to-dismiss stage, taking plaintiff’s allegations as true) the court held that “These specific actions – selecting, including, and retaining ESG-oriented investment managers – allow the Court to reasonably infer that Defendants’ process is flawed because it allowed Plan assets to be used to support ESG strategies.”
Duty of loyalty
With respect to his duty of loyalty claim:
Plaintiff alleges that Defendants breached their duty of loyalty in choosing to invest Plan assets with investment managers who pursue ESG objectives instead of exclusively financial ends. According to Plaintiff, Defendants did so as part of a company-wide commitment to ESG goals, knowing that investment managers – such as BlackRock – invest in and vote for ESG policies.
Defendants conceded that American Airlines had such a company-wide commitment to “ESG initiatives” but argued that that commitment “does not affect their obligations when wearing their ‘fiduciary hat.’”
The court, however, found plaintiff’s duty of loyalty allegations adequate to survive a motion to dismiss. First, it held that whether American’s commitment to ESG initiatives did or did not affect plan fiduciary decisions was a question of fact “not appropriate” to the motion to dismiss stage. Second, at the motion to dismiss stage, the plaintiff is not required to allege specific facts showing defendants’ motivation – “it would be unreasonable for Plaintiff to plead such facts at this early stage when this information resides with the Defendants.”
Thus, the court held that:
Plaintiff articulates a plausible story: Defendants’ public commitment to ESG initiatives motivated the disloyal decision to invest Plan assets with managers who pursue non-economic ESG objectives through select investments that underperform relative to non-ESG investments, all while failing to faithfully investigate the availability of other investment managers whose exclusive focus would maximize financial benefits for Plan participants.
Many sponsors will find this holding very surprising – that a corporate commitment to ESG, which has been regarded (by many) as a good thing, could be the sole basis for a breach of ERISA duty of loyalty claim that will survive a motion to dismiss.
* * *
This case will now proceed to discovery, unless it is settled.
It’s easy to imagine that a judge with (as it were) different sympathies might have simply rejected plaintiff’s claims as speculative and insufficiently specific. And (obviously) it’s not an accident that this case was brought in Texas.
But the issue of the proxy voting policies of the managers of index funds is emerging as a target. And, indeed, BlackRock target date funds have been (generally unsuccessfully) targeted in a series of ERISA prudence/underperformance lawsuits. None of that is an accident – target date funds, with considerable allocations to S&P 500 index funds, are “where the money is.” Whatever the merits, those funds/fund managers (and the ERISA fiduciaries that select them) will be a target for plaintiffs’ lawyers.
Whether plaintiff’s claims in this regard are viable, on an appeal of this decision, on a trial on the merits, or in other, similar litigation, remains to be seen.