Duty of loyalty should not ignore other human beings and social issues
Fiduciaries are the only class of investor legally obligated to care for other human beings. In recent decades, however, the fiduciary duty of loyalty has been turned on its head and converted into a duty to ignore other human beings. Financial returns are now considered more important than the interests of beneficiaries. This misstatement of the law in the quest for alpha is at the heart of the so-called “mainstream” rejection of social investing, and the opposition to divestment from gun makers in the wake of the horrific shooting in Newtown, Conn.
The opposition to divestment, including a Pensions & Investments editorial on Jan. 21, “Misdirected furor,” is based on several well-worn misconceptions about social investing and fiduciary duty. The foundational myth is the notion that “social” issues are unrelated to financial return and must therefore be ignored by fiduciaries. This myth was put to rest ages ago by the performance of the MSCI KLD 400 Social index, and numerous academic studies, including excellent reports on fiduciary duty from Freshfields Bruckhaus Deringer LLP, a London-based international law firm, and FairPensions, a London-based group that campaigns for responsible investing in the pension industry.
The individual performance of a gun investment is largely beside the point, however. There are many lucrative investment opportunities — a fiduciary must exercise prudence in selecting the most appropriate ones. There are only three small-cap publicly traded gun manufacturers in the United States, and a handful of gun-related private equity investments. Can a diversified portfolio be managed for the long term without these investments, which “externalize” unacceptable harm to participants and beneficiaries? This question is neither asked nor answered by P&I's editors.
First and foremost, fiduciaries must be dedicated to their beneficiaries' financial goals. This requires a deep understanding of risk and opportunity, including those relating to “social issues” that affect consumer demand and the broader economy, or impose legal risks and operational costs (e.g., cleanup costs). The debate has moved on from the artificial, bifurcated view of reality that views the investment portfolio in isolation from the real world. A modern fiduciary must understand how the corporation affects the health of the systems upon which it depends for its long-term survival.
P&I urges pension funds to ignore calls for divestment and to “step up and communicate the value of investments to their portfolios. ... They must stay focused on securing the highest risk-adjusted returns possible for their funds.”
This is roughly half right. As Justice Benjamin N. Cardozo famously wrote, the courts have kept “the level of conduct for fiduciaries ... at a level higher than that trodden by the crowd.” Fiduciaries should not respond to every demand — they need to set a higher standard and stay focused on long-term goals. But where P&I and other critics of divestment would ask fiduciaries to ignore these demands in favor of an exclusive pursuit of profit maximization, Mr. Cardozo had something else in mind: “A trustee is held to something stricter than the morals of the marketplace.”
In the marketplace, everything has a price. The market has no use for irreplaceable things of infinite value. As a result, finance lacks clear imperatives to maximize life and the priceless things that sustain it, such as clean air and water. Finance knows no imperative to safeguard children.
Fiduciaries, however, can check the more damaging aspects of finance through the process of prudent decision-making in conformance with a duty of loyalty — another priceless thing. “Price” is not a fiduciary's sole concern. If fiduciary duty meant “maximize returns,” we'd have no need for fiduciary duty at all. We would merely need to set the incentives right and guard against embezzlement.
Newtown presents a very concrete example of what a violation of the duty of loyalty looks like. If you use my money to make a weapon that kills my child, don't tell me that in 20 years I'll retire with more money as a result. If you claim that decision was made in my best interest, you have no right to call yourself a fiduciary.
On the question of divestment as a tactic, the P&I editors have the question exactly backwards — we should be asking about the impact of the investments, not about the tactic of divestment. Investors are not seeking to enter this debate on guns. They are already knee-deep in it, have been on the wrong side and are now looking for an exit.
Semiautomatic weapons are now widely available, not solely as a function of consumer demand, but also due to the ready availability of investor capital and investor demand for expanding markets. Is there any limit to these demands? The New York Times reports that industry strategies to increase market share now include an aggressive push to get guns into the hands of children. The editor of Junior Shooters magazine noted that if the industry is to survive, gun enthusiasts must embrace all youth shooting activities, including “semiautomatic firearms with magazines holding 30 to 100 rounds.”
This is your return on investment: Children touting semiautomatic weapons. Whether communicated through private or public equity ownership, the message, no doubt, has been the same — make more, and get these weapons into as many hands as possible.
Whether they like it or not, pension funds are, in fact, agents of social change. Freedom Group has used pension fund capital to change the retail gun landscape, with clear social consequences.
When we allocate billions of capital, we are also sketching out the parameters of future societal possibilities. The long-term growth of these companies depends upon Washington's inability to enact meaningful gun control. Trustees should consider whether that outcome is in their participants' best interests.
Divestment can be effective. The mere suggestion of divestment prompted Cerberus Capital Management LP to announce it would sell Freedom Group. For public equities, divestment sends a signal to management about what is and what is not acceptable. If it is done on a wide enough scale, it can certainly have an impact on a company's finances. But on the most basic level, it is an expression of the duty of loyalty.
P&I's editors noted that these divestment activities “reveal shortcomings as fiduciaries in portfolio oversight.” Here, I wholly agree. These funds should never have been invested in gun makers in the first place. But that is a very poor argument for taking no action now. n
Adam Kanzer is managing director and general counsel of Domini Social Investments LLC, New York.
This article originally appeared in the February 18, 2013 print issue as, "Divesting is an exercise in real fiduciary care".