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Key Takeaways
Article - Federal Court Ruling May Put Millions of US Companies In Breach of ERISA Fiduciary Duty
A recent ruling from a Federal judge in Texas has put nearly every company in the US that offers a retirement or pension fund at risk of being sued for failing to uphold their fiduciary duties to their employees.
The core issue of the case is whether an employer can be found in violation of the Employee Retirement Income Security Act (ERISA) as a result of entrusting retirement funds to investment managers that take into account corporate environmental, social, and governance (ESG) considerations when managing those funds.
Based on this latest court ruling, much to the surprise of many legal observers, the answer to that question appears to be ‘yes, companies can be held liable for retaining retirement fund investment managers whose investment practices incorporate ESG principles’ - at least for the time being.
What remains to be seen, however, is the amount of money that the defendant company will have to pay as a result of their adjudicated infraction, which in turn is likely to have a major impact on how widespread the repercussions of this ruling will be given that a string of both appeals and copycat plaintiffs are almost certain to follow any final order front the judge that includes a substantial amount of money changing hands.
Spence v. American Airlines
The lawsuit in question was filed in the Summer of 2023 when a senior pilot with American Airlines initiated a class action lawsuit against his employer on behalf of more than 100,000 participants in a 401(k) plan offered by American Airlines.
The issue at hand stems back to an incident that occurred 2 years prior in the summer of 2021 when global investment giant Blackrock joined other major investment managers and activist investors to exercise their shareholder voting rights and elect 3 ESG-friendly board members to the 12-member ExxonMobil Board of Directors, which is an outcome ExxonMobil leadership at the time had spent months fighting to prevent.
Spence claimed that Blackrock was engaging in the pursuit of ‘non-financial ESG policy goals’ and that American Airlines was in violation of their fiduciary duty by utilizing Blackrock as investment managers for the management of those 401(k) funds.
Fiduciary Duty: Prudence & Loyalty
In accordance with ERISA, employers, and their agents - such as plan trustees, plan administrators, and members of plan investment committees - owe a fiduciary duty to act and make decisions that are in the best interests of plan beneficiaries.
This fiduciary duty encompasses many responsibilities under the law, including a responsibility to diversify investments, avoid conflicts of interest, and follow plan guidelines, but in the class action lawsuit Spence brought against his employer American Airlines, however, he alleged only violations of the fiduciary duty of prudence and the fiduciary duty of loyalty.
Interestingly, the standards and regulatory guidance for evaluating prudence and loyalty in the context of fiduciary duty have been in flux in recent years, with the Department of Labor for the then-outgoing Trump administration issuing final rules with amendments regarding the fiduciary duty of prudence and loyalty in mid-November 2020.
According to those amendments, prudence requires plan fiduciaries to make investment decisions based exclusively on “pecuniary” or financial factors. Loyalty requires that plan fiduciaries determine that potential investment alternatives are ‘economically indistinguishable’ from each other before fiduciaries can take into account potential collateral benefits beyond investment returns, in which case those collateral benefits essentially function as a tie-breaker.
In November of 2022, however, the DOL for the Biden administration issued a final rule that interpreted the fiduciary duties of prudence and loyalty in a way much more favorable to ESG considerations.
According to the Biden DOL clarifications, prudence requires decisions to be based on relevant risk and return factors with ESG being among the factors that can be rightly considered, and loyalty does not prevent plan fiduciaries from taking collateral benefits into account so long as plan alternatives equally serve the financial interests of beneficiaries over time.
While the Biden DOL’s final rule overrode the final rule issued by the Trump administration DOL in November 2020, Biden’s final rule did not take effect until January of 2023, so the Trump DOL rules were still applicable when Blackrock was among the investors that won the proxy battle against ExxonMobil in the summer of 2021.
Now that Trump has returned to the White House, it’s also worth noting that the definitions of prudence and loyalty about fiduciary duty under ERISA are likely to revert to the interpretations his previous administration issued shortly before he left office in 2020.
Where Did American Airlines Go Wrong?
In evaluating Spence’s claims against American Airlines, the judge determined that American Airlines had been prudent, but they had not been loyal.
Although Spence claimed that American Airlines had violated its duty of prudence by not directly monitoring Blackrock’s proxy voting activism and instead depending on a third party to do so, the judge ruled that the employee benefit committee at American Airlines had been prudent and exceeded industry expectations by meeting regularly with both internal and external experts to review and monitor plan performance.
As for Spence’s claim that American Airlines had breached their duty of loyalty, however, the judge determined that American Airlines was in fact in violation of the law because they failed to keep their own “corporate interests separate from their fiduciary responsibilities” which led to “an impermissible cross-pollination of interests and influence on the management of the Plan.”
The judge found that Spence provided sufficient evidence showing American Airlines was incentivized to ignore BlackRock’s shareholder activism in part because BlackRock owns both hundreds of millions of dollars worth of American Airlines stock, as well as hundreds of millions of dollars worth of American Airlines debt, which may have led American Airlines to become lax in its oversight of BlackRock’s retirement fund management practices.
In support of his finding that the duty of loyalty had been breached, the judge also cited an American Airlines employee who served both as corporate liaison to BlackRock and as a member of the American Airlines fiduciary committee and said that billions of dollars of potential loans might have been at risk if American Airlines had not followed ESG reporting protocols.
The judge further noted in support of his conclusion that the American Airlines asset management group had not requested information about BlackRock’s proxy voting, nor had American Airlines expressly asked the third-party consultant to review Blackrock’s proxy activities, nor had American Airlines received mandated reports from BlackRock about their proxy voting intentions.
Although he made clear in his judicial opinion that ESG considerations are not entirely impermissible and can be taken into account purely from a financial perspective as another factor or tool that can be utilized to help maximize long-term financial gain, the judge did not find that to be the case in this instance where BlackRock’s climate change goals seem at odds with the financial interests of ExxonMobil, whose primary area of business involves selling fossil fuels.
What Happens Next?
Recommendations as to what losses were incurred and what remedies are most available and appropriate were due from both Spence and American Airlines by the end of January, which the judge will review before ultimately deciding on damages.
Although the judge has already found American Airlines to be in breach of its duty of loyalty, the penalties assessed for their infraction will likely be very influential both on a micro and macro level and can significantly impact how widespread the impact of this decision will be.
For one, the amount of damages owed will probably play a significant part in American Airlines’ decision on whether or not to appeal the ruling in this case, which would result in drawing more attention to the lawsuit and either solidifying or overturning the ruling.
Equally if not more importantly, the severity of the remedy that the judge ultimately hands down will directly determine whether the damages awarded are sufficiently large to inspire a wave of lawsuits initiated by employees against their employers on similar grounds now that they have been validated in court.
Mployer’s Take
The potential size of the seismic quake that could come in the wake of this ruling can hardly be overstated.
That said, at this stage of the game, it is not yet certain at all that the aftershocks of this lawsuit will extend beyond the Northern District of Texas.
If the judge decides to bring his hammer down on American Airlines and requires them to pay a steep penalty, there may well be tens to hundreds of millions of plaintiffs who come out of the woodwork ready to step up and sue their employers on similar grounds.
In fact, in the inciting incident in this case, BlackRock was joined by State Street and Vanguard in electing the 3 dissident members to ExxonMobil’s board. These firms have all been ESG proponents and collectively are responsible for managing over $5 trillion in retirement assets - more than 12% of total retirement funds in the US - which could lead to tens of millions of additional plaintiffs from this one incident alone.
It’s unclear at this point just how broad this decision will ultimately prove to be beyond this particular case and proxy voting incident, however, since the judge pointed to the friction between climate change economics and fossil fuel economics as particularly at odds, and there were several clear conflicts of interest and breakdowns in communication and/or oversight on the part of both American Airlines and BlackRock, as well.
On the other hand, despite the conflicts of interest and insufficient proxy voting oversight, it remains unclear just what American Airlines was supposed to do to avoid this outcome in the first place.
Regarding the conflicts of interest, American Airlines presumably utilized BlackRock as a creditor because they provided the most favorable loan arrangements, and the airline has no control whatsoever about the equity stake in their company that any given investor like BlackRock might control at any given time.
The judge even noted in his decision that BlackRock’s significant ownership stake and outstanding debt with American Airlines “are not enough on their own to constitute disloyalty,” which seems to indicate the crux of the fiduciary duty violation is really the lack of oversight.
Even if American Airlines had been monitoring BlackRock’s ESG advocacy more closely, however, they were in no position to meaningfully influence BlackRock’s investment strategy one way or the other.
Essentially, if American Airlines violated its duty of loyalty by not monitoring BlackRock’s ESG promotion, then American Airlines would also have been in violation of its duty of loyalty just the same if it had been monitoring BlackRock’s proxy voting and had continued utilizing its retirement investment services anyway, so what choice did American Airlines have except to find a different investment manager that did not incorporate ESG into their investment decision-making process?
Regardless of how this case proceeds, one central takeaway from this situation is that employers would be wise to minimize conflicts of interest with retirement fund investment managers wherever possible, in addition to maximizing communication and oversight reporting with internal and external auditors.
The question as to what standards and by what measures employers are expected to hold retirement investment fund managers to account, however, especially about ESG-related issues, may not be adequately addressed, let alone answered, until long after this case reaches its final resolution.
It is still very possible, even after the judge’s finding that American Airlines breached their fiduciary duty to their employees that this case will ultimately conclude relatively quietly. If this ruling is upheld and reinforced in follow-up cases, however, it may simply be the end of ESG investing or we may very well be on the cusp of experiencing a sea-change-like shift in the employee benefits management industry.
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