CalPERS’ fiduciary counsel, Robert Klausner, told the Vermont Pension Investment Committee (“VPIC”) that divestitures that have a meaningful negative economic impact would violate its fiduciary duty. Moreover, he cited CalPERS’ experience with its divestiture of tobacco stock a cautionary example, thus criticizing his most prominent client. Klausner’s testimony may have given the Vermont Pension Investment Committee the impression that this was the position that Klausner was taking with other public pension funds, in particular CalPERS. In fact, inn January, Klaunser gave the CalPERS board different advice, namely, that trust law allowed trustees to weigh considerations in addition to profit, and what mattered was the process by which they made decisions like divestiture, not the particular outcome.
This matters not simply because this example illustrates something that a former client of Klausner’s, the City of San Diego, complained about, that Klausner was all too willing to tell clients what they wanted to hear. This confirms a troubling history of dubious conduct, including a long-runing dispute in Jacksonville over a secret pension fund that the city contends is illegal, and his extensive involvement in pay-to-play, including taking payments from consultants he was warned were violating regulations and were later sanctioned by the SEC.
This testimony also has Klaunser criticizing a major client of his on a matter that is up before its board now. CalPERS is reconsidering its tobacco divestiture decision. That occurred in the early 2000s at the urging of former state Treasurer and CalPERS board member, Phil Angelides.
Finally, Klausner argued, both at CalPERS and Vermont, for not selling socially problematic investments, was that investors can influence companies by being a shareholder and lose that leverage when they sell. That belief is invalid when the problem is the company’s core business, and as for tobacco, coal, and oil producers, there is no way to reduce its damage in a meaningful way. As one academic put it, “It’s like telling a dog to become a cow.”
Admittedly, CalPERS’ divestiture of tobacco stocks was ill timed. Angelides was promoting a broad agenda of socially responsible investing, and his tobacco initiative was one component. What enabled him to persuade the board to sell tobacco stock was that tobacco looked to be on its way to being the next asbestos industry, where the major firms went bankrupt as a result of litigation costs.
The Federal-state tobacco settlement spared the tobacco industry that fate, and those stocks rebounded well. Even so, as we’ll discuss in due course, an analysis of divestiture costs by CalPERS’ consultant Wilshire is troublingly thin on methodology and looks to include a key assumption that produces higher costs than would have been the case had nature run its course.
Thus while the logic of getting out of tobacco was not financial in nature, the timing was influenced by board members acting out the poor reflexes, of being more willing to sell when a stock is doing badly. If the board approves going back into tobacco, it looks to be the result of the same dubious sense of timing. Tobacco stock have been performing handsomely of late. If CalPERS gets back in, it may well be that the stocks have become fully priced.
Klausner’s “Tell Them What They Want to Hear,” Vermont Versus California Versions
I’ve embedded Klausner’s short testimony to the VPIC at the post. Since his written testimony has an omission, we’ll first show how it was understood, then we’ll look at Klausner’s words. From an op-ed, Divestment violates Vermont’s fiduciary responsibility to pensioners, by State Representative Robert Bancroft in VermontBiz:
At the hearing, Robert Klausner, Principal of Klausner, Kaufman, Jensen & Levinson, explained that the push for divestment in Vermont is a clear violation of fiduciary responsibility as it has a “material, adverse effect on any objective measure.” He explained,
“It is precisely for this reason that divestment, for non-economic reasons, is a disfavored strategy. Divestment has a real cost which can only be made up, in the final analysis by a greater burden on the pension plan sponsors.”
Mind you, the Bancroft op-ed is wrong-headed in that it invokes ERISA and Department of Labor standards, which apply only to private pension funds, not their governmental cousins like Vermont’s or CalPERS. True, many public pension funds choose to operate in accordance with ERISA, and some states have incorporated part of ERISA language into their state laws. But citing ERISA as governing Vermont’s funds is incorrect.
Here are the key sections of Klausner’s testimony:
Based on the projected adverse economic effect on the pension systems and the loss of a seat at the table for Vermont in the important question of climate control initiatives, it is my view that divestment is not consistent with the fiduciary duty of the VPIC as articulated in 14A V.S.A. 902….
The VPIC has a fiduciary to invest the assets of the pension systems for the highest and best return at a reasonable rate of risk. Divestment of fossil fuels will, according to the CIO result in a foregone return of $9M annually and a loss of $4-$10M in transactional costs which can never be recovered. In relatively small Fund of $4B, that is a material, adverse effect on any objective measure….
In 2000, CalPERS divested from tobacco based on the belief that pending litigation against Big Tobacco would eventually drive it out of business. Besides the obvious morality to dispensing with investment in a health threat, the decision to divest had what is always required for an ESG decision; a sound basis in economics. As it has turned out, tobacco did not disappear and CalPERS losses from that divestment have reached approximately $3B.
Notice two things: one is that Klausner, in short written testimony, appears to have dropped the word “duty”: “The VPIC has a fiduciary [duty] to invest….” Was that accident or design? Second, in calling out CalPERS’ poorly-timed tobacco divestiture, he calls it solely a misguided ‘sell at the bottom” call, when the former board members to whom I have spoken say the driver was Angelides’ broader goals, and the litigation issue was not the motivation but moved some fence-sitters.
Contrast Klausner’s opposition to fossil fuel divestment based on purely economic considerations with his remarks to CalPERS in January:
Robert Klausner: Can you say that anything that has a cost as part of the process of divestment should prohibit you? No. The law in the Unites States has been for trusts has been summarized in a series of books called the restatement. There are restatements of various types, there’s a restatement of torts, and contracts, and,and trusts. It’s essentially an encyclopedia that takes all of the, the case law that’s been developed throughout the United States and puts it together. And in the area of taking into account factors other purely than profit in decision-making for trustees, it says, says well, you can’t put anything ahead of the interests of members and beneficiaries, but by the same token it’s OK to think about things other that the profit. Now what does that mean? It means you’re kind of on your own out there. And if you struggle with the impact of these things in the course of your decision-making, you’re not alone. And that’s why the law gives you a substantial amount of immunity for the exercise of your discretion. In my view, the best exercise of fiduciary responsibility, and this is the best practice in my experience is about the process. It’s not about the decision, because you’re decision’s going to be criticized by somebody no matter what you do. It’s all about the process.
Now one could argue that in the case of Vermont, the estimated of cost of divesting from fossil fuel stocks is unjustifiably high. But that’s not the case Klausner made. He argued that the “material adverse effect” was a per se violation of fiduciary duty, and later argued, citing no specific authorities, that divestiture was “disfavored”. In fact, an article at the Financial Times today show that is false, that the fossil fuel divestiture campaign is gaining supporters at other fiduciaries, including the endowment widely cited as the best-of-breed in investing, Yale:
Student movements have persuaded universities including Yale in the US and the UK’s London School of Economics to divest at least the heaviest carbon-producing companies from their investment portfolios. Earlier this year, the Rockefeller Brothers Fund, which manages the fortune of some descendants of the oil baron John D Rockefeller, said it would also divest from fossil fuels.
The campaign group 350.org claims that more than 500 institutions with assets totalling $3.4tn have made some form of divestment commitment, up from 181 institutions with $50bn in assets two years ago, although it is impossible to calculate the value of shares that have actually been sold. The group says divestment is designed to make companies listen “in terms they might understand, like their share price”….
The debate on divestment has intensified since the international climate change agreement in Paris in December, and the issue was repeatedly raised at last week’s Milken Institute Global Conference, which brought together investors, fund managers and others in Los Angeles.
Justin Rockefeller of the Rockefeller Brothers Fund said the decision to divest was meant as a symbolic gesture coming from a dynasty whose fortune is derived from the oil industry. “If you think that symbolism doesn’t matter, think of Rosa Parks,” he told the conference.
Let’s go back to the claim that the opponents of divestiture made in the Financial Times story, which echo ones Klausner made in his Vermont testimony and his earlier remarks at CalPERS (see starting at 19:30 here), that investors would do better by having a seat at the table and forcing change from the inside.
There are reasons to doubt that argument. CalPERS has been a high-impact corporate activist. But the fund has been the most effective (and profitable) in targeting governance practices that are deficient and hurt shareholders. But there are areas where even with clearly problematic practices, such as CEOs that overpay themselves, insider pressure has not succeeded. One famous example was when a group of unhappy institutional investors paid a visit to Goldman’s Lloyd Blankfein in 2009 and told him they wanted him to reduce his compensation. He was unmoved. And in the case of CEO pay, numerous studies have found that lofty CEO pay is correlated with lousy performance. With CEO pay, you are better off dumping the stock than trying to persuade a greedy CEO to be less greedy.
As Phil Angelides said via e-mail,
In his broad criticism of divestment included in those remarks, Mr. Klausner makes at least two fallacious assertions.
FIrst of all, he makes the case that engagement with corporations is always the best route to achieve success with respect to important investor goals. That certainly was not the case with respect to apartheid in South Africa and it is certainly not the case with tobacco companies. While engagement can be an effective tool, it is ludicrous to suggest that institutional investors can successfully engage with tobacco companies to mitigate the disastrous effects that their products have on our economy and society. It is a core business of these companies to produce products that addict our children, poison and kill millions of people, and impose enormous public costs. It is not credible to suggest that engagement will result in these companies ceasing the production and sale of these products.
Secondly, he assumes that divestment will inevitably result in economic losses. In fact, with a vast universe of investment options from which to choose, thoughtful, prudent investors can replace investments which wreak havoc on society with alternative investments that have a similar or better risk return profile. There is no shortage of viable alternative investment strategies to achieve such a goal. The choice presented by Mr. Klausner – either do well financially or do well by society – is a false choice. Pension funds can invest in ways that meet their financial objectives and strengthen our economy and society and their advisors should help, not hinder, their efforts to do so.
One lawyer took a similarly tart view of Klausner’s testimony:
In fact, Klausner’s testimony isn’t “legal” in any way, shape, or form. It’s just bland “change from within” pablum, not even citing the vast body of opinions supporting divestiture as a policy tool laid-down since Apartheid days. He cites the 2015 Wilshire whitewash about lost opportunities for CalPERS as pretty much the only authority that can actually be pinned down. Klausner uses the weasel-word that divestiture is “disfavored” without referencing by whom — legal scholars or the Koch brothers? He doesn’t say.
When the basic operation of a business causes societal harm, the idea that investors can persuade corporate officers to change course is ludicrous on its face. What are they supposed to do, liquidate the business and start doing something completely different? Even if they try to reduce their participation in their current destructive operations and build up in some other areas, why should an investor believe they are capable of competing in an area that is new or largely new to them? For instance, if a Dodgy Dirty Company wants to get into Green Clean industry via acquisition, it will pay an acquisition premium and then may (give the record of acquisitions, probably will) screw it up. By contrast, an investor can move his capital into Green Clean industry as much lower cost. In other words, the “persuade old management to do new tricks” has the unintended effect of keeping legacy management teams around past their sell-by date.
As Angelides pointed out, divestiture has worked, and the South Africa divestiture program is the textbook example. But it succeeded primarily not by driving down stock prices (which was a less important source of leverage in the 1970s ad 1980s, since the “maximize shareholder value” theory of management was not yet in vogue) but by mobilizing other actors, particularly customers and governments, to join in demanding fundamental change. From the Chicago Tribune in 2013:
In the mid-1970s, students began to demand that their universities divest stock in all companies doing business in South Africa, but they made little progress….
In the fall of 1977, urged on by students, I asked the Hampshire College board of trustees to divest. They agreed, and Hampshire College became the first U.S. college to divest completely from companies either trading with South Africa or doing business in South Africa..
By 1988, 155 universities had divested, and the dollars were significant…..faith organizations, unions, cities, counties and states joined in. Investment funds started to take a careful look at companies in their portfolios that had South African ties.
In 1986, in response to increasing violence in South Africa and protests in the United States, Congress passed the Comprehensive Anti-Apartheid Act that banned new investment in South Africa, sales to the police and military, and imports of a number of products…
Companies began to withdraw from South Africa. General Motors sold its plant in 1986. IBM left South Africa in 1987. Locally, Sara Lee and Borg-Warner got out. Doing business in South Africa became too expensive for U.S. companies…
One expert at the time argued that companies were leaving because of the ailing economy, not because of pressure. But the weakness of the economy had a lot to do with divestment, which caused a flight of capital, declining exchange rate and inflation. In South Africa, the government realized the damage of being isolated.
When I met F.W. de Klerk, the last president of the apartheid regime, in Chicago two years ago, he was clear: “When the divestment movement began, I knew that apartheid had to end.” And when I met with Mandela in 1990 in New York, he said that divestment was a crucial factor in ending apartheid. The movement against apartheid was led by South Africans, and Mandela was an inspiration throughout the decades, but the actions of U.S. investors gave the movement both visibility and legitimacy and had a decisive economic impact.
There are two lessons here. The first is that contrary to what Klausner and many investment professionals would like to believe, the political and the economic do not sit in tidy spheres. Divestment is a far more overtly political action. And notice how many investors rallied behind South African divestment, when apartheid cost their communities nothing. By contrast, we all pay for the cost of tobacco-induced death and disability, through higher medical costs as well as the emotional toll, and even more for the health and planet-wide damage of fossil fuel use.
Second is that divestment is a way to addressing market defects, just as activism is. Recall that CalPERS recently divested itself of hedge fund investments, without putting the decision in its “environmental, social and governance factors” box. Yet as we wrote in 2006, and again when CalPERS finally acted, in 2014, by its own admission it was not earning enough in hedge funds to justify the risks and fees. It nevertheless stayed in the strategy as it continued to underperform. CalPERS finally exited, failing to ‘fess up to the performance issues as before, but in fact is now engaging in hedge-fund-type strategies using much lower cost execution. In other words, CalPERS appears to have seen the hedge fund “governance” problem of excessive fees and lack of alpha (manager outperformance) as unfixable, and voted with its feet. Ironically, a divestiture that was not intended to have political impact appears to be having precisely that result. CalPERS’ abandonment of hedge funds has made it acceptable for other investors, particularly hidebound public pension funds, to exit or cut back on hedge fund investments, which is turn is leading funds to offer meaningful fee concessions.
Wilshire’s Questionable Computation of CalPERS’ Tobacco Divestiture Cost
Last October, Wilshire presented CalPERS with a report on the cost of its various “divestiture” programs. It’s troubling that it covers a full seven programs in mere 17 pages. While it provides tables of numbers by year for each issue, it does not describe assumptions or methodology to allow its work to be checked or challenged. For instance, it refers to its calculation of the cost of CalPERS’ South Africa divestiture campaign as of 1991. At that point, Nelson Mandela has been released from Robben Island, and he and de Klerk had started down the fraught path to ending apartheid. Although there was domestic violence, the transition was largely orderly. In the absence of international pressure, can one be sure South Africa would not have fallen into prolonged demonstrations and strikes? Although I cannot examine the older work, Wilshire, like many analysts, seems to underestimate the odds and costs of what they regard as tail events.
Let’s look at tobacco. Wilshire over-eggs the pudding by comparing CalPERS “tobacco free” benchmarks against “tobacco inclusive standard benchmarks” and then uses the difference to estimate the cost to CalPERS. But it is not at all clear how they did the computation. Did they take the value of the stock sold, grossed up for the investment cost, and compound it forward? And they are silent on exactly what “tobacco free” benchmarks and “tobacco inclusive standard benchmarks” they are using.
The tobacco stocks that CalPERS sold in the early 2000s were almost certainly largely domestic stocks. CalPERS has reduced its allocation to public stocks of all kinds, and domestic stocks most of all, since then.
In 2000. CalPERS had a 40% allocation to domestic equities. It now has a 51% allocation to public stocks, and half of that to foreign stock, which means the domestic stocks have fallen in terms of their weight in the portfolio by roughly 37%. Wilshire does not appear to have made that adjustment. If this take is correct, that means Wilshire has overstated the “cost” by a full third.
It’s also dubious for Wilshire to have included analyses of the CalPERS’ divestitures of its investments in the Iran and the Sudan. As a California attorney said via e-mail:
Article XVI sec. 17 of the California Constitution makes clear that the Legislature may ban certain investments — investments in Sudan, Iran, and “Thermal Coal” are currently banned under the Government Code (Section 7500 et seq.). All this “fiduciary duty” crap is a smoke-screen — divestiture was in fact sold as sound exercise of fiduciary duty, since tobacco is killing and maiming members and beneficiaries.
Finally, CalPERS’ staff and other board members have regularly criticized JJ Jelincic for taking issue with some decisions and actions as “embarrassing the system,” as if public relations mattered more than substance. The requirement that all CaLPERS board members must all sign form the same hymnal is inconsistent with the position view of virtually all other government bodies, that routinely have official making statements that disagree with the views of fellow board members, so long as they state it as their own view. This is routing at far more powerful bodies, such as the Federal Reserve Board of Governors and the SEC. Even more important, the Second Restatement of Trusts, an authority that Klaunser endorsed in his remarks above, imposes a duty on a trutsee to correct breaches of trust by a fellow trustee or trustees.*
But if CalPERS insists on this provincial point of view, Will they hold Klausner to the same standard for his critical remarks in Vermont? If not, they have no justification for trying to gag Jelincic.
* Fron an earlier post:
Here is a discussion of relevant law:
Subsection (b) is based on Restatement (Second) of Trusts Section 258 (1959). Cotrustees are jointly and severally liable for a breach of trust if there was joint participation in the breach. Joint and several liability also is imposed on a nonparticipating cotrustee who, as provided in Section 703(g), failed to exercise reasonable care (1) to prevent a cotrustee from committing a serious breach of trust, or (2) to compel a cotrustee to redress a serious breach of trust. Joint and several liability normally carries with it a right in any trustee to seek contribution from a cotrustee to the extent the trustee has paid more than the trustee’s proportionate share of the liability. Subsection (b), consistent with Restatement (Second) of Trusts Section 258 (1959), creates an exception. A trustee who was substantially more at fault or committed the breach of trust in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries is not entitled to contribution from the other trustees.
A board member of an apparently better functioning board indicated that this information is consistent with his memory of the issue from the fiduciary training he received, that board members are liable for breaches of fiduciary duty of their fellow board members if they failed to take steps to try to remedy the breach. That includes opposing board decisions they believe to be a breach of fiduciary duty. It is thus contrary to law to demand that board members all go lemming-like over the cliff together when they are concerned that their fellow board members are engaged in a breach of trust.