ESG backfire for Biden?

OPINION:

Last week, President Biden issued his first veto, rescuing a new Department of Labor rule that authorizes pension fund managers to consider environmental, social and governance factors when allocating capital.

The president’s veto is considered a big win for ESG. But by losing this battle, ESG’s opponents just may have won the war.

The Labor Department rule rests on a finding that ESG practices, such as increasing boardroom diversity or reducing carbon emissions, are “material” to investment decision-making. The legal consequences of that finding may be exactly the opposite of what the administration imagines.

By law, investment advisers like wealth managers and money managers must disclose to their clients all material facts about any investment they propose. Yet all over the country, investment advisers have placed — and continue to place — hundreds of billions of dollars of client capital with BlackRock and other behemoth asset management firms without disclosing to their clients that these firms use every share they own to promote the ESG agenda. If ESG practices are material to investors, that failure to disclose is unlawful. 

Contrary to what most people think, firms like BlackRock do not back the ESG agenda merely by offering ESG funds to interested investors. Instead, they promote ESG objectives in all their portfolios, including their nominally passive index funds, through so-called stewardship, which refers to proxy voting and shareholder engagement, defined by Vanguard as “[d]irect contact with companies to discourage undesirable corporate behavior.”  

Because the world’s three largest asset managers — BlackRock, State Street and Vanguard — control some $20 trillion in investment capital and own 20% to 25% of the voting shares of all major U.S. corporations, their “stewardship” has extraordinary power to force the ESG agenda on corporate America. For example, the Big Three have used their immense proxy voting power — derived substantially from their supposedly passive index fund portfolios — to force Exxon Mobil to cut oil production. How that benefited Exxon Mobil, its shareholders, or the American public is unclear. BlackRock and State Street also forced Apple to conduct a companywide “racial equity audit.”

Most investors in Big Three index funds were never told and had no idea that their money had been placed in an ESG-promoting investment vehicle. Is that material information? The new Labor Department rule suggests that it is, and well-established law confirms it. Information is “material if there is a substantial likelihood that a reasonable [investor] would consider it important.” And for two different reasons, reasonable people could surely consider “important” the fact that their money has been placed in an ESG-promoting portfolio.   

First, considerable evidence now contradicts the mantra that ESG enhances returns. A 2022 analysis found that the top 10 ESG funds “underperformed the broader ETFs by between 0.71% and a whopping 73.68%.” As Vanguard’s own CEO, Tim Buckley, recently stated, “Our research indicates that ESG investing does not have any advantage over broad-based investing.”

State Street’s chief information officer, Lori Heinel, made an even stronger concession last fall: Because “basic investment principles” dictate that “imposing a constraint on a portfolio” is performance-negative, “I’ve steadfastly encouraged our teams to not think of ESG as a performance enhancement.”

Surely when even Vanguard’s CEO and State Street’s CIO acknowledge that the ESG agenda has no financial justification, reasonable investors have a right to know if their money is being placed with an asset manager seeking to force portfolio companies to adopt that agenda.

Equally fundamentally, many investors may oppose ESG as a matter of principle. Just as people have a right to invest with ESG-promoting asset managers if they so choose, people who oppose ESG have a right not to. As the Securities and Exchange Commission has stated, investment advisers are legally required to make reasonable inquiries into their clients’ objectives and must “adopt the [client’s] goals, objectives, or ends.”

Investors with reservations about the ESG agenda deserve to know how their shares are being voted on and whether those shares are being leveraged to advance that agenda.

Thus for both value and values-based reasons, investment advisers have a fiduciary duty to tell clients about asset managers’ ESG-promoting policies. U.S. securities law has always favored disclosure over top-down mandates. Let the investing public decide whether to put money into ESG-promoting index funds. People have a legal right to make that decision for themselves.

As the Supreme Court held in SEC v. Capital Gains Research Bureau Inc. (1963), an investment adviser’s failure to disclose material information to clients is “fraud” regardless of whether the adviser intended to deceive. Investors victimized by such fraud can sue to recover commissions and fees even when lower returns can’t be proven. So if ESG practices are as material as the Biden administration says they are, investors and investment advisers all over the country should take note. People can go to court if their money has been used to promote the ESG agenda without their consent.

• Jed Rubenfeld is a senior adviser at Strive Asset Management.