The American Airlines ESG Fiduciary Case Exposed the Problem With Mandated Proxy Voting

The American Airlines ESG Fiduciary Case Exposed the Problem With Mandated Proxy Voting

March 12, 2024

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The American Airlines ESG Fiduciary Case Exposed the Problem With Mandated Proxy Voting
by Christopher Carosa March 12, 2024

In January 31, 2003, the SEC adopted Rule 206(4)-6(c) under its Rules and Regulations of the Investment Advisers Act of 1940. Since that time, it has revised that rule to account for some concerns that arose out of the original regulations. The question is whether they’ve addressed the real problem.

The letter of the rule is quite specific. It states, in part, the adviser must “Adopt and implement written policies and procedures that are reasonably designed to ensure that you vote client securities in the best interest of clients, which procedures must include how you address material conflicts that may arise between your interests and those of your clients.”

There’s that key phrase: “in the best interest of the clients.” That’s how advisers are supposed to vote proxies in client securities.

What happens when they don’t?

That’s one of the (ever-changing, it seems) key issues in the American Airlines ESG Fiduciary Breach case. But the issue of voting proxies in commingled portfolios goes well beyond ESG. A “Commingled portfolio” refers to any portfolio that includes assets from multiple individuals. This can include mutual funds, multi-beneficiary trustees, and ERISA plans.

The core conflict arises when portfolio managers vote security proxies in a manner dictated by prioritizing political interests rather than the beneficiary’s best interest.

Part of the American Airlines case includes this allegation.

Authors Brantly Webb, Ankur Mandhania, and Kaushik K. Goswami of the law firm Mayer Brown in Washington, DC, summarized the current (as of March 7, 2024) status of the case in an online report. Regarding the proxy issue, they wrote, “American Airlines offers a 401(k) plan to its employees with four tiers: target date funds, index funds, actively-managed funds, and a self-directed brokerage window. The first two tiers include funds which are either managed by BlackRock or invest in funds which are managed by BlackRock. Plaintiff does not allege that any fund in the first three tiers uses Environmental, Social, or Governance (‘ESG’) factors in selecting investments. Instead, Plaintiff contends that certain investment managers of those funds engage in ancillary ESG-related activities like proxy voting in favor of carbon-neutral shareholder proposals. That alone, Plaintiff argues, makes it a breach of American Airlines’ duties of prudence and—when combined with American Airlines’ own corporate policy in favor of ESG efforts—loyalty to permit participants to invest in those managers’ funds. Plaintiff alleges that an investment manager’s broader pursuit of ‘ESG goals’ is necessarily incompatible with maximizing financial benefits to investors, such that a prudent fiduciary would not have offered funds from such a manager.”

Herein lies the potential for a direct conflict of interest. This applies generally to all proxy voting in commingled portfolios. Layering on the ESG issue within an ERISA plan represents an extreme case. Still, at the very least, it certainly clarifies the problem.

“Will McDonalds offer ‘Beyond Meat’ stock and push it as a choice on their 401k plan?” says Terry Morgan, president of Ok401k in Oklahoma City, Oklahoma. “Will an oil company offer fund companies that ware directly against the energy business? Unfortunately, today companies still do these stupid things rather than look under the hood and see what fund companies are doing behind the scenes. Yes, more of this is going to happen and liability will continue to be in play.”

The ERISA environment makes this issue particularly significant as it adds a second layer of fiduciary duty to the one already put in place by the SEC.

“Voting proxies based on non-pecuniary factors could increase plan sponsor fiduciary liability under ERISA, as it mandates that fiduciaries are to act solely in the interest of participants and beneficiaries to maximize financial benefits,” says Richard Bavetz, investment advisor at Carington Financial in Westlake Village, California. “If proxy voting is influenced by ESG considerations that do not directly relate to financial performance, it may be seen as deviating from this mandate. This could expose plan sponsors to legal challenges if the proxy voting practices are perceived as prioritizing social or environmental outcomes over the financial interests of the plan participants.”

If you think about it, the potential breach inherent in voting proxies is not so different from that of any other transaction.

“Any decision, proxy, purchase, or buy in which the fiduciary may be expected to result in an adverse economic outcome, which depends on a risk-return analysis, violates fiduciary standards,” says Albert Feuer at the Law Office of Albert Feuer in New York City. “Keep in mind that comparable economic decisions can involve a variety of risk/returns and it is often far from obvious what is the appropriate investment horizon to measure these risk/returns. However, it is usually imprudent to look at returns over short time periods when the sustainability of an approach is hard to determine.”

Will the American Airlines ESG Fiduciary case finally expose the flaws inherent in the SEC requirement that Investment Advisers (including mutual funds) vote proxies? If so, will portfolio managers finally have the opportunity to return to the old days? You remember those days, right? That’s when proxy voting was considered irrelevant and the only vote that mattered was the one you made with your feet.

Moreover, will regulators once and for all acknowledge the potential conflict created with portfolio managers voting proxies of underlying securities without asking the owners of interest in those securities how they’d like to vote?

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.