Should The American Airlines ESG Fiduciary Case Be Dismissed?

Should The American Airlines ESG Fiduciary Case Be Dismissed?

February 27, 2024

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Should The American Airlines ESG Fiduciary Case Be Dismissed?
by Christopher Carosa February 27, 2024

A judge recently refused to dismiss the ESG fiduciary liability case against American Airlines. This may open up a hornet’s nest if the plaintiff wins the case. There are a lot of moving parts in this one, so you’ll need to pay attention.

Given the complexity of this case, it will require more than one article to cover it. Let’s start with the basics: Should the judge have dismissed the case? At the heart of it, “the case against American Airlines alleges a fiduciary violation from adding investments that prioritized ESG metrics to the core investment menu,” says Jack Towarnicky, Of Counsel, Koehler Fitzgerald, LLC Powell, Ohio. “Selecting Core menu investments is always a fiduciary decision.”

But is this a non-starter from the get-go? Well, it turns out ESG investing as it pertains to fiduciary duty remains a very muddled scene.

In ERISA Fiduciary Responsibility § 6.10(C)(1) in ERISA: A Comprehensive Guide (Wolters Kluwer 9th ed.), author Peter Gulia writes, “Whether a fiduciary may choose or vote investments based on environmental, social, and governance (ESG) criteria remains a topic of considerable debate. A fiduciary may consider ESG information in the evaluation of an investment if the fiduciary, in good faith, prudently considers that information as a part of the investment analysis for the plan’s exclusive purpose, and a prudent person would not find that considering the information impedes the proper investment analysis. Further, a fiduciary must consider ESG information if, in the circumstances, a prudent person would do so. Conversely, a fiduciary must not consider ESG information if the information truly is not part of the fiduciary’s investment analysis for the plan’s exclusive purpose.”

That’s what the sober legal analysis says. However, on top of that you must layer the political calculus, for ESG isn’t merely a concept, it represents an advocacy some feel should be left out of the retirement plan environment.

“This lawsuit was filed against American Airlines attacking ESG investment in its fund lineup and proxy voting in support of ESG without providing a benchmark to determine whether returns were really lower as alleged,” says Carol Buckmann, partner at Cohen & Buckmann P.P. in New York City. “It appears to be a politically motivated lawsuit intended to deter ESG investment in general and was deliberately filed in Texas. Initially, it didn’t even allege that the plaintiff had invested in the challenged funds.”

Regarding that latter point, Terry Morgan, president of Ok401k in Oklahoma City, Oklahoma agrees. He says, “The pilot had no standing. He was not invested in any ESGs offered.”

Haven’t you always heard of cases being dismissed because the plaintiff had no standing? What makes this case against American Airlines different?

“There have been a couple of iterations in the allegations, but at a high level the pilot-participant-plaintiff (now) argues that not only having ESG-labeled investments, but that having ESG-biased investment managers on the plan menu undermines his retirement security by providing under-performing options,” says Nevin Adams, “retired” industry author, thought leader, and gadfly who resides in Maryville, Tennessee. “He’s also said that the corporate embrace of ESG has essentially tainted the plan fiduciaries’ perspective.”

“Which brings us to the current status,” continues Adams. “Judge Reed O’Connor of the U.S. District Court for the Northern District of Texas (Spence v. Am. Airlines, Inc., N.D. Tex., No. 4:23-cv-00552, 2/21/24) outlined two issues raised by participant-plaintiff Spence that constituted a breach of the duties of loyalty and prudence; first that by including the (allegedly underperforming) ESG funds in the plan the defendants failed to act in the best interests of participants—though Judge O’Connor noted that the plaintiff had since dropped this ‘Challenged Fund Theory to streamline this case and focus on the primary issue.’ As for that primary issue—the suit now alleges that ‘Defendants violated their fiduciary duty by knowingly including funds that are managed by investment managers that pursue non-financial and nonpecuniary ESG policy goals through proxy voting and shareholder activism’ on their investment portal (the ‘Challenged Manager Theory’).’ More specifically, Judge O’Connor noted that Spence’s argument was that the plan ‘primarily contains funds administered by investment management firms like BlackRock, Inc.,’ and that those firms ‘pursue pervasive ESG agendas’—an ‘engagement strategy’ that ‘… covertly converts the Plan’s core index portfolios to ESG funds’—which, in turn, harms participant financial interests ‘because BlackRock focuses on socio-political outcomes instead of exclusively on financial returns.’”

It should be noted that BlackRock and two other major investment advisers (JPMorgan Asset Management, BlackRock and State Street Global Advisors) “retreated from the Climate Action 100+ investor compact because they don’t want the political and legal liability” according to The Wall Street Journal. The article also reported that members of Climate Action 100+ “are supposed to ‘engage’ 170 ‘focus companies’ such as Boeing, Home Depot and American Airlines—that is, threaten to vote against non-compliant corporate directors and back shareholder resolutions that pressure management.”

That American Airlines was both a specific target of the group and that BlackRock was both a member of the group and had the target company as a client may have represented a conflict of interest that may rise to the level of a fiduciary breach, at least on the part of BlackRock. Now that BlackRock has left Climate Action 100+, it’s not clear whether this will bear the suit.

One of the three goals listed on the Climate Action 100+ website says companies should act in a manner that is “consistent with the Paris Agreement’s goal of limiting global average temperature increase to well below 2°C above pre-industrial levels, aiming for 1.5°C. Notably, this implies the need to move towards net-zero emissions by 2050 or sooner.”

You can’t get more political than that. By aligning themselves with this group, retirement plan service providers like Blackrock risk offending their customers. This appears to have been what happened with American Airlines.

“The complaint argues that an ESG-focused investment approach prioritizes a political agenda over maximizing financial benefits for retirement plan participants, in breach of the fiduciary duties outlined in ERISA,” says Richard Bavetz, investment advisor at Carington Financial in Westlake Village, California. “It contends that the ESG funds included in the airline’s 401(k) plan are more expensive and have underperformed compared to similar non-ESG investment funds, thus being imprudent investment choices that should be removed from the plan. The lawsuit also challenges the oversight of fund managers’ proxy voting and shareholder activism, suggesting they have been engaged in activities that do not align with the financial interests of the plan participants. The lawsuit is notable as it is among one of the first instances of litigation focusing on the use of ESG factors within a defined-contribution retirement plan, and it highlights the growing political and legal scrutiny surrounding ESG investing practices in the United States.”

But the plan sponsor’s fiduciary liability when selecting investment options has always been about being consistent with the documented process, not about picking winners.

“Plan sponsor decisions should not increase fiduciary liability if they follow a prudent process, but that requires them to know how funds available to their participants are invested,” says Buckman. “They may not have that information. But one of the many flaws in this litigation is that ERISA has never prohibited an entire class of investments by name, which is what plaintiffs are trying to do. The Supreme Court has recognized that a range of investments can all be considered prudent and appropriate. But documenting the process is essential.”

On the face of it, American Airlines seemed to follow its documented process. So, what did the company do wrong?

“The American Airlines 401k Plan for Pilots permits participants to choose how to invest their plan accounts, in any combination of investments from four tiers: (1) target date funds; (2) index funds; (3) actively managed funds; and/or (4) a self-directed brokerage account,” says Albert Feuer at the Law Office of Albert Feuer in New York City. “The court described the case that the fiduciaries breached their duty of loyalty to plan participants and beneficiaries by ‘invest[ing] 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.’”

That ESG has been allowed into ERISA plans has been controversial. In particular, the appearance of non-pecuniary factor, as some say ESG represents, may not be in the best interest of the plan participants, the very thing plan sponsors have a fiduciary duty to watch out for.

“If these ESG investments underperform or are more costly compared to non-ESG options without clear financial justification, this could be seen as not acting in the best financial interest of the plan participants, violating fiduciary duties of prudence and loyalty,” says Bavetz. “Moreover, the inclusion of ESG funds based on non-financial criteria might be challenged as prioritizing social or political goals over maximizing returns for beneficiaries. Litigation, like the case against American Airlines, underscores these risks, alleging that the airline’s ESG investment strategy compromised the retirement plan’s financial performance for political agendas, which could be viewed as a breach of fiduciary duties under ERISA. Such decisions expose the plan sponsor to legal challenges, regulatory scrutiny, and reputational damage, emphasizing the importance of thorough, prudent investment decision-making and ongoing monitoring to align with the exclusive benefit rule of ERISA.”

Others disagree, questioning the court’s decision to not dismiss the case.

“Plan sponsor decisions may only affect fiduciary liability if the sponsor acts as a fiduciary, or sets up the plan in a manner in which the fiduciaries assume greater liability, such as by giving fiduciaries responsibility for making asset investment decisions rather than by investment option decisions,” says Feuer. “This conclusion is odd for a number of reasons: (1) the plan fiduciaries do not make plan investments on behalf of plan participants and beneficiaries, but make investment options available to plan participants and beneficiaries; (2) there is a presumption to that ESG factors are always unrelated to financial performance; (3) there is no attempt to distinguish between ‘economic ESG factors’ and ‘non-economic ESG factors’; (4) no specific poorly performing funds are mentioned; and (5) allegations of underperformance make no sense unless there is underperformance against some appropriate benchmarks, which the court found were unnecessary to cite, which is very odd since some of the funds being criticized were index funds.”

Once we get beyond the merits of dismissal, we enter the more interesting aspects of this case. The story continues next week with the first question underlying posed by this case: will it hurt all actively managed funds whether or not they invest with an ESG tilt?

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, and several other books.