Does the American Airlines ESG Fiduciary Case Suggest The End of Active Management?

Does the American Airlines ESG Fiduciary Case Suggest The End of Active Management?

March 05, 2024

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Does the American Airlines ESG Fiduciary Case Suggest The End of Active Management?
by Christopher Carosa March 05, 2024

Here’s the thing. For some time now, ESG has been associated with active management. There are those who feel the push for ESG funds, primarily by active managers, signaling a need for justification for active management.

The plaintiff in the American Airlines case asserts the company violated its fiduciary duty by picking ESG-oriented funds and managers. Could ESG’s association with active management bring the entire active management complex down with it?

“I am on record and in print (3rd Quarter 2022 issue of Benefits Quarterly, ‘Tripping over Our Own Fee(t)s’) predicting ‘greater use of passive investments—even when the actively managed funds are not necessarily imprudent,’” says Jack Towarnicky, Of Counsel, Koehler Fitzgerald, LLC Powell, Ohio. “Plan investment fiduciaries would be best served by reducing the Core investment lineup to no more than low-priced index funds, a low-cost capital preservation investment, and a low-cost self-directed brokerage account (SDBA). My QDIA would be personalized target date model allocations across the Core investments.”

It may be too early to tell what the American Airlines ESG Fiduciary Liability Case might bring. It is clear to some, though, that it opens up a fissure that may have been there before.

“In the short term, it could have a chilling effect on ESG investing and any investment in a pooled fund that looks at ESG factors,” says Carol Buckmann, partner at Cohen & Buckmann P.P. in New York City. “But this is just the first step in the litigation. While this complaint should have compared actual returns against a benchmark under the usual pleading standards, American Airlines may yet win it. The jury is out on what this will ultimately mean for actively managed funds. Clearly there are situations in which ESG factors directly affect returns, as the Biden regulations, not even discussed in this decision, recognize.”

But not everything sees the case as having a significant impact because it is so flimsy.

“I don’t happen to think this case portends very much in the final analysis,” says Nevin Adams, “retired” industry author, thought leader, and gadfly who resides in Maryville, Tennessee. “Arguably, this federal judge has ‘implausibly’ lowered the ‘plausible’ argument threshold for bringing suit. It’s particularly suspicious (at least to me) that this plaintiff has been shifting his arguments with regard to his standing, as to whether/how he was actually invested in these-type funds and thus injured. American Airlines has flat out denied that he was invested in some of the funds he claims to have been.”

Indeed, as Adams has reported in his blog, “American Airlines Moves (Quickly) for Summary Judgment in ESG 401(k) Suit,” the frail case may not be long for this world. That may not matter. Plan sponsors might already be spooked.

“I assert that if you get sued, you lose – cost, reputation, resources,” says Towarnicky. “The only way to avoid becoming a loser is to avoid litigation. Note that American Airlines was sued even though the plan offers a self-directed brokerage account (SDBA), which American asserts in its response to the complaint that the SDBA allows participants to choose ‘freely from thousands of mutual funds, exchange-traded funds, and individual stocks at their own risk.’”
The point is: Why would plan sponsors put themselves in a position to be sued?

“The American Airlines case against ESG investments underscores the heightened legal scrutiny and regulatory considerations for all actively managed funds within retirement plans,” says Richard Bavetz, investment advisor at Carington Financial in Westlake Village, California. “Plan sponsors may face increased pressure to justify the selection of actively managed funds, ensuring they align with fiduciary duties of prudence and loyalty under ERISA. This could lead to more rigorous due diligence processes.”

“The case may also set a precedent, influencing future legal challenges and regulatory guidance on how plan sponsors evaluate and select investment options, including those with specific strategies like ESG,” continues Bavetz. “In essence, the lawsuit represents a cautionary tale for plan sponsors about the complexities of incorporating specific investment strategies within retirement plans and the importance of adhering to ERISA’s fiduciary standards.”

Or, as Adams implies, it could be all ado about nothing.

“This depends upon whether the decision is upheld,” says Albert Feuer at the Law Office of Albert Feuer in New York City. “Prior decisions of the judge have not always been followed, such as the 2018 decision that Obamacare was unconstitutional. His 2023 decision that the Obamacare preventive care mandate is unconstitutional is now awaiting review by the Fifth Circuit. Nevertheless, the decision may discourage the use of actively managed by retirement plans subject to the ERISA investment duties because it appears that plaintiffs can defeat motions to dismiss even though they point to no benchmarks under which the investments fall short.”

Since actively managed funds have lagged index funds, does this case put their continued use in ERISA plans at risk?

“As demonstrated by the suit, by merely selecting actively managed ESG funds, plan sponsors may be at a higher risk of litigation if the investments are perceived as not acting in the best financial interest of the plan participants,” says Bavetz. “The added legal attention will likely prompt plan sponsors to closely reexamine their investment offerings, potentially favoring options that are easier to defend under ERISA’s standards, such as lower-cost index funds or actively managed funds with clear, demonstrable financial benefits.”

Ah, yes, but we need to return to a point made by Feuer in last week’s article (“Should The American Airlines ESG Fiduciary Case Be Dismissed?”, February 27, 2024). In discussing the role of ESG in the case, he indicated “…some of the funds being criticized were index funds.”

Maybe the American Airlines case is more about ESG and less about active management.

The case, however, may have also unintentionally introduced an issue that has far greater consequences for all portfolio managers. Whether they be active managers or passive managers, they must all abide by this one SEC requirement. And that requirement certainly opens up a can of fiduciary worms.

Christopher Carosa is an award-winning online news producer and journalist. A dynamic speaker, he’s the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA.