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Funds that focus on environmental, social, and governance issues are picking up momentum. Inflows in 2020 more than doubled compared to the previous year, with 2021 likely to show more acceleration. Yet to a large degree the success of these and other ESG initiatives hinges not on market conditions, investor demand, or even on legislative action, but instead on the decisions of unelected agency administrators. The regulatory state is the iceberg beneath the surface. Even though unseen, it has the power to scuttle seemingly unassailable vessels.
Over the last few months of President
Donald Trump’s
administration, political appointees at the Securities & Exchange Commission and the Department of Labor have issued new rules to curtail ESG-related investment activity, often over the objection of Democratic appointees to those agencies. What is remarkable about all of this is not only how politicized these results were, but the fact that these decisions were made largely out of the public eye, except to specialists in investment and regulatory affairs. Yet these regulations—which could potentially impact trillions of dollars in investment decisions—would likely not have been enacted if a different party occupied the White House.
Three actions stand out for their partisan nature and their potentially far-reaching impact on ESG investors. First, in August, the SEC adopted changes to Regulation S-K, which governs how public companies make certain disclosures. Commenters had urged the SEC to adopt requirements for companies to disclose specific climate risk issues and data on workforce diversity—matters of concern for ESG investors. Ultimately, the SEC voted 3-2 not to require the inclusion of disclosures relating to certain ESG issues unless management determined they were material. Allison Herren Lee and
Caroline A. Crenshaw,
the two Democratic commissioners, delivered vigorous dissents.
As Lee wrote, ESG concerns are a “significant driver” behind the allocation of trillions of dollars of assets, and the majority’s “principles-based” approach to disclosure requires investors to trust that companies have accurately assessed the materiality of climate risks and workplace diversity. “Should we assume that management at the hundreds (if not thousands) of companies that don’t provide data on workforce diversity have carefully and accurately determined that the information is not material to their business?” Lee asked, skeptically. The SEC’s decision hinged on the view that ESG concerns, regardless of investor interest, were not inherently material, and that it was management’s sole prerogative to determine their materiality.
In October, the Department of Labor adopted rules governing the duties of fiduciaries selecting and monitoring investments of private sector retirement and employee benefit plans. The new rules require certain plan fiduciaries considering a plan’s investment objectives to evaluate investments and investment courses of action based solely on factors with a material effect on a risk/return analysis. Fiduciaries cannot subordinate the interests of participants to unrelated objectives—such as preventing climate change—or sacrifice investment return or assume additional investment risk to promote such nonpecuniary goals. Unlike the SEC, the Department of Labor is not required to have bipartisan staffing, so there was no formal dissent. But 95% of the comments received by the department over the summer opposed it.
Then, in December, the Department of Labor issued final rules establishing a regulatory framework to guide the exercise by private employee benefit plans’ fiduciaries of certain shareholder rights, including proxy voting. Like the October regulation, these rules require plan fiduciaries to consider only the pecuniary interests of beneficiaries, and forbids them from subordinating those interests to other, nonfinancial benefits, such as the environmental, hiring, or governance practices potentially implicated by such votes. These rules seem premised on the belief that ESG issues are somehow separate from the main financial questions facing most businesses, a point of view that the investors pouring money into ESG funds largely dispute.
Against this backdrop of regulatory hostility to ESG concerns, on Dec. 1, the Nasdaq Exchange announced a proposal for new listing requirements. Under the rule proposal it filed with the SEC, listed companies would be required to have at least one director who identifies as female and one who identifies as an underrepresented minority or LGBTQ person—or explain why they don’t. The SEC must approve the proposal. While looking too far ahead is fraught, it is likely that President-elect
Joe Biden’s
SEC, which will eventually give Democrats a 3-2 majority, will approve it substantially its current form. Notably, the Nasdaq announcement cited multiple studies that diverse boards improved economic performance to justify the proposal.
The Nasdaq proposal is just one of the stark choices the Biden administration and its administrative appointees will soon face. They can leave the Trump administration’s ESG rules in place, or expend political capital to reverse prior regulation. The SEC and Department of Labor rules can be viewed as an unusual effort by an administration that purportedly valued business freedoms to constrain not only investor, but also corporate options.
Yet if the Biden administration acts to change or modify these rules, given the current political polarization and Biden’s razor-thin margins in each chamber, there is a significant risk that it will be portrayed not as facilitating corporate or investor choice, but as promoting “politically correct” outcomes. Biden’s agency appointees will have to determine whether or not to expend time and effort to reverse these rules now, which will likely provide an opportunity for attacks by political opponents, or simply wait until ESG momentum becomes inexorable.
These decisions will ultimately be made outside of the spotlight of legislative action, in the trenches of administrative agencies. Potentially controversial decisions can be made without sufficient public attention to their scope, especially when, as with the second Department of Labor regulations mentioned, they were issued by an outgoing administration after losing an election. And these decisions will affect trillions of dollars of investment capital.
Whether rough seas or smooth sailing lie ahead depends in large part on the choices made by these unelected officials. Remarkably, too few people will be paying attention to this fact.
Howard Fischer is a partner with Moses & Singer’s securities litigation and white collar practices. He was senior trial counsel at the SEC from 2010 to 2019.
