Free to Prosper: Corporate governance

Issues pertaining to corporate governance impact every facet of our financial lives. The regulations from agencies like the Securities and Exchange Commission greatly affect our 401(k)s, 403 (b)s, individual retirement accounts, and ultimately our ability to invest our hard-earned money freely for the future or otherwise. 

With increased rulemaking in these areas, paired with the rampant growth of environmental, social, and governance (ESG) investing mandates, it is necessary that Congress adopt reforms to restore freedom to these markets and ensure the ability of American investors to make the decisions best suited to their interests and needs. To achieve those ends, Congress should:

  • Amend the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Company Act of 1940;
  • Amend Title I of Employee Retirement Income Security Act of 1974; and
  • Eliminate any SEC requirement that financial advisors must vote on proxy ballots.

Amendment securities acts: The popularity of environmental, social, and governance (ESG) theory in the business world for many years fueled an enthusiasm for integrating such factors into both individual firm management and portfolio selection. This generally takes one of two major forms: as a purely profit-driven way of avoiding business risks associated with things like climate change and via a semi-concessionary altruistic method in which investors accept the likelihood of lower investment returns through divestment from firms that are legal, but considered ethically problematic, such as fossil fuel, tobacco, and firearms producers. 

While ESG integration and investing has often been defended as a mainstream, non-ideological approach to financial management, it is in fact part of an ideologically driven effort to introduce controversial policy positions into management practice, industry standards, and regulatory policy. In the last few years, conservative, centrist, and even some left-leaning ESG critics have multiplied, as have legislative and regulatory efforts to stop or reverse government policy that encourages this trend. Currently, enthusiasm for ESG investing is waning, with many industry and policy experts considering its popularity to have peaked. 

One of the most significant instances of ESG-related overreach enacted when enthusiasm was at its peak, however, is the climate disclosure rule published by the Securities and Exchange Commission (SEC) in March 2024. This rule effectively requires firms to prioritize an array of politically motivated “stakeholder” groups ahead of the true legal owners of corporations, their shareholders. The proposal is legally unjustified, not needed to cover legitimate climate concerns, misapplies the concept of materiality, will not lead to consistent data reporting, and ignores significant compliance costs.

SEC commissioners have also hinted at even more far-reaching disclosure mandates in this area, including one regarding management of “human capital,” (i.e., a diversity, equity, and inclusion or DEI requirement) which would suffer from many of the same flaws. Even if the federal government were to create a quantitative method for measuring all of the relevant data categories in question, no prescriptive rule can replace the discernment of corporate managers, board members, and voting shareholders when it comes to the relative costs and benefits of engaging with these topics. Different firms will be exposed to climate and workforce management risks to differing degrees and the calculus for what policies to adopt and what data to disclose will vary by firm. This is what the SEC’s long-standing “principles-based” materiality standard is built around and why the SEC’s one-sized fits all climate rule is inappropriate

Furthermore, the SEC seems to be acting on flimsy legal authority in this regard. Former SEC Deputy General Counsel Andrew Vollmer argues that the agency does not have the authority to issue the kind of climate disclosure rule it has proposed. He writes in an August 2021 study that “even if climate-change information is material to investors, the SEC does not currently have statutory authority to make rules requiring companies to disclose it.” 

Moreover, the kind of disclosures that the SEC seeks to mandate would be subjective and inherently disparaging in the context of an administration policy explicitly seeking to choke off access to capital by energy-intensive firms. This would put the legality of the rule in significant peril in light of the precedent in National Association of Manufacturers v. SEC (2014).

The legitimacy of the SEC’s climate disclosure rule is currently being litigated in the Eight Circuit, with the claims of multiple plaintiffs having been consolidated into a single proceeding. That should not stop Congress from proceeding on its own to solve the problem, however. Amending the SEC’s statutory authority to eliminate policymaking consistent with the climate disclosure rule would simply moot the current legal challenge.

Congress should Amend the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Company Act of 1940 to reestablish and permanently define the traditional understanding of “materiality” and limit the SEC’s ability to establish disclosure requirements and prescribe other behavior by registrant firms in ways that are outside of that definition. The SEC should not have the authority to prescribe for managers and investors which risks and considerations are “more equal” than others. The Prioritizing Economic Growth Over Woke Policies Act (H.R. 4790), passed by the House in the 118th Congress, can serve as a model here. 

Amend retirement act: Being able to provide oneself with a financially secure retirement represents the final phase of the American Dream and the capstone of the path that generally includes getting an education, building a career, buying a home, and raising a family.

After a string of high-profile corporate and union pensions defaults in the mid-20th century raised the salience of the issue politically, Congress passed the Employee Retirement Income Security Act (ERISA) in 1974. ERISA requires pension fund managers “to act solely in the interest of the plan’s participants and beneficiaries, and for the exclusive purpose of providing benefits to participants.” However, in recent years, politically motivated pension managers have sought to direct capital toward other, unrelated “non-pecuniary” goals, including those associated with environmental, social, and governance (ESG) theory. 

During the Trump administration, under the leadership of former Secretary of Labor Eugene Scalia, the Department of Labor published a final rule, “Financial Factors in Selecting Plan Investments,” to protect pension plan beneficiaries from having the value of their retirement assets eroded by this trend. The department subsequently published a related rule, “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights,” modifying the expectations for proxy voting by pension fund managers with respect to ESG considerations. This rule, as with the previous one, had the goal of protecting retirees’ assets from politically motivated mismanagement. 

However, in March 2021 the Biden administration’s Department of Labor announced that it would not enforce these recently enacted rules and intended to “revisit” them. This was, in part, an effort to comply with President Biden’s executive order 13990 “Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis,” which directed federal agencies to review existing regulations promulgated under the previous administration that may be inconsistent with the then-current administration’s policies on climate change. The new rule on ESG and pension management from the Department of Labor, overturning the two previous rules from the Trump administration, was published in November 2022.

That new rule cites the language of Executive Order 13990 as justification but omits the section of the order that calls for it to be “implemented in a manner consistent with applicable law.” Overriding the investment security of pension fund beneficiaries in pursuit of unrelated policy goals is not consistent with the requirements of current law, and therefore the new rule should not be considered valid. ERISA requires pension funds and the people who administer them to render investments decisions solely toward funding the retirements of workers. There is no mention of climate change, gender diversity, or denying capital to firms that are not considered to be “socially responsible.” 

The two Trump-era rules restated that expectation and warned against the increasingly frequent practice of using ESG factors to select investments and guide their proxy voting, rather than traditional calculations of risk-adjusted return. Managers who did choose to include ESG factors in their investment decisions were expected to demonstrate that these political considerations were not resulting in lower returns but were only being used as a tiebreaker among options with otherwise identical expected returns.

Safeguarding the retirement security of working Americans is a vital societal goal, and a key element of the American dream. Men and women who have worked and saved for decades, especially when they have no ability to take their pension benefits into an individualized plan, should not have their financial futures determined by the political and social whims of whomever is hired to manage their fund’s investments. 

Congress should End the back-and-forth rulemakings at the Department of Labor by amending Title I of ERISA to clarify that pension fiduciaries must pursue only pecuniary benefits for beneficiaries, as was the standard expectation since the law was passed. For a model on how to proceed, see Protecting Americans’ Investments from Woke Policies Act (H.R. 5339), which the House passed during the 118th Congress.

Nix proxy voting mandates: Asset managers and financial advisors that hold securities on behalf of their clients are called on every year to consider and cast proxy ballots on a wide range of shareholder resolutions. Fully researching every individual proposal being considered by every public company would be a costly and onerous task. Outsourcing that function to a proxy advisory firm may offer a reasonable solution. Current federal regulation, however, has upended the natural market demand for proxy advisors and led to perverse consequences in financial markets.

Prior SEC rules requiring asset managers to vote on proxy ballots that they don’t necessarily consider relevant, coupled with the provision that any proxy advisor’s recommendations is deemed to fulfill their duty under this rule, has created an entirely artificial demand for these services. This has given an unwarranted amount of influence to what has, for many years, been a narrow duopoly of dominant firms in the industry. Moreover, proxy advisory firms routinely engage in coordinated business practices of both advising on votes and selling consulting services on how to navigate the proxy ballot process that clearly presents a conflict of interest to institutional clients and to the underlying shareholders for whom the proxy advisors’ clients work.

Worryingly, the SEC has not upheld its own policy regarding the proper classification of proxy advisory firms, in particular its 2020 Proxy Advisor Rule that categorizes proxy advisor recommendations to companies and shareholders as “solicitations.” Failing to do so has only emboldened the proxy advisor duopoly of Glass Lewis and ISS to operate as if the securities laws do not apply to them. The classification of proxy services as solicitations means that they are subject to oversight and transparency expectations, including providing clear guarantees against any conflicts of interest. 

Today’s SEC has refused to enforce the solicitation provision of its 2020 rule in court and has amended two key requirements that otherwise hold proxy advisory firms accountable to the companies they are affecting. These amendments have unjustly insulated the proxy duopoly and have even sparked a circuit court split. The Fifth Circuit recently ruled that the SEC’s amendments were unlawful, while the Sixth Circuit sided with the SEC. The SEC should not selectively decide whether to uphold its rules (or sabotage them) to secure legal privileges for ideologically aligned proxy firms. Much of the duopoly’s undue influence in the ESG space has flown under the radar because of the lack of rigorous SEC oversight.

Congress should eliminate any SEC requirement that financial advisors must vote on proxy ballots unless they determine such voting to be in their clients’ best interest. Additionally, Congress should reverse the presumption that purchasing proxy advisory voting services relieves them of further due diligence when they do choose to participate in the proxy ballot process on behalf of clients.