May 12, 2022

Reputational risk is the wonderfully vague term that is being used more and more to justify decisions to terminate a business relationship when an objective reason is unavailable. According to an excellent article in the Georgia Law Review, “Regulating Bank Reputation Risk,” the concept of reputational risk really took off in the 1990s when federal regulators were looking for a way to incorporate subjective policy and social considerations when examining financial institutions.

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The first phase of using reputational risk as a regulatory tool culminated in Operation Choke Point, which was a joint effort of the Treasury Department and the FDIC to target certain undesirable, but legal, businesses. The exposure of Operation Choke Point ended the direct use of reputational risk by regulators to force behaviors at individual banks, but the concept was so powerful it continued to incubate and expand. Today, large banks and big corporations are using the reputational risk tool to drive social-justice policies.

As pointed out in the Georgia Law Review article, the reputational risk tool heavily relies on the concept of stakeholder capitalism. Initially, the stakeholder in question was the regulator itself, but just as the power of reputational risk was becoming evident, so too was the role of stakeholders. The concept of stakeholder capitalism has continued to grow and now is an important element of the environmental, social, and governance (ESG) movement.

Like reputational risk, “stakeholders” is a subjective and malleable concept to drive social and political ends. The trick is to broaden the search for stakeholders to identify groups sympathetic to the political cause, but not so broad as to identify stakeholders who oppose, or are harmed by that political cause. Stakeholder capitalism, a cottage industry, had been born.

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Weaponizing reputational risk has almost exclusively been used to isolate and punish conservatives and to advance progressive causes, but it may just swing the other way. Are there stakeholders, such as public pension beneficiaries and taxpayers, who may be harmed by certain political or ideological actions? Public pension fiduciaries may soon be looking to distance themselves from advisors leading them down the ESG path.

As I wrote here, public pension plans, public university endowments, and state trust funds are powerful tools to implement ESG investments and Net-Zero 2050 initiatives. Several states have moved to divest public funds from fossil fuels, leaving their pension plans on the outside looking in as share prices of many fossil-fuel companies have posted nice returns in a challenging market so far in 2022.

State and local pension plans are primarily defined-benefit plans and the fiduciaries for these plans are generally held to a higher standard of conduct. This makes sense because the participants in these plans have little to no input or knowledge of plan investment decisions and rely heavily on the prudence of the fiduciaries. These fiduciaries are supposed to act in the sole interest of the plan participants consistent with the goals as documented for each plan. Public funds are subject to the laws and rules of each state and the individuals responsible to manage these funds are fiduciaries who owe certain duties and obligations to the beneficiaries of the particular fund. The fiduciaries also have personal liability for their actions or inactions managing the fund whether they are aware of this or not.

Private qualified retirement plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA), a statute so long that only the Internal Revenue Service Code is longer. These plans are regulated by the IRS, the Department of Labor (DoL) and other federal agencies. The Employee Benefit Security Administration under DoL is considering revisions to the definition of fiduciary duties to include a consideration of climate impacts and other ESG factors in making investment decisions. This focus on ESG investing follows Executive Order 14030 from the Biden administration and would give fiduciaries of private retirement plans some regulatory protection when using ESG criteria for plan investments. However, this revised definition would not apply to fiduciaries of state and local pension plans.

The ESG movement is well established in boardrooms of large corporations and on Wall Street. ESG proponents see the vast wealth held by state public investment funds and want to use those assets to remove any remaining barriers to the Great Reset. The fiduciary statutes in the 50 states may be the last meaningful roadblock to the brave new ESG world.

And, the use of other people’s money (public funds) by the large money managers to push environmental and social policy comes at a time when the majority of public pensions are underfunded, putting fiduciaries pushing ESG investing in a tough spot. Many plan fiduciaries want to follow the ESG movement, to be seen as one of the cool kids, but there is a potential downside risk. We live in a litigious society.